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FEDERAL RESERVE BANK OF NEW YORK

63

The Role of the M oney Supply in Bu siness C ycle s
By R ichard G. D av is *

Most, if not quite all, economists are agreed that the
behavior of the quantity of money makes a significant
difference in the behavior of the economy—with “money”
usually defined to include currency in circulation plus
private demand deposits, but sometimes to include com­
mercial bank time deposits as well.1 Most economists,
for example, setting out to forecast next year’s gross
national product under the assumption that the money
supply would grow by 4 per cent, would probably want
to revise their figures if they were to change this assump­
tion to a 2 per cent decrease.
In the past five to ten years, however, there has come
into increasing prominence a group of economists who
would like to go considerably beyond the simple assertion
that the behavior of money is a significant factor influ­
encing the behavior of the economy. It is not easy to
characterize with any precision the views of this group
of economists. As is perhaps to be expected where com­
plex issues are involved, their statements about the impor­
tance of monetary behavior in determining the course of
business activity encompass a variety of individual posi­
tions, positions which may themselves be undergoing
change. Moreover these positions are rarely stated in
quantitative terms. More frequently, the importance of
money as a determinant of business conditions will be
characterized as “by far the major factor”, “the most im­
portant factor”, “a primary factor”, and by similar qualita­
tive phrases inescapably open to various interpretations.
Of course as one moves from the stronger phrases to
the weaker, one comes closer and closer to the view that
money is simply “a significant factor”, at which point it be­

comes virtually impossible to distinguish their views from
those of the great majority of professional opinions. In
order to bring a few of the issues into sharper focus, this
article will take a look at some evidence for the “money
supply” view of business fluctuations in one of its more
extreme forms. Without necessarily implying that all the
following positions are held precisely as stated by any
single economist, an extreme form of the money supply
view can perhaps be characterized somewhat as follows:
The behavior of the rate of change of the money supply is
the overriding determinant of fluctuations in business ac­
tivity. Government spending, taxing policies, fluctuations
in the rate of technological innovation, and similar matters
have a relatively small or even negligible influence on the
short-run course of business activity. Hence, to the extent
that it can control the money supply, a central bank, such
as the Federal Reserve System, can control ups and downs
in business activity. The influence of money on business
operates with a long lag, however, and the timing of
the influence is highly variable and unpredictable. Thus
attempts to moderate fluctuations in business activity
by varying the rate of growth of the money supply
are likely to have an uncertain effect after an uncertain
lag. They may even backfire, producing the very instability
they are designed to cure. Consequently, the best policy
for a central bank to follow is to maintain a steady rate of
growth in the money supply, year in and year out, at a
rate which corresponds roughly to the growth in the
economy’s productive capacity.
The implications of these views are obviously both
highly important and strongly at variance with widely
held beliefs. Thus they deny the direct importance of
fiscal policy (except perhaps in so far as it may influence
monetary policy), while they attribute to monetary policy
a virtually determining role as regards business fluctua­
* Assistant Vice President, Research and Statistics, Federal
tions. At the same time, they deny the usefulness of dis­
Reserve Bank of New York.
cretionary, countercyclical monetary policy. The issues
1 More rarely, other types of liquid assets such as mutual sav­
ings bank deposits are also included in the definition of money. involved are highly complex and cannot possibly be ade­




64

MONTHLY REVIEW, APRIL 1968

quately treated in their entirety in a single article.2 The
present article, therefore, confines itself to examining the
historical relationship between monetary cycles and cycles
in general business. The article concludes that the relation­
ship between these two kinds of cycles does not, in fact,
provide any real support for the view that the behavior
of money is the predominant determinant of fluctuations
in business activity. Moreover, the historical relationship
between cycles in money and in business cannot be used
to demonstrate that monetary policy is, in its effects, so
long delayed and so uncertain as to be an unsatisfactory
countercyclical weapon.
The first section shows how proponents of the money
supply view have measured cycles in money and exam­
ines the persistent tendency of turning points in monetary
cycles, so measured, to lead turning points in general
business activity. It argues that these leads do not neces­
sarily point to a predominant causal influence of money
on business. A second section suggests that the cyclical
relationship of money and business activity may be as
much a reflection of a reverse influence of business on
money as it is of a direct causal influence running from
money to business. A third section indicates why, for some
periods at least, the tendency for cycles in money to lead
cycles in business may reflect nothing more than the im­
pact on money of a countercyclical monetary policy. Next,
the relative amplitudes of monetary contractions and their
associated business contractions are examined. Again it
is argued that these relative amplitudes fail to provide any
clear evidence for a predominant causal influence of
money. A fifth section examines the timing of turning
points in money and in business for evidence that the in­
fluence of money operates with so long and variable a lag
as to make countercyclical monetary policy ineffective. A
final section suggests that there may well be better ways
to evaluate the causal influence of money on business than
through the examination of past cyclical patterns.
C Y C L E S IN M O N E Y A N D C Y C L E S IN
B U S I N E S S A C T IV I T Y

provides major support for their views on the causal
importance of money in the business cycle. For the most
part, these economists have delineated cycles in the money
supply in terms of peaks and troughs in the percentage
rate of change of money (usually including time deposits),
while cycles in business have been defined in terms of
peaks and troughs in the level of business activity as
marked off, for instance, by the so-called “reference cycles”
of the National Bureau of Economic Research (N B E R ).3
They have argued that virtually without exception every
cycle in the level of business activity over the past century
of United States experience can be associated with a cycle
in the rate of growth of the money supply. The exceptions
that are observed occurred during and just after World
War II— although the events of 1966-67 may also be
interpreted as an exception, since an apparent cyclical
decline in monetary growth was not followed by a reces­
sion but only by a very brief slowdown in the rate of
business expansion.4 The money supply school also finds
that cycles in business activity have lagged behind the
corresponding cycles in the rate of growth of the money
supply, with business peaks and troughs thus following
peaks and troughs in the rate of monetary change.
While the evidence supporting these generalizations is
derived from about a century of United States data, the
nature of the measurements and some of the problems

3 See, for example, Milton Friedman and Anna J. Schwartz,
“Money and Business Cycles”, Review of Economics and Statistics
(February 1963, supplement), pages 34-38. While the procedure of
these economists in comparing percentage rates of growth of
money with levels of business activity can certainly be defended,
it is by no means obvious that this is the most appropriate ap­
proach, and there are many possible alternatives. Thus, for ex­
ample, cycles in the rate of growth of money could be compared
with cycles in the rate of growth, rather than the level, of business
activity. For some purposes the choice among these alternatives
makes a considerable difference, as is noted later in connection
with measuring the length of the lags of business-cycle turning
points relative to turning points in the monetary cycle.

4 Granting the difficulties of dating specific cycle turning points
for series as erratic as the rate of growth of the money supply, a
peak (for the definition of money that includes time deposits)
As already implied, proponents of the money supply seems to have occurred in October 1965, with a trough in October
1966. While there was a slowdown in the rate of growth of busi­
school have argued that the historical relationship between ness activity in the first half of 1967, there was clearly no business
cycles in money and cycles in general business activity cycle peak corresponding to the peak in the money series. Indeed,
the current dollar value of GNP moved ahead in the first two
quarters of 1967, although at a reduced rate. The 1965-66 decline
in the rate of growth in the money supply was relatively short
(twelve months). In amplitude it was clearly among the milder
declines, but it was nevertheless still nearly twice as steep as the
mildest of past contractions in the rate of monetary growth (No­
2 Among the many interesting and relevant issues not discussed vember 1951 to September 1953). In any case, the 1965-66 de­
are the advantages and disadvantages of the money supply as an cline does appear to represent a specific cycle contraction for the
immediate target of monetary policy or as an indicator of the rate of monetary change under the standard NBER definition. See
effects of policy, the proper definition of the money supply, and Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles
(National Bureau of Economic Research, 1946), pages 55-66.
the nature and stability of the demand for money.




FEDERAL RESERVE BANK OF NEW YORK

65

Chart I

CHANGES IN MONEY SUPPLY PLUS T!ME DEPOSITS
M onth-to-month p ercen tag e ch a n g e s; com pound an n u a l rates

-1 0

111 !
Note: P e rcen tage c h a n g e s are b ased on se a so n a lly ad justed d ata. S h a d e d are a s represent recession p erio d s, a c c o rd in g to
N atio n al Bureau of Econom ic Research ch ro no lo gy.
Source: Board of G overnors of the Fed eral Reserve System.

of interpretation can be illustrated from the postwar
experience represented in Chart I. The chart shows
monthly percentage changes in the money supply, defined
here to include currency in the hands of the public plus
commercial bank private demand and time deposits, on a
seasonally adjusted daily average basis.5 The shaded areas
represent periods of business recession as determined by the
NBER. The first point to note is the highly erratic nature
of month-to-month movements in the rate of change of
the money supply. Indeed, the reader might be excused if
he found it difficult to see any clear-cut cyclical pattern in

the chart. The erratic nature of the money series, which
partly reflects short-run shifts of deposits between Trea­
sury and private accounts, does make the precise dating
of peaks and troughs in the money series somewhat arbi­
trary. This introduces a corresponding degree of arbitrari­
ness in measuring timing relationships relative to turning
points in business activity. Waiving this difficulty, how­
ever, peaks and troughs in the money series as dated in
one well-known study of the problem are marked on the
chart for the 1947-60 period.6 As can be seen, each mone­

6 The dates used are essentially those presented in Milton Fried­
5 While, as noted, many analysts would prefer to define the man and Anna J. Schwartz, op. cit., page 37, Table I. Minor
money supply to exclude commercial bank time deposits, such an modifications of the Friedman-Schwartz dates have been made
exclusion would not materially affect the general picture, at least when these seemed obviously dictated by revisions in the data
subsequent to publication of their work.
not for the period illustrated by the chart.




66

MONTHLY REVIEW, APRIL 1968

tary peak occurs during the expansion phase of the busi­
ness cycle and thus leads the peak in business. Similarly,
there is a monetary trough marked during three of the
four postwar recessions acknowledged by the NBER. A
fourth monetary trough, however, in February 1960
occurs somewhat before the onset of recession three
months later.
The leads of the peaks in the money series with respect
to the subsequent peaks in business activity are, it should
be emphasized, quite variable, ranging from twenty
months to twenty-nine months for the period covered in
the chart and from six months to twenty-nine months
for the entire 1870 to 1961 period. The corresponding
range of leads of money troughs relative to subsequent
troughs in business cycles varies from three months to
twelve months for the charted period and up to twentytwo months for the longer period.
The significance, if any, of these leads in assessing the
importance of cycles in money in causing cycles in busi­
ness is highly problematical. Firstly, chronological leads
do not, of course, necessarily imply causation. It is per­
fectly possible, for example, to construct models of the
economy in which money has no influence on business but
which generate a consistent lead of peaks and troughs in
the rate of growth of the money supply relative to peaks
and troughs in general business activity.7 Secondly, the ex­
treme variability of the length of the leads would seem to
suggest, if anything, the existence of factors other than
money that can also exert an important influence on the
timing of business peaks and troughs. Certainly even if a
peak or trough in the rate of growth of the money supply
could be identified around the time it occurred, this would
be of very little, if any, help in predicting the timing of a
subsequent peak or trough in business activity. Thirdly,
there is a real question as to whether anything at all can
be inferred from the historical record about the influence
of money on business if, as is argued in the next section,
there is an important reverse influence exerted by the
business cycle on the monetary cycle itself.

money supply economists to be highly suggestive of such
an influence. Certainly the consistency with which these
leads show up in cycle after cycle is rather striking and
does suggest that cycles in money and cycles in business
are related by some mechanism, however loose and un­
reliable. Nevertheless, it is important to recognize that
this mechanism need not consist entirely or even mainly
of a causal influence of money on business. It might, in­
stead, reflect principally a causal influence of business on
money, or it could reflect a complex relationship of mutual
interaction. As noted earlier, virtually all economists be­
lieve that there is, in fact, at least some causal influence
of money on business, and it may be that this influence
alone is enough to explain the existence of some degree of
consistency, albeit a loose one, in the timing relationships
of peaks and troughs in business and money. However, the
existence of a powerful reverse influence of the business
cycle itself on the monetary cycle would have important
implications. By helping to explain the timing relation­
ships of the money and business cycles, the existence of
such an influence would certainly tend to question severely
any presumption that these timing relationships are them­
selves evidence for money as the predominant cause of
business cycles.
There are, in fact, a number of important ways in which
changing business conditions can affect, and apparently
have affected, the rate of growth of the money supply over
the 100 years or so covered by the available data. First, the
state of business influences decisions by the monetary
authorities to supply reserves and to take other actions
likely to affect the money supply— as is discussed in detail
in the next section. Business conditions can also have a
direct impact on the money supply, however. For example,
they may affect the balance of payments and the size of
gold imports or exports. These gold movements, in turn,
may affect the size of the monetary base— the sum of cur­
rency in the hands of the public and reserves in the banking
system. Various official policies have tended to reduce or
offset this particular influence of business on money, but
at least prior to the creation of the Federal Reserve System
it may have been of considerable significance.
T H E IN F L U E N C E O F B U S IN E S S O N M O N E Y
Second, business conditions may influence the money
Although the persistent tendency of cycles in monetary stock through an influence on the volume of member bank
growth rates to lead business activity does not, as noted, borrowings at the Federal Reserve. While the size of such
necessarily imply a predominant causal influence of money borrowings is, of course, importantly conditioned by the
on business, this tendency has nevertheless seemed to the terms under which loans to member banks are made, in­
cluding the level of the discount rate, it may also be
significantly affected by the strength of loan demand and
by the yields that banks can obtain on earning assets.
These matters, in turn, are clearly related in part to the
7 See James Tobin, “Money and Income: Post Hoc Propter
state of business activity.
Hoc?”, to be published.




FEDERAL RESERVE BANK OF NEW YORK

A third influence of business on money operates
through the effects of business on the ratio of the public’s
holdings of coin and currency to its holdings of bank de­
posits. A rise in this ratio, for example, tends to drain
reserves from banks as the public withdraws coin and
currency. Since one dollar of reserves supports several
dollars of deposits, the loss of reserves leads to a multiple
contraction of deposits which depresses the total money
supply by more than it is increased through the rise in
the public’s holdings of cash. While no one is very sure
as to just what determines the cyclical pattern of the cur­
rency ratio, a pattern does seem to exist which in some way
reflects shifts in the composition of payments over the
business cycle as well as, in the historically important case
of banking panics, fluctuations in the public’s confidence
in the banks themselves.8
A final avenue of influence of business on money is
through the influence of business conditions on the ratio
of bank excess reserves to deposits. When the ratio of
excess reserves to deposits is relatively high, other things
equal, the money supply will be relatively low since banks
will not be fully utilizing the deposit-creating potential of
the supply of reserves available to them. Business condi­
tions can affect the reserve ratio in various ways. Thus
they can influence bank desires to hold excess reserves
through variations in the strength of current and prospec­
tive loan demand, through variations in the yields on the
earning assets of banks, and through variations in banker
expectations. When business is rising, loan demand is apt
to be strengthening, yields on earning assets are apt to be
rising, and banker confidence in the future is likely to be
increasing. Thus excess reserves are apt to decline, with
the reserve ratio rising and thereby exerting an upward
influence on the money supply.
The influence of business on money— acting through
its influence on the growth of the monetary base, the cur­
rency ratio, and the excess reserve ratio— is extremely
complex and is not necessarily stable over time. The
cyclical behavior of the monetary base and the cur­
rency and reserve ratios have in fact varied from cycle to
cycle. Moreover the relative importance of these three
factors in influencing the cyclical behavior of money has

67

varied over the near 100-year period for which data are
available. In part, these variations have reflected the ef­
fects of the creation and evolution of the Federal Reserve
System. A detailed examination of the behavior of the
monetary base, the currency and reserve ratios, and the
role of business conditions in fixing their cyclical patterns
is beyond the scope of this article. Recently, however, a
very thorough analysis of the problem has been done for
the NBER by Professor Phillip Cagan of Columbia Uni­
versity. He finds that “although the cyclical behavior of
the three determinants [of the money stock] is not easy
to interpret, it seems safe to conclude that most of their
short-run variations are closely related to cyclical fluctua­
tions in economic activity. . . . Such effects provide a
plausible explanation of recurring cycles in the money
stock whether or not the reverse effect occurred.” 9
The fact that the business cycle itself has an important
role in determining the course of the monetary cycle se­
riously undermines the argument that the timing relation­
ships of monetary cycles and business cycles point to a
dominant influence of money on business. By the same
token, ample room is left for the possibility that many
other factors, such as fiscal policy, fluctuations in business
investment demand, including those related to changes in
technology, fluctuation in exports, and replacement cycles
in consumer durable goods, may also exert important in­
dependent influences on the course of business activity.
M O N E T A R Y P O L IC Y A N D T H E
C Y C L IC A L B E H A V IO R O F M O N E Y

One important, though perhaps indirect, influence of
business on money requires special mention, namely the
influence it exerts via monetary policy. The relevance of
monetary policy to the behavior of monetary growth dur­
ing the business cycle was perhaps especially clear during
the period beginning around 1952 and extending to the
very early 1960’s. In this period, policy was more or less
able to concentrate on the requirements of stabilizing the
business cycle relatively (but not entirely) unimpeded by
considerations of war finance, the balance of payments,
and possible strains on particular sectors of the capital
markets. The ultimate aim of stabilizing the business cycle
is, of course, to prevent or moderate recessions and to
forestall or limit inflation and structural imbalances during

8 It might be noted that while the Federal Reserve has for many
years routinely offset the reserve effects of short-term movements
in coin and currency, such as occur around holidays, for example,
the ratio of coin and currency in the hands of the public to deposits
9 Phillip Cagan, Determinants and Effects of Changes in the Stock
has apparently continued to show some mild fluctuations of a of Money, 1875-1960 (National Bureau of Economic Research,
cyclical nature.
1965), page 261.




68

MONTHLY REVIEW, APRIL 1968

periods of advance. The tools available to the Federal
Reserve, however, such as open market operations and
discount rate policy, influence employment and the price
level only through complex and indirect routes. Hence, in
the short run, policy must be formulated in terms of
variables which respond more directly to the influence of
the System. Some possibilities include, in addition to the
rate of growth of the money supply, the growth of bank
credit, conditions in the money market and the behavior of
short-term interest rates, and the marginal reserve position
of banks as measured, for example, by the level of free re­
serves or of member bank borrowings from the Federal
Reserve. It is clear that the money supply need not always
be the immediate objective of monetary policy, and indeed
it was not by any means always such during the 1950’s.
Given this fact, the behavior of the rate of growth of the
money supply during the period cannot be assumed to be
simply and directly the result of monetary policy decisions
alone.
Nevertheless, it is clear that the current and prospective
behavior of business strongly influenced monetary policy
decisions, given the primary aim of moderating the cycle,
and that these decisions, in turn, influenced the behavior
of the rate of growth of the money supply. Thus, for
example, as recoveries proceeded and threatened to gen­
erate inflationary pressures, monetary policy tightened to
counteract these pressures. Regardless of what particular
variable the System sought to control—whether the money
supply itself, conditions in the money market, or bank mar­
ginal reserve positions—the movement of any of these vari­
ables in the direction of tightening would, taken by itself,
tend to exert a slowing influence on the rate of monetary
expansion. In this way, the firming of monetary policy in
the presence of cumulating expansionary forces would no
doubt help to explain the tendency of the rate of monetary
growth to peak out well in advance of peaks in the busi­
ness cycle. Similarly, the easing of policy to counteract a
developing recession would help to produce an upturn in
the rate of monetary growth in advance of troughs in busi­
ness activity.
In addition to the feedback from business conditions to
policy decisions and thence from policy to the money
supply, there are circumstances in which developments in
the economy can react on the money supply even with
monetary policy unchanged. Consider, for example, a
situation in which the focus of policy is on maintaining
an unchanged money market “tone”— a phrase that has
been interpreted to imply, among other things, some rough
stabilization of the average level of certain short-term in­
terest rates such as the rate on Federal funds. Now a
speedup in the rate of growth in economic activity would




ordinarily accelerate the growtn of demand for bank credit
and deposits. This, in turn, would normally result in up­
ward pressure on the money market and on money market
interest rates. Maintaining the stability in money market
tone called for by such a policy would require, however,
under the assumed circumstances, supplying more reserves
to the banks in order to offset the upward pressures on
money market rates. Thus, with unchanged policy, an
acceleration in the rate of business expansion could gen­
erate an acceleration in the rate of growth of reserves,
and thence in the money supply. Similarly, a tapering-off
in the rate of business expansion could, in these circum­
stances, generate a tapering-off in the rate of monetary
expansion well before an absolute peak in business activ­
ity occurred. It should be emphasized that unchanged
monetary policy could be perfectly consistent with counter­
cyclical objectives under these conditions if the slowdown
(or speedup) in the rate of business advance either were
expected to be temporary or were regarded as a healthy
development.
The reaction of monetary policy to changing business
conditions and the reaction of the money supply to mone­
tary policy undoubtedly help explain the tendency of
peaks and troughs in the rate of growth of the money
supply to precede peaks and troughs in the level of eco­
nomic activity during this period. The resulting monetary
leads, however, cannot then be interpreted as demonstrat­
ing a dependence of cycles in business on cycles in mone­
tary growth. These leads would very likely have existed
even if the influence of money on business were altogether
negligible.
S E V E R I T Y O F C Y C L IC A L M O V E M E N T S

Apart from matters of cyclical timing, some proponents
of the money supply school have also regarded the rela­
tionship between the severity of cyclical movements in
money and the severity of associated cyclical movements
in business as suggesting a predominant causal role for
money. They argue, perhaps with some plausibility, that,
if the behavior of money were the predominant deter­
minant of business fluctuations, the relative sizes of cyclical
movements in business and roughly contemporaneous
cyclical movements in money should be highly correlated.
For example, the severity of a cyclical decline in the rate
of growth of the money supply should be closely related
to the severity of the associated business recession or
depression. The evidence for such a correlation, however,
is actually rather mixed.
Cyclical contractions in the monetary growth rate can
be measured by computing the decline in the rate of mone­

FEDERAL RESERVE BANK OF NEW YORK

tary growth from its peak value to its trough value.10 On
the basis of these computations, monetary contractions
can be ranked in order of severity. Similarly, the severity
of business contractions can be ranked by choosing some
index of business activity and computing its decline dur­
ing each business contraction recognized and dated by
the NBER. If the resulting rankings of monetary contrac­
tions are compared with the rankings of their associated
business declines for eighteen nonwar business contrac­
tions from 1882 to 1961, the size of monetary and
business contractions proves to be moderately highly
correlated.11 It turns out, however, that this correlation
depends entirely on the experience of especially severe
cyclical contractions. Among the eighteen business con­
tractions experienced during the period, six are generally
recognized as having been particularly deep. They include
three pre-World War I episodes and the contractions of
1920-21, 1929-33, and 1937-38. In the latter three de­
clines, the Federal Reserve Board’s industrial production
index fell by 32 per cent, 52 per cent, and 32 per cent,
respectively, compared with a decline of only 18 per cent
for the next largest contraction covered by the production
index (1923-24).
These six most severe contractions were in fact asso­
ciated with the six most severe cyclical declines in the rate
of growth of the money supply, though the rankings within
the six do not correspond exactly. As was argued earlier,
business conditions themselves exert a reverse influence
on the money supply, and it seems probable that partic­
ularly severe business declines may tend to accentuate
the accompanying monetary contractions. Thus, for exam­
ple, the wholesale default of loans and sharp drops in the
value of securities that accompanied the 1929-33 depres­
sion helped lay the groundwork for the widespread bank
failures of that period. These failures were in part caused
by, but also further encouraged, large withdrawals of cur­
rency from the banking system by a frightened public. By
contracting the reserve base of the banking system, in
turn, these withdrawals resulted in multiple contractions

69

of the deposit component of the money supply.
Developments of this type help to explain the associa­
tion of major monetary contractions with major depres­
sions but do not seem to account fully for it.12 Thus it
m aybe that catastrophic monetary developments are in fact
a pre-condition for catastrophic declines in business activ­
ity. In any case, for more moderate cyclical movements,
the association between the severity of monetary contrac­
tions and the severity of business contractions breaks down
completely. There is virtually no correlation whatever be­
tween the relative rankings of the twelve nonmajor con­
tractions in the 1882-1961 period and the rankings of
the associated declines in the rate of monetary growth.13
Certainly this finding does not support the theory that
changes in the rate of monetary growth are of predominant
importance in determining business activity.
M E A S U R I N G L A G S IN T H E I N F L U E N C E O F
M O N E Y O N B U S IN E S S

Despite their belief in the crucial role of the money
supply in determining the cyclical course of business activ­
ity, some members of the money supply school neverthe­
less argue, as suggested at the beginning of this article, that
discretionary monetary policy is a clumsy and even danger­
ous countercyclical weapon. The starting point for this
view is again the fact that peaks and troughs in the level
of business activity tend to lag behind peaks and troughs
in the rate of change of the money supply— in particular
the fact that these lags have tended to be quite long on
average and highly variable from one cycle to another.
Thus long average lags of about sixteen months for
peaks and twelve months for troughs have suggested to
these economists that the impact of monetary policy is
correspondingly delayed, with actions taken to moderate
a boom, for example, having their primary impact during
the subsequent recession when precisely the opposite in­
fluence is needed. Moreover, the great variability from
cycle to cycle of the lags as measured by the money supply
school has suggested that the timing of the impact of
monetary policy is similarly variable and unpredictable.
For this reason, they argue, it will be impossible for the
monetary authorities to gauge when their policy actions

10 Generally, three-month averages centered on the specific cycle
turning point months have been used to reduce the weight given
to especially sharp changes in the peak and trough months them­
selves.
11 The Spearman rank correlation, for which satisfactory signifi­
cance tests apparently do not exist when medium-sized samples
(10 < n < 2 0 ) are involved, is .70. The Kendall rank correlation
coefficient, adjusted for ties, is .53 and is significant at the 1 per cent
level. Rankings of business contractions are based on the Moore
index. See Friedman and Schwartz, op. cit., Table 3, page 39.




12 See Phillip Cagan, op. cit., pages 262-68.
13 The Kendall coefficient for the twelve nonmajor contractions
is a statistically insignificant .03, while the corresponding Spear­
man coefficient is .01.

70

MONTHLY REVIEW, APRIL 1968

will take effect and therefore whether these actions will
The fact that such lags do exist, however, shows only
turn out to have been appropriate.
that monetary policy cannot be expected to produce imme­
It is true, of course, that monetary policy affects the diate results. Like fiscal policy, its effectiveness depends
economy with a lag. The full effects of open market pur­ in part on the ability to anticipate business trends so
chases on bank deposits and credit, for example, require that policy actions taken today will be appropriate to
time to work themselves out. More important, additional tomorrow’s conditions. Of course the longer the lags in
time must elapse before businessmen and consumers ad­ the effects of policy prove to be, the further out in time
just their spending plans to the resulting changes in the must such anticipations be carried and the greater is the
financial environment. For this reason, the pattern of risk that policy actions will prove to be inappropriate.
spending at any given time will to some degree reflect ^Moreover, if the lengths of the lags are highly variable and
the influence of financial conditions as they existed several thus perhaps unpredictable, the risks of inappropriate
months or quarters earlier. fHence it is certainly possible, policy decisions are obviously increased and the need for
for example, that some of the effects of a restrictive mone­ continuous adjustments in policy is apt to arise.
The timing of cycles in money and cycles in business,
tary policy could continue to be felt during a recession
even though the current posture of monetary policy were however, provides absolutely no basis for believing that
the lags in the effects of monetary policy are so long or
quite expansionary.

Chart 1
!

CHANGES IN GROSS NATIONAL PRODUCT AND IN MONEY SUPPLY PLUS TIME DEPOSITS
P

Qucsrter-to-quarter percentage ch an g e s; com pound an n u a l rates

28.3

Note: P e rcen tage ch a n g e s are based on sea so n ally cd ju ste d data.
Sources: Board of G overno rs of the Fed eral Reserve System; United States Department of Com m erce.




71

FEDERAL RESERVE BANK OF NEW YORK

so variable as to vitiate the effectiveness of a counter­
cyclical policy. First, there are many reasons for doubting
that the lag in the effects of monetary policy should be
measured by comparing the timing relationships between
cyclical turns in money and in business. It has been
argued, for example, that other variables more directly
under the control of policy makers, such as member bank
nonborrowed reserves, or variables more clearly related to
business decisions, such as interest rates, must also be
taken into account. Yet, even if the behavior of the money
supply be accepted as the indicator of policy, there are many
alternative ways in which “the lag” between monetary and
business behavior can be measured, and it makes a great
deal of difference which measure is used. If, for example,
the rate of change in the money supply is replaced by
deviations in the level of the money supply from its longrun trend, the average lag between monetary peaks so
measured and peaks in general business apparently shrinks
from the sixteen months previously cited to a mere five
months.14 Alternatively, it can be plausibly argued that
the appropriate measure is the lag between the rate of
change in the money supply, and the rate of change,
rather than the level, of some measure of business activity
such as gross national product (GNP) or industrial pro­
duction. When peaks and troughs for money and business
are compared on this basis, the lead of money over busi­
ness appears to be quite short.15 The near simultaneity,
in most cases, of peaks and troughs in the rates of change
of the money supply and of GNP during the post-World
War II period can be seen in Chart II. To be sure, move­
ments in the two series are quite irregular, so that the deci­
sion on whether to treat a particular date as a turning
point is sometimes rather arbitrary. Nevertheless, the lead
of peaks and troughs in the rate of growth of money over
peaks and troughs in the rate of growth of GNP appears
to average about one quarter or less.16

14 This estimate is presented by Milton Friedman in “The Lag
Effect in Monetary Policy”, Journal of Political Economy, Octo­
ber 1961, page 456.
15 See John Kareken and Robert Solow, “Lags in Monetary
Policy”, Stabilization Policies (Commission on Money and Credit,
1963), pages 21-24.
16 when quarterly dollar changes in the money supply are cor­
related with quarterly dollar changes in GNP experimenting with
various lags, the highest correlation is achieved with GNP lagged
two quarters behind money. (For the 1947-11 to 1967-III period
the R2 is .34.) The correlation with a one quarter lag is almost
exactly as high, however (R2 = .33). When percentage changes in
the two series are used instead, the correlation virtually disappears,
no matter what lag is used.




The point of these various comparisons is not to prove
that the lag in monetary policy is necessarily either very
long or very short, but rather to illustrate how hard it is
to settle the matter through the kind of evidence that has
been offered by the money supply school. Similar difficul­
ties, as well as others, beset attempts to measure the
variability of the lag in the influence of money on business
by comparisons of cyclical peaks and troughs in the two.
However the turning points are measured, the resulting
estimates may seriously overstate the true variability of the
lag in the influence of money on business. The reason is
that observed differences from cycle to cycle in the timing
of turning points in money relative to turning points in
business are bound to reflect a number of factors over
and beyond any variability in the influence of money on
business.17 These “other” sources of variability include
purely statistical matters such as errors in the data and
the arbitrariness involved in assigning precise dates to
turning points in money and in business. More funda­
mentally, the fact that there exists a reverse influence of
business on money, an influence that is probably uneven
from one cycle to the next, imparts a potentially serious
source of variability to the observed lags. Moreover, if
there are important influences on the general level of busi­
ness activity other than the behavior of money, these
factors would also increase the variability of the observed
timing relationships between turning points in money and
in business. Taking all these possibilities into account, it
seems fair to say that whatever the true variability in the
impact of money on business, its size is overstated when
it is measured in terms of the variability of the lags in
cyclical turning points.
W A Y S IN W H IC H M O N E Y M A Y I N F L U E N C E
B U S IN E S S

If there is a broad conclusion to be drawn from a study
of the historical pattern of relationships between cycles in
money and cycles in business, it is that there are distinct
limits to what can be learned about the influence of money
on business from this kind of statistical analysis. Perhaps
this should not be surprising. During the business cycle
many factors of potential importance to the subsequent
behavior of business activity undergo more or less con-

17 Other sources of variability are discussed in some detail by
Thomas Mayer in “The Lag in the Effect of Monetary Policy:
Some Criticisms”, Western Economic Journal (September 1967),
pages 335-42.

72

MONTHLY REVIEW, APRIL 1968

tinuous change. At the same time the business cycle itself
feeds back on the behavior of these factors. Hence it is
extremely difficult to isolate the importance of any single
factor, such as the behavior of money, and post hoc,
propter hoc reasoning becomes especially dangerous. In
these circumstances there appears to be no substitute for
a detailed, and hopefully quantitative, examination of the
ways in which changes in the money supply might work
through the economy ultimately to affect the various com­
ponents of aggregate demand. Some brief and tentative
sketches aside, the proponents of the monetary school
have not attempted such an analysis.
The possible ways in which an increase, for example,
in the money supply might stimulate aggregate demand
can be separated into what are sometimes called “income
effects”, “wealth effects”, and “substitution effects”. In­
come effects exist when the same developments that pro­
duce an increase in the quantity of money also add di­
rectly to current income. Examples would be increases in
bank reserves and deposits resulting from domestically
mined gold or an export surplus. Similarly, a wealth effect
occurs when a process increasing the money supply also
increases the net worth of the private sector of the econ­
omy. A Treasury deficit financed by a rundown of Trea­
sury deposit balances might be regarded as an example of
such a process, since the resulting buildup of private de­
posits would represent an increase in private wealth.
Far more important than the income or wealth effects
in the present-day United States economy are substitution
effects such as result when the Federal Reserve engages
in open market operations and banks expand loans and
investments.18 When the Federal Reserve buys Govern­
ment securities from the nonbank public, the public of
course acquires deposits and gives up the securities. There
is no direct change in the public’s net worth position,19 or
in its income; rather there is a substitution of money for
securities in the public’s balance sheet. The same is true
when the banks expand the money supply by buying se­
curities from the nonbank public: the public substitutes
money for securities, but neither its wealth nor its income

18 These substitution effects are sometimes also known as “port­
folio balance” or “liquidity” effects.
19 This statement has to be modified to the extent that the Fed­
eral Reserve’s buying activity bids up the market value of the
public’s holdings of Government securities. The significance of
this wealth effect is probably minimal and is further limited in its
consequences by the tendency of many holders to value Govern­
ments at original purchase price or at par rather than at current
market value.




is directly changed by the transaction. Similarly, when
banks expand deposits by making loans, the monetary
assets of the borrowers rise, but their liabilities to the
banking system rise by an equal amount and their net
worth and income are unchanged.
Since these substitution effects associated with open
market operations and with the expansion of bank de­
posits are by far the most important operations by which
the money supply is changed, it seems especially relevant
to study the ways in which these effects may influence
economic activity. The main avenues appear to be through
changes in interest rates on the various types of assets
and changes in the availability of credit. When the Federal
Reserve or the commercial banks buy securities from the
nonbank public in exchange for deposits, funds are made
available for the public to purchase, in turn, a wide va­
riety of private securities such as mortgages, corporate
bonds, or bankers’ acceptances.20 The increased demand
for these securities tends to push rates on them down. And
with borrowing costs down, business firms may be induced
to expand outlays on plant and equipment or inventory
while consumers may increase spending on new homes. In
most cases, the effects of lower interest rates on capital
spending probably stem from the fact that external financ­
ing has become cheaper. In some cases, however, lower
market yields on outstanding government and private
securities might induce business holders to sell such assets
in order to purchase higher yielding capital goods and
thus, in effect, to make direct substitution of physical
capital for financial assets in their “portfolios”. Finally,
lower interest rates on securities may reduce consumer
incentives to acquire and hold financial assets while tempt­
ing them to make more use of consumer credit, thereby
reducing saving out of current income and increasing con-

20 The newly created deposits may of course in principle be
used immediately to buy goods rather than financial assets, thus
tending directly to stimulate business activity. Even in this case,
however, the effects of the money-creating operations work
through and depend upon reactions to interest rates. When the
Federal Reserve or the commercial banks enter the market to buy
securities, their bids add to total market demand, making market
prices for securities higher (and yields lower) than they otherwise
would have been. Indeed it is these relatively higher prices (lower
yields) that induce the nonbank public to give up securities in
exchange for deposits. If the deposits are in fact immediately used
to purchase goods, then the process can be regarded as one in
which lower market interest rates on securities stemming from
bids by the Federal Reserve or the commercial banks have induced
the public to give up securities in exchange for goods. The extent
to which such switching will occur obviously depends upon the
sensitivity to interest rates of business and consumer demands for
goods.

FEDERAL RESERVE BANK OF NEW YORK

73

sumption purchases.2
1
With regard to bank lending, open market purchases of
Government securities increase bank reserves and may
ease the terms on which banks are willing to make loans.
Changes in lending terms other than interest rates, which
include repayment procedures, compensating balance re­
quirements, and the maximum amount a bank is willing
to lend to a borrower of given credit standing, are often
bracketed as changes in “credit availability”. Such changes
are regarded by many analysts as being more important
influences on many types of spending than are changes in
interest rates. Moreover, changes in credit availability re­
lated in part to changes in the money supply are not con­
fined to lending by commercial banks, as was dramati­
cally illustrated in 1966 with regard to nonbank mortgage
lenders. In any case, an increased availability of funds
permits and encourages potential borrowers to increase
their loan liabilities, thereby providing funds which can be
used to build up financial assets (perhaps mainly money
market instruments) or to purchase physical assets in the
form of business capital goods, inventories, or consumer
durables. Stepped-up purchases of financial assets add to
downward pressures on interest rates, stimulating spend­
ing through the processes already described, while addi­
tional demand for physical assets stimulates business
activity directly.
Studies of the influence of changes in interest rates and
the availability of credit on spending in the various sectors
of the economy have appeared with increasing frequency
in the post-World War II period, especially within the
past few years. Some of these studies have taken the form

of interviews of businessmen and consumers with regard
to the influence of credit cost and availability conditions
on their spending decisions. Other studies have employed
modem statistical and computer technology in an attempt
to extract such information from data on past behavior.22
With regard to spending on housing, there has been gen­
eral agreement that the cost and availability of credit are
highly important. A number of studies have also found
varying degrees of influence on business spending for
plant and equipment and for inventories as well as on
consumer spending for durable goods such as autos and
appliances. All these studies, however, have also found
factors other than cost and availability of credit to be
highly important. Moreover, a large degree of disagree­
ment exists with regard to the exact quantitative impor­
tance of the financial factors.
Given the serious technical problems that surround these
studies, major areas of disagreement are virtually certain
to exist for some time to come. Nevertheless, studies of
the type referred to here appear to offer the hope at least
that firmly grounded and widely accepted conclusions on
the importance of money in the business cycle may ulti­
mately be reached. Of particular interest are large-scale
econometric models which attempt to provide quantitative
estimates of the timing and magnitude of the effects of
central bank actions on the money supply and other finan­
cial magnitudes and the subsequent effects, in turn, of these
variables on each of the various major components of
aggregate demand. One such model is currently under
construction by members of the Federal Reserve Board
staff in cooperation with members of the Economics De­
partment of the Massachusetts Institute of Technology.23
Granting the major technical problems still unresolved,
projects of this kind appear promising as a means of
eventually tracking down the importance of money in ex­
While there is little general agreement that such direct effects plicit, quantitative terms.

21
on consumption are important, a recent study of the problem has in
fact found a significant influence of interest rates on consumer de­
mand for automobiles and other durables. (See Michael J. Ham­
burger, “Interest Rates and the Demand for Consumer Durable
Goods”, American Economic Review, December 1967.) In general,
proponents of the monetary school feel that analyses of the role of
interest rates in consumer demand undertaken to date have ne­
glected to take into account certain important factors. In particular,
they think that the most relevant interest rates may not be the ones
usually studied, namely the rates on financial instruments, but rather
the interest rates “implicit” in the prices of the durable goods them­
selves—i.e., where the value of the services yielded by a consumer
durable, such as an auto or a washing machine, is treated as
analogous to the coupon or dividend yielded by a bond or stock.
The obvious difficulties of defining and measuring the value of
such services have probably been responsible for the notable
dearth of research into this possibility, however, and the issue
must be regarded as completely unsettled.




22 For a summary of some of these studies, see Michael J. Ham­
burger, “The Impact of Monetary Variables: A Selected Survey of
the Recent Empirical Literature” (Federal Reserve Bank of New
York, July 1967). Copies of this paper are available on request
from Publications Services, Division of Administrative Services,
Board of Governors of the Federal Reserve System, Washington,
D.C. 20551.
23 Some preliminary results of this work are discussed in “The
Federal Reserve-MIT Econometric Model” by Frank deLeeuw and
Edward Gramlich, Federal Reserve Bulletin (January 1968),
pages 9-40.

74

MONTHLY REVIEW, APRIL 1968

The Business Situation
The economy is continuing to expand strongly. Boosted
by an increase in the minimum wage, personal income ad­
vanced sharply in February, and another large rise prob­
ably occurred in March, partly reflecting stepped-up social
security benefit payments. Retail sales have been showing
new buoyancy so far this year, suggesting a strong ad­
vance in total outlays by consumers during the current
quarter. The housing sector moved ahead in February,
with starts in January and February averaging somewhat
above their fourth-quarter rate. At the same time, the
latest Government survey of businessmen’s plant and
equipment spending plans points to increases in such out­
lays in the current quarter and in 1968 as a whole. Indus­
trial production held at a high level in February, and new
orders posted a modest advance. Although the unemploy­
ment rate edged up from January’s fourteen-year low, the
labor market remains extremely tight. Consumer and
wholesale prices continue to climb sharply, and the rise in
labor costs in manufacturing has accelerated, intensifying
the inflationary pressures in the economy. The hectic
scramble for gold in the first half of March reflected in
part the adverse impact of continued domestic inflation on
confidence in the dollar and dramatically pointed up the
need for fiscal restraint.
P R O D U C T IO N , O R D E R S , A N D C O N S T R U C T IO N

Industrial production held at about the January level
in February despite the dampening effect of labor disputes.
The Federal Reserve Board’s seasonally adjusted produc­
tion index edged up 0.1 percentage point to 161.3 per
cent of the 1957-59 average but remained below the
162.0 per cent December peak. Local work stoppages in
the auto industry continued to hold back auto assemblies
in February, and the glassblowers’ strike also cut into
durables output. The production of industrial materials
weakened, despite the high rate of activity in the steel
industry. Investment outlays and military requirements
pushed business and defense equipment output higher in
both January and February. The utilities index rose
sharply, in part reflecting increased use of electricity dur­
ing February’s unusually cold weather.




In March, strike-hedge buying continued to keep steel
production at a record level. On a seasonally adjusted
basis, March output was more than 13 per cent above the
October level before strike-hedge buying began. Automo­
bile production expanded in March to a seasonally adjusted
annual rate of 9.0 million units, nearly 11 per cent higher
than February’s rate. New car sales surged 1016 per cent
to an annual rate of 8.7 million units in March.
New orders to manufacturers of durable goods increased
slightly in February to a seasonally adjusted level of $24.8
billion. This indicator of future production has behaved
erratically in the past few months. In December, or­
ders surged to an unsustainable level, and then declined
sharply in January. Steel and defense products industries
spurred the February advance. Durable goods shipments
eased somewhat in February and, since the volume of new
orders exceeded shipments, the backlog of unfilled orders
rose.
The latest Government survey of business plans for
capital spending, taken in late January and early February
by the Department of Commerce and the Securities and
Exchange Commission, indicates that businessmen antici­
pated a $2.1 billion upturn in such outlays in the first
quarter of 1968 to a seasonally adjusted annual rate of
$64.8 billion. Most of the first-quarter gain is due to an
upsurge in investment spending by manufacturers. After
a small decline of $0.5 billion in the second quarter, the
survey points to advances averaging $1.2 billion per
quarter in the last half of the year. Thus, for the year as
a whole, the survey reports that businessmen plan a
moderate 5.8 per cent increase in the pace of plant and
equipment investment.
The sharp upswing in corporate profits late in 1967 may
have contributed to the planned rise in investment spend­
ing. After edging downward in the first half of 1967,
corporate profits before taxes stabilized in the second and
third quarters and then leaped $5.4 billion in the fourth
quarter to a record $85.4 billion at a seasonally adjusted
annual rate.
Manufacturers’ inventories increased by a seasonally
adjusted $0.3 billion in February, with the gain occurring
entirely in durables stocks. At the same time, shipments

75

FEDERAL RESERVE BANK OF NEW YORK

fell by a seasonally adjusted $0.7 billion, and the inventorysales ratios for both durable and nondurable goods turned
up but remained close to the lowest levels reached in 1967.
The latest survey of manufacturers’ inventory and sales
expectations, taken by the Department of Commerce in
February, shows that manufacturers expect their inven­
tories to rise by about $2 billion in each of the first
two quarters of this year, a bit more than the $1.6 billion
fourth-quarter increase. At the same time, they expect
invent ory-s ales ratios to edge down from fourth-quarter
levels for durables and to remain about unchanged for
nondurables.
Construction was strong in February, in contrast to the
mixed picture of the two previous months. Private non­
farm housing starts rose in February by 7.1 per cent to
a seasonally adjusted annual rate of 1,528,000 units, fol­
lowing a sharp gain in January and a precipitous decline
in December. In February, starts increased in most sections
of the country, with the southern and north central areas
leading the advance. Half of the December decline had
been in the South, and starts there were practically un­
changed in January. The index of permits for new private
housing shot up 24.6 per cent in February to 121.2 per
cent of the 1957-59 base, the highest level since the early
months of 1964. The permits index, which is usually less
volatile than the series on housing starts, had risen by
14.3 per cent in December only to fall by 16.7 per cent
in January.

less rate to the lowest level in more than fourteen years.
A large increase in the teen-age labor force, which had been
declining throughout most of 1967, accounted for most
of the February rise in unemployment. Three quarters of
the teen-agers entering the job market were searching for
part-time work. The unemployment rate for adult women
also rose in February. The rate for adult men held steady
at 2.3 per cent, and underlying labor market tightness was
evident in the continued low rate of unemployment for
married men, which edged up only 0.1 percentage point
to 1.7 per cent.
The large rise in employment and the higher minimum
wage raised personal income by a seasonally adjusted
annual rate of $7.5 billion in February. This was the larg­
est increase since September 1965, when a rise in social
security benefits increased incomes by $14.9 billion. Ac­
cording to the Department of Commerce, $2 billion to $3

Chart I

PERSONAL INCOME AND RETAIL SALES
Billions of dollars

Billions of dollars

E M P L O Y M E N T , P E R S O N A L IN C O M E ,
AND CO N SU M ER DEM AND

The continued strength of the labor market was evi­
denced by the strong February expansion in employment.
Nonfarm payroll employment rose by an impressive
550,000 persons in February, following a small advance
in January. While most sectors of the economy contributed
to the gain, nearly half of the increase was concentrated
in the construction industry as workers returned to con­
struction sites they had been forced to leave because of
unusually bad weather in January. Construction employ­
ment has picked up substantially since October, after
showing little growth during most of 1967. Manufacturing
payroll employment, which has been recovering from the
reduced levels of 1967, advanced by 66,000 persons to
a new high in February.
While employment grew vigorously in February, the
civilian labor force expanded even more rapidly, and the
unemployment rate edged up 0.2 percentage point to 3.7
per cent of the labor force. February’s rise followed a
0.2 point decline in January, which had dropped the job­




196 5

1966

1 96 7

Source: United States Department of Commerce, Bureau of the Census.

196 8

76

MONTHLY REVIEW, APRIL 1968

billion of the advance resulted from the February hike in
the minimum wage. While other special factors also served
to magnify the February rise, it was substantial even apart
from these adjustments. Wage and salary payments in­
creased by $6.3 billion, and manufacturing payrolls rose
by $2.3 billion. Better weather conditions lengthened
working hours in the construction industry, and payrolls
consequently rose sharply there. Personal income will
receive still another boost in March of approximately $3.6
billion, at an annual rate, from the step-up in social
security benefit payments.
Bolstered by the impressive gains in personal income,
retail sales in February rose by 1.5 per cent to $27.4 bil­
lion, following a larger advance in January (see Chart I).
Durables sales, boosted by increased auto sales, were up by
2.1 per cent. Sales at nondurables outlets increased, with
the apparel and general merchandise groups (notably de­
partment store sales) showing strong advances. Further
evidence of the resurgence in consumer spending was given
by the large February rise in consumer credit, the sharpest
gain since March 1966. Instalment credit advanced
strongly; gains in automotive credit and personal loans
were particularly striking.

Chartll

WHOLESALE PRICES
Percent

1 95 7 -5 9 = 10 0

Percent

P R IC E S A N D C O S T S
Note: Plottings shown forMarch 1968 are preliminary.

Prices and costs rose sharply in February. The wholesale
price index jumped 0.8 percentage point, the largest in­
crease in two years, to 108.0 per cent of the 1957-59
base (see Chart II). Preliminary data for March indicate
a further advance of 0.3 percentage point. The rise in
industrial commodity prices, which began last August, has
accelerated in the current quarter. Prices of farm products
reached a trough in November, but since then have been
rising at a rapid pace; in February they surged 2.3 per­
centage points to 101.3 per cent of the 1957-59 base and
are expected to rise another 0.9 percentage point in
March.
The consumer price index climbed 0.4 percentage point
in February to 119.0 per cent of the 1957-59 base. The
upturn in wholesale food prices was reflected in a 0.4
percentage point rise in retail food prices. All the major
components of the consumer price index showed large




Source: United States Department of Labor, Bureau of Labor Statistics.

increases in line with their recent rate of advance. Prices
of services rose 0.5 percentage point, as health, housing,
and recreation costs moved higher.
Labor costs jumped sharply in February— 1.8 per cent
— the largest monthly increase since 1956. The combina­
tion of a higher minimum wage, longer overtime, and a
decline in output per man-hour in manufacturing raised the
index of unit labor costs in manufacturing to 110.3 per
cent of the 1957-59 average. Unit labor costs have risen
by a rapid 2.9 per cent in the first two months of the cur­
rent quarter, considerably faster than the 0.4 per cent in­
crease during the second half of 1967.

FEDERAL RESERVE BANK OF NEW YORK

77

The M oney and Bond M arkets in M arch
Developments in domestic financial markets during
March were largely dominated by events in the foreign
exchange and gold markets. Renewed speculative pressures
on the pound sterling and the Canadian dollar, which com­
menced in the final days of February, spread to the United
States dollar. Through midmonth, the demand for gold
built up to unprecedented proportions, forcing into
sharper focus the fundamental problems of the interna­
tional monetary system and the domestic economy. The
pressure on member bank reserve positions increased
steadily over the month, and between March 15 and 22
the discount rates of all twelve Federal Reserve Banks
were increased by Vi percentage point to 5 per cent, the
highest level in almost forty years. Nine Federal Reserve
Banks announced increases in their discount rates on
March 14, effective on March 15, and the Federal Re­
serve Banks of San Francisco and Philadelphia later an­
nounced similar increases in their rates effective on March
15 and 18, respectively. The Federal Reserve Bank of
New York did not take similar action until March 21, ef­
fective the following day.
The structure of interest rates shifted moderately up­
ward in March, reflecting concern in the credit markets
over international developments and the degree of mone­
tary stringency that would ultimately be required to de­
fend the dollar. The effective rate for Federal funds was
generally quoted at 5Vi per cent after the discount rate
increase. At midmonth, the large New York City banks
increased their offering rates on new negotiable time cer­
tificates of deposit (C /D ’s) in the shortest maturity cate­
gory to 5 V2 per cent, the maximum permissible rate under
Regulation Q. Rates on bankers’ acceptances, finance com­
pany paper, and commercial paper rose as much as V2
percentage point. Market yields on Treasury bills closed
the month about 15 basis points higher, as a sharp in­
crease through March 14 was partially reversed later un­
der the impact of a strong investment demand due to
seasonal and other influences.
The market for Treasury notes and bonds was shaken
by the events in international financial markets, and price
losses on long-term issues mounted to more than 4 points
by mid-March. Subsequently, after international agree­




ment on a two-price system for gold had been reached, the
market recovered a substantial part of these losses. Par­
ticipants were also encouraged when the discount rate in­
crease proved smaller than many had expected and when
the Administration expressed willingness to consider the
budget cuts that may be necessary in order to secure pas­
sage of the needed surtax legislation by the Congress.
Yields trended sharply higher in the corporate and munici­
pal bond markets. The volume of new corporate financing
fell off from recent levels, while tax-exempt offerings in­
creased sharply as a result of a rush to market industrial
revenue bonds before the effective date of an expected
Treasury ruling which would subject interest payments on
these securities to Federal income taxation.
BANK RESER V ES AND THE M ONEY M ARKET

The availability of reserves at member banks contracted
sharply in March, since severe reserve drains through gold
and foreign account transactions were not fully offset by
System open market operations. On a daily average basis,
aggregate net borrowed reserves increased steadily over
the month, from $136 million in the final statement week
of February to $410 million in the closing March week
(see Table I). For the month as a whole, average net bor­
rowed reserves of $306 million contrasted with average free
reserves of $16 million in February. The increased pressure
on member bank reserve positions produced heavier bor­
rowings from the Reserve Banks; daily average borrowings
for the four March statement weeks jumped to $649 mil­
lion from $368 million in the preceding four weeks.
The pronounced contraction of nationwide net reserve
availability had the greatest impact on the banks in major
money centers outside New York City. The basic reserve
position of the eight New York City money market banks
improved, on average, in March but fluctuated widely
from week to week within the period (see Table II).
After declining to $16 million in the first statement week,
the average basic reserve deficit of the city banks rose
to $371 million in the week ended on March 13, largely
as a result of sizable outflows of demand deposits asso­
ciated with the quarterly corporate dividend payments

MONTHLY REVIEW, APRIL 1968

78
Table I

Table H

FACTORS T E N D IN G TO INC R EA SE OR D ECREASE
M EM BER B A N K R ESERVES, M ARCH 1968

RESERVE POSITIONS OF MAJOR RESERVE CITY BA NK S
MARCH 1968

In m illions o f dollars; (+ ) denotes increase,
(—) decrease in excess reserves

In millions of dollars
Daily averages-—week ended on
Factors affecting
basic reserve positions

Changes in daily averages—
week ended on

Net
changes

Factors
March
6

March
13

March
20

March
27

M em ber b a n k req u ired reserves* ..................

— 165

+ 408

— 179

+

99

+

O perating tra n s a c tio n s (su b to tal) ................

— 233

— 754

— 405

—

10

— 1,402

March
6

March
13

Averages of
four weeks
ended on
March March 27*
27*

March
20

Eight banks in N ew York City

“ Market” factors
163

F e d e ra l Reserve f l o a t .................................

+ 173

— 256

+ 195

— 151

—

39

T re asu ry o p e ra tio n s t ......................................

+

+

372

—

5

+
6
— 781

+ 309

Gold a n d foreign a c c o u n t .............................

+
8
— 244

— 427

— 1,457

C urrency o utside b a n k s * ...............................

— 395

— 330

+

+ 229

—

42?

O ther F e d e ra l R eserve acco u n ts ( n e t ) | . .

—

+

67

+ 108

+

28

+

— 584

+

89

— 1,239

33

-

11

126

43

15 1

114
860
975

42
966
924

90
6i
882
821

i

149

— 348

Reserve excess or deficiency(—) f .....
24
125
Less borrowings from
—
Reserve Banks ........................................
219
Less net interbank Federal funds
purchases or sales (—) .......................
40
277 797
906
Gross purchases ..............................
Gross sales ......................................
629
756
Equals net basic reserve surplus
or deficit (—) .......................................... — 16 — 371
N et loans to Government
securities dealers .................................... 1,077
841

T o ta l “ m a rk e t" f a c t o r s .............................

49

54

— 398

69

Direct Federal Reserve credit
transactions
Open m ark e t in stru m e n ts
O u trig h t h o ld in g s:
G overnm ent se cu ritie s ...............................

-j- 295

B a n k e rs' a c c e p ta n c e s .................................

—

1

+ 147
—

+

52

+ 674

— 219

+

+

-

1

—

R e p u rc h ase a greem ents:
G overnm ent secu rities ...............................

+

49
—

B a n k e rs' a c c e p ta n c e s .................................
F e d e ra l agency o b l ig a tio n s ......................

+

9

M em ber b a n k borrow ings .................................

+

58

+

1

O ther loans, d iscounts, a n d a d v a n ce s.........
T o ta l

................................................................

Excess reserves* ................................................

+ 411

13

+

+

2

+ 279
+

7

—

11

— 46
+

+

46
—

—

-

+

140

+

— 151

7

1

_

+ 46

—

897

_

— 101

—

1

15

+ 488

+ 522

— 323

+ 1,098

+

—

— 234

—

142

62

21

-

68

— 109

860

866

911

Thirty-eight banks outside N ew York City
Reserve excess or deficiency(—) t .....
9
2
47
Less borrowings from
Reserve Banks .......................................
236
232
179
Less net interbank Federal funds
purchases or sales (—) .......................
753
831
863
Gross purchases ............................... 1,735
1,761
1,776
Gross sales ..........................................
982
913
931
Equals net basic reserve surplus
or deficit (—) .......................................... — 980 —1,015 —1,039
N et loans to Government
securities dealers ....................................
581
813
435

5

16

110

189

552
1,861
1,309

750
1,783
1,034

-6 5 7

— 923

338

542

N ote: Because of rounding, figures do not necessarily add to totals.
* Estimated reserve figures have not been adjusted for so-called “as of” debits
and credits. These items are taken into account in final data,
t Reserves held after all adjustments applicable to the reporting period less
required reserves and carry-over reserve deficiencies.

141

Table III

Daily average levels

A V ER A G E ISSU IN G RATES*
AT REG U LA R TR EASURY BELL AUCTIONS
Member bank:
25,548

25,665

25,332

25,590§

OO
00

In per cent
25,814

25,080

25,259

25,160

25,247§

326

468

406

172

343§

CK

T o ta l reserves, in clu d in g v a u lt c a s h * .........

500

N onborrow ed reserves* ......................................

779

733

582

649§

— 174

— 311

— 327

— 410

— 306§

25,314

24,769

24,932

24,750

Weekly auction dates— March 196S
Maturities

24,941§

March
4

March
11

March
IS

March
25

Three-month..

5.000

5.107

5.285

5.186

Six-month......

5.173

5.321

5.378

5.301

Changes in Wednesday levels
Monthly auction dates— January-March 196S
System Account holdings of Government
securities maturing in:
M ore th a n one y e a r ............................................

+

T o ta l

................................................................

84

+ 466

— 170
— 170

+ 716

— 419

+

+

N o te : B ecause of ro u n d in g , figures do n o t necessarily a d d to to tals.
* T hese figures are estim ated,
t In clu d es changes in T reasu ry currency a n d cash.
$ In clu d es assets d en o m in ated in foreign currencies.
§ Average of four weeks ended on M arch 27.




50

+ 766

+

67

+

5.254

5.239

5.424

5.267

5.281

5.475

201

+

March
26

509

— 352

February
21

One-year...........................................

+ 382

January
25
Nine-m onth......................................

Less th a n one year ............................................

710

*

Interest rates on bills are quoted in terms of a 360-day year, with the discounts
from par as the return on the face amount of the bills payable at maturity.
Bond yield equivalents, related to the amount actually invested, would be
slightly higher.

FEDERAL RESERVE BANK OF NEW YORK

79

few days in reaction to news reports of a possible need
for an extraordinarily large troop buildup in Vietnam, evi­
dence of increased reserve pressure in the banking system,
and the reappearance of speculative demand for gold
abroad following two months of relative calm in inter­
national financial markets. Later, the decline in prices of
Treasury coupon issues accelerated as gold buying reached
a feverish pitch. The market was also adversely affected by
announcements of sizable offerings of securities to be made
later in the month by the Federal National Mortgage Asso­
ciation (FNMA) and the International Bank for Recon­
struction and Development. By Thursday, March 14, price
declines from end-of-February levels were as much as
4n/i6 points in the long-term area, and increases in market
yields available on intermediate- and long-term Treasury
issues averaged about 40 basis points.
Subsequently, on Friday and Monday, March 15 and
18, a sharp reversal of the earlier losses occurred, after
which prices fluctuated moderately and irregularly through
the month end. The sudden improvement in the market
tone at midmonth stemmed from a succession of official
moves undertaken to restore confidence in the dollar and
to end the gold crisis. On March 15, the discount rate
increase became effective at ten Federal Reserve Banks,
gold trading was suspended in most major markets abroad,
and the markets looked forward to the results of a spe­
cial weekend meeting of the heads of seven central banks
and two international financial organizations. The meet­
ing produced agreement on the adoption of a two-price
system for gold, whereby the participating monetary
authorities will no longer supply gold to the free market
but will transfer gold among themselves at official prices,
leaving the free market price to fluctuate independently.
(The Congress had passed legislation removing the gold
cover requirement on Federal Reserve notes on March 14.)
Moreover, President Johnson indicated a willingness to
accept across-the-board budget cuts in nondefense spend­
ing as a means of inducing the Congress to enact the longsought tax increase, and he apparently also decided on a
more moderate buildup of troops in Vietnam than had
been requested by the military authorities.
The Treasury bill market opened March on a strong
note, reflecting a sizable investment demand for shorter
issues originating in part from would-be buyers of equities
and long-term debt instruments, who were affected by a
general weakening of market confidence. In the first regular
weekly auction held on March 4, the three- and six-month
T H E G O V E R N M E N T S E C U R IT IE S M A R K E T
bill issues were awarded at average issuing rates of 5.00
In the Treasury coupon market, the confidence that per cent and 5.17 per cent (see Table III), down some­
had prevailed throughout February broke down rapidly what from rates established in the last regular February
in early March. Prices weakened moderately in the first auction. However, bidding was not as aggressive as had

concentrated in that week. In the following statement
week, containing the March 15 corporate income tax pay­
ment date, the city banks moved into a position of basic
reserve surplus, as corporate tax borrowing was relatively
limited and the banks gained funds through the crediting
of corporate income tax payments to Treasury Tax and
Loan Accounts. In addition, the city banks benefited from
recent sizable increases in Euro-dollar balances due to their
own foreign branches, and they were quite successful in
replacing the bulk of the C /D ’s that matured in volume
around the corporate tax date. In the final week of March,
the city banks reverted to a position of basic reserve deficit,
primarily due to a decline in average Euro-dollar holdings.
The money market was firm during March. Transac­
tions in Federal funds generally took place at a premium
over the discount rate. This premium rose to 1 per cent
on the eve of the discount rate increase but was generally
Va to l/ i per cent at other times during the month. Other
t
short-term interest rates rose during March. Dealers in
bankers’ acceptances lifted their offering rate on ninetyday unendorsed paper by Vi percentage point to 53 per
A
cent. Commercial paper dealers raised their offering rates
on prime four- to six-month paper by Vx percentage point
to 53 per cent, and major finance companies raised their
A
rates on paper placed directly with investors by % per­
centage point. The published rate on finance company
paper maturing in 30 to 179 days is now 5Vi per cent.
Earlier, major finance companies had paid a rate of 5 Vs
per cent on paper with maturities of sixty days or more.
Market yields on outstanding three- and six-month Trea­
sury bills increased over the month by 15 basis points, as
the sharp increases through March 14 were later partially
erased (see chart on page 80).
The large New York City banks raised their offering
rates on C /D ’s to the ceiling rate of 5 V2 per cent “across
the board” by midmonth. Until March 13, a rate of 43
A
per cent had generally been posted on one- to three-month
maturities. The increases in offering rates aided the city
banks in replacing all but $145 million of the heavy vol­
ume of C /D ’s maturing in the week of March 20. At large
commercial banks throughout the country, $5.8 billion
of C /D ’s matured in March, about 30 per cent of the
total amount they had outstanding. In the four statement
weeks ended on March 27, C /D ’s outstanding at these
institutions declined by $540 million.




MONTHLY REVIEW, APRIL 1968

80

SELECTED INTEREST RATES
Ja n u ary-M arch 1968

M O N EY M ARKET RATES

Ja n u a ry

Feb ruary

M arch

B O N D M ARKET YIELDS

Ja n u a ry

Feb ruary

M arch

Note: Data are shown for b usiness d ays only.
M O N EY MARKET RATES QUOTED: D aily ran ge of rates posted by major New York City banks
on new call loans (in Federal funds) secured by United States G overnm ent securities (a point

point from underw riting syn d icate reo fferin g yield on a given issue to m arketyield on the
sam e issue im m ediately after it has been released from syndicate restrictions); d aily

ind icates the ab sen ce of any ran ge); offering rates for d irectly p lace d finance com pany paper;
the effective rate on Fed eral funds (the rate most representative of the transactions executed);

a v erage s of yields on lo n g-term Governm ent securities (bonds due or c a lla b le in ten years

clo sing bid rates (quoted in terms of rate of discount) on newest outstanding three- and six-month

clo sing bid prices; Thursday a v erage s of yields on twenty seasoned twenty-year tax-exem pt

Treasury b iiis .
BO N D MARKET YIELDS Q UO TED: Y ie ld s on new A a a - and A a-rated p ublic utility bonds are plotted
around a line show ing d a ily av e ra ge yie ld s on seasoned A aa-ra ted corporate bonds (arrows

been anticipated. Market participants showed some con­
cern over new pressures on the pound sterling and the dol­
lar in international markets and their implication for do­
mestic monetary policy. Subsequently, dealers began to
press offerings of bills aggressively on the market, as the
money market firmed and financing costs rose and as the
atmosphere of tension in the financial markets heightened.
Consequently, market yields on Treasury bills maturing
within six months rose by about 43 basis points through
March 14. In the regular weekly bill auction held on
March 18, after market yields had subsided from their
monthly peaks, the three- and six-month issues were
awarded at average issuing rates of 5.29 per cent and
5.38 per cent, 29 and 21 basis points higher than cor­
responding rates established in the March 4 auction. Over




or more) and of G overnm ent securities due in three to five ye a rs, computed on the b asis of
bonds (carrying M oody's ratings of A a a , A a, A , and Baa).
Sources: Fed eral Reserve Bank of New York, Board of G overno rs of the Federal Reserve System,
M oody's Investors Service, and The W eekly Bond Buyer.

the remainder of the month, bill rates trended lower under
the influence of a broad demand from investors, reflecting
both seasonal factors and the search for a safe haven.
Prices of Federal agency obligations also weakened
during March under the influence of the new uncertainties
stemming from the gold crisis and a large increase in the
supply of securities in the market. On March 26, the
FNMA sold $1 billion of participation certificates, $730
million to the public and the remaining $270 million di­
rectly to Government investment accounts. The public
offering, which sold out immediately, consisted of a $200
million issue due in 1971, priced to yield 6.30 per cent,
plus a $330 million issue due in 1973 and a $200 million
issue due in 1988, both priced to yield 6.45 per cent. The
6.45 yield on the longer term noncallable issues is the high­

FEDERAL RESERVE BANK OF NEW YORK

est on any “full faith and credit” obligation of the Gov­
ernment in more than a century. In secondary market
trading, the certificates met with an overwhelming demand
from individuals and small investors, and yields available
on the three securities were driven down to 6.15 per cent,
6.30 per cent, and 6.42 per cent for maturities ranging
from the shortest to the longest.
O T H E R S E C U R IT IE S M A R K E T S

The calendar of tax-exempt bond offerings was heavy
in early March, largely reflecting a new surge in industrial
revenue bond financing in advance of an expected Trea­
sury ruling on March 15 which would deny the taxexemption privilege to bonds issued subsequent to that
date. However, the ruling was not issued until later in the
month, when it was made effective as late as September
1968 for those offerings for which sufficient preparatory
steps had been taken by March 15. Then, on March 28,
the Senate voted to end the tax-exemption privilege on
such bonds, effective January 1, 1969, and made no transi­
tional provision. Many of the industrial revenue issues
that were marketed were accorded excellent receptions,
though at yields which were often close to historic highs.
One issue was reoffered, after competitive bidding, to
yield 6.75 per cent. Other new tax-exempt offerings mar­




81

keted during the month fared less well, and dealers re­
sorted to widespread price cutting in order to move un­
sold balances of recent issues. Over the month, the Blue
List of dealers’ advertised inventories declined slightly
from $489 million to $454 million. The Weekly Bond
Buyer's yield series of twenty seasoned tax-exempt issues
(carrying ratings from Aaa to Baa) rose sharply to 4.62
per cent at midmonth but declined to close the period at
4.54 per cent (see chart), 10 basis points above the level
at the end of February.
In the corporate bond market, new issue activity tapered
off in the first half of March and expanded later in the
month. Syndicate pricing restrictions were terminated on
a number of recent issues in early March, in adjustment to
rising yields in all sectors of the capital market. One Aaarated public utility offering of bonds due in 1993 and
carrying five-year call protection met an excellent re­
ception on March 11 at a reoffering yield of 6 V2 per cent,
20 basis points higher than the yield on a comparable
offering on February 19. By the end of the month, how­
ever, a smaller Aaa-rated public utility offering with sim­
ilar features was accorded only a fair reception at a
reoffering yield of 6.67 per cent, a record high for this
type of offering. Over the month, the Moody’s index of
yields on Aaa-rated seasoned corporate bonds rose to
6.19 per cent from 6.08 per cent.

MONTHLY REVIEW, APRIL 1968

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