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Federal
Reserve Bankof
NewYbrk
Quarterly Review

Autum n 1980
1

9
12

Volum e 5 No. 3

Financial Innovation in Canada
C urrent developm ents
The business situation
The financial markets

Recent Trends in the Federal Taxation
of Individual Incom e

Increasing Personal Saving: Can
C onsum ption Taxes Help?

Treasury and Federal Reserve Foreign
Exchange O perations

The Quarterly Review is published by
the Research and Statistics Function
of the Federal Reserve Bank of New
York. Among the members of the func
tion who contributed to this issue are
LAURIE LANDY (on financial innova
tion in Canada, page 1); CARL J.
PALASH (on recent trends in the Fed
eral taxation of individual income,
page 15); ROBERT DeFINA (on wheth
er consumption taxes can help
increase personal saving, page 21).

A semiannual report of Treasury and
Federal Reserve foreign exchange
operations for the period February
through July 1980 begins on page 28.

Financial Innovation in Canada

Many of the same factors leading to financial innova
tion in this country during the 1970s— such as high
interest rates and rapid inflation— have also played an
important part in Canadian financial innovation. Given
the distinctive financial structure of each country, how
ever, the innovations have not taken necessarily the
same form. For the United States the result has been
the rapid development of highly liquid nondeposit as
sets both inside and outside the banking system, such
as money market mutual funds and repurchase agree
ments (RPs). In Canada, however, financial innovation
has been contained largely within the banking struc
ture. Although the channels through which innovations
developed in Canada and the United States have
differed, in both countries the result has been that
consumers and corporations are managing their trans
actions balances much more efficiently and are econ
omizing on their holdings of this money.
This consequence of recent financial innovation has
created difficulties for the conduct of monetary policy
in Canada, just as it has in the United States. Since
1975 the Bank of Canada has placed great importance
on controlling, through monetary targeting, the growth
of the narrow money stock— M-1 — defined as currency
plus demand deposits at chartered (commercial) banks.
The author would like to thank several members of the Bank
of Canada’s Department of Monetary and Financial Analysis
and numerous individuals of the Canadian banking community
who were extremely helpful in the preparation of this paper.
None of these individuals, however, are responsible for errors of
fact and interpretation.

Financial innovation can cause problems for a mone
tary targeting strategy, however, because it is difficult
to assess its impact on M-1 and to adjust appropriately
the targeted growth rate over time. Consequently, the
Bank of Canada has expressed some uneasiness about
“ the confidence that one can have in the stability of
the relationship between M-1, national expenditures,
and interest rates” and has cautioned that, given the
rapid evolution of the banking system, “ one cannot put
uncritical reliance on this measure of the money sup
ply as a guide to monetary policy ”.1
The most important Canadian banking innovations
affecting corporate and household money holdings
during the past few years are described in the follow
ing sections. Given this rapidly changing financial pic
ture, the final section examines the impact of these
financial innovations on the demand for money.

Corporate sector
A large part of the explanation for the slower growth
of transactions balances relative to economic activity
can be found in the changing banking practices of the
corporate sector. Since the last comprehensive Bank
Act revision in 1967, there has been a significant re
distribution in corporate banking assets .2 The propor
tion of nonpersonal deposits held as interest-bearing
1 Bank of Canada Annual Report (1979), page 25.
2 In Canada a comprehensive review of banking legislation is
conducted roughly every ten years. The last review took place in
1967, and a new Bank Act has been pending for over three years.

FRBNY Quarterly Review/Autumn 1980

Chart 2
Chart 1

D istribution of Personal Deposits at
Canadian Chartered Banks

D istribution of Business Deposits at
Canadian Chartered Banks

Percent

Percent
80------------------------------------------------------------------------

*
86-

Personal demand
deposits

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

'196566 67 68 69 70 71 72 73 74 75 76 77 78 79 80
2 0 ' ---- 1---- 1---- 1---- 1---- 1---- 1---- 1---- 1---- 1---- 1---- 1—

J ---- 1
---- 1---- 1----

1965 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80
Source:

*B o th checkable and noncheckable deposits, including
daily-interest savings accounts.

Bank of Canada Review.

Source:

Bank of Canada Review.

Chart 3

Chart 4

V elocity of Canadian Monetary Aggregates

Velocity of United States Monetary
Aggregates

Velocity
14

Velocity
8 -----------

4
M- 3

2
____

1970

2 FRBNY Quarterly R eview/Autum n 1980

11111111
1970 71

M-2

I I I I II I I II III I II I I I II I I
72
73
74
75
76
77

-»*
III
78

I I I I III
79
80

assets increased from about 35 percent in 1967 to more
than 70 percent last year, while the proportion held as
demand deposits decreased from 65 percent to 29
percent (Chart 1). The reason for this dramatic change
in the composition of corporate deposit holdings can
be found largely in the 1967 Bank Act revision. Prior to
the last Bank Act, Canadian chartered banks did not
compete aggressively for corporate deposits. Although
no legal interest rate ceiling existed on deposits, the
banks were hindered from offering a competitive inter
est rate by a 6 percent legal ceiling on bank lending.
They were also discouraged by a relatively high 8 per
cent reserve requirement on both demand and savings
deposits.
The 1967 Bank Act eliminated the interest rate ceil
ing on lending and lowered to 4 percent the reserve
requirement for savings deposits, while raising the de
mand deposit requirement to 12 percent. Also, the
remaining restrictions on residential mortgage lending
by the chartered banks were eased. These legislative
changes gave the chartered banks incentive to solicit
actively large blocks of short-term corporate funds and
to channel new and existing deposits into interestearning accounts .3
During the last five years the increased availability
of cash management techniques in Canada has
encouraged corporations to economize further on their
noninterest-earning deposits. Cash management in the
Canadian context takes the form of bank consolidation
of dispersed corporate funds into a centralized con
centration account each day. Typically, the corporate
treasurer receives a report of the company’s con
solidated balance on the morning after deposits are
made. The treasurer then has the option of placing
the funds in a bank deposit instrument, of investing in
the money market, or of paying down bank loans.
Demand accounts can thus be maintained with a zero
or near-zero balance.
The impetus for developing these cash concentra
tion accounts first came from the Canadian subsidi
aries of United States transnational corporations,
whose parents had been pressing for similar services
in their home market. During the last half dozen years,
concentration accounts in Canada have become wide
spread in the wake of protracted sharp increases in
interest rates.

3 The legislative environment remained relatively unrestricted
during the 1970s with the exception of a period between mid-1972
and early 1975 when the so-called “ Winnipeg Agreement” was in
effect. During this period the Canadian Finance Minister and the
chartered banks agreed that an interest rate ceiling of 51/2 percent
(which was raised on subsequent occasions) would be applied to
chartered bank term deposits, with maturities of less than one
year, of Can.$100,000 or more.

Coincident with the rise in interest rates were im
portant breakthroughs in computer technology. These
computer advances made the concentration of dis
persed accounts economically feasible for the banks.
Also, the oligopolistic structure of Canadian banking,
which is comprised of five major banks, each with a
nationwide network of branches, is ideally suited for
the provision of these services.
Several of the chartered banks have special com
mercial deposit accounts for their corporate cash
management customers with minimum balances of
Can.$100,000 or more. These accounts are designed
to provide an interest-bearing instrument for automatic
investment of funds from concentration accounts. The
interest rate paid on these special savings accounts is
related to the prime rate and thirty-day certificate of
deposit (CD) rate and is computed on a combination
of the minimum and average monthly balance in the
account.
In contrast to the United States, Canada does not
prohibit the issue of CDs with less than a thirty-day
maturity (CDs frequently are contracted for as short
as one day).4 Furthermore, as noted earlier, Canada
does not have an interest rate ceiling on such deposits.
As a result, interest rates for deposits at banks are fully
competitive with money market alternatives. Conse
quently, Canada has seen little, if any, growth of a
market for RPs— a mechanism which in the United States
developed largely in response to regulatory constraints.
Over recent years, cash management techniques in
Canada have spread to progressively smaller busi
nesses. What is important to the Bank of Canada’s
future targeting strategy is whether the innovations
will continue to draw in smaller accounts over time,
or whether they have already worked through the
financial system, so that all customers who would
benefit from these new arrangements are now included.

Household sector
The distribution of household banking assets between
demand deposit accounts and savings accounts pre
sents a very different picture from the business sector.
At the time of the last Bank Act in 1967, only 3 percent
of consumer accounts was held in noninterest-bearing
checking accounts, so there was not much scope for
household economizing on these types of transactions
balances. Part of the reason why so small a percentage
of total consumer- banking funds was held as demand
deposits is that Canadian consumers could also place
their assets in a bank account which was both check4 The Monetary Control Act of 1980, however, has shortened the
minimum maturity for time deposits in the United States from
the present thirty days to fourteen days.

FRBNY Quarterly Review/Autumn 1980

Box I: United States and Canadian Definitions of the Monetary Aggregates
Canada
M-1 . . . C u rre n cy p lu s d em and d e p o s its at ch a rte re d
banks.

M -1B . . . M-1 p lu s p e rso n a l and no n pe rso n a l c h e cka b le
in te re s t-b e a rin g C anadian d o lla r d e p o sits at
c h a rte re d banks.

M - 2 . . . M - 1 B plu s C anadian d o lla r perso n a l nonc h e c k a b le and fixe d -te rm d e p o s its at c h a r
te re d banks and n o n personal n o n ch e cka b le
sa vin g s d e p o sits at c h a rte re d banks.

M -3 . . . M-2 p lu s C anadian d o lla r n o n pe rso n a l fixe d term d e p o sits and b e a re r term notes at c h a r
te re d banks and fo re ig n c u rre n c y d e p o sits of
C anadian
re sid e n ts b ooked
at c h a rte re d
b a n ks in Canada.

*ATS — Automatic transfer account;
NOW — Negotiable order of withdrawal account;
RPs — Repurchase agreements.

United States
M-1 A . . . C u rre n cy plu s dem and d e p o sits at co m m e r
cia l banks.
M - 1 B . . . M - 1 A plus NOW and ATS a c c o u n ts * at banks
and th rift in stitu tio n s, c re d it union sh a re d ra ft
a cco u n ts, and dem and d e p o sits at m utu a l sav
in g s banks.
M - 2 . . . M-1 B p lu s sa vin g s and s m a ll-d e n o m in a tio n
tim e d e p o sits at a ll d e p o s ito ry in s titu tio n s ,
o ve rn ig h t RPs* at c o m m e rcia l banks, o v e rn ig h t
E u ro d o lla rs held by U n ited S tates reside n ts
o th e r than ba n ks at C a rib be a n b ra n ch e s of
m em b e r banks, and m oney m arke t m utual
fu n d shares.
M - 3 .. . M -2 plu s la rg e -d e n o m in a tio n tim e d e p o s its at
a ll d e p o s ito ry in s titu tio n s , and te rm RPs at
c o m m e rc ia l banks and sa vin g s and loan
a sso cia tio ns.
I____ M -3 plu s o th e r liq u id assets such as te rm
E u ro d o lla rs h e ld by U nited S tates reside n ts
o th e r than banks, b a n ke rs’ a cce p ta n ce s, c o m
m e rcia l paper, T re a su ry b ills and o th e r liq u id
T re a su ry s e c u ritie s, and U nited S tates sa vin g s
bonds.

Box II: Foreign Currency Deposits in Canada
F oreign c u rre n c y d e p o sits of Canadian
reside n ts
bo o ked at th e c h a rte re d banks in Canada, w h ic h are
in c lu d e d in M-3, have no e q u iva le n t in th e United
States m on e ta ry d e fin itio n s. T h e ir im p o rta n ce in C anada
re fle c ts th a t c o u n try ’s clo se fin a n cia l and co m m e rcia l
tie s to the U nited States. B o o ke d -in-C a n a d a fo re ig n
c u rre n c y d e p o s its as a p ro p o rtio n of M -3 in crea se d
fro m 3.5 p e rc e n t at the end o f 1972 to 7.7 p e rc e n t at
the end of 1979. A b o u t 95 p e rce n t of th e se d e p o sits
is d e n o m in a te d in U nited States d o lla rs, b u t no in fo r
m ation is a v a ila b le on the term co m p o sitio n .
R esident d e p o s its of fo re ig n cu rre n cy fu n d s bo o ked
in C anada have co m e to p la y an im p o rta n t role as
s u p p le m e n ts to Canadian d o lla r-d e n o m in a te d de p osits.
In p e rio d s o f m on e ta ry restrictive n e ss, these fo re ig n d e n om in a te d d e p o sits can a ffo rd the banks an a d d i
tio n a l so u rc e of fin a n ce fo r a d ju stin g to p re ssu re on

Digitized for
4 FRASER
FRBNY Quarterly Review/Autum n 1980

th e ir d o m e stic cash and liq u id ity p o sitio n . M on e ta ry
m anagem ent is also c o m p lic a te d in p e rio d s o f c u r
ren cy w eakness by re sid e n ts’ use of unhedged fo re ig n
cu rre n c y d e p o sits fo r sp e c u la tio n on fu rth e r d e p re c ia
tio n of th e Canadian d o lla r. In the pe n ding B ank A c t
revisio n the g o ve rn m e nt p ro p o se d fo r th e firs t tim e a
reserve re q u ire m e n t o f 3 p e rce n t on b o o k e d -in -C a n a d a
fo re ig n c u rre n c y d e p o sits of C anadian reside n ts.
The m onetary a g g re g a te s do n o t in c lu d e th e fo re ig n
cu rre n c y d e p o sits of C anadian reside n ts b o o ked o u t
sid e C anada. T hese d e p o s its are not th o u g h t to be
sig n ific a n t. W ith the new reserve re q u ire m e n t on
b o o ke d -in -C a n a d a fo re ig n c u rre n c y d e p osits, how ever,
th e re m ay be in ce n tive fo r th e ch a rte re d ba n ks to
tra n s fe r busin e ss to o ffsh o re centers, and the im p o r
ta n ce o f fo re ig n c u rre n c y d e p o sits b o o ked o u tsid e
C anada c o u ld thus in crease.

able and interest bearing. This checkable savings ac
count paid a nonmarket-related fixed-interest rate of
3 percent and bore some similarity to the negotiable
order of withdrawal (NOW) account in the United
States.
As in the business sector, practices introduced after
the 1967 Bank Act revision played an important role in
determining the way consumers held their banking as
sets during the last decade. Legislative changes in the
1967 Bank Act, which eliminated the lending ceiling
and changed the reserve requirement, encouraged the
chartered banks to introduce a new, noncheckable
savings account paying a market-related interest rate.
Over the next few years the banks also introduced
a number of practices to discourage consumer use of
the NOW-like checkable savings account by making it
less convenient to use than demand deposits. Many
banks thought at that time it would be more efficient to
have a two-account system, in which a part of the
funds was held as demand deposits and a portion kept
in the recently introduced noncheckable savings ac
count. Thus, deposits held in checkable savings
account form actually declined for several years after
the 1967 Bank Act and then grew very slowly during
the 1970s.
Overall, the proportion of personal banking deposits
held in savings accounts decreased in the years im
mediately following the 1967 Bank Act. A sharp fall in
checkable savings accounts more than offset the
movement into the new noncheckable savings ac
counts. The proportion held as demand deposits in
creased in this initial period. Over most of the 1970s,
however, the distribution of personal deposits at
Canadian chartered banks remained relatively stable.
(Chart 2).
Last year, though, when interest rates rose to his
torically high levels, the proportion of personal banking
funds held in demand deposits declined, as consumers
tended to economize on noninterest-bearing assets.
During this period of very high interest rates, con
sumers were able to earn a market rate of return on
their banking funds because there was no interest rate
ceiling on personal savings accounts in Canada.
Recent innovations in banking practice could make
these shifts in funds even more responsive to move
ments in interest rates. One new practice concerns
the computation of interest on the minimum daily
balance in savings accounts. An important nonprice
barrier to mobility between interest- and noninterestbearing accounts in the past was the chartered banks’
practice of calculating interest for personal savings
accounts on the basis of the minimum amount of funds
in the account each month.
The Canadian government had attempted unsuc

cessfully on two earlier occasions during the 1970s to
legislate a change in this practice. The banks argued,
however, that daily-interest payment was prohibitively
expensive, given their nationwide branch banking sys
tem, as long as the majority of their branches did not
have computer access. In the meantime, two of the
smaller chartered banks and several of the trust com
panies and credit unions had initiated daily-interest
payment accounts. Finally, in August and September
1979, with the banks well on their way to a fully com
puterized network, all five of the large chartered banks
introduced daily-interest noncheckable savings ac
counts. Interest on these accounts is 1/4 to % percent
below interest paid on minimum monthly balance
accounts.
The introduction of daily-interest savings accounts
can influence the distribution of personal bank de
posits in two ways: (1 ) funds can be shifted from other
interest-bearing savings accounts into daily-interest
accounts and (2 ) individuals can economize on demand
deposits by switching funds into daily-interest ac
counts. It is the latter course which may cause difficul
ties for a targeting strategy based upon the narrow
money stock.
One major factor presently hindering movement
between demand deposit accounts and daily-interest
savings accounts is a large fee charged by three of
the chartered banks after more than one or two month
ly withdrawals from the savings account. The fee
ranges from Can.$0.50 to Can.$1.00 for each additional
withdrawal. To some extent, individuals may begin to
avoid the fee by using credit extended through charge
cards instead of drawing down savings account bal
ances. The monthly charge card payment could then
be met by a single transfer of funds from a dailyinterest savings account to a demand deposit account.
Another recent innovation in the household sector
is an improved version of the checkable savings ac
count, introduced by two of the major banks in the
spring of this year. Like the existing checkable savings
account, this hybrid account pays a fixed 3 percent
interest rate. It represents an improvement over the
old version, however, because interest is computed
daily, and free checking is available with a small mini
mum balance. Deposits in these new accounts are
included in personal savings deposits and are subject
to a lower reserve requirement than demand deposits.
If this innovation spreads to other chartered banks, it
could become a competitor with demand deposits for
personal transactions balances.

A closer look at the Canadian monetary aggregates
The Canadian definitions of the monetary aggregates,
although generally similar to the United States mone

FRBNY Quarterly Review/Autumn 1980

tary measures, have certain distinctive features (Box I).
The Canadians in their money stock definitions include
only deposits at the chartered banks, while the United
States monetary aggregates now include, not only
deposits at commercial banks as well as thrift institu
tions, but also nondeposit instruments, such as money
market mutual funds and commercial bank RPs.5
Another important distinction is that the broadest
Canadian monetary aggregate— M-3— includes foreign
currency deposits of Canadian residents, booked at
the chartered banks in Canada (Box II). There is no
counterpart to these deposits in the United States
financial structure.
To highlight the different growth patterns over the
last decade of the Canadian monetary aggregates
relative to gross national product (GNP), the velocity
of each aggregate is illustrated in Chart 3. The veloci
ties of the narrow Canadian money measures— M-1
and M-1B— have tended to rise over the time period.
This is in marked contrast to the broader aggregates
which include savings and term deposits. The veloci
ties of these money measures— M-2 and M-3— have
been comparatively constant over the last decade.
The velocity movements of the United States mone
tary aggregates (Chart 4) are very similar to those of
Canada. The velocities of M-1 A and M-1B, which are
meant to comprise transactions balances, exhibited
a rising trend over the 1970s, while movements in
the velocities of broader aggregates— M-2 and M-3—
like their Canadian counterparts remained relatively
constant.
These velocity patterns suggest that over the 1970s
the Canadian and United States banking public desired
to hold an increasingly larger proportion of their fi
nancial assets in interest-earning instruments and had
economized on their transactions balances. The sharp
increases in the general level of inflation and interest
rates during the 1970s were important factors be
hind the velocity growth patterns. When the cost
of holding noninterest-bearing transactions balances
rose, the public tended to economize on its demand
deposits relative to the level of transactions. These bal
ances were turned over more quickly to maximize hold
ings of interest-bearing instruments.
5 The most important deposit-taking institutions in Canada, in addition
to the chartered banks, are trust companies, mortgage loan companies,
credit unions, and caisses populaires. In 1979, these nonbank
institutions accounted for 19 percent of all checkable deposits (interest
and noninterest bearing), while in 1975 their share of transactions
and quasi-transactions balances was 17 percent.
Despite their relative importance, these near-bank deposits are not,
as noted above, included in the Canadian definitions of the monetary
aggregates. An important technical problem with doing so is that
data for nonbank institutions are reported only monthly or
quarterly, as opposed to the weekly reporting procedure for the
liabilities of federally regulated chartered banks.

6 FRBNY Quarterly Review/Autumn 1980

The growth pattern of the narrow money stock—
M-1— is of particular interest to the Bank of Canada
because it has set its monetary objectives in terms
of this aggregate. The authorities decided to focus
exclusively on M-1 since earlier research suggested
that this money measure was best suited to Bank of
Canada monetary control through adjustments in the
general level of short-term interest rates.
During the mid-1970s, in both Canada and the
United States, there was a decided slowing for a
period in the growth of their respective narrow money
stocks, relative to what would be expected from
past relationships with aggregate income and interest
rates. Corporate banking innovations, in the form of
improved cash management techniques, appear to
have been important for both countries in the public’s
changing pattern of money holdings. According to the
Bank of Canada: “ In the course of 1976 and 1977 there
was a considerable acceleration for a while in the rate
at which banks’ larger customers took advantage of
new facilities provided by the banks to manage their
affairs satisfactorily with lesser current account bal
ances relative to their transactions than they had pre
viously needed.”4
In the United States a similar slowing in the growth
of the narrow money supply had been evident for
some time. The Federal Reserve Board staff describes
how “ In the period encompassing 1975 and 1976 the ex
panding use of cash management techniques was
largely responsible for the paring of transactions
balances relative to GNP— particularly by large busi
nesses— and for the corresponding jump in M-1
velocity .”7
Some rough estimates of the impact these innova
tions have had in the United States and Canada can
be made by estimating a conventional money demand
equation for each country and by calculating the outof-sample prediction errors for the periods during
which the innovations occurred. The cumulative outof-sample errors in projecting the narrow money stock
for each country as a percentage of actual levels are
illustrated in Box III. After allowing for the different
timing in the widespread adoption of the innovations,
the pattern is very similar for the two countries. In
each case, the errors in predicting quarterly growth
rates tended to cumulate very quickly during the initial
periods. As the new practices worked through the
financial systems, however, the rate of increase in the
percentage errors slowed. At the end of the two years
following the widespread adoption of cash manage6 Bank of Canada Annual Report (1979), page 24.
7 "A Proposal for Redefining the Monetary Aggregates” , Federal
Reserve Bulletin (January 1979), page 21.

Box III: Comparison of Canadian and United States Money Demand Equations
Canada:
M, = - 1 . 6 2 + 0 .7 92 M t _1 (4.37)
(13.63)

Chart 5

Out-of-Sam ple Forecasting Errors as a
Percentage of Actual Levels *

0.046F P t + 0 .184Y t
(6.73)
(5.15)

+ 0.038DUM1 -

0.026DU M 2

(3.98)

(2.68)

Percent
w h e re :
Pt :
Mt:
M t _x:
FPt :
Yt:

1974

1975

1976

1977

1978

1979

1980

* Out-of-sample forecasting errors for the two countries
are shown for different periods because widespread
usage of cash management techniques in Canada
occurred somewhat later than in the United States.

GNP p ric e d e fla to r
In (M o n e y t /P ,)
In (M o n e y ,_ ,/P ,)
In (Finance p a p e r ra te ,)
In (G N P ,/P ,)

DUM 1:

Postal s trik e dum m y va ria b le set
e qual to 1 fo r 1974-Q2 and 1975-Q4,
zero o th e rw is e *

DUM 2:

Q u a rte r a fte r p o stal s trik e dum m y va ria b le
set e qual to 1 fo r 1974-Q3 and 1976-Q1,
zero o th e rw is e *

E stim a tio n p e rio d : 1956-Q2 to 1976-Q1
United States:
M r = 0.550 + 0.7 08 M t_x (1.62)
(6.85)

0 .011R t (3.24)

0.021 D,
(1.44)

+ 0.157Y,

t Postal strike.

(4.11)
w h e re :
The e stim a te d p a ra m e ters o f the m oney dem and equa
tio n s used to m ake these fo re c a s ts are show n to the
rig h t (t s ta tis tic s are in p a rentheses beneath the c o
e fficie n ts).
* The disruption in the flow of payments during the Canadian
postal strikes (in the spring of 1974 and last quarter of 1975)
tended to inflate the level of demand deposits since checks
sent through the mail were not delivered. The resolution of the
strikes was followed by a sharp downward adjustment in the
level of demand deposits as previously undelivered checks
weie cleared. Dummy variables were included for the postal
strike quarter and the quarter immediately after the strike to
account for these temporary interruptions in payments patterns.

ment techniques, there was an 8.5 percent cumulative
overestimation in the equation for the United States and
a 7.9 percent overestimation for Canada.
The recent innovations in the household banking
sector are probably too new to have worked through
the banking system. Therefore it is still too early
to evaluate fully the impact of these innovations on
the growth of M-1 in Canada. The Bank of Canada

pt:

GNP p ric e d e fla to r

Mt:

In (M oney, / P ,)

W Rt :

In ( M o n e y ,_ ,/P t )
In (C o m m e rcia l pa p er ra te ,)

Dt :

In (E ffe ctive p a ssb oo k rate ,)

Yt;

In (G N P ./P ,)

E stim a tio n p e rio d : 1959-Q2 to 1973-Q4
(The United States e q u a tio n w as c o rre c te d fo r firs t
o rd e r a u to -c o rre la tio n w ith p = 0.650.) T he e rro rs are
c a lc u la te d by s u b tra c tin g the p re d ic te d va lu e s from
the a ctu al va lues w ith o u t any c o rre c tio n fo r past e rro rs.

said in its latest Annual Report, however, that so far
the indications are that the effect is not large .8 The
Bank does, nonetheless, consider the increasing usage
of the daily-interest savings account significant enough
to have cited the innovation as one explanation
for the relatively slow growth of M-1 during the second
8 Bank of Canada Annual Report (1979), page 25.

FRBNY Q uarterly Review/Autum n 1980

quarter of 1980.’ No action has been taken, however,
to adjust the targets for M-1 because of this develop
ment.

Conclusion
Under the stimulus of rising inflation and interest rates,
important financial innovations in the United States
and Canada during the last decade have altered the
way the public holds its monetary assets. These chang
ing practices have implications for the conduct of
monetary policy because they can make the definition
and setting of monetary growth targets more difficult.
In the United States the regulatory environment for
banking has been relatively more restrictive than in
Canada. Innovation in this country thus led, in some
part, to the development of new financial instruments
less subject to regulations. Given the impetus of rising
interest rates, the public found new nondeposit assets
to manage their transactions balances more efficiently.
The Federal Reserve’s redefinitions of the monetary
aggregates in February was partly a response to these
changing practices. With the implementation of the

9 Bank of Canada Review (June 1980), page 9.

Digitized for
8 FRASER
FRBNY Quarterly Review/Autumn 1980

Monetary Control Act over the next several years,
some of the restrictions on the banking system will be
eased.
In Canada the regulatory environment for the char
tered banks’ deposit-gathering activities has remained
relatively constant and unrestrictive through most of
the period since the 1967 Bank Act. The pending
Bank Act revision largely continues this approach.
Because bank deposit interest rates in Canada are
fully competitive with other market alternatives, there
has not been the same stimulus as in this country for
investors to place funds outside the banking system.
Recent bank innovation in Canada, in fact, particularly
for the household sector, has been more the conse
quence of advances in computer technology which
made certain practices feasible for the Canadian sys
tem of nationwide branch banking.
The Bank of Canada, while expressing caution,
remains committed to its current monetary control
strategy and the existing definitions of the money
supply. The monetary authorities will naturally have
to monitor these recent banking innovations, and
others which may follow, to evaluate their impact on
the Canadian public’s demand for transactions bal
ances over the months to come.

Laurie Landy

The
business
situation
Current
developments
Chart 1

During the summer months, econom ic
indicators signaled tha t the recession
was com ing to an end.
Millions
1.8

.61____ I____ !____ ____ l____ 1____ I____ !____ i____ I____ i____ i____ I
Percent
140----------------------------------------------------------------------------------------

1979

1980

Sources: United States Department of Commerce and
Board of Governors of the Federal Reserve System.

During the summer months, economic statistics
seemed to indicate that the recession was ending. The
index of leading economic indicators rose in June,
July, and August. Automobile sales increased from the
very low spring levels, and consumer purchases of
other goods and services picked up as well. Home
building activity also rebounded during the summer,
as mortgage rates declined rapidly from the record
levels attained during the spring (Chart 1). As the sum
mer ended, however, sharp increases in both shortand long-term rates raised questions about whether
the rebound in housing activity could be sustained and
about how strong the economic recovery would be.
Consumer spending was the primary factor con
tributing to the stronger outlook for the economy.
Retail sales in constant dollars rose 3.3 percent from
May to August, reversing about one third of the decline
of the January-May period. Consumers, nonetheless,
remained cautious, repaying an unprecedented $9.5 bil
lion in debt and maintaining a higher savings rate
(Chart 2). In part, the upturn in consumer spending
may have been spurred by the July cost-of-living ad
justment in social security benefits, which amounted
to almost $18 billion at an annual rate. The lifting of
the March credit control program also contributed to
the rebound in consumer spending. However, it is dif
ficult at this time to assess whether there has been a
lasting change in consumer spending attitudes.
Automobile sales, which had accounted for roughly
three fourths of the decline in retail sales earlier in
the year, gave a large boost to consumer spending
during the July-September period. Consumers, how
ever, still are showing a strong preference for foreign
cars, and the domestic auto producers’ share of the
market remains at a low level. The new lines of fuelefficient cars may help domestic producers gain a

FRBNY Quarterly R eview/Autum n 1980

Chart 2

Consumers have increased expenditures . ..
Index value, 1972=100
125
120
115
110

105^

N D
1979

M J
1980

A S

. . . while paying o ff a large volum e
of instalm ent debt . . .
Billions of dollars

PQR1___ 1___ I___ ___ l___ l___ I___ 1___ 1___ 1___ 1___ 1__
O

N D
1979

M J
1980

. . . and maintaining a higher savings rate.
Percent

Sources: United States Department of Commerce and
Board of Governors of the Federal Reserve System.

larger market share. At the same time, the demand
for these cars will be an important factor in determin
ing the strength of the prospective recovery.
Another key factor in determining the strength of the
recovery will be the performance of the housing mar
ket. Largely as a result of the decline in mortgage
rates during the summer, the housing market re
bounded sharply. Housing starts rose from a 900,000unit annual rate in May to 1.4 million in August, and
permits to build new housing units also increased by
more than 50 percent during these months. Despite
these large increases, housing production remains well
below the levels recorded during the third quarter of
1979.
An increase in industrial production also signaled a
turn in the economy. After six consecutive monthly de
Digitized for
10 FRASER
FRBNY Q uarterly R eview/Autum n 1980

clines, the Federal Reserve Board’s index rose in Au
gust and September. The two-month advance in the
index was broadly based. Indeed, the sizable increase
in production of durable goods was surprising because
the inventory-to-sales ratio in the durables manufactur
ing sector has not declined significantly from levels com
parable to the highest reached in the last recession.
The labor market reflected the improvement in eco
nomic activity. After rising steadily from February
to May, the unemployment rate edged down to 7.5
percent during the summer. At the same time, the
number of employed persons began to rise. A drop in
initial claims for unemployment benefits also signaled
improvement in the labor market.
Indeed, developments in the labor market— a decline
in the layoff rate and an increase in the workweek—
were important factors behind the summer advance in
the leading economic indicators. This index rose in
June, July, and August, the first series of three con
secutive increases since the summer of 1978. Besides
recent developments in the labor market, the strength
in M-2 since June also contributed to the rise in the
leading indicators.
Even as the recession seemed to be bottoming out,
inflation continued at a rapid rate. Led by a sharp
increase in food prices during July and August, the
producer price index advanced at an annual rate of
nearly 20 percent. Though the index edged down in
September, its three-month gain was still more than
twice the 6 percent rate of the second quarter.
The summer’s food price increases at the producer
level are beginning to be reflected at the consumer
level as well. In August, consumer food prices rose at
nearly a 30 percent annual rate. Despite the rise in
food prices, the consumer price index has increased
at a relatively moderate rate in recent months, largely
as a result of the rapid decline in mortgage rates
during the spring and summer and a decrease in
energy prices. In coming months, however, some of the
factors affecting the consumer price index are likely
to shift again. There is some evidence that the rapid
rise in food prices is winding down for the time
being. By October, however, the rise in mortgage rates
that began at the end of August will add to the rate
of increase in the index. In addition, energy prices are
likely to rise as a result of the continuing removal of
domestic price controls and the disruptive effects of
the military conflict in the Middle East.
All in all, the recent economic signals seemed to sug
gest that the recession was ending. Some of the recent
developments, however, raise questions about how
strong the recovery will be and leave open the pos
sibility that economic activity could decline again
after a brief upturn. The strong increase in consumer

spending, to the extent that it reflects the increase in
social security payments and the lifting of credit con
trols, may not be sustainable over the next several
months. For the automobile industry, tighter credit
conditions and possible consumer resistance to the
high prices for the new-model year point to an uncer
tain sales picture.
Home buyers also will be facing a tighter credit
market this fall. If mortgage rates rise to spring levels,

the housing recovery would be curtailed. In the busi
ness sector, inventory levels that were more comfortable
during the summer could become burdensome again
if sales taper off, particularly in light of higher financ
ing costs. And businesses continue to be cautious in
their investment plans, reducing their planned capital
expenditures for the rest of the year. Thus, even with
business indicators pointing to an end to the recession,
the economic outlook remains uncertain.

FRBNY Quarterly Review/Autumn 1980

The
financial
markets
Current
developments
Chart 1

Interest rates advanced during the summer
and early fall.
Percent
22 --------------------------------

Short-term rates

Percent
1 8 --------------------------------Long-term rates
Five-year
■Government s e c u ritie s*

Aaa-rated
corporate bonds

4l I FI I MI l I I I I IA! I I I MM I I JI I I l-l J I I I I AM IS I M l
1980
* These yields are adjusted to five-year and twenty-year
maturities and exclude bonds with special estate tax
privileges.
Sources: Federal Reserve Bank of New York, Board of
Governors of the Federal Reserve System, Moody’s
Investors Service, Inc., and The Bond Buver.

12 FRBNY Quarterly Review/Autumn 1980

The financial markets tightened substantially over the
summer and early fall. Rapid inflation, signs of a
bottoming-out of the recession, and strong monetary
growth all added to expectations of higher interest
rates. By late September, short-term interest rates
stood more than 400 basis points above the lows
reached last June (Chart 1). Long-term yields, includ
ing those on mortgage market instruments, were also
much higher than they had been at the start of the
summer. At the end of September, the Federal Reserve
raised the discount rate from 10 to 11 percent.
In announcing the increase in the discount rate, the
Federal Reserve reaffirmed its intent to contain the
pace of monetary growth. Indeed, the narrower mone
tary aggregates, M-1A and M-1B, had grown very
rapidly over the summer, making up for the shortfalls
earlier in the year when these aggregates had fallen
below the targets set by the Federal Open Market
Committee (FOMC) for 1980 (Chart 2). According to
the latest monthly statistics, M-1A was near the mid
point of the FOMC’s targets while M-1B had risen above
the top of the range. In terms of quarterly averages,
however, M-1A was in the bottom half of its target
range in the third quarter while M-1B was in the top
half of its target range. The different positions of M-1A
and M-1B relative to their respective target ranges re
flect the extremely rapid growth of “ other checkable
deposits” , which are included in the definition of M-1B
but not of M-1A.1 As a result, M-1B has outpaced M-1A
by a margin of about 2 percentage points, compared
1 Included in "other checkable deposits” are automatic transfer service
(ATS) accounts, negotiable order of withdrawal (NOW) accounts,
credit union share drafts, and demand deposits at mutual savings
banks. For additional discussion of the definitions of the monetary
aggregates, see the article “ The Financial Markets, Current
Developments” in the Spring 1980 issue of this Quarterly Review.

with the 1/2 percentage point difference between the
M-1 A and M-1B targets. The growth of the broader
monetary aggregates also picked up. For example, the
annual growth rate of M-2 over July and August was
almost twice what it had been over the three previous
months. As a result of the recent speedup, the Sep
tember level of M-2 was slightly above the upper bound
of the FOMC’s target for 1980.
In the wake of the renewed monetary growth, market
sentiment turned cautious and money market rates
jumped. After bottoming out at 6.2 percent in mid-June,
for example, the yield on three-month Treasury bills
rose to about 11 Vi percent by the beginning of October.
Similarly, the rates on certificates of deposit (CDs),
commercial paper, and other money market instru
ments paralleled the Treasury bill rate.
In response to the higher cost of funds, most com
mercial banks raised prime lending rates from the low
of 11 percent to 14 percent. At the current level,
prime lending rates are less than 2 percentage points
above the rates on commercial paper of various ma
turities— well within the spread usually separating
these rates. Just last spring, this spread had widened
to as much as 7 percentage points.
As the spread between the prime lending rate and
the rate on commercial paper narrowed, many com
panies have turned to banks for their short-term credit
needs instead of tapping the commercial paper mar
ket. In addition, some banks are bidding very aggres
sively to increase their share of this business, with
scattered reports that several major money-center
banks are making short-term, below-prime loans to
select large national corporations. Consequently, busi
ness loans expanded at a very strong pace in recent
months. From June 25 to October 1, business
loans (including loans sold to affiliates but excluding
bankers’ acceptances) increased by $8.3 billion
whereas the amount of commercial paper issued by
nonfinancial companies declined $2.7 billion. This was
essentially the reverse of the situation that had oc
curred over the previous three months when the siz
able increase in commercial paper outstanding offset
the decrease in business loans.
The recent bulge in short-term credit demand may
in part be the result of sharply higher long-term financ
ing costs. Indeed, longer term yields rose sharply
over the summer and early fall, impelled by investors’
worries that an economic recovery was beginning even
before there had been any significant letup in infla
tionary pressures. By the end of September, the rate
on five-year Government issues was 3 percentage
points above the low reached in mid-June. While yields
on Government issues with longer maturities also in
creased, the extent of the rise tended to be smaller

Chart 2

By Septem ber, M-1A stood near the
m idpoint of the FOMC’s 1980 target . . .
Billions of dollars
390
M-1A
6.0 percent
Upper bound

385
380
375
370

3.5 percent
Lower bound

Actual
365
360

I
N
D
1979

I
A

M
1980

I
J

. I.____

. . . w hile M-1B and M-2 were s lig h tly
above the upper bounds.
Billions of dollars
410

M-2
1640
1620

Upper bound

A r ''

1600
1580
1560

—/

/
",

1540

' ' '

Actual

6.0 percent
Lower bound

1520
1500

I .J - .
N
D
1979

i
J

i
F

!
A

i
i
M
J
1980

I
J

i .
i
A
S

Sources: Federal Reserve Bank of New York and
Board of Governors of the Federal Reserve System.

FRBNY Quarterly Review/Autumn 1980

the longer the maturity. Consequently, the yield curve
on United States Treasury obligations has flattened out
(Chart 3). It is unusual for the yield curve to flatten out
so soon after reverting to an upward slope during a
recession. For example, after the recovery from the
severe 1974 recession commenced in March 1975,
the yield curve remained upward sloping until mid1978. Elsewhere in the bond market, the upward pres
sure on rates has been just as strong for corporate
and tax-exempt securities as for Government issues.
With bond yields on the rise, new corporate bond
offerings have fallen off from the hectic pace of last
spring. New corporate bond issues amounted to about
$41/2 billion per month in the third quarter, more
than $2 billion below the monthly average for the
second quarter and far below the record $8.2 billion
posted in June. Some of the recent decline in new
issues involves temporary postponements, as com
panies chose to withhold new issues from the
market in the hope that interest rates will soon come
down. Still, at the pace of recent months, the volume
of new corporate bond issues remains large by histori
cal standards.
New municipal bond offerings also have been
strong in recent months, although certain strains and
stresses do appear to be developing within the taxexempt market. New issues amounted to $41/2 billion
on average in each month of the third quarter, off only
about $ 1/2 billion from the volume of the previous
three months. However, the yield curve for tax-exempt
municipal securities has taken on a very steep slope,
with the spread between one-year and thirty-year se
curities exceeding 300 basis points during much of
August. Over the past year, this yield spread was as
low as 60 basis points and averaged roughly 130 basis
points. One of the private rating companies has been
downgrading many municipal securities, and this ap
pears to have generated concern on the part of market
investors about the long-term financial prospects of
municipalities.
Mirroring the developments in the money and bond
markets, albeit with a short lag, the mortgage markets
began to get noticeably tighter toward the end of
August. Earlier in the summer, conditions had eased
considerably from the winter. In both June and July,
the effective interest rate on lenders’ new mortgage
commitments declined and lending activity picked up.

14 FRBNY Quarterly R eview/Autum n 1980

Chart 3

The yield curve on United States Treasury
obligations moved from a downward slope
in March to an upward slope in June, and
then flattened out by September.
Percent
18.00
17.00
16.00
15.00
14.00
13.00
12.00
11.00
10.00

9.00
8.00
700

10
15
20
Number of years to maturity

Source: United States Department of the Treasury and
the Federal Reserve Bank of New York.

Outstanding mortgage commitments by thrift institu
tions increased $41/2 billion during June and July, a
sizable 23 percent gain over the low reached in
May. But, as interest rates in the money and bond
markets continued to rise, conditions in the mort
gage markets started firming up in late August. By the
end of September, the yield on conventional-mortgage
commitments by the Federal National Mortgage Asso
ciation (FNMA) was about 2 percentage points above
what it had been at the mid-July auction. At the same
time, the rate on newly issued mortgage commitments
by lenders rose as much as 21/4 percentage points.
Hence, lending activity is beginning to taper off. Al
though the latest data show that the volume of new
mortgage commitments was still increasing in August,
most of these newly issued commitments were the re
sult of inquiries made many weeks earlier. Scattered
reports suggest that new inquiries from prospective
home buyers are now below what they were earlier
in the summer.

Recent Trends in the Federal
Taxation of Individual Income
The Federal individual income tax is the largest source
of Government revenue and a primary feature of the
United States economy. The tax, however, was de
signed for a noninflationary economy. As a result, in
an environment of rising prices, the impact of a partic
ular tax code on the economy changes continually.
The tax bite out of income— the tax as a percentage of
income— expands, marginal tax rates— the highest
statutory tax rates faced by individuals— climb, and the
distribution of who pays the tax is altered.
The tax code, of course, has not remained the same.
Major tax legislation was enacted in almost every year
during the 1970s. Up until recently, the tax cuts that
emanated from these legislative actions were essen
tially successful in holding down the aggregate tax
bite. However, at present the tax bite appears to be at
a historically high level. Moreover, the way in which
taxes have been cut— relying heavily on raising the
standard deduction and credits— has had dissimilar
impacts on different income levels. Individuals with
low income have benefited greatly by the tax reduc
tions, so that their tax bite actually has declined over
the years. Upper middle and upper income individuals,
on the other hand, have experienced growing tax bites.
Not until the 1978 tax legislation, the last piece of tax
legislation in the decade, was most of the tax reduc
tion directed toward them, but the reduction only partly
offset the trends of the earlier years.

Individual income taxes, growth, and inflation
The primary purpose of the Federal individual income
tax is to raise revenue. Each year the tax accounts for
almost half of the receipts of the Federal Government.

In addition to raising revenue, lawmakers have at
tempted to design the income tax system to be fair
and equitable. The income tax also has been designed
to promote certain economic goals. These goals have
been advanced by a host of incentives, such as ex
empting several types of income from taxation, apply
ing special tax rates, permitting credits for specific
purposes, and reducing the tax base— the taxable part
of income— for particular outlays .1 For example, the
exclusion from the tax base of a part of realized long
term capital gains aims in part at encouraging invest
ment and at mitigating the tax on the inflation-induced
price appreciation of capital assets.
The many goals that the income tax attempts to
achieve have led to some conflicting results. For in
stance, while the tax system attempts to ease the tax
burden of families, under certain circumstances it in
fact can impose a higher burden on married couples
than on single persons. In addition, although the tax
favors income in the form of long-term capital gains,
the taxation of dividends— another form of income from
investment— to individuals represents double taxation
as that income already has been taxed through the
corporate income tax.
In addition to promoting specific economic objec
tives, the tax system affects the economy in other
major ways. Because some features of the tax, i.e.,
personal exemptions, are fixed in dollar terms or have
a maximum limit associated with them, the taxable
portion of income swings more widely than income
1 The tax base is calculated by adjusting income for certain expenses
and then subtracting deductions and personal exemptions.

FRBNY Quarterly Review/Autumn 1980

itself. In addition, as taxpayers’ incomes expand or
contract, individuals tend to move into higher or lower
tax brackets. Both the swing in the share of income
that is taxable and the movement between tax brackets
— the bracket effect— tend to exaggerate the response
of taxes to changes in income. The elasticity of the tax
with respect to income— the percentage change in the
tax as a result of a 1 percent change in income— has
been estimated to be about 1.5.2
In a period of price stability, the high income elas
ticity of the tax makes the tax a powerful stabilizing
force in the economy. In a cyclical upturn, the tax
claims a growing share of income, reducing house
holds’ purchasing power and spending. During a busi
ness downturn, employment falters and income de
clines. As a result, the tax bite falls, thereby cushioning
the decline in spendable income.
In an inflationary period, the response of the tax to
income growth can lead to a higher collection of taxes
that compounds a cyclical downturn. Even in a reces
sion, incomes may continue to expand as a result of
climbing wages and prices. This inflation-induced rise
in income leads to a larger tax bite, which tends to
reduce households’ spending power and economic
activity. At the same time, inflation continually pushes
individuals into higher tax brackets with correspond
ingly higher marginal tax rates.
To mitigate these effects of inflation, legislation to
lower the income tax has been enacted frequently. The
tax reductions were accomplished in many different
ways. The personal exemption and standard deduction
were raised, credits expanded, and rates lowered.
The net impact of the interaction of growth, infla
tion, and legislation on the individual income tax will
be examined here, using tax return data published
annually by the Internal Revenue Service.3 The study
begins in 1965, a year after a major tax reduction was
passed into law and the start of a period marked by
high levels of inflation, and ends in 1978, the latest
year for which comprehensive data are available.
Has the tax bite risen?
In each year since 1965, individual income taxes have
grown more rapidly than incomes, except when there
was a statutory tax reduction.4 Between 1965 and 1969,
2 See Joseph A. Pechman, “ Responsiveness of the Federal Individual
Income Tax to Changes in Income” . Brookings Papers on Economic
Activity (Vol. 2, 1977).
3 Internal Revenue Service, Statistics of Income, Individual Income
Tax Returns.
4 Income is defined here to encompass the major components of cash
inflow that are related most directly to taxation. Starting with personal
income, individual social security contributions and realized capital
gains are added in. and government transfer payments are
subtracted out.

16 FRBNY Quarterly Review/Autum n 1980

While taxes tend to rise sharply with
inflation, frequent legislation has tempered
the tax bite and, to a lesser extent, the
effective m arginal tax rate.
Percent
2 0 -------

Effective marginal
tax rate*

18
16
14

Tax bite
(Individual income taxes as a
----- percentage of income)-----

12
10

J___I___I___L
1965 66

J___I___ I
74

However, the bulk of the tax reductions
have benefited lower income individuals,
so that their tax burdens have declined
w hile the tax burdens of upper income
individuals have risen.
Percent
20

15 -

Tax bite (individual income taxes as a
percentage of income)
1965
1969

1978

3
4
Income group by rank+

*The effective marginal tax rate is constructed here
by weighing statutory rates by the fraction of tax
returns for which the particular rate constitutes the
marginal rate.
t Each income group represents 20 percent of all tax
returns filed.
Sources:
United States Internal Revenue Service,
Statistics of Income: Individual Income Tax Returns,
and United States Department of Commerce.

aggregate demand pressures were strong and taxes
were raised by imposing a surcharge —10 percent at
its highest level— from 1968 to 1970. As a result, the
tax bite out of income grew sharply in the second half
of the 1960s (upper panel of the chart). The demand
pressures on capacity in the latter part of the 1960s
were not sustained continuously throughout the 1970s.
Nevertheless, inflation pressures were unrelenting, and
incomes in current dollar terms rose rapidly even in
years of considerable economic slack.
Legislation to counteract the response of taxes to
this income growth managed for most of the decade
to prevent the tax bite from rising above its peak level
of 1969.® (However, data on Federal income tax pay
ments suggest that the tax bite attained its highest level
of the postwar period in the fourth quarter of 1979 at
close to 13 percent.)4 Between 1970 and 1978 the tax
bite hovered around a level of 11 percent, about 1/2 per
centage point above its average in 1965-69. If taxes
had not been reduced by law, the fraction of income
paid as individual income taxes would have repre
sented a significantly greater share of income. Accord
ing to the estimate of income elasticity presented
above, the tax bite would have been 14 percent on
average in the 1970-78 period, or about a third more
than its actual level.
In contrast to the Federal income tax, other taxes
paid by individuals advanced more sharply in those
years. The sum of individual social security contribu
tions and state and local individual income taxes as a
percentage of income rose from 4.2 percent on aver
age in 1965-69 to 6 percent on average in 1970-78. The
rate of advance of these combined taxes was about
eight times that of Federal individual income taxes.
While the income tax bite registered only a small
increase during 1970-78, all income groups were not
affected uniformly. During the 1970s, there was a wid
ening dispersion among households in the fraction of
income paid as income taxes. The change in the dis
tribution of tax bite was primarily the result of the way
in which legislation held down the expanding taxes,
mainly through boosts in the standard deduction.

Rise in deductions
The standard deduction was raised in seven of the ten

5 The major legislation to reduce Federal personal income taxes
includes: the Tax Reform Act of 1969, the Revenue Act of 1971,
the Tax Reduction Act of 1975, the Tax Reform Act of 1976,
the Tax Reduction and Simplification Act of 1977, and the Revenue
Act of 1978.
•The payments data probably overstate the tax bite in 1979. There
seems to have been substantial overwithhoiding of taxes that year.

years between 1970 and 1979.7 This, in combination
with the inherent income sensitivity of itemized deduc
tions, caused deductions to grow faster than income
in almost every year since 1965 (table).
The standard deduction was introduced in 1944 to
simplify tax preparation. For the next twenty years, it
equaled 10 percent of a taxpayer’s income, up to a
maximum deduction of $1,000. In 1964, the minimum
standard deduction was established, setting a “ floor” to
deductions at $200 plus $100 for each personal exemp
tion. The minimum standard deduction now is $3,400
for married couples and $2,300 for single persons and
unmarried heads of household. The percentage deduc
tion was eliminated in 1977 to simplify tax preparation.
The raising of the standard deduction has led to
many more people taking the standard deduction than
in the past. Only a little more than half (52.3 percent)
of those individuals filing a tax return took the stan
dard deduction in 1970. By 1978, this percentage stood
at 73.6 percent. This growing role of the standard de
duction in the determination of taxes deserves some
analysis.
To the extent that deductions rise with income, they
are a major factor that mitigates the responsiveness of
the tax to income growth. Itemized deductions tend
to increase by themselves in line with inflation. To a
lesser extent, when the percentage deduction was
permitted, the standard deduction also rose with infla
tion. The ending of the percentage deduction therefore
increased the income elasticity of the tax.
The great expansion in the number of people taking
the standard deduction also may have made the tax
more responsive to income growth. Because the stan
dard deduction is less sensitive to growth and inflation
than are itemized deductions, the substitution by many
people of the standard deduction for itemizing has
reduced the role of deductions as a moderating factor.
However, the rise in the standard deduction has re
duced individuals’ taxable incomes, and the consequen
tial reduction of their marginal brackets has had the

7 The minimum standard deduction was increased in 1970 to between
$300 and $1,100, with the exact level depending on a taxpayer’s
income and number of exemptions; in 1971 to $1,050; in 1972
to $1,300; in 1975 to $1,600 for unmarried persons and $1,900 for
married persons; in 1977 (renamed the zero bracket amount) to
$2,200 for unmarried persons and $3,200 for married persons; in 1979
to $2,300 for unmarried persons and $3,400 for married persons.
The percentage deduction was raised in 1971 to 13 percent up to
a maximum of $1,500; in 1972 to 15 percent up to a maximum of
$2,000; in 1975 to 16 percent up to a maximum of $2,300 for
unmarried persons and $2,600 for married persons. In 1976 the
percentage deduction remained at 16 percent, but the maximum
amount that could be deducted through the percentage deduction
was lifted to $2,400 for unmarried persons and $2,800 for married
persons. In 1977 the percentage deduction was eliminated.

FRBNY Quarterly Review/Autumn 1980

opposite effect of lowering the income-responsiveness
of the tax.
The raising of the standard deduction also has in
fluenced the distribution of the tax bite. Inasmuch as
upper income individuals are most likely to itemize,
the higher standard deductions have not benefited
them very much. The tax saving from these legislative
actions has accrued mainly to lower-income and lower
middle-income groups.
This impact on the distribution of taxes has been
reinforced by the decline in exemptions relative to
income.
Relative decline in personal exemptions
Because the personal exemption is fixed in dollar
amount, its value is eroded over time by inflation. De
spite this characteristic, the exemption has not been
raised often, even though for many years it was con
sidered by the Congress to be the most straight
forward way to acknowledge the basic costs of support
ing one’s self, spouse, and dependents. From 1948 to
1969, the personal exemption stood at $600 per per
son. In the early 1970s, it was boosted in several
steps to $750.8 In 1979, it was lifted again, this time to

$ 1,000 .

As a percentage of income, exemptions have fallen
precipitously over time. Even in the period under
study they have not kept pace with income despite
the statutory increases of the early 1970s. By 1978,
the ratio of exemptions to income had fallen to half its
1965 level (table).
The impact of the relative decline of exemptions on
the tax bite has been largely offset by the rise in de
ductions. The sum of deductions and exemptions as a
fraction of income has changed little since 1965
(table). Between 1970 and 1978, the ratio of the sum
of deductions and exemptions to income was merely
0.4 percentage point lower than in the second half of
the 1960s.
While the total of deductions and exemptions as a
percentage of income has been stable since 1965, the
expansion of deductions relative to exemptions has
substantially changed the distribution of taxes across
income groups. As mentioned above, the raising of
the standard deduction has benefited mainly lower
income taxpayers inasmuch as they tend to take the
standard deduction rather than itemize. In addition, the
decline of exemptions relative to income has been
felt most heavily by upper income taxpayers because
they tend to claim a somewhat greater number of
exemptions than do lower income taxpayers, many of
•The personal exemption was set at $625 for 1970, $675 for 1971,
and $750 for 1972 and years following.

Digitized18
for FRASER
FRBNY Quarterly Review/Autumn 1980

Deductions and Exemptions as a Percentage
of Income
In percent

Year
...........
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978

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

Deductions
...............
...............
...............
...............
...............
...............
...............
...............
...............
...............
...............
...............
...............
...............

11.9
11.8
11.9
12.2
12.8
13.4
14.9
15.7
15.5
15.8
16.0
16.2
17.1
18.7

Exemptions

Sum of
deductions
and
exemptions

17.3
16.7
15.9
15.0
14.5
13.9
14.1
14.1
13.1
12.6
10.7
10.0
8.8
8.2

29.2
28.5
27.8
27.2
27.3
27.3
29.0
29.8
28.6
28.4
26.7
26.2
25.9
26.9

HHHHfna inill
whom are single individuals. Other features of the tax
also influenced the distribution of taxes in this period,
namely, the rate structure and tax credits.
Tax rates and credits
Taxes are calculated by applying tax rates to the
tax base and then subtracting credits. The rate
schedules differ according to the taxpayer’s marital
status. At present, for the same level of income, mar
ried couples filing jointly are subject to the lowest
rates, followed by unmarried heads of household,
single persons, and married couples filing separately.
All the schedules are progressive, meaning that the
tax rates escalate with income. The rates range from
14 percent to 70 percent, each rate applying to only
the increment of taxable income that falls in the rate’s
bracket. The sizes of the brackets are uneven and
tend to widen as one moves up the income scale.
The tax rate schedules have been altered occasion
ally since 1965 to influence consumer spending, the
distribution of the tax bite, and work incentives. A
surcharge was in effect between 1968 and 1970 to help
reduce aggregate demand pressures. In 1969 the
schedule for single taxpayers was lowered to bring it
more closely in line with that for married couples. The
minimum tax on preferentially treated income was
made effective in 1970 to ensure that upper income
individuals paid some amount of tax, and as of 1971
the maximum rate on earned income was set at 50
percent so as to reduce the adverse impact of the tax
on work incentives. In another major change aimed at
lessening the work disincentive effects of the income

tax, the twenty-five brackets were consolidated into
sixteen wider ones, effective in 1979. The widening of
brackets lowered tax rates by expanding the income
intervals of each rate. This change reduced the sensi
tivity of the tax to income growth by moderating the
bracket effect.
The bracket effect arises from the progressivity of
the rate schedule. In a period of growth and inflation,
taxpayers are pushed into higher rate brackets, which
act to raise taxes at a faster pace than the growth
of income. The widening of these brackets reduces the
chance that taxpayers enter a higher bracket because
of income growth. The bracket effect is largest for
those low-income households that cross the taxable
threshold. For these households, the tax rate rises
from zero to 14 percent. Thereafter, the statutory rate
advances slowly. For married couples who file a joint
return— the predominant filing status— the bracket
effect on earned income disappears at levels of earned
taxable income (i.e., wages and salaries) of $63,400 or
higher because the maximum 50 percent rate then be
comes applicable. However, increases in the level of
earned income above $63,400 still can cause “ un
earned” income, i.e., interest income, to be taxed at a
higher rate.
After tax rates are applied to the tax base, an indi
vidual’s tax liability is determined by subtracting tax
credits. Tax credits gained importance in 1975 when a
per capita credit (renamed the general tax credit in
1976) and an earned income credit were instituted. (A
one-time tax rebate on 1974 tax liability and a temporary
home purchase credit also were granted at that time.)
The general tax credit expired at the end of 1978 when
it was replaced by an increase in the personal exemp
tion. The earned income credit is available only to
low-income taxpayers who maintain a household and
have dependent children. Its purpose is to lessen the
burden of social security taxes and to mitigate some
of the work disincentives created by the income tax.
Other available credits are for child credit, retirement
income, energy, and work incentives. Apart from the
general tax credit, the tax credits have totaled only
about 2 percent of personal income taxes.
Many of the credits that have been legislated have
tended to benefit lower income taxpayers relatively
more than higher income taxpayers. This is because
some credits, i.e., the earned income and work incen
tive credits, are applicable only to lower income tax
payers. In addition, all these credits have maximum
limits which prevent them from rising proportionately
with income. These dollar ceilings of the credits also
have enlarged the income responsiveness of the tax.
In these two respects, the reliance on credits to cut
taxes has reinforced the effects of the increased stan

dard deduction. In particular, the distribution of taxes
displays the imprint of these legislative changes.

Shifting distribution of taxes
The net effect of growth, inflation, and legislation on
the distribution of the tax bite out of income has varied
over time (lower panel of the chart).9 Between 1965
and 1969, years when there were no statutory reduc
tions, taxpayers in the lowest income group sustained
the largest percentage increase in tax, with their tax
bite rising by a third. Taxpayers in the top income
group experienced the smallest advance in the tax bite,
although it still was a hefty jump. Their taxes rose
from 15 percent in 1965 to 17.9 percent of income
in 1969, a rise of 19 percent.
After 1969, the frequent tax reductions mostly im
proved the positions of the lower income groups. In
deed, in 1978 the bottom 20 percent of taxpayers paid
only 0.5 percent of their income as income taxes,
compared with 2.9 percent in 1969. All income classes
except the top 20 percent were taxed relatively less in
1978 than in 1969. The 1978 legislation, however, did
not maintain this trend. By emphasizing rate reduc
tions, replacing the general tax credit with a higher
personal exemption, and cutting the capital gains
tax ,14 the legislation targeted much of the tax reduc
tion toward more affluent groups.”
The change in income taxes for lower income indi
viduals is only part of the story, however. The sharp
decline in the tax bite of lower income groups between
1969 and 1978 in part reflected the introduction of the
earned income credit in 1975. As mentioned above, the
credit is meant to offset the social security contribu
tions of the lower income groups. Consequently, a
complete analysis of taxes needs to take account of
the impact of social security contributions on the dif
ferent income groups.
If estimates of individuals’ social security contribu
tions are added to income taxes, the tax bite dis
plays different intertemporal patterns. Between 1965
and 1969 the middle-income groups, rather than the
lower income groups, experienced the steepest ad
vance of the combined taxes as a percentage of in
come. A sharp 62 percent increase in the maximum

’ Changes over time in filing requirements make an intertemporal
comparison such as this only approximate.
1#The 1978 legislation increased the percentage of realized long-term
capital gains that could be excluded from taxable income, from 50
percent to 60 percent, and eliminated this excluded portion of these
gains from the list of items subject to the minimum tax. However,
the legislation also introduced an alternative minimum tax to which
the excluded share of long-term capital gains would be subject.
11 See Benjamin A. Okner, “ Distributional Aspects of Tax Reform
During the Past Fifteen Years” , National Tax Journal (March 1979).

FRBNY Quarterly Review/Autumn 1980

taxable earnings base for the social security tax was
primarily responsible for this result. In addition, the
social security tax rate climbed 32 percent. With the
inclusion of social security contributions, the top 40
percent of taxpayers sustained a larger tax bite in
1978 than in 1969.
Overall, the interaction of growth, inflation, and
legislative actions since 1969 has caused the distribu
tion of the tax bite to become more progressive. The
largest increase in the fraction of income paid as in
come and social security taxes has occurred among
the top 20 percent of taxpayers.

Marginal tax rates
Another important facet of the tax system is the mar
ginal tax rate— the highest statutory tax rate that
applies to a person’s tax base. The marginal tax rate
plays a significant role in many economic decisions.
For example, whether to work additional hours or to
increase the amount of income that is saved depends
to some extent on the aftertax earnings or rate of re
turn. Because the pay for working more hours or the
return from greater saving comes on top of an indi
vidual’s income, it is the marginal tax rate that de
termines the aftertax value of the extra compensation.
Since 1965 the effective marginal tax rate— the
marginal tax rates averaged over all taxpayers— has
risen in every year that did not experience a tax
reduction and even in some years in which a reduction

Digitized
FRASER Quarterly Review/Autumn 1980
20for FRBNY

did occur (upper panel of the chart). The tax cuts of
the early 1970s pared the effective marginal rate.
However, from 1973 to 1977 the rate rose without inter
ruption as the tax legislation in those years emphasized
the use of credits to reduce taxes. These credits did
not push many individuals into lower brackets. Between
the periods 1965-69 and 1970-77 the effective marginal
rate rose about 75 percent faster than the tax bite.
The marginal tax rate has risen unequally across
the income distribution, with upper income taxpayers
— those in the highest 20 percent— having experienced
the sharpest increase (lower panel of the chart). Their
average marginal rate climbed by more than 40 per
cent, from 23.7 percent in 1965 to 33.6 percent in 1977.
In contrast, the lowest 20 percent, benefiting the most
from the tax cuts of this decade, actually faced lower
marginal tax rates in 1977 than in 1965.

Conclusion
The net impact of inflation, growth, and legislation on
the taxation of individual income since 1965 has led
to several significant changes. Legislative actions to
reduce taxes have relied heavily on raising the stan
dard deduction and credits. As a result, the relative
tax reductions have accrued mainly to lower income
groups. However, except for the lowest income groups,
the marginal tax rates have increased. It was not until
close to the end of the decade that legislation began
attempting to turn around these trends.

Carl J. Palash

Increasing Personal Saving:
Can Consumption Taxes Help?

Substituting a tax on consumer spending for the per
sonal income tax is widely viewed as a way to
stimulate saving. Basically, this notion stems from the
fact that income saved is exempt from a consumption
tax while it is subject to an income tax. However, care
ful examination suggests that it is less than certain
whether higher saving will result from this replace
ment. Moreover, the many difficulties associated with
the introduction and use of a Federal consumption tax
— its potential inflationary impacts, administrative
problems, and issues of equity and intergovernmental
relations— must be weighed against any prospective
savings gains.

A Federal consumption tax: the alternatives
Americans are familiar with paying taxes on their ex
penditures for goods and services. At the state level,
for example, retail sales taxes are commonplace. While
the Federal Government also uses such levies—
mainly selective excise taxes such as the telephone
tax— it has never taxed consumer spending in a com
prehensive way. Rather, the primary sources of Federal
receipts are income-type taxes— the personal, payroll,
and corporate taxes— which account for about $9 out
of every $10 of revenue.
The Federal Government could tax overall consumer
spending in several different ways. Two of the most
widely discussed alternatives are the value-added tax
and the household expenditures tax. While the basic
concept and economic effects of these taxes are similar,
their structure and administration differ.

Value-added tax
As the name indicates, the value-added tax is levied
on a firm ’s value-added in production and distribution
of goods and services. Basically, value-added is the
difference between the dollar amount of a firm’s sales
and its purchases from other businesses. For example,
the value-added of a miller is equal to the value of the
flour he sells less the cost of wheat. In the income
statement of a firm, the value of output of the firm
is matched by the earnings of the factors used to pro
duce the product. Thus, value-added can also be cal
culated as the total payments made to a firm ’s produc
tive resources (wages, rents, interest, and profits as a
residual). In the total economy, the gross national
product (GNP) is a familiar example of a value-added
computation, totaling the value-added of a nation’s
output.
While three variants of the value-added tax are often
discussed, the so-called consumption type is the only
one seriously considered for use in the United States.1
This version is unique because it deducts from the tax
base the purchase price of newly acquired capital
assets. Since all business purchases— including acqui-

1 In addition to the consumption type, there are also the gross-product
and income types of the value-added tax. Under the gross-product
type, the deduction of neither capital purchases nor depreciation
is permitted so that the national tax base is equivalent to the GNP
in the current year. In contrast, the income type allows depreciation
deductions but is still levied on newly purchased capital goods as
well as on consumption goods.

FRBNY Quarterly Review/Autumn 1980

sitions of new capital goods— are deducted, the base
is equivalent to total consumer spending .2
In calculating the value-added tax liability, the socalled credit or invoice method is generally favored
due to its self-enforcing nature .3 Under this form, a firm
applies the tax rate to its sales in order to obtain its
gross tax liability. The firm subtracts the taxes paid by
suppliers (which are shown on its invoices) from this
gross liability, yielding a net tax liability figure. To sub
stantiate the computed liability, purchasers would de
mand receipts from suppliers stating the amount of tax
in the sales price.
Firms incur no tax liability on the purchases of inter
mediate goods, because they receive a credit from the
government for the value-added tax already paid by
suppliers. Rather, the invoice mechanism acts to push
the tax forward through subsequent production and
distribution stages to the final sales price .4 Since the
consumer does not receive a credit for this tax, it is
economically equivalent to a retail sales tax. In con
trast to retail sales taxes, however, the value-added
tax is usually not distinguished from the price of the
goods at the retail level. Indeed, this is the case in the
European Community’s use of this tax. Of course,
“ hiding” it is not a necessity, and a separate account
ing of the tax could be required.
2 The consumption-type variant of the value-added tax is the most
popular type for several reasons. On a practical level, it is easier to
apply than other forms of the tax. Since all production-material
purchases are deducted, there is no need to distinguish between
investment goods and intermediate inputs. The resulting simplifica
tion in tax accounting (e.g., elimination of the need to determine
depreciation allowances) is a feature that the income type does not
have. Also, due to the particular treatment of capital in its base
calculation, the consumption type is relatively more advantageous to
new or growing firms than other variants. By allowing the immediate
deduction of the total cost of a newly acquired asset, the consump
tion type puts firms in a better initial cash position than if the
deduction for capital were taken later on, when the resources actu
ally contribute to value-added. Firms will then be more able to
meet the substantial start-up costs encountered when initiating a
business.
3 There are two other methods of calculating the base. The addition
method is based on the fact that value-added can be calculated as
the sum of factor payments— that is, wages, rents, interest, and
profits. A firm then applies the statutory tax rate to the total in
order to calculate its tax liability. Under the subtraction method, the
firm calculates value-added by simply subtracting purchased inputs
from sales. Its tax bill is then determined by applying the appropriate
tax rate.
* It is generally assumed that the entire consumption-type valueadded tax liability is passed forward to consumers in the form of
higher prices. For example, in Britain, the Richardson Committee
stated that in all probability the value-added tax would be fully
passed on in higher prices. Full forward shifting is also assumed
in the description of such a tax by a European Community research
group in a report studying tax reform. In the Netherlands, estimates
made by the Central Planning Board prior to the implementation of
this tax assumed full forward shifting, as did the French government.
For an extended discussion, see Eric Schiff, Value-Added Taxation
in Europe (Washington, D.C.: The American Enterprise Institute,
1978), pages 24-25.

22 FRBNY Quarterly Review/Autumn 1980

Household expenditures tax
Another form of consumption taxation— though one
commanding far less attention than the value-added
tax— is the household expenditures tax (also known as
a spendings tax ).5 Under this tax, consumers file an
annual return, providing information necessary for the
calculation of their total expenditures during the year,
with the amount of the tax due based on these outlays.
In this way, the administration of the tax resembles
that of the existing personal income tax and differs
from the collection procedure of the value-added tax,
under which the legal liability falls on the producers of
goods and services even though the consumer ulti
mately pays the tax.
A tax on spending does not require extensive records
on expenditures during the year. Instead, consumers
would figure annual expenditures indirectly as the
difference between their income and the net increase
in saving. The net increase in saving is determined as
the amount by which the value of financial assets added
to saving in a year exceeds the value of assets with
drawn from saving during that same period. (Unrealized
capital gains or losses are not recognized in the mea
surement of net saving, since they would not affect the
expenditures estimates. Any adjustment in asset value
represents an equal change in both income and saving
if it is unrealized during the year and would, therefore,
net to zero in calculating expenditures as the residual.)
Careful bookkeeping of changes in wealth is required,
though this task is most likely less onerous than ac
counting for all outlays.

Consumption taxes and saving
Replacing the income tax with a consumption tax (such
as the value-added tax or spendings tax) is widely
viewed as a boon to saving. Total saving is expected
to rise because of two adjustments which result from
the tax substitution: an increase in the aftertax rate of
return to saving and a redistribution of disposable in
come.
Alternative taxes and the return to saving
When a person saves, present consumption is delayed
in exchange for future consumption. By replacing the
income tax with a consumption tax, the rate of return
to saving (that is, the value of additional future con
sumption per dollar of postponed current consumption)
increases. The basis for this lies in the amount of in-

5 Both India and Ceylon used a personal spendings tax in the late
fifties and early sixties. However, both countries restricted the tax
base to such a small number of upper income persons that the
revenue yield was not considered worth the burden of compliance
and administration.

Rate of Return to Saving under the Alternative Taxes
Derivation of the rate of return
Income ....................................................................................................................................... ........................
Tax rate ..................................................................................................................................... ...................................
Maximum current period consumption* .............................................................................
Maximum current period savingf .......................................................................................
Assumed market rate of return on saving .........................................................................
Gross market return on saving}: .........................................................................................
Maximum consumption possible with gross return on saving! ................................... .................................

Income tax

Consumption tax

$ 100
20%

$100
25%
$ 80
$100
10%
$ 10
$ 8

$6.40

Rate of return to postponed consumption!! ....................................................................... ........................ - S ± ° = e%
$80

$8
-— =10%
$80

* With a 20 percent income tax, only $80, i.e., $100 (1—0.2), is left after taxes to spend. With a 25 percent expenditures tax, a similar
result obtains. The tax liability incurred by $1 of expenditure is 250. Thus, $80 worth of expenditure would exhaust the $100 in
income since the remaining $20 is owed as tax.
f Under an income tax, only $80 is available after tax to save. Since under a consumption tax a tax liability is incurred only
if income is spent, the entire $100 can be saved.
t The gross return (i.e., before taxes) under the income tax equals the amount saved and invested times the market rate:
$80 x 10% = $8. Under the consumption tax, $100 was saved, thus the return equals $100 X 10% = $10.
§ The return under the income tax provides only $6.40 of additional consumption, since the gross return ($8) is subject to a 20
percent tax rate before it can be spent. As described above, the $10 return arising under the consumption tax can buy at most $8 of
consumption, with the remaining $2 representing the tax payment.
|j Expressed as the ratio of the additional spending made possible by saving to the present consumption postponed due to that saving.
i.e., line 7 of the table divided by line 3.

come available for investment under each tax.6
The differing rates of return associated with the alter
native taxes are illustrated in the table. For purposes
of comparison, the income and consumption tax rates
are set so that the most an individual can consume
with his current income is the same under each tax
($80 in the example), and that all his present income
is saved and invested at some assumed market rate
(10 percent). Under the income tax, the tax liability is
incurred before the individual decides what to do with
his money— whether he spends or saves all of it, or
does some combination of the two. This is not true in
the case of the consumption tax. Here, the tax liability
is created only when the income is spent. By postpon
ing current spending the tax liability associated with
that spending is also deferred and is thereby available,
in addition to the value of the delayed consumption, for
investment. Thus, in the example, a total of $100 can
be invested under the consumption tax ($80 of post
6 The following is influenced by Richard Goode, The Individual
Income Tax (Washington, D.C.: The Brookings Institution, 1976).
It is assumed throughout, for purposes of comparison, that the taxes
considered give rise to equal yields. For a related discussion,
see the paper by James Fralick in Jared Enzler, ed., Public Policy
and Capital Formation (Board of Governors of the Federal Reserve
System, forthcoming, 1980).

poned consumption and $20 of postponed tax liability),
as opposed to $80 under the income tax.
Since more of the taxpayers’ income can be invested
under a consumption tax than under an income tax, the
earnings on the initial investment will also be greater.
But it is not simply the money earned that is of prime
concern. Rather, in determining the rate of return on
the initial postponed consumption, the value of future
consumption that can be purchased with that money is
of key importance. Under the income tax, interest in
come is subject to the tax before being spent, and thus
only a fraction of the gross return represents additional
consumption (80 percent or $6.40). Likewise, the in
come earned under the consumption tax will not totally
represent additional consumption, since part of the
money must be used to pay the tax on purchases of
goods and services. After taxes are fully accounted for,
and the net-of-tax return in each case is compared
with the amount of postponed spending which gave
rise to the additional consumption, the rate of return
under the consumption tax exceeds that available un
der the income tax (in the example, 10 percent as
opposed to 8 percent), and equals the market rate of
return.
In sum, taxpayers can escape the current consumption

FRBNY Quarterly Review/Autumn 1980

tax liability on income that is saved. By being allowed
to invest both the value of the postponed consumption
and the deferred tax liability, enough additional future
consumption is made available to yield a market rate
of return on the initial postponed spending. The benefit
of investing the delayed tax liability on income intended
for saving is not available under the income tax, the
result being an aftertax rate of return less than the
market rate.
Although it is sometimes taken for granted that an
increase in saving will result from the higher return,
the impact is, in principle at least, unclear. While the
incentive to save is increased by a more lucrative re
turn than under the income tax, there is also reason to
decrease saving since the higher rate of return allows
a desired level of wealth to be achieved with less
saving.
Empirical studies on the impact of the rate of return
on saving also fail to provide a consensus. Some of
the results support the notion of a positive response of
saving to an increase in the aftertax rate of return,
while others indicate no response at all.7 Moreover,
even in those studies which find a positive relation be
tween interest rates and saving, the impact is found to
be numerically modest— on the order of a 0.4 percent
rise in private saving for every 1 percent increase in
the aftertax rate of return. One point seems clear: the
presumption that a higher return to saving (resulting
from the tax substitution) will spark a substantial in
crease in the amount of saving undertaken (or any
increase at all) is not well founded. Much ambiguity
remains and, until more information becomes available,
such a conclusion is premature.
Increasing the capacity to save by redistributing taxes
A change in the form of taxation also can increase
total saving by redistributing income. Insofar as differ
ent groups have differing tendencies to save out of an
additional dollar of income, total saving can be in
creased by simply shifting the distribution of income
toward consumers likely to save an above-average
portion of the extra income. If a consumption tax is
substituted for the income tax, disposable income will
be distributed differently, but the question remains
whether saving will be increased.
7 Estimates of a positive response can be found in Colin Wright,
“ Some Evidence on the Interest Elasticity of Consumption” , American
Economic Review (September 1967), pages 850-55; and Michael
Boskin, “ Taxation, Saving and the Rate of Interest", Journal of
Political Economy (Part 2, April 1978), pages 1-25. A critique of the
Boskin results, as well as evidence for the insensitivity of saving
to interest rate changes, is contained in Philip Howrey and Saul
Hymans, “ The Measurement and Determination of Loanable-Funds
Saving” , Brookings Papers on Economic Activity (1978, 3),
pages 655-85.

Digitized24
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FRBNY Quarterly Review/Autumn 1980

Available evidence indicates that in any given year
saving as a fraction of income tends to increase with
income. Since the income tax is progressive— i.e., the
higher the income level the greater the tax payments
as a percentage of income— its burden is heavier for
those with above-average ratios of saving to income.
In contrast, the consumption tax burden is heavier for
those with lower savings rates. Hence, the tax sub
stitution would reallocate disposable income toward
the group which, on average, saves more.
However, this does not necessarily insure an In
crease in aggregate saving, since a group with a higher
average savings rate may not save the average rate
out of an additional dollar of income. The high-income
groups might save more or less, making it difficult to
know precisely what the net effect would be. To the
extent that high-income groups do save more out of
each additional dollar than low-income groups, intro
ducing a consumption tax would tend to increase total
saving since the additional saving of upper income
groups resulting from their increased income would ex
ceed the fall in saving of lower income groups result
ing from their decreased income. Alternatively, if the
proportions in which different income groups save and
spend the additional income are the same, there w ill be
no effect. In this case, income is simply redistributed
among groups which have an equal tendency to save
(or dissave) the additional income. The additional sav
ing of upper income groups would exactly offset the
decreased saving of lower income groups.
Empirical studies of consumption behavior provide
indirect information on this redistributive effect, though
the results are not clear-cut.8Analyses of the consump
tion behavior of different income groups in a single
period reveal a positive relationship between the aver
age and the incremental behavior.9 Calculations based
upon these findings indicate that the increase in saving
resulting from a redistribution of tax burdens would
range from 6 percent to 10 percent of the total tax yield
involved in the switch .10 In other words, saving would
• The potential effect on saving cannot thoroughly be studied without
also considering the impact of the redistribution on investment and
on total income. However, rather than complicate matters, a useful
first approximation to the effect on saving can be obtained by assum
ing that personal income remains constant. With this simplification,
the question of how much people save from an additional dollar of
income can be reinterpreted as how much is consumed from that
dollar— a question which has been studied extensively.
9 For example, Ralph Husby, “ A Nonlinear Consumption Function
Estimated from Time-Series and Cross-Section Data", Review of
Economics and Statistics (February 1971), pages 76-79.
10 A survey and brief discussion of these estimates can be found in
George Break, "The Incidence and Economic Effects of Taxation",
in Alan Blinder, et at.. The Economics of Public Finance (Wash
ington, D.C.: The Brookings Institution, 1974), pages 192-94. These
estimates only consider flat-rate consumption taxes.

increase by $6 billion to $10 billion for every $100
billion of personal income tax replaced by a consump
tion tax. However, there is a difficulty in the interpre
tation of cross-sectional results for the purpose of
resolving questions about income redistributions. More
over, in contrast to the cross-sectional results, timeseries analysis supports the idea that a redistribution
of income will not affect total saving .11 While current
thought favors the time-series conclusion that little
permanent savings gain can be obtained by redistrib
uting income, it appears that, in practical terms, no
definite conclusions about this mechanism can be
drawn at present.12 More information is necessary.
Furthermore, even if the redistributive mechanism
resulted in an increase in saving, any progressivity in
the structure of a consumption tax which replaced the
income tax would likely lower the gain in saving rela
tive to that available with a flat-rate consumption tax.
Simply put, replacement of the income tax with a pro
gressive tax would shift less of the tax burden from
upper to lower income groups than replacement by a
flat-rate tax. Most policies recommending the use of a
personal spendings tax usually include the provision of
a graduated or progressive rate structure. While a
progressive rate structure, per se, is not an issue in
the case of the value-added tax, certain exclusions in
the tax base used to mitigate the potential increased
tax burden to low-income households (discussed be
low) would cause a similar reduction of the gains in
saving from the redistributive effect.

Costs of the tax change
The possibility of increased personal saving is only
one aspect of the tax substitution scheme. Such a
massive overhaul of our tax structure raises several
other difficult questions which need to be explored.
These include the potential inflationary impact of the
tax switch, considerations of equity, the relative ad
ministrative burdens of the taxes, and issues of inter
governmental relations.
Inflationary potential of the substitution
Concern is often expressed that the replacement of
11 For example, Alan Blinder, “ Distribution Effects and the Aggregate
Consumption Function” , Journal of Political Economy (June 1975),
pages 447-75.
12 Even if aggregate saving is not independent of the income distri
bution, a qualification related to the redistributive effect must be
noted. The magnitude of the change in aggregate saving will not,
in general, be reflected in the simple difference between the average
of the marginal savings propensities of the high and low savers.
Rather, it will depend upon the weighted average of the marginal
propensities to save, where the weights are the fraction of the total
tax burden borne by each group. Thus, the redistributive effect may
be diminished substantially, depending upon the incidence patterns
of the taxes considered.

the income tax with a value-added tax may initiate or
intensify inflationary pressures. However, a major
structural tax change primarily alters the method by
which government funds are collected from taxpayers.
Surely relative prices can change, but how is it pos
sible for the average level of prices to rise continu
ally, or to increase at all, because of the tax substitu
tion? The answer lies both in the way price changes
are measured and in the potential reactions to price
level increases.
The nation’s foremost barometer of inflation— the
consumer price index— does not treat all taxes equally.
In particular, the income tax is not reflected in the
price index whereas a value-added tax would be, since
the latter is included in the price of goods at the retail
level. As a result, a retail price increase attributable to
an increase in the value-added tax is reflected in the
index just as is a price rise due to cost or demand
pressures. By shifting from an income tax to a con
sumption tax, the consumer price index would initially
jump because the reduction of income taxes would not
be tallied in the index while the increase in the valueadded tax would. Of course, the one-time increase in
measured inflation is not, on its own, disconcerting.
However, this essentially spurious rise in measured
prices can have longer term effects. In particular, the
initial price increases could both indirectly exacerbate
inflation by raising inflationary expectations and di
rectly spur inflation through cost-of-living adjustments.
These likely reactions make hiding the value-added tax
in the final sales price detrimental from an inflationary
perspective, since consumers and government would
be less able to differentiate tax changes from price
changes due to market forces.
Equity considerations
In addition to inflationary concerns, another source of
opposition to the use of consumption taxes in place
of an income tax is rooted in equity considerations.
Because consumption taxes are borne relatively more
heavily by lower income groups, in contrast to the pro
gressive income tax, the substitution diminishes the
progressivity in the Federal tax structure. This charge,
while perhaps not applicable to a spendings tax with a
graduated rate structure, is relevant for a consumption
value-added tax levied in a flat-rate, no-exemption form.
Dealing with equity issues always involves difficult
trade-offs. One important problem is that schemes to
relieve the regressivity of a consumption tax may be
self-defeating, since the potential gains in saving from
a redistribution of disposable income are reduced as
the consumption tax is made more progressive. More
over, these schemes necessarily complicate the admin
istration of the tax.

FRBNY Quarterly Review/Autumn 1980

Among the ways of reducing the regressivity of the
value-added tax are selected deductions— e.g., the
exclusion of food purchases from the tax base— or the
use of multiple rates.13 However, in addition to a signifi
cant erosion of the tax base, preferential treatment can
also cause inefficient use of society’s resources, since
the relative prices of items would not reflect their rela
tive production costs. As a result, too many resources
are channeled into the production of the exempt goods,
while too little resources are allocated to making the
taxed goods. A credit for low-income consumers, simi
lar to the earned income credit, is one alternative to
offering exemptions. Another possible solution is to
adjust other taxes to compensate for the reduction of
progressivity, although this, too, can have adverse side
effects.
Administrative considerations
A truly comprehensive tax is difficult to implement, and
both the value-added tax and the spendings tax have
troublesome administrative aspects. Some of the prob
lems also arise with the income tax, but others are
unique to consumption tax use. Any realistic consump
tion tax proposal must face up to these technical mat
ters .14 In the case of the value-added tax, for example,
a different procedure for calculating the tax base might
be necessary in certain industries for which valueadded is difficult to identify. Examples of these are
banking and insurance, where the addition method, as
opposed to the invoice method, is more appropriate.
A spendings tax also introduces new and complex
compliance requirements both for taxpayers and the

13 The Ullman value-added tax bill, H.R.7015, exempts the retail sale
of food and nonalcoholic beverages (including restaurant sales), the
sale and rental of residential real property for use as a principal
residence, medical care (including prescription drugs), and sales
to government entities. Also exempt are exports, nonretail sales by
farmers and fishermen, mass transit in urban areas, activities of
tax-exempt organizations (as described in Section 501 (c) (3) of
the Internal Revenue Code), other than unrelated business activities,
educational activities of governmental entities, and interest. In addi
tion, a small business with sales below $20,000 a year could elect
to be exempt from the value-added tax.
14 The following discussion is by no means a comprehensive catalog
of the administrative issues associated with the consumption taxes.
For a more complete discussion, see The Value-Added Tax and
Alternative Sources of Federal Revenue (Washington, D.C.: Advisory
Commission on Intergovernmental Relations, August 1973); Richard E.
Slitor, “ Administrative Aspects of Expenditures Taxation", in Richard
Musgrave, ed., Broad-Base Taxes: New Options and Sources
(Baltimore: Johns Hopkins University Press, 1973); and the contrast
ing papers of David Bradford and Richard Goode in Joseph Pechman,
ed., What Should Be Taxed: Income or Expenditure? (Washington,
D.C.: The Brookings Institution, 1980). For some possible approaches
to certain administrative difficulties arising with consumption tax use,
see the United States Treasury publication, Blueprints for Basic Tax
Reform (Washington, D.C.: United States Government Printing Office,
January 1977).

26 FRBNY Quarterly Review/Autumn 1980

government. The calculation of net saving means ac
counting for income items not recognized by the in
come tax. These cover, among others, cash gifts and
interest on state and local bond holdings. Moreover,
extensive purchases and sales of assets would make
government monitoring of tax returns extremely difficult.
The purchase of durable goods would also present a
unique problem. The cost of a consumer durable good
should be spread over several years to reflect more
accurately both the flow of service provided by the
good (that is, the actual consumption of the good)
and the purchaser’s capacity to pay taxes. Obviously,
such an adjustment greatly complicates the tax. A re
lated issue is the treatment of the sale of a durable
good prior to the end of its full service life. Some type
of credit provision would be necessary if tax is initially
paid on the full purchase price.
Expenses due to hardship would most likely require
special consideration under a spendings tax, though
this would cause administrative difficulty. For example,
spending on repairs to a storm-damaged home would
surely warrant different treatment from that for luxury
items. Certain medical expenses are another involun
tary expenditure that could be treated separately. How
ever, a unique handling of hardship outlays introduces
arbitrariness into the calculation of the spendings tax
base, since that expenditures category is fairly broad
and open to various interpretations .15 Furthermore,
such special treatment would increase the record
keeping requirements and reporting complexities of the
tax. Expenditures could no longer be calculated as
simply the difference between income and the net in
crease in saving, since preferential treatment of certain
expenditures requires explicit accounting for those
items.
Life insurance payments, too, would cause adminis
trative difficulty under a spendings tax since these
partly represent saving, with the proportion depending
upon the particular type of policy held. A technically
accurate method of handling these payments is to
allow as saving that part of the premium which in
creases the cash value of the policy. However, this
would introduce a significant record-keeping burden to
1SThat special treatment of certain categories causes administrative
problems is evident from actual experience. In Britain, for example,
authorities were forced to determine if a popsicle was foodstuff, and
thus exempt from their value-added tax ( Wall Street Journal, No
vember 21, 1979), page 1. Similarly, Burberry’s Ltd. is currently
engaged in a dispute with the United States Customs Service over
the categorization of its trench coats. Due to epaulets on the coat,
the Customs Service wants it classified as an "ornamented garment”
and thus subject to more than four times the tax rate of garments
that are not ornamented. Burberry’s argues that the epaulets are not
just ornamentation but
. . the essence of the garment’s traditional
appeal” ( ‘‘Trench Coat under Fire from Customs” New York Times,
August 13, 1980, page D4).

taxpayers, in addition to being difficult for the govern
ment to monitor.
Issues of intergovernmental relations
Since not all areas have similar income distributions
and consumption patterns, the replacement of the in
come tax with a consumption tax will result in an
increased tax burden in certain regions. Thus, the
tax change could make it politically impossible for
these states and localities to increase their taxes fur
ther in the case of budget needs, as the combined tax
bill would provoke resistance. This direct competition
for state and local funds is an important issue in the
decision to introduce consumption taxes.

Conclusions
Substituting a consumption tax for the personal income
tax is a tax reform of huge proportions with potentially
significant consequences. Proponents view it as a
policy measure to increase saving. But careful review
suggests their arguments are not completely convinc
ing. Indeed, the evidence in favor is fragmentary at
best, and at present there is no conclusive evidence
that this change would increase saving significantly.
Moreover, there are negative side effects which could
result from the replacement. Before such a change is
implemented, more assurance should be given that the
gains from the tax substitution outweigh its prospec
tive costs.

Robert DeFina

FRBNY Quarterly Review/Autumn 1980

February-July 1980 Semiannual Report
(This report was released to the Congress
and to the press on September 3,1980.)

Treasury and Federal Reserve
Foreign Exchange Operations
Dollar exchange rates fluctuated widely over the sixmonth period under review. Numerous political and
economic crosscurrents tended to impart volatility to
the exchange markets. These included the profusion
of uncertainties surrounding political developments in
Iran and Afghanistan and the shifting prospects for
major industrial economies in dealing with the ill
effects on their inflation rates and current account
positions caused by the further rise in prices for oil.
Market participants were also concerned about the
possibilities of unsettling capital flows as the Or
ganization of Petroleum Exporting Countries (OPEC)
sought to invest the excess funds generated by their
massive current account surpluses. Nevertheless, the
broad movements in exchange rates during the pe
riod resulted largely from the relative pressures of
the demand for money and credit in the United States,
compared with other industrial countries and as re
flected in sharp swings in interest differentials between
investments in dollars and other major currencies. On
balance, the dollar advanced sharply through early
April during the time in which there was an intense
scramble for funds and soaring interest rates in the
United States. Once that scramble subsided and United
States interest rates fell back through mid-June, the
dollar also declined. Thereafter, the dollar remained
A report by Scott E. Pardee. Mr. Pardee is Senior Vice President in
the Foreign Department of the Federal Reserve Bank of New York and
Manager of Foreign Operations for the System Open Market Account.

Digitized28
for FRASER
FRBNY Quarterly Review/Autumn 1980

vulnerable to bouts of selling pressure each time do
mestic interest rates tended to soften. But the selling
pressures did not cumulate. By late July, with money
demand in the United States picking up once again,
interest rates here turned firmer and dollar rates in
the exchange market also firmed. By this time also,
the dollar was bolstered by the underlying improvement
in the United States trade and current account posi
tions and by indications of some reduction of our
inflation rate.
For its part, throughout the period the Federal
Reserve continued to adhere to the approach adopted
last October 6, emphasizing bank reserves rather than
the Federal funds rate as the primary operating vari
able in seeking to limit the growth of the monetary
aggregates. When the demand for money and credit
became extremely heavy in February and March, large
ly on the buildup of inflationary expectations at the
time, the Federal Reserve’s approach meant that
not all the demand was met by increases in bank
reserves. This effort was reinforced by the broader
anti-inflation program announced by President Carter
on March 14, which featured a tightening of fiscal
policy but also included a program of special credit
restraint by the Federal Reserve. Subsequently, when
the demand for money and credit fell slack, and indeed
the economy began to contract sharply, interest rates
declined. Consistent with its approach, the Federal
Reserve provided bank reserves at about the same
pace as before. In late May and early July the special

credit restraints were eliminated in two steps. Many
market participants expressed concern that, by allow
ing interest rates to decrease so sharply and by elim
inating the special credit restraints, the Federal Re
serve was giving up on its anti-inflation efforts. This
was hardly the case as reiterated by Chairman Volcker
in testimony to the Senate Banking Committee in late
July. Moreover, as the demand for money and credit
regained strength in the United States toward the end
of the period, the Federal Reserve’s approach again
meant that these demands were not fully accommo
dated.
In the context of unsettled exchange market condi
tions and volatility of exchange rates, the United States
authorities intervened frequently during the six-month
period, operating on both sides of the market. In the
early phase through early April when the dollar was in
demand, the United States authorities were able to
acquire sufficient currencies in the market and from
correspondents to repay earlier debt and to build up
balances, buying German marks, Swiss francs, and Jap
anese yen. By late March-early April, the Trading Desk
intervened on several occasions openly as a buyer of
currencies to counter disorderly conditions in the mar
ket. Subsequently, when the dollar came under bursts
of heavy selling pressure, the United States authori
ties intervened in size, selling German marks, Swiss
francs, and French francs. By the end of July, the
United States authorities were again accumulating cur
rencies to repay swap debt and rebuild balances.
For the period as a whole, total intervention sales of
currencies amounted to $3,982.7 million equivalent, of
which $3,530.6 million was in German marks, $291.4
million was in Swiss francs, and $160.7 million in
French francs. Total acquisition of currencies amounted
to $6,266.9 million, of which $1,476.2 million was in the
market and $4,790.7 million was from correspondents;
by currency, the acquisitions were $5,691.1 million of
German marks, $357.8 million of Swiss francs, $216.8
million of Japanese yen, and $1.2 million of French
francs. As indicated in Table 2, as of July 31, the
Federal Reserve’s swap debt to the German Bundes
bank was $879.7 million equivalent and to the Bank
of France was $166.3 million equivalent. Also during
the period, as shown in Table 1, the Federal Reserve’s
reciprocal swap arrangement with the Bank of Sweden
was increased by $200 million to $500 million.
Through the first seven months of the year, the
Federal Reserve and the Treasury both realized profits
on foreign exchange operations. Table 5 shows that
the System realized $14.5 million, the Exchange Stabi
lization Fund realized $45.8 million, and the Treasury’s
General Account realized $71.2 million in profits. On
a valuation basis, as of July 31 the System showed

$19.2 million in gains on outstanding foreign exchange
assets and liabilities. However, the Exchange Stabili
zation Fund and the Treasury’s General Account
showed $325.8 million and $163.0 million in losses, re
spectively, on outstanding foreign exchange holdings
and commitments.

German mark
During the winter of 1979-80, as the exchange markets
focused on the uncertainties surrounding the United
States strategic and financial position in the Middle
East and on the dollar’s role as a reserve asset, the
German mark had been bid up in the exchanges to a
record high against the dollar. But before long the
prospects for the continued appreciation of the mark
became clouded. The massive increase in world oil
prices and the expansion of the German economy had
generated a far more rapid increase in import expendi
tures than in export revenues, leading to a dramatic
turnaround in Germany’s current account position. The
current account had already swung from surplus into
a DM 10 billion deficit in 1979, and an even larger defi
cit of as much as DM 20 billion was expected this year.
Inflation also accelerated rapidly under the pressures
of an economy running close to productive capacity
and the persistent buildup of energy costs. Moreover,
events in the international arena added to the market’s
sense of caution. Although political tensions in the
Middle East still raised the possibility that holders of
dollars from that region might switch into marks, the
deterioration in great power relations following the
Soviet invasion of Afghanistan also raised concern
about Germany’s exposure in Western Europe. As a
result, capital began to flow out of the mark in search
of other havens.
In these circumstances the mark had already slipped
back from its highs early in the year to DM 1.7414 by
end-January, and subsequent bouts of buying pressure
did not readily cumulate. Thus, on two occasions in
early February when concern about the dollar brought
the mark into bursts of demand, the United States au
thorities quickly restored balance to the market with
sales of $240.8 million equivalent of marks. These sales
were financed out of balances of the Treasury and the
Federal Reserve and by drawings of the Federal Re
serve in the amount of $115.4 million under the swap
line with the German Bundesbank. These operations
raised the System’s total mark swap debt with the
Bundesbank to a peak of $2,746.3 million equivalent
for the six-month review period and steadied the mark
around DM 1.7375.
In view of the deterioration in Germany’s inflation
and balance-of-payments performance, German eco
nomic policy moved toward greater restraint. The

FRBNY Quarterly Review/Autumn 1980

Table 1

Federal Reserve Reciprocal Currency Arrangements
In millions of dollars
Amount of facility
January 1, 1980

Institution

Increase effective
May 23, 1980

Austrian National B a n k ...................................................................
Bank of Canada .............................................................................
National Bank of D e n m a rk............................................................
Bank of England ...........................................................................
Bank of F ra n c e .................................................................................
German Federal Bank ...................................................................
Bank of I t a ly .....................................................................................
Bank of Japan .................................................................................
Bank of M e x ic o ...............................................................................
Netherlands Bank ...........................................................................
Bank of N o rw a y ...............................................................................
Bank of S w e d e n ...............................................................................
Swiss National B a n k .......................................................................
Bank for International Settlements:
Swiss francs-dollars .................................................................
Other authorized European currencies-dollars.....................

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

6,000

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

700
500

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

300

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

600
1,250

200

Chart 2

The Dollar Against Selected
Foreign Currencies

Selected Interest Rates
Three-month m aturities*

Percent

I ................
Japanese ven
A

v \ r~

V ^ S w is s franc

// \\
* \\
// A
A \
£ f\\

4 *

»*
t\
\
S

/N
*

r
German mark
-

Pound sterling

10 -

I I
—15L
J

I
A

I I
S O
1979

I
N

I
D

I
F

1 1
1 1 1 J
A M
J J
A
1980

Percentage change of weekly average of bid rates
for dollars from the average rate for the week of
July 2-6, 1979. Figures calculated from New York
noon quotations.

Digitized 30
for FRASER
FRBNY Q uarterly R eview/Autum n 1980

♦Weekly averages of daily rates.

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
500
4,000
600
1,250

200

Chart 1

Amount of facility
July 31, 1980

30,300

authorities feared that rising energy prices would un
leash a cycle of wage-price increases. Already there
was some evidence of accelerating purchases by con
sumers and a buildup of business inventories, partly
on the expectation of more inflation to come. Also, the
uncertain outlook for capital inflows raised concerns
about the prospects for financing the large current ac
count deficit. Accordingly, the pace of government
expenditures had already been reduced. On February
28 the Bundesbank raised the discount rate by 1 per
centage point to 7 percent and the Lombard rate by
1 1/2 percentage points to 81/2 percent. But, to prevent
liquidity from tightening too far in the face of a sea
sonal increase in money demand, the Bundesbank also
increased commercial banks’ rediscount quotas by DM
4 billion and removed borrowing limits under the Lom
bard facility. These actions brought official rates in
line with German money market rates which were ris
ing as the authorities kept the growth of central bank
money within the 5 to 8 percent annual growth range
in the face of mounting credit demands.
Meanwhile, however, short-term dollar interest rates
were rising even more sharply as the Federal Reserve,
adhering to the monetary policy adopted last October
6, restrained the growth of bank reserves in the face
of a sudden resurgence in the demand for money and
credit in the United States. As reports began to circulate
that the United States authorities might impose credit
controls to help stem the rise in inflationary expecta
tions, a surge of precautionary borrowing ensued,
which pushed United States domestic and Eurodollar
rates to new highs. With interest differentials adverse
to the mark widening progressively to reach 81/2 per
centage points in the early weeks of March, capital
flowed heavily out of Germany and the mark declined
rapidly in the exchanges. These outflows took the
form of adverse commercial leads and lags, port
folio shifts by foreign investors, and a buildup of dollar
balances by German residents. In addition, some pro
fessional and corporate borrowers around the world
began meeting their financing needs in other curren
cies by borrowing marks and converting the proceeds
in the exchanges.
The German authorities were concerned that the
sharp depreciation of the mark would further aggravate
domestic inflationary pressures through higher prices
for oil and other imports. The Bundesbank intervened
heavily to blunt the mark’s decline, entering the Frank
furt market, where the pressures tended to concen
trate, almost daily as a heavy seller of dollars both
spot and forward. The authorities also took measures
to induce sufficient capital inflows to help finance the
current account deficit and to help offset the outflows
of capital. In part, these entailed the relaxation of re

strictions on capital inflows by permitting foreigners to
purchase government securities, domestic bonds, and
other mark-denominated promissory notes with matu
rities of more than two years (as opposed to four years
previously). In addition, the government negotiated di
rectly with foreign official institutions, notably those
from OPEC, to obtain investments in mark assets.
Meanwhile, through mid-March the United States au
thorities acquired $2,751.7 million equivalent of marks
from correspondents, mainly from the Bundesbank.
Also, the Trading Desk intervened in New York, pur
chasing $115 million equivalent of marks in the market.
These marks were used to liquidate in full the Federal
Reserve’s outstanding swap debt with the Bundesbank
and to make interest payments on the Treasury’s se
curities issued in the German capital market. On bal
ance, by mid-March the mark had declined 5 percent
from early-February levels to DM 1.8265.
On March 14, President Carter announced a broad
anti-inflation program that included actions aimed at
balancing the fiscal 1981 budget, a surcharge on im
ported oil, and authorization for the Federal Reserve
under the terms of the Credit Control Act of 1969 to
impose special restraints on credit expansion. Ac
cordingly, the Federal Reserve asked the commercial
banks to hold their growth of lending to United States
residents to 6-9 percent during 1980, required special
deposits from nonmember banks and other lending in
stitutions, and raised the marginal reserve require
ment on managed liabilities from 8 to 10 percent for
large member banks and United States agencies and
branches of foreign banks. In addition, the Federal
Reserve imposed a 3 percentage point surcharge on
large member banks’ discount window borrowings.
The exchange market reacted positively to the pack
age of special credit restraints as a sign of the United
States authorities’ determination to curb persistent and
accelerating inflationary pressures.
Following these measures the interest disincentive
against the mark widened to some 10 percentage points
as short-term dollar interest rates climbed further in
late March and into early April, reaching peaks of
20 percent. As a result, interest-sensitive capital flowed
even more heavily from Germany at a time when the
continued deterioration of the current account deficit
left the mark spot rate partipularly vulnerable to down
ward pressure. Vigorous intervention to support the
mark in these circumstances threatened a drain on
Germany’s foreign exchange reserves which the au
thorities feared would undermine confidence in the
mark all the more. Therefore, the Bundesbank inter
vened somewhat less forcefully than in previous weeks
and also supported the mark through sales of markdenominated bonds to foreign official holders. By

FRBNY Quarterly Review/Autumn 1980

Chart 3

Germany
Movements in exchange rate and official
foreign currency reserves
Marks per dollar
1.60

Billions of dollars

1.65
1.70
1.75
1.80
1.85
1.90
1.95
2.00

2.05 ---------------------------------------------------------------------J
A S O N D J
F M A M J J A
1979
1980
Exchange rates shown in this and the following charts
are weekly averages of noon bid rates for dollars in
New York. Foreign currency reserves shown in this
and the following charts are drawn from IMF data
published in International Financial Statistics.
^Foreign exchange reserves for Germany and other
members of the European Monetary System, including
the United Kingdom, incorporate adjustments for
gold and foreign exchange swaps against European
currency units (ECUs) done with the European
Monetary Fund.

April 8 the mark declined another 8V2 percent, reach
ing a low of DM 1.9810 in Far Eastern trading while
also dropping to the bottom of the European Monetary
System (EMS). As the sale of marks against dollars
gathered momentum between mid-March and early
April, the United States authorities intervened force
fully to counter disorderly trading conditions, operating
frequently in the New York market and, on one occa
sion, overnight in the Far East. The authorities pur
chased an additional $741.5 million equivalent of marks
in the market and another $654.7 million equivalent
from correspondents, which were added to System and
Treasury balances. Meanwhile, the Bundesbank’s heavy
dollar sales were reflected in a $5.1 billion decline in
Germany’s foreign exchange reserves from end-January
to $41.2 billion by end-March.
By this time, however, the German money market
had tightened considerably and, even though the
Digitized 32
for FRASER
FRBNY Quarterly R eview/Autum n 1980

Bundesbank had begun to offset the drain on liquidity
of its dollar sales by entering into foreign exchange
swaps, market participants expected a further rise in
German official interest rates. By contrast, with the
scramble for funds in the United States tapering off
and with economic indicators suggesting a sharp slow
ing in the United States economy, market participants
sensed that dollar interest rates would soon turn down.
Under these circumstances, the mark came into im
mediate and heavy demand once interest rates in the
United States showed unmistakable signs of declin
ing in early April. Moreover, diminished prospects for
a resolution of the hostage situation in Iran renewed
concerns that official dollar holders in the Middle East
would switch more of their surplus funds into European
currencies— the mark in particular— as an alternative
to dollar assets. On April 8-10 as dollar exchange rates
declined across the board, the mark soared 51/2 per
cent to DM 1.8730 in extremely disorderly conditions.
In response, the Trading Desk intervened as a seller
of marks and Swiss francs and, to avoid aggravating
the weakness of the mark relative to the French franc
within the EMS, also intervened as a seller of French
francs. The Bundesbank also sold French francs to
support the mark within the EMS.
In the weeks that followed, United States interest
rates continued to drop precipitously, at times fall
ing by as much as 1-2 percentage points a day. Traders
generally recognized that the Federal Reserve’s policy
of restraint on money supply growth was consistent
with some easing in financial market conditions, as
demands for money and credit weakened and as
evidence of recession mounted. But the abruptness of
the change in market conditions generated uncertainty
about the policies of the United States authorities. At
the same time, German interest rates remained firm,
so that interest differentials adverse to the mark were
rapidly narrowing. As commercial and professional par
ticipants continued to unwind their short mark posi
tions, the mark advanced another 41A percent to as
high as DM 1.7940 by late April. However, the United
States and German authorities were quick to enter the
market to moderate the mark’s rise, and their coordi
nated intervention helped bring the market into better
balance around the month end.
Meanwhile, in Germany, inflationary pressures re
mained strong by recent standards, and the con
tinued growth of credit demands was boosting borrow
ings from the central bank. On April 30, the Bundesbank
hiked its discount rate by V2 percentage point to W 2
percent and the Lombard rate by 1 percentage point
to 91/2 percent. At the same time, the Bundesbank
moved to curtail excessive reliance on the Lombard
facility by reducing reserve requirements by 8 percent

and raising commercial banks’ quotas under the redis
count facility, thereby providing about DM 8 billion in
domestic liquidity. The effect of these actions was to
leave the restrictive stance of monetary policy un
changed while keeping short-term liquidity tight. But
market participants initially found it hard to assess the
impact of these measures and focused instead on
broader economic developments in the United States.
Monthly data showed that the United States trade
position was improving, while some evidence sug
gested that price increases were slowing from the
rapid pace early in the year. As a result, the mark
fluctuated only narrowly higher as the dollar gained
some resiliency in the exchanges, to trade around
DM 1.78-1.79 through mid-May.
On those occasions when upward pressures on the
mark threatened to cumulate, the United States and
German authorities intervened to restore balance to
the market. Total intervention sales by the United
States authorities between early April and mid-May
amounted to $1,370.2 million equivalent of marks, in
cluding $732.4 million equivalent for the System, fi
nanced out of balances and by drawings on the swap
line with the Bundesbank, and $637.8 million equiv
alent for the Treasury financed from balances. At times
when the mark eased back, the Federal Reserve took
the opportunity to acquire $60.4 million equivalent of
marks in the market and $169.6 million equivalent from
correspondents in order to finance intervention and to
repay part of the newly acquired swap debt with the
Bundesbank. On balance, by mid-May the System’s
swap indebtedness with the Bundesbank stood at
$331.4 million equivalent of marks. For its part the
Treasury bought $29.8 million equivalent of marks on a
spot basis and received delivery of $400 million equiv
alent of marks on a forward basis from correspondents.
Nevertheless, market participants remained ex
tremely sensitive to monetary policy developments in
Germany and in other industrial countries. Coming into
the summer, Bundesbank officials were stressing the
need to rein in further central bank money growth to
the lower end of the 5-8 percent target range. In the
United States, meanwhile, interest rates continued to
decline. Participants questioned whether the sharp
drop in rates was more a response to the falloff in
credit demand or to the provision of bank reserves by
the United States authorities. Traders closely scruti
nized the actions of the domestic Trading Desk, and
the mark frequently came into demand when declines
in the Federal funds rate were interpreted as a sign of
monetary ease. Moreover, in view of the exceptional
weakness of the United States economy and increasing
public discussion about the need for stimulus, the ex
change market was alert to any evidence of a weak

ening in the priority of the United States fight against
inflation. Consequently, bidding for the mark gathered
force in late May and again in early July, when the
United States authorities first relaxed and then phased
out completely the special credit restraint program
adopted early in the spring.
Demand for the mark propelled the spot rate to as
high as DM 1.7335 by early July. But against the major
European currencies the mark remained weak. Ger
many’s current account deficit, already larger than that
of any of its trading partners, continued to widen, and
a number of private and official organizations were
predicting a deterioration of up to as much as DM
25-30 billion for the year as a whole. Although capital
continued to flow back into Germany, a number of
other EMS countries with higher interest rates than
those prevailing in the German money and capital mar
kets were also attracting substantial inflows of funds.
In these circumstances, the Trading Desk again coun
tered the outbreak of disorder in the market by sup
plementing its mark intervention with sales of French
francs so as to avoid aggravating the strains on the
mark within the EMS.
By mid-July the mark began to lose some of its
buoyancy as traders grew more cautious in the face of
changing economic conditions in Germany. Evidence
mounted that domestic economic growth was tapering
off, as industrial production and construction activity
posted declines. Inflation on the wholesale and con
sumer levels also abated somewhat, reflecting some
relief in the food and energy sectors, the slowing in
demand pressures, and moderate wage settlements
negotiated over the spring. Moreover, several EMS
countries had begun to allow monetary conditions to
ease. Accordingly, domestic pressures built up for a
relaxation of policy in Germany. The authorities were
nevertheless concerned that a reduction of official
interest rates would undercut the progress under way
in bringing inflation under control and in financing the
current account deficit. Instead, the Bundesbank an
nounced that it would provide a new repurchase facility
in the amount of DM 5.4 billion. Bundesbank President
Poehl described this action as a cautious easing in
monetary policy.
At the same time, the outlook for the dollar was im
proving. The dollar was benefiting from new data on
production and employment which suggested that the
United States economy was no longer contracting as
rapidly as before. As the demand for credit picked up
and the monetary aggregates recorded large increases,
short-term United States interest rates rebounded. In
this light, Chairman Volcker’s Congressional testimony,
reaffirming the Federal Reserve’s commitment to a
policy of monetary restraint, was particularly well re-

FRBNY Quarterly Review/Autumn 1980

Table 2

Federal Reserve System Drawings and Repayments under Reciprocal Currency Arrangements
In millions of dollars equivalent; drawings ( + ) or repayments ( — )
System swap
commitments
January 1, 1980

Transactions with

Bank of France ...........................
German Federal B a n k ...............

1980

....................................................
T o ta l..............................................

100.2
; + 996.1
l — 132.4

+ 60.6
f +265.7
( —263.4

J + 11.2

f + 316.0
\ — 3,489.2
\+
22.7
22.7

3,150.4
-

1980
July

. 0-

Swiss National B a n k ...................

1980
II

f + 338.7
{-3 ,5 1 1 .9

3,150.4

System swap
commitments
July 31, 1980
166.3*
879.7 f
-

J — 11.2

( +337.5
|- 2 7 4 .7

1,046.0

Because of rounding, figures do not add to totals. Data are on a value-date basis with the exception of the last two columns
which include transactions executed in late July for value after the reporting period.
* Includes revaluation adjustments from swap renewals, which totaled $5.5 million for drawings on the Bank of France renewed during July,
f Includes revaluation adjustments from swap renewals, which totaled $36.6 million for drawings on the German Federal Bank
renewed during the first quarter and July.

Table 3

Drawings and Repayments by Foreign Central Banks and the Bank for International Settlements
under Reciprocal Currency Arrangements
In millions of dollars; drawings ( + ) or repayments ( —)
Bank drawing on
Federal Reserve System

wm h mmmmm s i

* 0 W .a s ? ^ !T i!

Outstanding
January 1, 1980

1980
I

1980
II

1980
July

Outstanding
July 31, 1980

-0-

^ + 192.0
97.0

\+ 50.0
1 -1 4 5 0

-0-

* Bank for International Settlements
(against German m a rk s )...........................

■
Data are on a value-date basis.

* BIS drawings and repayments of dollars against European currencies other than Swiss francs to meet temporary cash requirements.

Table 4

United States Treasury Securities, Foreign Currency Denominated
In millions of dollars equivalent; issues ( + ) or redemptions ( — )

Issues

Amount of
commitments
January 1, 1980

1980

4,065.7
1,203.0

+ 1,168.0
- 0-

5,268.6

+ 1,168.0

Public series:
Germany
Switzerland ..
Total
rft

•«!*:,.»

s a#

gg|is.'uwait

Data are on a value-date basis. Because of rounding, figures do not add to totals.

34 FRBNY Quarterly Review/Autum n 1980

1980
II

00-

1980
July

Amount of
commitments
July 31, 1980

00-

5,233.6
1,203.0

6,436.6

ceived. As a result, the mark dropped lower to close
the period at DM 1.7860, for a net decline of 21/2 per
cent over the period under review.
After mid-May, the United States authorities inter
vened to sell $1,919.4 million equivalent of marks in
cluding $1,096.0 million equivalent for the System and
$823.4 million equivalent for the Treasury. The Sys
tem’s sales were financed from balances and by draw
ings on the swap line with the Bundesbank. However,
the authorities were also able to purchase $160.0 mil
lion equivalent of marks in the market and $608.2 million
equivalent from correspondents. As a result, the System
was able to reduce its outstanding indebtedness to the
Bundesbank from as high as $1,080.9 million equivalent
to $879.7 million equivalent by end-July (including re
valuation adjustments for swap renewals), while the
Treasury was able to begin replenishing its mark bal
ances. Meanwhile, Germany’s foreign exchange re
serves rose $4.5 billion in the four months through endJuly, largely reflecting revaluation gains of its gold and
foreign currency holdings with the European Monetary
Fund. The Bundesbank’s purchases of dollars also con
tributed to the rise in foreign exchange reserves which
stood at $45.7 billion at end-July, little changed on
balance.*
Swiss franc
By early 1980, the upsurge of oil and other interna
tional raw materials prices was being quickly trans
mitted to the Swiss economy. Indeed, inflation in
Switzerland, at 5 percent per annum, remained low by
comparison with that in other countries but was ac
celerating at a worrisome pace. At the same time, the
sharp rise in imports of oil and other goods cut
deeply into Switzerland’s traditional current account
surplus. The Swiss authorities, like those in most other
industrial countries, were pursuing a policy of mone
tary restraint in an effort to combat inflationary pres
sures, and Swiss interest rates moved higher. But
economic activity in Switzerland was expanding more
slowly than in other countries. Consequently, the de
mand for funds was not so intense, and Swiss interest
rates— while rising sharply by historical standards— did
not begin to keep pace with those abroad.
The shrinking current account surplus, accelerat
ing inflation, and adverse interest differentials exerted
a drag on the Swiss franc during February and March.
At times when the dollar came on offer in early FebruForeign exchange reserves for Germany and other members of the
EMS, including the United Kingdom, incorporate adjustments for gold
and foreign exchange swaps against European currency units (ECUs)
done with the European Monetary Fund. Foreign exchange reserve
numbers used in the report are drawn from International Monetary Fund
data published in International Financial Statistics.

ary the Swiss franc was bid up. On such occasions, the
Swiss National Bank intervened to counter a disorderly
rise in the franc. At one point, the Federal Reserve
joined in the intervention by selling $22.5 million equiv
alent of Swiss francs out of balances. But otherwise
the Swiss franc tended to ease. By late February, in
vestors began liquidating Swiss franc-denominated as
sets, switching into higher yielding mark and sterling
assets and, when United States interest rates began
their upward climb, moving into dollar-denominated
investments as well. In fact, the franc fell more sharply
than the mark against the dollar, declining to SF 1.7111
in late February, some 4% percent below the opening
level of SF 1.6325.
In response to these pressures on the franc, the
Swiss authorities acted in late February and early
March to liberalize restrictions on capital inflows by
lifting the ban on interest payments on nonresident
savings deposits and on foreign central bank deposits
with maturities of six months or more. The authorities
also eased restrictions on foreigners’ purchases of
forward Swiss francs. On February 28, the Swiss
National Bank raised the discount and Lombard rates
by 1 percentage point each to 3 and 4 percent, respec
tively. But these measures were not sufficient either to
satisfy market expectations of more comprehensive
action to dismantle barriers to inflows or to bring
official rates in line with interest rates prevailing in
the domestic or Eurofranc money markets.

Chart 4

Switzerland
Movements in exchange rate and official
foreign currency reserves
Francs per dollar
1.50-------------------------------

Billions of dollars
-----------------— 3.0

See exchange rate footnote on Chart 3.

FRBNY Q uarterly Review/Autum n 1980

Meanwhile, domestic economic activity was picking
up following two years of sluggish growth. With the
economy now operating close to full employment, con
sumers and businesses accelerated their purchases of
imported goods at a time when import prices were
still rising rapidly. As a result, the trade deficit de
teriorated further. During March selling pressures in
tensified. Commercial leads and lags swung against
the franc, and investors kept shifting funds out of
Switzerland. Moreover, higher interest rates abroad
prompted professional and commercial borrowers to
turn to Switzerland’s money and capital markets where
interest rates remained comparatively low.
In response, the Swiss National Bank began inter
vening more openly and heavily as a seller of dollars,
thereby absorbing Swiss francs. The authorities also
lifted completely restrictions on forward franc sales
to foreigners and removed the interest payment ban
on nonresident bank deposits of three months or
longer. As a further stimulus to capital inflows, foreign
central banks were allowed to subscribe to a second
Swiss franc-denominated bond issued by the World
Bank and to short-term certificates of the Swiss gov
ernment. Even so, with interest differentials remaining
highly adverse to franc-denominated assets, the franc
spot rate continued to weaken, dropping through the
psychologically important SF 0.95 level against the
mark.
On March 27, Swiss National Bank General Manager
Languetin stated that the Swiss central bank would
intervene as forcefully as required to prevent a further
weakening of the franc. At the same time, the authori
ties were alert to the domestic liquidity situation. The
heavy volume of capital outflows and official dollar
sales had led to a decline in the monetary base below
desired levels, and a further contraction threatened to
dampen economic activity. To support the franc with
out generating further liquidity strains, the Swiss Na
tional Bank supplemented its spot intervention with
forward dollar sales and provided commercial banks
with a substantial amount of franc liquidity through
short-dated foreign exchange swaps. The Federal Re
serve also took advantage of the opportunity to buy
Swiss francs in New York to add to balances, buying
$185.1 million equivalent of Swiss francs, including
$140.4 million equivalent in the market between Febru
ary and early April. Whereas the franc soon steadied
against the mark, the spot rate continued to decline
against the dollar, bottoming out at nearly SF 1.88 on
April 8 in the Far East.
The abrupt decline of dollar exchange rates begin
ning early in April had its counterpart in a surge of
heavy bidding for the Swiss franc. Professional and com
mercial interests rushed to cover short franc positions

http://fraser.stlouisfed.org/
36 FRBNY Q uarterly Review/Autum n 1980
Federal Reserve Bank of St. Louis

Net Profits (+ ) and Losses ( —) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In millions of dollars

assets and liabilities
as of July 31, 1980
Data are on a value-date basis

in response to the decline in United States interest rates
that happened to coincide with reports that the Swiss
National Bank might raise its interest rates in line
with an expected hike of official interest rates in
Germany. On April 8-10 the franc soared 7% percent
to SF 1.7330, outpacing the rise in the mark. To
counter the disorderly market conditions, the Federal
Reserve sold $35 million equivalent of francs, while
operating in other currencies as well. Although the
Swiss authorities left official rates unchanged, the franc
frequently led the rise in the European currencies
against the dollar in the weeks that followed. Many
participants bid for the franc on the view that the Swiss
authorities welcomed a rise in the franc. Investors,
having ready access to franc investments as a result
of the virtual elimination of exchange controls, reacted
to the reduction of adverse interest difierentials by
purchasing a broad range of franc-denominated assets.
Moreover, commercial and professional interests in
creasingly covered Swiss franc liabilities incurred over
the winter months.
As the demand for Swiss securities increased, long
term yields in Switzerland declined. But the Swiss
National Bank signaled its resistance to the rapid fall
in interest rates by selling securities. Also, Swiss
National Bank President Leutwiler reaffirmed the au
thorities’ commitment to a restrictive monetary policy
course. Traders were also heartened by new statistics,
suggesting that Switzerland’s inflation rate was level
ing off. By contrast, the market remained concerned
over the sharp decline in United States interest rates.

Many traders questioned the priority of the anti
inflation fight in the United States, particularly when
in late May and again in early July the Federal
Reserve successively dismantled the special credit
restraint program. On both those occasions, the Swiss
franc came into demand, rising to a high of SF 1.5840
by early July. To avoid an exaggerated movement in
the spot rate, the Swiss National Bank intervened as
a buyer of dollars in Zurich and through the agency
of the Federal Reserve in the New York market. For
their part, the United States authorities sold $233.9 mil
lion equivalent of Swiss francs in the eleven weeks
from mid-April, with the bulk financed from balances
and $11.2 million equivalent drawn on the System’s
swap line with the Swiss National Bank.
In the final weeks of July when market sentiment
toward the dollar improved, the franc lost its upward
momentum. Signs that the United States economy
was no longer contracting as rapidly as before, and
that interest rates were backing up, contrasted with
evidence of some slowing of economic growth and
easing in financial conditions in Western Europe. With
market participants sensitive to the possibility that
Swiss interest rates might also ease, the Swiss franc
fell back in the exchanges to SF 1.6570 by end-July.
In fact, however, Swiss interest rates held firm. When
the franc came on offer after mid-July, the United
States authorities took the opportunity to purchase
$42.0 million equivalent of francs in the market and
$130.5 million equivalent from correspondents. These
francs were used to liquidate the System’s outstanding
swap debt with the Swiss National Bank and to rebuild
System and Treasury balances.
For the period as a whole, the Swiss franc declined
IV 2 percent from end-January levels, while rising
1 1/4 percent against the German mark. Meanwhile,
Switzerland’s foreign currency reserves fluctuated from
month to month in response, not only to the central
bank’s intervention, but also to foreign exchange swap
operations undertaken for domestic monetary purposes.
On balance, Switzerland’s foreign exchange reserves
declined $850 million over the six months under re
view to stand at $12.3 billion as of July 31.

Japanese yen
Last year, the Japanese economy had made good
progress in adjusting to earlier imbalances. Efforts to
boost domestic demand had generated solid growth
while also helping reduce Japan’s previously exces
sive current account surplus. Export and import vol
umes had responded to the previous appreciation of
the yen, with the effect of reducing the current account
surplus. The yen rate had moved back up to around
¥220 to the dollar. But the sharp new rise in interna

tional oil prices in 1979 and early 1980, coupled with
the risk of major disruptions to oil supplies, was a
serious blow to Japan which depends on imported oil
for three fourths of its energy needs. Consequently,
the authorities found that they had to reverse gears
and adjust to a new set of problems, as inflationary
pressures at the wholesale level built up drastically,
as the current account was pushed into deep deficit
under the weight of a sharply higher import bill, and
as the yen came heavily on offer and depreciated
sharply in the exchange market. In response, the
Japanese authorities progressively tightened monetary
and fiscal policies, primarily to contain inflationary
pressures. The authorities also sought to correct the
current account deficit gradually by adjustment of the
real economy and, in the meantime, to finance the defi
cit by capital inflows. The government’s budget for the
1980-81 fiscal year called for a cutback in public works
spending that would permit a reduction of deficit fi
nancing. The Bank of Japan raised interest rates in
cluding a 1 percentage point increase to 71/4 percent
in its discount rate on February 19. It also raised
reserve requirements and kept tight reins on bank
credit expansion.
Nevertheless, by February, short-term interest rates
abroad, especially on dollar instruments, were rising
even more sharply than the advance of Japanese
money market rates. Consequently, the yen continued
on offer. With the exchange rate declining, market sen
timent toward the yen turned increasingly bearish so
that commercial leads and lags as well as speculative
outflows of funds added to the downward pressure on
the yen vis-a-vis the dollar and other major currencies.
By the month end the yen had plummeted to ¥251.75,
a decline of 51/2 percent from late-January levels and
fully 43 percent from the high recorded in October
1978. As before, the Bank of Japan intervened to mod
erate the decline of the yen, supplementing its inter
vention in Tokyo with operations in New York through
the Federal Reserve Bank of New York.
The sharp decline of the yen complicated the author
ities’ efforts to contain inflation. The rising cost of im
ports had already helped push wholesale prices up
over 20 percent on a year-over-year basis. This sharp
increase was feeding into the consumer price index
which by then was rising at a rate of about 8 percent.
The key spring wage negotiations were about to start.
In these circumstances, a further weakening of the yen
threatened to reinforce inflationary expectations.
The Japanese authorities therefore undertook several
initiatives to support the yen in the exchanges. Fol
lowing intensive discussions, on March 2 the Bank of
Japan announced that the Federal Reserve, the Ger
man Bundesbank, and the Swiss National Bank would

FRBNY Quarterly Review/Autumn 1980

Chart 5

Japan
Movements in exchange rate and official
foreign currency reserves
Yen per dollar

Billions of dollars
--------------------- 3.0

2 0 0 -------------------------------------

210-

2.0
Foreign currency
-----reserves------Scale------►

Exchange rate
-*---- Scale
2701
J

I
A

1 I

S O
1979

I
N

D J

M A M
1980

I - 4 .0

See exchange rate footnote on Chart 3.

cooperate to avoid an excessive decline of the yen.
The Federal Reserve, for its part, indicated its willing
ness to purchase yen in the New York market for its
own account and to provide resources to the Bank of
Japan if needed under the existing $5 billion swap ar
rangement. The German and Swiss central banks also
pledged their support and subsequently concluded
swap agreements with the Bank of Japan. Also, on
March 2 the Japanese authorities adopted a number of
measures to encourage inflows so as to help finance
the current account deficit. Banks were allowed to
bring in Euroyen deposits from their foreign offices,
and Japanese banks were permitted to make mediumand long-term foreign currency loans (so-called “ im
pact” loans) to domestic customers. Controls on pri
vate placements abroad of yen-denominated bonds by
Japanese residents were relaxed. And free-yen de
posits held by foreign official institutions were ex
empted from interest rate ceilings. Later during the
month, the Bank of Japan abolished its 1970 arrange
ment with commercial banks providing for yen-dollar
swap facilities to finance imports, thereby rescinding
the last of the major import promotion schemes. The
authorization of increased ceilings for the issuance
of yen-denominated certificates of deposit (CDs) by
banks operating in Japan also provided more scope for
short-term capital inflows from abroad.

38 FRBNY Quarterly R eview/Autum n 1980

These measures were reinforced by a broad anti
inflation program, introduced on March 19, that was
keyed to the domestic economy. The Bank of Japan
raised its discount rate another 1% percentage points
to 9 percent and subsequently increased both reserve
requirements and “ window guidance” limits on bank
lending. Public works expenditures, already trimmed
back, were postponed. In addition, the government
announced that henceforth it would monitor price de
velopments more closely, would sell commodities out
of stockpiles if needed to prevent shortages from de
veloping, and would accelerate energy conservation
efforts. The authorities reaffirmed their commitment to
a disciplined monetary policy and to the priority of
the fight on inflation.
These measures helped relieve some of the imme
diate selling pressures, and the yen strengthened
against most of the major European currencies over
the course of March. But reflows back into yen were
slow to materialize, particularly since the pull of United
States interest rates was so strong in late March and
early April. Along with other major foreign currencies,
the yen continued to decline against the dollar through
early April. By April 8, the yen had fallen a further
5 percent to as low as ¥ 264 against the dollar in
Far Eastern trading. The Bank of Japan continued to
intervene forcefully to moderate the decline of the yen
rate, and its dollar sales were reflected in the $2.2
billion decline of foreign exchange reserves during
February-March. Meanwhile, as part of the March 2
agreement, the Federal Reserve bought $216.8 million
equivalent of yen in the New York market in coordinated
operations with the Bank of Japan. These purchases
were added to System balances.
By mid-April, with United States interest rates turn
ing down, the yen began to recover along with other
major currencies. At first the yen’s recovery was ten
tative. Wholesale prices were still rising sharply in
Japan, and concerns about oil supplies resurfaced
amid discussions of economic sanctions against Iran.
Nevertheless, the spring wage negotiations resulted in
moderate wage increases, while evidence continued to
point to substantial gains in labor productivity. The
market increasingly came to the view that declining
unit labor costs would mitigate domestic inflationary
pressures and would provide the basis for Japanese
exporters to take advantage of the now substantial de
preciation of the yen to increase sales abroad. A sharp
improvement in exports was already showing through
in Japan’s trade figures, and the overall trade and cur
rent account deficits were beginning to level off.
In response, market sentiment toward the yen im
proved and the spot rate began to rise more rapidly at
the end of April. Speculative short positions were cow-

ered, while commercial leads and lags shifted back in
favor of the yen. With United States interest rates con
tinuing to decline and interest rates in Japan holding
steady, the differential in rates swung back to favor the
yen in early May and the pace of capital inflows
quickened. By that time, funds were moving into yendenominated assets of all maturities amid reports
of large placements by OPEC central banks and other
foreign authorities in the Japanese market. As the flow
of funds gathered force, the yen began to outpace the
rise in the European currencies against the dollar, soar
ing by mid-June to as high as ¥ 214.95, some 181/2 per
cent above its early-April lows. As the rate rose, the
Bank of Japan intervened in size to counter disorderly
conditions, on balance buying back about half of the
dollars it had sold earlier during the period.
By that time, the reflux of funds had about run its
course. Moreover, traders had become cautious in light
of the upcoming parliamentary election on June 22, es
pecially since the sudden death of Prime Minister Ohira
had inserted an added element of uncertainty into the
campaign. The outcome— a victory by the ruling
Liberal-Democratic Party with sufficient margin to pro
vide for continuity in Japan’s leadership— reassured
the market. The yen rate settled in a trading range of
¥ 215-219 through early July.
Coming into summer, however, the debate over eco
nomic policy heated up, as the pace of economic ex
pansion began to slow and industrial production regis
tered a decline. With slower economic growth abroad,
the authorities in several other industrial countries
were beginning to allow monetary conditions to ease
somewhat. Meanwhile, large inflows of interestsensitive funds had generated an easing in the Tokyo
money market. As a result, the authorities were urged
to ease up on monetary policy, particularly by allowing
interest rates to decline. In response to this pressure,
some commercial and professional selling of yen
emerged and the yen declined in mid-July.
The Japanese authorities nevertheless remained
concerned about the need for further adjustment of the
economy. Governor Mayekawa of the Bank of Japan
stressed that an easing of monetary policy was prema
ture in light of the continuing inflationary pressures.
Moreover, the new government under Prime Minister
Suzuki quickly affirmed its support for a firm antiinflationary effort. Consequently, the yen rate soon
steadied and closed the period at ¥ 227.80 for a net
advance of 4% percent over the six-month period un
der review. Meanwhile, the Bank of Japan’s dollar gains
after March were partially reflected in an increase in
Japan’s foreign exchange reserves of $4.2 billion.
At the end of July, reserves stood at $18.8 billion, up
$2.0 billion on balance.

Sterling
Last year the government under Prime Minister Margaret
Thatcher came into office, pledging to reduce the role of
the public sector in the British economy and to restore
private incentives. To achieve this objective, the govern
ment committed itself to alleviate the burden of taxation
by reducing government spending over the long term
while in the meantime shifting the tax structure
away from direct toward indirect taxation. Meanwhile,
the United Kingdom’s inflationary spiral was being
given another twist by an upsurge in wage demands,
following the abandonment of formal wage restraints
a year earlier, rising energy prices, and a 4 percent
increase in the value-added tax to finance reductions
of income tax. To contain these pressures the British
authorities had imposed an increasingly restrictive
monetary policy, raising domestic interest rates to
record highs to bring the expansion of sterling M-3, the
targeted monetary aggregate, back within the 7-11
percent annual growth range. By late 1979 the econ
omy was slipping into recession. The combined impact
of rising labor costs and high interest rates was im
posing increasingly severe financial strains on British
industry. Companies were cutting back on their inven
tories and scaling down their investment plans. Even
so, monetary expansion was proving difficult to control,
since companies were borrowing heavily from banks
to meet their financing needs while waiting for interest

Chart 6

United Kingdom
Movements in exchange rate and official
foreign currency reserves
Dollars per pound
Billions of dollars
2.45---------------------------------- ---------------------------------------------- 3.0

2.35

2 .10----------------- | | W ---------------------------------------------------------- 0.5
2 0 5 1

I_ _ _ _ L l _ J _ _ _ _ 1

O N
1979

M A M J
1980

1-1.0

See exchange rate footnote on Chart 3.

FRBNY Quarterly R eview/Autum n 1980

rates to come down. Moreover, despite the govern
ment’s best efforts, public spending was proving diffi
cult to contain, and the public-sector borrowing re
quirement for fiscal 1979-80 was running nearly £1 1/2
billion above target at just under £10 billion per annum.
In the exchange market, sterling had strengthened.
British interest rates were high relative to those in
most other countries. Moreover, the United Kingdom’s
approaching self-sufficiency in oil was seen as leaving
the current account well protected against possible
cutoffs in oil supplies and further increases in energy
prices. The breadth and depth of British capital mar
kets also provided attractive investment opportunities
for international investors, especially OPEC members
who were seeking outlets for their burgeoning sur
pluses. As a result, foreign capital flowed heavily into
sterling-denominated assets, enabling the United King
dom to finance in 1979 a $5 billion current account
deficit, official debt repayments of over $2 billion, and
outflows of more than $4 billion stemming from the
abolition of exchange controls. Even after these out
flows, sterling traded around $2.27 by end-January 1980
and around 71.7 on a trade-weighted basis as a percent
age of the Smithsonian parities. Meanwhile, Britain’s for
eign exchange reserves, after increasing by over $2
billion in 1979, stood at $18.8 billion on January 31 of
this year.
In the late winter-early spring, evidence cumulated
of declining industrial output and employment. Mone
tary growth was also showing signs of declining. Publicsector borrowing needs were temporarily reduced by
the tax-gathering season. The authorities were able to
sell a large amount of government debt in the wake of
the earlier measures, and external factors continued to
have a contractionary influence on the money supply. At
the same time, however, private-sector loan demand
continued to grow strongly, with the result that the bank
ing system was faced with a reduced supply of publicsector debt and hence of reserve assets. The authorities
were thus obliged to provide temporary assistance to the
money market so as to counter the upward pressures on
short-term interest rates created by this drain on bank
ing liquidity. These initiatives helped stabilize British
short-term interest rates around 17 percent per annum.
Meanwhile, however, dollar interest rates were rising
sharply in response to rising credit demand in the
United States, with the result that in late March interest
differentials moved against sterling and in favor of the
dollar. As multinational corporations and international
portfolio managers switched funds out of sterling into
dollar-denominated assets, the pound came on offer
against the dollar and the spot rate fell to as low as
$2.1285 on April 7. But, since British interest rates re
mained substantially above those on the European con

Digitized
40for FRASER
FRBNY Quarterly Review/Autumn 1980

tinent, sterling fell less against the dollar than the other
European currencies. The turnaround in the dollar on
April 8 brought sterling into renewed demand. As United
States interest rates fell sharply, interest differentials
moved back into sterling’s favor. Therefore, the pound
bounced back to $2.2275 by mid-April.
Meanwhile, with the domestic economy clearly head
ed into a recession, pressures were building up within
British industry for relaxation of fiscal and monetary
policy. But, in a consultative paper on monetary
control issued jointly by the British Treasury and the
Bank of England, the authorities reaffirmed sterling
M-3 as the appropriate target variable for monetary
policy, emphasized that lowering the government defi
cit played a major role in reducing that aggregate’s
growth rate, and asserted that quantitative controls were
not an alternative to high interest rates as a means of
reducing monetary expansion. In the annual budget
message, Chancellor Howe followed up by announcing
that the government still intended to reduce the publicsector borrowing requirement to £8.5 billion and the
growth of sterling M-3 to a 7-11 percent annual target
range. Thereafter, both the Prime Minister and the
Chancellor repeatedly affirmed the government’s com
mitment to reduce inflation by containing monetary
growth. In this context, British interest rates remained
high even after the end of the tax-payment season,
while United States interest rates continued to fall.
Moreover, the recession was leading to a rapid elimina
tion of the current account deficit. As a result, sterling
led the advance of other European currencies against
the dollar, soaring to as high as $2.3770 in late May.
By early June, after prolonged negotiations, agree
ment had been reached to reduce by £750 million
Britain’s contribution to the European Community (EC).
These developments generated expectations in the
exchange markets of near-term reductions of British
interest rates. Fearing heavy outflows of interestsensitive funds, traders reacted initially by selling
sterling. As a result, the pound came on offer during
June, falling as much as ZV2 percent below its lateMay highs.
For their part, however, the authorities remained re
luctant to cut interest rates until firmer evidence ap
peared of a sustained reduction of monetary growth.
Unfortunately, interpreting the data was being made
increasingly difficult at this time by the imminent re
moval of the supplementary special deposit scheme—
the “ corset” . Inevitably, the mid-June termination of
this scheme was followed by a statistical explosion in
sterling M-3, as banks restored direct lending to all
their customers, which had been temporarily replaced
by bankers’ acceptances arranged to avoid hitting the
limits on the expansion of interest-bearing eligible lia

bilities imposed earlier by the corset. Nevertheless,
credit demand was still thought to be relatively strong.
Moreover, despite rising unemployment, wages were
still increasing at just under 20 percent per annum as
the trade unions sought full compensation for price
increases due to rising energy costs and higher indirect
taxation. Therefore, the authorities felt unabie to cut
interest rates during June and, in fact, allowed a re
purchase facility— introduced earlier in the year to pro
vide liquidity— to run off. As a result, sterling moved
back up to fluctuate around $2.34 in late June.
In early July the authorities provided some interest
rate relief by cutting the minimum lending rate 1 per
centage point below its all-time high to 16 percent.
The pound came on immediate offer but then steadied.
During the rest of the month, some professionals in
the market continued to look for further reductions
of British interest rates. But the authorities remained
cautious in light of continued strong inflationary pres
sures, and no further action was taken. As a result,
sterling continued to be buoyed by capital inflows
coming from OPEC and other international investors
seeking to diversify their portfolios and to lock in
high yields on British government securities. Expec
tations of a near-term cut in British interest rates re
ceded, and the pound was propelled to a five-year high
of $2.3992 against the dollar on July 24. Subsequently,
the rebound in United States interest rates produced a
steep decline to $2.3305 at the month end, for a net
increase of 2 1/2 percent over the six-month period.
However, the pound continued to trade firmly against
the other major currencies, so that it closed at 74.4
on a trade-weighted effective basis on July 31.
During the six-month period, the Bank of England
intervened to smooth fluctuations in the sterling rate.
These operations had a negligible impact on Britain’s
foreign exchange reserves. Instead, the $1.6 billion
increase over the period to $20.4 billion mostly re
flected further revaluation gains from periodic renew
als of gold and dollar swaps against ECUs done with
the European Monetary Fund.
French franc
The French economy was embarked on a sustained
recovery late in 1979 when the sharp hike in imported
oil costs threatened to aggravate domestic inflationary
pressures, lower real incomes, and impose a sharp
reversal in France’s current account position. The
authorities faced the prospect that the significant im
provements achieved in curbing inflation, restoring the
balance of payments to a surplus position, and im
proving the competitiveness of French industry, after
years of stabilization policies, would now be seriously
undercut. By early 1980, consumer prices were rising

Chart 7

France
Movements in exchange rate and official
foreign currency reserves
Francs per dollar

Billions of dollars

See exchange rate footnote on Chart 3.

at an annual rate of more than 13 percent. Last year’s
$1.2 billion current account surplus had just about dis
appeared. And the huge increase in France’s oil import
bill was expected to lead to a $4-5 billion deficit in the
current account this year. Meanwhile, a shakeout of
noncompetitive French industries, together with a bulge
in young entrants to the work force, had generated a
rise in unemployment even as the economic recovery
continued.
In response, the government had provided some
fiscal stimulus on a selective basis (expanding pro
grams to create jobs, providing additional low-cost
financing to industry, and increasing low-income sub
sidies to offset increases in public-sector energy
prices) while keeping the government’s borrowing
requirement at a relatively low 1.3 percent of GDP
(gross domestic product). Meanwhile, France’s already
restrictive monetary policy was reinforced in order not
to accommodate the accelerating rate of domestic
inflation. The 11 percent target for monetary expan
sion set for 1979 was carried forward into 1980 and
the system of credit ceilings was tightened. Inasmuch
as a strong demand for credit was fueling a growth
of the money supply well above the target rate, the Bank
of France’s efforts to curb this expansion generated a
progressive rise in both short- and long-term interest
rates.
In the exchange markets, the French franc benefited
from this rise in interest rates. Moreover, France’s
current account deficit, though a source of con

FRBNY Quarterly Review/Autum n 1980

cern, was expected to be substantially smaller than
the current payments imbalance of Germany, its
principal trading partner. Also, in the context of
the Iranian crisis, the traditionally good relations be
tween France and the Middle East were expected to
favor the franc in two respects. Part of the anticipated
increase in OPEC’s surplus would gravitate into the
franc. Also, the impact of any further oil supply dis
ruptions would be less severe for France than for
most other major countries. In this atmosphere, com
mercial leads and lags remained favorable to the
franc, and international investors steadily moved some
of their funds into domestic and Eurofranc assets.
These inflows enabled the French franc to stay
at the top of the EMS band throughout the early
spring. Indeed, the Bank of France regularly had to
intervene in European currencies to keep the franc
within the obligatory EMS margins, and often it pur
chased dollars as well. These operations were, for the
most part, reflected in the $1.5 billion increase in
France’s foreign exchange reserves over the months
January through March.
When the scramble for dollars developed between
late February and early April, the franc fell along with
the other European currencies. But the franc declined
less than the mark against the dollar. Even so, it
dropped some 12 percent from its opening level of
FF 4.0725 to as low as FF 4.5550 on April 7. When the
dollar turned around after the Easter holiday, the franc
came back into heavy demand. Amid reports of large
Middle Eastern demand for French francs, the rate
was bid up sharply, prompting the Bank of France to
intervene vigorously both in EMS currencies and
in dollars. With the franc remaining at the top of a
nearly fully stretched EMS and the mark at the bottom,
the Federal Reserve supplemented its intervention
operations in New York by selling on three occa
sions between April 9 and April 16 $73.9 million equiv
alent of French francs. These sales were financed by
drawings on the swap line with the Bank of France.
During the late spring the French economy showed
signs of turning down. Domestic demand weak
ened, industrial output declined, and the continuing
rise in unemployment was generating some pressures
for more stimulative measures. Nevertheless, the
money supply was still expanding slightly above the tar
geted rate, the current account deficit was widening,
and inflation continued at a troubling double-digit
pace. In late June, the French government announced
it would provide some additional funds for investment
by the nationalized industries into the housing sector.
But the authorities were unwilling to ease their restric
tive monetary stance. Instead, restrictions on the ex
pansion of bank lending were maintained and the limits

42 FRBNY Quarterly Review/Autumn 1980

were tightened for the second half of the year. As a
result, French interest rates stayed relatively high dur
ing May and June.
Thus the franc continued to benefit from various
types of capital inflows. It also was bolstered by
unusually large repatriations of investment income
and favorable tourism receipts. The franc therefore
joined in the continued, albeit more gradual, rise of
the European currencies against the dollar, moving
up some 1 1 1/2 percent from the early-April low to
FF 4.0235 by July 8. The Bank of France continued
buying modest amounts of dollars and EMS currencies.
The Federal Reserve again included the French franc
in its intervention operations, selling $86.8 million
equivalent on four occasions between mid-June and
end-July. This intervention was financed by further
drawings on the swap line with the Bank of France,
raising the System’s swap indebtedness with the
French central bank to $166.3 million equivalent includ
ing revaluation adjustments from renewals of earlier
drawings.
During July, French interest rates eased somewhat.
Nonetheless, the franc fell less than the mark when
the dollar rose in late July. At this time the Federal
Reserve was able to buy $1.2 million equivalent of
French francs from a correspondent to begin covering
its outstanding swap debt. On July 31 the franc was
trading at FF 4.1350, for a net decline of 1 1/2 percent
over the six-month period.
Meanwhile, France’s foreign currency reserves con
tinued to increase during April through July. The large
rise in April and July resulted in part from the revalu
ation gains stemming from quarterly renewals of its
swaps with the European Monetary Fund. But, in addi
tion, the continuing purchases of dollars and EMS
currencies also contributed to a rise in foreign cur
rency reserves, which stood at $25.3 billion at the
end of July.

Italian lira
Throughout 1979 the Italian lira had been bolstered in
the exchange markets by a substantial current account
surplus, together with relatively high interest rates and
restrictions on domestic credit expansion that had
drawn in large movements of capital from abroad. As
a result, the lira had risen during the second half of
the year to trade at LIT 807.50 against the dollar by
end-January 1980, while also remaining in the upper
half of its 6 percent band within the EMS. Meanwhile,
the favorable balance-of-payments position and valu
ation adjustments stemming from quarterly renewals of
Italy’s swaps with the European Monetary Fund had
generated an increase in Italy’s foreign exchange re
serves to $18.5 billion even after repayment of some

Chart 8

Italy
Movements in exchange rate and official
foreign currency reserves
Billions of dollars
---------------------- 5.0

Lira per dollar

1
■
■

V r

Foreign currency
reserves
Scale------►
1
J

1
A

1 I I
S O N
1979

1
D

1
F

1 !
1 1 1
1
M A M
J J A
1980

See exchange rate footnote on Chart 3.

official debt. By February, however, Italy’s substantial
current account surplus was rapidly disappearing. The
impact of sharply higher oil prices, estimated to add
$8 billion to the overall import bill, was already be
ginning to weaken Italy’s trade position. And the pros
pect that Italy could avoid a return to current account
deficit with a further upsurge in its exports looked
dubious, in view of the deteriorating economic outlook
for Italy’s principal trading partners. Moreover, the
domestic economy was expanding at a brisk pace,
several sectors were encountering capacity constraints,
and inflationary pressures were again building up.
In response, over the course of the winter months,
the Italian authorities had begun to turn to a more re
strictive posture. The government raised fuel prices in
line with worldwide increases in the price of oil,
thereby absorbing purchasing power. But, with the
1980 fiscal budget still moderately expansive and ex
pected to generate a LIT 40 trillion public-sector defi
cit, much of the burden of containing inflationary
pressures continued to fall on monetary policy. Accord
ingly, the Bank of Italy had raised interest rates,
drained domestic liquidity, and tightened the enforce
ment of domestic credit ceilings by requiring that
banks lending above those limits maintain noninterestbearing deposits at the central bank. With these ac
tions producing steadily rising money market rates,
Italian companies continued to satisfy their financing

needs by borrowing abroad. Thus, the Italian lira held
within the top half of the EMS joint float throughout
the early spring.
Against the dollar, however, the lira weakened along
with other currencies after mid-February. The sharp
rise in United States interest rates soon eliminated the
interest differentials that had previously favored the
lira. To the extent that Italian companies repaid their
Eurodollar borrowings with domestic funds, they came
into the market to sell lire, thereby contributing to the
drop in the rate which fell as much as 13 percent to
LIT 912.10 by early April. But, with Italian interest rates
significantly higher than those prevailing in other EMS
countries, the lira maintained its generally favorable
position within the EMS. Consequently, the Bank of
Italy provided little support for the lira through inter
vention. Indeed, Italy’s foreign exchange reserves rose
through end-April to $21.5 billion, reflecting valuation
adjustments in its EMS holdings.
Around mid-April the lira began to recover against
the dollar as United States interest rates retreated.
The lira’s rise, however, lagged behind that of other
EMS currencies so that, while just below the center
of its 6 percent EMS band, the lira emerged as the
weakest currency within that arrangement by May.
Italy’s current account had now fallen into clear
deficit, exerting a drag on the currency’s performance
in the exchange market. Italy’s prices and wages
had continued to rise at more than 20 percent per
annum without a corresponding adjustment in the ex
change rate, so that the competitiveness of Italian
goods was being eroded. Also, poor weather had cut
into tourist revenues. Moreover, a government crisis
late in March had generated some questions as to
whether the authorities’ anti-inflation efforts would
be sustained. A new center-left coalition cabinet was
soon put in place, committed to defend the lira’s posi
tion in the EMS and to check inflation. But during the
spring, as the cabinet sought to reach an understand
ing with the trade unions on ways to limit the rise in
labor costs and to get the agreement of other political
groups on an industrial policy that might help main
tain employment, the exchange market for the lira re
mained nervous.
Against this background, pressures began to mount
for a devaluation of the lira within the EMS to restore
the competitiveness of Italian industry in world markets
so as to bolster exporters’ profit margins and to sus
tain economic growth in the face of a spreading slow
down abroad. Although government officials in their
public statements stressed the argument that devalua
tion was not a viable alternative in a highly indexed
economy, the lira came on offer as market participants
continued to anticipate that a new economic package

FRBNY Quarterly Review/Autum n 1980

from the government might include a devaluation. In
this environment, short-term capital outflows quickly
materialized. As the outflows persisted during June,
the Bank of Italy entered the market in force, selling
large amounts of dollars to prevent the lira from weak
ening further within the EMS.
In early July, the government announced new mea
sures to bring both the economy and the exchange
market into better balance. The measures included
higher indirect taxes to finance a reduction of employer
social security contributions, more export credits, and
a reduction of the public-sector deficit. Also, the gov
ernment proposed a Vz percent withholding scheme for
wages and salaries, in which the proceeds would be
invested in bonds redeemable in five years to finance
economic development. In addition, the Bank of Italy
announced a further restriction of domestic credit ex
pansion to 13 percent per annum.
The exchange market reacted favorably to the pack
age. With devaluation fears dissipating, funds flowed
back into the lira during the balance of July, as com
mercial and professional participants covered short
positions. The lira, therefore, traded more comfortably
at the bottom of the joint float through the month end.
On July 31, the lira traded at LIT 838.80, for a net
decline of 3% percent over the six-month period.
In addition, the flows of funds back into the lira,
together with further valuation adjustments of EMS
gold holdings produced a $500 million increase in
foreign exchange holdings, to $22.0 billion, for a net
rise of $3.5 billion over the six-month period.

European Monetary System
By the period under review, the countries whose cur
rencies were members of the EMS’s joint float were
faced with the problem of having to adjust their econ
omies to large increases in the price of oil. Most of
the economies were already expanding fairly briskly,
generating upward pressure on prices and wages. Con
sequently, for the authorities in each country the great
est concern was to prevent higher energy prices from
setting off an inflationary spiral. Each country thus
adopted restrictive policies both to restore external and
internal balance to their economies and to fund their
current account deficits. Monetary policy was the major
instrument for achieving restrictiveness and interest
rates remained high in the EMS countries.
Within the joint float the configuration of currencies
remained relatively stable, even as the entire EMS
fluctuated widely against the dollar. For the most part
the French franc stayed at the top of the band, while
the German mark remained near the bottom. The
Netherlands guilder traded firmly near the top of the
band. By contrast, the Belgian franc came under per

44 FRBNY Quarterly Review/Autumn 1980

sistent selling pressure between February and early
April, reflecting the market’s concerns over Belgium’s
fiscal and current account deficits and the political dif
ficulties facing the coalition government. The National
Bank of Belgium intervened forcefully to keep the franc
within its 21A percent band. Domestic interest rates
were also raised. These actions stemmed the outflows,
and during the last three months of the period the
franc traded comfortably within the limits of the band.
The Danish krone also came under selling pressure
early in the period and required some official support
through intervention. However, the krone gradually
came into better balance in the early spring. There
after, it traded steadily in the lower half of the EMS
through the end of July.
The remaining two currencies fluctuated more widely.
The Italian lira fell from the top to the bottom of the
joint float and required substantial official support in
June before stabilizing in July. By contrast, after trad
ing near the bottom through mid-March, the Irish punt
rose into the upper half of the EMS band during the
spring and remained there through the end of July.

Canadian dollar
The sharp jump in international oil prices during 1979
had somewhat different consequences for Canada
than for most other industrialized countries. Its un
tapped reserves of oil, natural gas, and other energy
resources gave Canada considerable potential for in
creasing energy production in the future, both for use
at home and for export. In the meantime, the oil price
hike had little direct effect on Canada’s trade account,
since the country is self-sufficient in oil and gas. It
did have implications, however, for the distribution of
income between the oil-producing provinces of the
west and the oil-consuming provinces of the east.
Moreover, if oil prices in Canada were allowed to
adjust more rapidly to international price levels, the
escalation of energy prices would add to inflationary
pressures. A proposal to that effect in the budget,
which had brought about the government’s defeat in
December, was still under debate pending a general
election in mid-February.
Canada’s current account had begun to show signs
of improvement. As a net exporter of raw materials,
Canada benefited in 1979 from the favorable shift
in terms of trade that reflected pressures in world
commodities markets generally. In addition, the sharp
depreciation in the Canadian dollar of previous years
and the sustained efforts to curb cost and price pres
sures at home had substantially enhanced the inter
national competitiveness of domestic industry. But,
with much of the manufacturing sector up against
capacity constraints, Canada was all the more vulner

able to the demand and price pressures in the United
States, Canada’s principal trading partner. In these cir
cumstances, economic policies continued to focus on
the need to counter inflationary tendencies. Fiscal
policy had been tightened in an effort to reduce the
sizable budget deficit. Monetary policy was aimed at
restraining the growth of the money supply while seek
ing an interest rate relationship between Canada and
the United States that did not contribute to an accel
eration of inflation through a further substantial decline
in the Canadian dollar. As United States interest rates
had risen, interest rates in Canada moved up and the
Bank of Canada raised its discount rate in several
steps to 14 percent.
By early February, Canada’s rich energy resources
and its improving current account performance had
contributed to a generally positive sentiment toward
the Canadian dollar. Also, its relatively high interest
rates and North American location made Canada an
attractive investment opportunity, especially at a time
of growing political uncertainty and security concerns.
The Canadian dollar had strengthened considerably
over the preceding two and a half months to trade at
Can.$1.1574 by the beginning of the month. Then, when
it was clear that the general election had provided for
a majority government, the Canadian dollar came into
stronger demand. Capital inflows intensified as re
peated reports of new oil discoveries off the Newfound
land coast attracted foreign funds into a rising Canadian
stock market. The Canadian dollar was thus propelled
to Can.$1.1419 on March 3, its highest level in nearly
a year. Meanwhile, the Bank of Canada, operating to
moderate the fluctuations in its currency, had pur
chased dollars in the exchange market. These acqui
sitions were reflected in the $433 million increase in
official foreign currency reserves during the month
from the end-January level of $1.9 billion.
Nevertheless, the Canadian dollar remained vulner
able to actual or anticipated shifts in capital flows.
When the intense demand for credit in the United
States pushed up interest rates so sharply as to raise
doubts in the market whether Canadian interest rates
would keep pace, the spot rate began to ease early in
March. Already interest rates in the United States had
risen above comparable levels in Canada, and market
participants were unsure how long this unusual pattern
would continue without siphoning off the inflows
needed to offset Canada’s current account deficit.
Monetary growth in Canada had slowed considerably.
Indeed, the monetary aggregates were now just within
the lower end of the Bank of Canada’s 5 to 9 percent
target range. But inflation was still running at 9.5 per
cent per annum, and the authorities were concerned to
avoid a substantial depreciation that might set off more

Chart 9

Canada
Movements in exchange rate and official
foreign currency reserves

1979
1980
See exchange rate footnote on Chart 3.

Chart 10

Interest Rates in the United States,
Canada, and the Eurodollar Market
Three-month m aturities*
Percent
Eurodollars
London market

fr \
j \

\\y

- — ~j
Canadian
U \
finance paper \ \
\\
Certificates of deposit
of New York banks
(secondary market)

V \_^-—««/

0 I------- i
1--------- ill
1------- 1------- 1--------- ill
1------- 1------- 1--------- I
1------1-------i
1---------i
1-------i
1-------i
1-------j
.I
J

S O N
1979

A M
1980

^Weekly averages of daily rates.

cost-price pressures at home. Therefore, to provide
itself with more flexibility to react to rapidly changing
external conditions and to avoid increases in short-term
interest rates beyond those necessary to contain infla
tion, the Bank of Canada announced on March 10 it
would set its official discount rate each week at 1A per

FRBNY Quarterly Review/Autum n 1980

centage point above the average rate on the weekly
tender of three-month Treasury bills.
Following this announcement, Canadian money mar
ket rates continued moving up, while longer rates re
mained close to their peaks during March. At the same
time, congestion had developed in the United States
bond market, leading to the postponement of several
Canadian borrowings while Canadian companies were
repaying dollar-denominated loans as United States
interest rates continued to rise. The Canadian dollar
thus came on offer. Against the United States dollar, it
declined nearly 5 percent from its earlier high to
Can.$1.1983 on April 1. The Bank of Canada intervened
heavily at times to cushion the decline; foreign cur
rency reserves decreased by $728 million during March.
Even so, the decline in the Canadian dollar from earlyFebruary levels was modest, relative to the much larger
drops of other major currencies.
After early April, interest differentials moved back
into Canada’s favor as Canadian interest rates eased
more slowly than those in the United States. Although
Canadian entities still did little borrowing in the United
States, this traditional source of finance for Canada’s
current account deficit was being replaced by invest
ment funds flowing into Canadian dollar and EuroCanadian dollar assets. Moreover, the Canadian trade
account remained in larger surplus than had been
anticipated earlier in the year.
The Canadian dollar, therefore, traded more stead
ily during the early spring. For a time, uncertainty over
the outcome of a May 20 referendum in Quebec, in
which the governing Separatist Party sought authori
zation to negotiate with the federal government on the
sovereignty issue, gave pause to the market and tem

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FRBNY Quarterly Review/Autumn 1980

pered the currency’s previous buoyancy. But, once the
market sensed that the referendum would be defeated,
the Canadian dollar began to rise again. News of fur
ther increases in the price of oil, fears of more price
increases to come out of the OPEC meeting in Algiers,
and reports of new energy discoveries in Canada added
to the upward momentum of the rate. Also, announce
ments by some Canadian provinces of plans to float new
issues in the New York bond market generated some
professional bidding. Consequently, the Canadian dol
lar was bid up in steps to Can.$1.1407 by July 7. The
Bank of Canada again bought dollars to moderate the
rise, thereby recouping much of the reserves it had
lost during March.
During the rest of July, the Canadian dollar lost its
upward momentum in the face of political tensions
arising over the question of pricing Alberta oil and
natural gas, growing uncertainties over the outlook for
United States interest rates, and concern in the market
that Canadian interest rates would ease further. As
interest rates in the United States backed up and a
heavy supply of new issues in the United States bond
market led some of the planned Canadian issues to be
postponed, the Canadian dollar dropped off along
with most other currencies late in the month.
At the end of July, therefore, the Canadian dollar,
at Can.$1.1594, was down a net Va percent over the
six-month period. During the period under review, the
Bank of Canada intervened, heavily at times, on both
sides of the market. In addition, the government sold
small quantities of its gold holdings at market prices
well above book value. Over the six-month period, to
tal official foreign currency reserves were unchanged
at $1.9 billion.

FEDERAL RESERVE READINGS ON INFLATION
Inflation remains one of the most bedeviling phenomena of
our time. Despite being readily observed and easily measured,
inflation has been relatively impervious to containment, and
the consequent damage to the social, economic, and political
fabric of our society is far reaching.
The Federal Reserve Bank of New York has compiled, in
one volume, a selection of speeches and articles by officials
and staff economists throughout the Federal Reserve System
which is designed to provide a comprehensive explanation of
the inflationary process, its effects and its policy implications.
This 272-page book is primarily intended as a teaching
resource for college economics teachers and all interested
economy watchers. It will also be of use to high-school social
studies teachers.
We are pleased to offer complimentary copies of Federal
Reserve Readings on Inflation to readers of the Quarterly
Review. For your copy, please write to:

FRBNY Quarterly Review/Autum n 1980

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