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Federal
Reserve Bankof
NewYork

Quarterly Review

Summer 1983
1

Volume 8 No. 2

Shifts in Money Demand:
Consum ers versus Business

C redit Cycles and the P ricing of
the Prim e Rate

Recovery w ith o u t A ccelerating
Inflation?

Federal D eficits and Private C redit
Dem ands: Econom ic Im pact Analysis

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 staff
who contributed to this issue are
LAWRENCE J. RADECKI and JOHN
WENNINGER (on shifts in consumer
and business money demand, page 1 );
MARCELLE ARAK, A. STEVEN
ENGLANDER, and ERIC M. P. TANG
(on credit cycles and the pricing of
the prime rate, page 12); A. STEVEN
ENGLANDER and CORNELIS A. LOS (on
recovery without accelerating inflation,
page 19); JAMES R. CAPRA (on the
economic impact analysis of Federal
deficits and private credit demands,
page 29).
An interim report of Treasury and
Federal Reserve foreign exchange
operations for the period of February
through April 1983 begins on page 45.

Shifts in Money Demand:
Consumers versus Business

The year 1982 was particularly difficult for interpreting
M-1 data. The growth of money (M-1) during 1982,
whether viewed in terms of velocity (Chart 1) or in
terms of the levels predicted using a conventional
money demand equation (Chart 2), was much stronger
than past experience would have suggested. More
over, rapid M-1 growth has continued through the first
half of 1983. Not only was the strength in M-1 sur
prising, but virtually all of the strength was in the
money holdings of the consumer sector and concen
trated in NOW account deposits. The business sec
tor, in contrast, economized on cash balances.
These markedly different trends among the com
ponents of M-1 raise questions about whether the
relationship between M-1 and the level of economic
activity is changing. A higher percentage of total
money holdings is in the consumer sector. Of these
holdings a higher percentage is being held in interestbearing deposits. Moreover, in recent years consum
ers have been offered additional liquid market-rateyielding alternatives to transactions balances. This
makes it very likely that the response of consumer
money holdings to changes in interest rates is quite
different from what it was before.
In many ways, 1982 was a year that points to sev
eral problems that are likely to be encountered in
the future with M-1 as an intermediate target for
monetary policy. And the data available thus far in
1983 point to the conclusion that these problems
are persisting beyond 1982. Thus, it is important to
learn as much as possible from monetary develop
ments in 1982.
Of course, 1982 was not the first time there was a

sizable disparity between the actual growth of M-1
and the growth predicted by a conventional money
demand equation (Chart 2). For example, in 1974 and
1975, the money stock tended to grow at rates con
siderably less than would have been expected from
past relationships with income and interest rates, i.e.,
a negative prediction error. In contrast, from 1976 to
1980, the prediction error over each year tended to be
rather small.1 But in 1981 there appears to have been
another substantial overprediction of money (perhaps
even larger than in 1974 or 1975) and in 1982 a sizable
underprediction. Not only is an underprediction of
money surprising during a period of advancing tech
nology in managing money balances, but in absolute
terms the 1982 prediction error is one of the two
largest out-of-sample errors for any year in the post1973 simulation period! Thus, the stability of the pub
lic’s demand for money has become an issue once
again.
In this article, the consumer and business sectors
are examined individually. Clearly, the money holdings
of the two sectors were not responding to the same
sets of forces in 1982 or, for that matter, in 1981.

1 In Chart 2, errors are plotted from a static simulation in which the
actual values of the lagged money stock are used during the projec
tion period rather than the values predicted by the equation. If the
predicted values had been used and a "dynamic” simulation run had
been taken, the overall pattern in the errors would have been roughly
the same, although the downward shift in the mid-1970s would appear
somewhat larger. Some deterioration in the equation's ability to track
movements in money would have been expected as the simulation
period is extended farther away from the sample period, but nonethe
less the recent behavior of M-1 relative to the forecasts is quite
striking compared with the 1976-80 period.

FRBNY Quarterly Review/Summer 1983

Chart 1

In 1982 the velocity of M-1 was extremely
weak, whether viewed relative to
recent years . . .
Percent
10

Q uarter four to quarter fo u r growth rates

M-1

‘ adjusted

4
2

0
-2

-4
-6

I_1971
_ I_72
_ I_73
_ I_74
_ I_75
_ I_76
_ I_77
_ LJ
__ I__ I__ i__
78 79 80 81 82
. . . or in terms of cyclical movements.

Percent
10 ----------------------------------------------------------------------Postwar business cycles

8--------------------------------------------

6 ----------------------

------------------------------

4—

-----

-----------------------------------

—

---------------------------

-2

-4
Recoveries

First year
of recoveries

Recessions

Last
recession
1981-IV to
1982 -IV

Consumers were permitted to hold interest-bearing
checking accounts— NOW accounts— while firms were
not. Businesses, however, it could be argued, con
tinued to emphasize cash management, particularly in
1981 when interest rates were very high. Thus, it should
be more revealing to examine separately the check
able deposit holdings of these two sectors during the
past few years, rather than to look just at economywide velocity or money demand results for the M-1
measure of money.
In the next section of this article, velocity trends
for the consumer and business sectors are examined
for a general idea of their contributions to the large
decline in aggregate velocity in 1982. The section
following that explores the problem in terms of sepa
rate checkable-deposit-demand equations for the two
sectors, while in the third section some of the possible

FRBNY Quarterly Review/Summer 1983

reasons for the steep decline in velocity in the con
sumer sector are explored in more detail. In the con
clusion, some of the policy implications are spelled out.
By and large, the analysis suggests that rapid
growth of NOW account balances held by the con
sumer sector was the primary reason for the decline
in velocity during 1982.
• New NOW accounts continued to be opened in
1982 and hence, as was the case in 1981, M-1
was inflated somewhat as savings and demand
deposits were combined into NOW accounts.
• The responsiveness of M-1 to changes in mar
ket rates appears to be increasing in part
because NOW accounts earn a 5Va percent
rate of interest and in part because several
highly liquid alternatives to M-1 deposits that
bear market yields have become widely used
in recent years by the consumer sector. After
allowing for the opening of new accounts in
1982, even a very conservative market rate
response by the consumer sector would ex
plain the increase in deposits.
This conclusion, of course, has important implica
tions for policy in the future because money market
deposit accounts (MMDAs) could add further to the
market interest rate response of the consumer sector’s
money holdings. This will be offset, at least in part by
the Super NOW account— a component of M-1 that
bears a market-related rate. Nevertheless, all these
developments mean that it will be difficult to interpret
M-1 for some time, and alternative approaches will be
required in implementing policy.
Velocity trends in the consumer and business sectors
Prior to 1979, velocity— GNP/checkable deposits—
in both the consumer and business sectors was in
creasing (Chart 3) and the sectoral velocities tended
to move in a parallel manner. (Box 1 gives more detail
on the sectoral decomposition of demand deposits
and total checkable deposits.) Since that time, how
ever, it has not been widely noted that the velocity of
checkable deposits— demand deposits plus NOW de
posits— in the consumer sector has been declining,
while in the nonfinancial business sector velocity
has continued to increase. In fact, velocity in the busi
ness sector increased so rapidly in the past few years
that the volume of demand deposits held by businesses
at the end of 1982 was virtually equal to what it was
four years earlier. This occurred even though nominal
GNP rose 36 percent over that period. In contrast, the
consumer sector increased its holdings of checkable
deposits by 81 percent during that time.

What this means is that the predictability or stability
in the trend of aggregate velocity in 1979, 1980, and
especially 1981 was the result of a coincidence. The
divergent movements in the consumer- and businesssector velocities just happened more or less to offset
each other in those three years. Consequently, aggre
gate velocity appeared to be roughly in line with
its trend over the previous ten years. The year 1981
was particularly fortuitous in that velocity in the busi
ness sector increased by 15 percent, while simulta
neously velocity in the consumer sector decreased by
13 percent. But it is difficult to imagine that offsetting
movements such as these would continue indefinitely.
And, in 1982, velocity growth in the business sector
returned to its long-run trend, while velocity growth in
the consumer sector remained as weak as it had been
in 1981. These developments thereby produced the re
markable drop in aggregate velocity observed in 1982.
As a result of the large increase in checkable de
posit holdings by the consumer sector over the past

few years, compared with no increase by the business
sector, consumers held at the end of 1982 about 48
percent of total checkable deposits and the business
sector 38 percent. As recently as 1976, the breakdown
was 38 percent for the consumer sector and 52 percent
for the business sector, a swing of 10 to 14 percentage
points in relative checkable deposit holdings. (Other
sectors currently hold about 14 percent of total check
able deposits.) Because of this shift in the composition
of total checkable deposits, changes in the trend of
aggregate velocity and in its behavior over the busi
ness cycle could occur, particularly since consumers
can also earn interest on certain types of checkable
deposits. Moreover, for the same reasons, estimates
of economywide money demand equations could suffer
from considerable aggregation bias. And, finally, the
changing sectoral composition of M-1 points to po
tential problems for the implementation of monetary
policy based on M-1 as the intermediate target.

C hart 2

E rro rs fro m C on v en tio n a l M oney D em an d Equation
Q uarterly growth rates and annual averages
PerceVit
S ta tic sim u la tion

1\
/"V

—

---- -------------------------

—

L x f ^ r ^ y
n/ \7

< /-\7 \ f
V \ I

\ A
-•*4—

\u
-1.5
0.9

I
1974

- 2 .0
2.8

0.1
1.1

1975

0.3
1.5

1976

-0 .6
0.6

1977

10.15

- 0 .4
2.8

1978

Estimation period is 1959-11 through 1973-IV
M=0.61 + 0.69M(—1) - 0.016CP - 0.024RCBP + 0.16Y
(1.81) (6.74)
(3.61)
(1.79)
(4.38)

1979

- 2 .5
3.5

7.I6

1980

I
1981

2.4
4.8 t

1982

1983

M=ln (M-1/GNP deflator)
CP=ln (commercial paper rate)
RCBP=ln (commercial bank passbook rate)
Y=ln (real GNP)

R2=0.98
* Row of figures indicates annual average errors for indicated years.
"^Row of figures indicates average quarterly absolute deviation for indicated years.

FRBNY Quarterly Review/Summer 1983

Chart 3

V e lo c ity G row th of C h e c k a b le D epo sits
Fourth quarter to fourth quarter
Percent
IE -----------A
Nonfinancial f
business /

✓ CL- —

5
0

\
~~ .

■

-----------------------Consumer \

5
-1 0

I
I
I
I
i V
-1 5 l ------- 1------- 1------- 1------- L
1972 73 74
75
76 77
78
79
80
81
Source:

l
82

Federal Reserve Bulletin.

Checkable-deposit-demand equations for the
consumer and business sectors
Tracking velocity trends is one of two approaches
frequently used to analyze the growth of money or
checkable deposits. In this statistical section of the
article, separate checkable-deposit-demand equations
for the consumer and business sectors are employed.
The regression equations indicate that for the con
sumer sector the demand for checkable deposits re
mained stable through 1980 but shifted sharply up
ward in 1981 and again in 1982. By the end of 1982,
the consumer sector was holding about $33 billion
more of checkable deposits than past experience
would have suggested. In contrast, the equation for
the business sector points to a relatively stable de
mand in that sector in the 1981 and 1982 period,
although business money holdings were overpredicted
to a moderate degree, about $7 billion.
For the consumer sector, however, a variable
that serves as a proxy for the number of NOW ac
counts opened stabilizes the coefficient estimates of
the equation when the sample period is extended
through 1981. Moreover, when this modified equation
is simulated through 1982, the prediction error is re
duced to $8 billion. The remaining error appears to
have been associated with the decline in interest rates,
and that aspect as well as others are explored in the
section on 1982 growth of checkable deposits and
the decline in market interest rates.
In estimating the regression equations for the two
sectors, three difficulties immediately arise. First, the
quarterly Demand Deposit Ownership Survey (DDOS),
from which the breakdown for consumer and business

FRBNY Quarterly Review/Summer 1983

demand deposit holdings is obtained, begins in 1971,
thereby limiting the sample period over which any
such equation might be estimated. Second, it is diffi
cult to incorporate the effects of technological change
and financial innovation on money demand in the two
sectors.2 And, third, the widespread use of NOW ac
counts by consumers is not the only important change
in financial services affecting the checkable deposit
holdings of consumers. Most notably, over the past
few years there has been a considerable change in
the instruments used by consumers for liquid savings
and, therefore, also in the closest alternatives to hold
ing checkable deposits. Consumers have moved
largely from conventional savings and small time de
posits earning low, fixed rates of interest to money
market certificates (MMCs), money market mutual
funds (MMMFs) and most lately MMDAs, all earning
market rates of interest and in some cases offering
limited transactions features.
Recognizing that these difficulties limit the confi
dence that can be placed in the results, a checkabledeposit-demand equation was estimated first for the
consumer sector over the 1971-11 to 1978-IV period,
and then reestimated with the sample period ex
tended one year at a time through 1982-IV. The
results are reported below.3 Since the DDOS is not
seasonally adjusted, seasonal dummy variables were
also included in the regressions, but the coefficient
estimates are not reported.4
1971-11 to 1978-IV:
TCD = - 6 . 6 0 + 0.98Y - 0.23PBR - 0.09D1
(13.7) (13.3)
(2.8)
(7.0)

R2 = 0.88
p = 0.31

1971-11 to 1979-IV:
TCD = - 6 . 9 0 - f 1.03Y - 0.25PBR - 0.10D1
(6.8)
(15.4) (14.8)
(2.8)

R2 = 0.90
p = 0 .2 4

1971-11 to 1980-IV:
TCD = - 6 . 8 7 + 1.03Y - 0.25PBR - 0.10D1
(6.5)
(15.4) (14.2)
(2.6)

1971-11 to 1981 -IV:
TCD = - 0 . 5 3 + 0.29Y - 0.59PBR - 0.12D1
(1.6)
(0.1)
(0.6)
(1.7)

R2 = 0.15
p = 0.99

R2 = 0.90
= 0 .2 7

2 A dummy variable is included in each equation to account for the
shift in the demand for checkable deposits since 1974.
3 To allow for lagged effects in the demand for checkable deposits, the
independent variables are two-quarter moving averages. The equations
were estimated with an adjustment for first-order autocorrelation.
4 While the use of dummy variables is a simple way to allow for seasonal
variation, it is unlikely that alternative methods would have affected
the results substantially. For example, when the money demand
equation used to simulate the 1974-82 period as shown in Chart 2 is
estimated with not seasonally adjusted M-1 data and seasonal
dummies rather than with seasonally adjusted M-1, the coefficient
estimates as well as the predicted values of M-1 are much the same.

(5) 1971-11 to 1982-1V:
TCD = -0 .9 4 + 0.16Y - 0.70PBR - 0.14D1
(0.2) (0.3)
(2.0)
(1.9)

R2 = 0.19
= 0 .9 9

where: TCD = In (total real checkable deposit holdings of the
consumer sector, obtained by using the implicit
price index for personal consumption expendi
tures).
Y

= In (real consumption expenditures).

than would be expected from past relationships. The
demand for checkable deposits in the business sector,
as can be seen from the regression results reported
below, appears to have remained relatively stable
through 1982, although there has been a fairly large
increase in absolute value in the income and interest
rate coefficients, as well as the intercept, when the
sample period includes the past two years.

PBR = In (passbook rate).
D1

= a dummy variable that increases from zero to
one over the 1974 to 1976 period.

A comparison of equations (1), (2), and (3) indicates
that the demand for checkable deposits remained
stable in the consumer sector through 1980— the co
efficient estimates are virtually the same, and the ex
planatory power of the equation remained high and
quite constant. But adding to the sample just the four
observations for 1981 causes the_ explanatory power
of the equation to fall sharply, the R2 drops from 0.90 to
0.15. This implies that the increase in NOW account
holdings during that year could not have repre
sented just a substitution of demand deposits for
NOW account deposits, leaving the demand for total
money balances unchanged. Indeed, when equation (3)
is simulated out of sample for the 1981-82 period, the
underestimate— amount by which the actual value
exceeds the predicted— by the fourth quarter of 1982
reaches $33 billion. About $13 billion or 40 percent
of the total error for the period occurs in the first
quarter of 1981, when NOW accounts were intro
duced nationwide, and about another $11 billion in the
fourth quarter of 1982 (Table 1), right after short-term
interest rates had declined sharply.
The second large increase in the cumulative predic
tion error suggests that this equation does not capture
the market interest rate response of consumer check
able deposit holdings, since a large part of these
holdings is in the form of NOW account deposits and
consumers have and use more market-yielding alterna
tives to checkable deposit holdings than in the past,
1.e., MMMFs and MMCs. Regardless of the exact na
ture of the additional $33 billion o( money holdings
by the consumer sector, this figure represents about
43 percent of the total increase in NOW account vol
ume over the 1981-82 period (and 54 percent of the
increase in checkable deposits held by the consumer
sector). It shows that the introduction of NOW ac
counts nationwide has changed dramatically the
desired quantity of checkable deposits the consumer
sector holds.
What about the business sector? The velocity charts
shown earlier pointed out that this sector, in contrast to
the consumer sector, has been holding lower balances

(6) 1971-11 to 1978-1V:
DD = —1.92 + 0.94Y - 0.04CP - 0.44D 2
(0.9)
(3.2)
(1.3)
(4.2)

(7) 1971-11 to 1979-IV:
DD = - 1 .5 9 + 0.89Y - 0.05CP - 0.43D2
(0.8)
(3.2)
(1.8)
(4.8)

(8) 1971-11 to 1980-IV:
DD = - 1 .6 0 + 0.89Y - 0.05CP - 0.43D2
(1.0)
(4.0)
(2.4)
(6.6)

(9) 1971-11 to 1981-IV:
DD = -3 .5 1 + 1.17Y - 0.08CP - 0.52D2
(1.8)
(4.3)
(3.4)
(7.4)

(10) 1971-11 to 1982-IV:
DD = -4 .1 8 + 1.27Y - 0.08CP - 0.57D2
(2.3)
(5.0)
(3.3)
(9.9)

R2 = 0.91
p = 0 .7 6

R2 = 0.89
p = 0 .6 4

R2 = 0.90
p = 0 .6 2
R2 = 0.90
p = 0 .7 3

R2 = 0.92
p = 0 .7 7

where: DD = In (real demand deposit holdings of the business
sector obtained by using the GNP implicit price
index).
Y

= In (real GNP).

CP = In (three-month commercial paper rate).
D2 = a dummy variable that increases gradually from
zero to one over the 1974-82 period.

If equation (8), estimated through 1980, is simulated
for the next two years, it overpredicts demand de
posit holdings of the business sector by about $7
billion by the fourth quarter of 1982 (Table 2). This is in
sharp contrast to the $33 billion underprediction for the
consumer sector’s holdings of total checkable deposits.5
The cumulative error for the business sector at the
end of 1981 was about $7 billion but grew no larger
during 1982. This pattern in the prediction error agrees
with what was noted earlier in the discussion of
Chart 3: the business sector’s velocity-increasing cash
management practices did not offset the velocityreducing buildup in consumer NOW accounts to so
large a degree in 1982 as in 1981, and thus the large
decline in overall velocity in 1982 resulted.
With the growth of M-1 in 1982 concentrated in the
consumer sector’s holdings of other checkable de
posits, the question arises as to what extent the rapid
growth of M-1 could be attributed to consumers cons A further indication that aggregate money demand equations could
suffer considerable aggregation bias comes from the opposite signs
of the errors for these two sectors.

FRBNY Quarterly Review/Summer 1983

Box 1: Demand Deposit Ownership Survey
The results of the Demand D eposit O w nership Survey
(D D O S) are published in the Federal Reserve B ulletin.
Four tim es each year, the Federal Reserve System c o n
ducts a survey of 232 banks co n cerning the dem and
d eposit h o ld in g s of individuals, partnerships, and c o rp o
rations. From the survey’s findings, estim ates are made
of dem and de p osit ho ld in g s o f five ow nership categories:
financial business, nonfinancial business, consum er, fo r
eign, and other. The estim ates are on a d a ily average
basis for the last m onth of each quarter. To ca lculate the
total checkable de p osits of the consum er sector, other
checkable de p osits— co n sistin g prim arily of NOW account
deposits— fo r the last m onth of each quarter are added
to the consum er s e cto r’s dem and deposits as shown in
this survey.
The Board of G overnors’ staff tested the va lid ity of the
DDOS data in d irectly and fo u nd it to be “ reasonably re
lia b le ” . This test was part o f the study by Helen T. Farr,
Richard D. Porter, and Eleanor M. Pruitt, “ Dem and D eposit
O w nership Survey” , in Im proving the M onetary A ggregates
(Staff Papers, Board of G overnors of the Federal Reserve
System, 1 9 7 8). For a d d itio na l inform ation on the DDOS,
see the Federal Reserve B ulletin (June 1 971).

tinuing to shift funds from outside M-1 into NOW ac
counts as they opened additional NOW accounts. An es
timate of the number of accounts opened nationwide
can be derived from a survey on average balances in
NOW accounts (Box 2). Incorporating this information
in the regression equation can then give an estimate
of how much the opening of NOW accounts has
been adding to the total checkable deposit holdings
of the consumer sector. The results from estimating
the demand equation with a number-of-NOW-accounts
variable (N) included are shown in equation (11).6
(3) 1971-11 to 1980-IV:
TCD = - 6 . 8 7 + 1.03Y - 0.25PBR - 0.10D1
(15.4) (14.2)
(2.6)
(6.5)

R5 = 0.90
p = 0 .2 7

(11) 1971-11 to 1981 -IV (w ith n u m b e r-o f-a cco u n ts va ria b le ):
TCD = - 6 . 8 6 + 1.03Y -0 .2 5 P B R - 0.095D1 + 0.014N
(15.8) (14.5)
(2.7)
(6.6)
(12.0)
W = 0.96
p
= 0 .2 3
(4) 1971-11 to 1981-IV (w ith o u t n u m b e r-o f-a cco u n ts v a ria b le ):
TCD = - 0 . 5 3 + 0.29Y - 0.59PBR - 0.12D1
R2 = 0.15
(0.1)
(0.6)
(1.7)
(1.6)
p
= 0 .9 9

4 Prior to the introduction of nationwide NOWs in January 1981, the
value of this variable is zero. It is not intended to control for the
gradual development of NOW accounts in a few states prior to 1981
but for the introduction of NOWs nationwide in 1981.

FRBNY Quarterly Review/Summer 1983

Comparing equations (3) and (11), it can be seen
that with the number-of-accounts variable included in
the regression the estimated coefficients remained very
stable when the sample period was extended through
1981. In contrast, with the number-of-accounts variable
omitted the estimated coefficients not only change dras
tically but also become insignificant (equation 4). This
result for 1981 raises the question whether a very sig
nificant portion of the M-1 growth during 1982 was
due to consumers combining savings and transactions
balances when opening a NOW account. (The transfer
of savings into NOW accounts is probably partly to
meet the higher minimum balance requirements on
NOW accounts than on demand deposit accounts.)
When equation (11) is simulated through 1982-IV, it
underpredicts consumer money holdings by $7.6 bil
lion, whereas if it is simulated keeping the number-ofaccounts variable constant at the 1981 -IV level, the
prediction error is $15.8 billion. This implies that ap
proximately $8 billion represents funds flowing into
checkable deposits from outside M-1 because of the
opening of new accounts (Box 2). That leaves an
additional $71/2 billion of consumer checkable deposit
holdings to be explained by other factors. All of this
remaining prediction error is concentrated in the fourth
quarter of 1982, following the large decline in short
term interest rates in the third quarter. The timing
suggests a sizable response on the part of consumers,
especially those that hold NOW accounts, to the de
cline in market interest rates. This possibility is ex
plored in more detail in the next section.
1982 growth of checkable deposits and the
decline in market rates

With the econometric results of the previous section
in mind, the article now explores in more detail
whether the strength in the consumer sector’s hold
ings of checkable deposits can be explained by the
decline in market interest rates. A basic problem, how
ever, in attempting to attribute the observed strength
to the decline in market rates in 1982 is that this
strength could just as well have been the consequence
of an increased precautionary demand for money. The
severe recession of 1981-82 certainly created a sense
of financial insecurity, or at least caution, on the part
of households. Consequently, to some unknown ex
tent, consumers enlarged their overall holdings of
liquid precautionary balances. Small time deposits
and MMMF shares grew very rapidly— 6.0 percent and
31.6 percent— and, after exhibiting a general decline
for the past few years, even passbook savings accounts
showed a significant increase. (These were measured
from December 1981 to November 1982 before the
introduction of the MMDA.) Along with these increases,

some of the growth of NOW accounts, since they earn
nearly the same rate of interest as passbook accounts,
must have represented additions to precautionary,
rather than transactions, balances. This makes it diffi
cult to estimate how much of the bulge in M-1 was
due to the decline in market rates.7
Even though it is not possible to disentangle the ef
fects of an increased precautionary demand for money
during 1982 from the decline in interest rates, the
question remains whether a reasonable interest rate
elasticity can be used to explain the buildup in con
sumer checkable deposit holdings. The differential be
tween the explicit rates paid on checkable deposits
(0 percent for demand deposits, 51A percent for NOW
and ATS accounts) and the rates paid on the savings
vehicles most popular among consumers during 1982
— MMCs and MMMFs— narrowed considerably.8 During
1981 -IV consumers were able to earn about 12.5
percent on highly liquid savings but during 1982-IV
only about 8.5 percent. This means that the opportunity
cost of holding demand deposits fell by about one third,
and the opportunity cost of holding NOW and ATS
deposits fell by over one half, from about 7.25 per
cent (12.5 percent minus 51/4 percent) to about 3.25
percent (8.5 percent minus 51/4 percent).
According to the conventional theory of the demand
for money, an increase in consumer checkable deposit
holdings would be expected as the opportunity cost
of holding checkable deposits falls. The magnitude of
the increase depends on the value of the elasticity
of demand with respect to opportunity cost. Thus, to
get a rough idea of how great an increase could have

7 A further problem in attributing all the strength in M-1 to the con
sumer sector stems from the consideration that the demand deposit
holdings of financial businesses at commercial banks increased $7
billion or 25 percent during 1982 after holding fairly steady for a
number of years. Financial businesses include thrift institutions, securi
ties dealers, insurance companies, finance companies, and invest
ment companies. The rise in the deposit holdings of this category,
however, is very difficult to interpret in terms of M-1. Some of the
deposit holdings of the thrift institutions are netted out of M-1 when the
demand deposit component is consolidated across institutions. Hence,
part of this $7 billion increase shown in the DDOS might not show up
at all in M-1. Furthermore, it is hard to believe that government
securities dealers and some of the other financial businesses would
increase their demand deposit holdings very much while nonfinancial
businesses are not increasing their holdings because these financial
businesses are among the most sophisticated of cash managers. It
could be argued, of course, that some increase in the deposit holdings
of these firms might be expected as a result of the increased volume
of trading in the stock market in the second half of 1982. But, again,
while that might increase consumers’ or some nonfinancial businesses'
demand for checkable deposits for the purpose of making financial
transactions, it is still hard to understand why the deposit holdings of
the sophisticated dealers and brokers would increase very much.
* The rate on MMCs is the discount rate on 26-week Treasury bills, set
at auction, plus 25 to 50 basis points; the rate on MMMFs is roughly
the market rate on one-month certificates of deposit (CDs) less the
charges imposed, usually around 50 basis points.

Table 1

Prediction Errors from a Simulation of Equation (3)
In billions of dollars
Period

Actual

1981:

Predicted

I ................................

144.8

II
III
IV

149.9
153.8
165.0

I ................................

1982:

H ................................
HI ................................
IV ................................

168.4
170.9
176.6
192.1

Error
131.6
138.3
142.4
145.9
146.3
150.7
154.3
159.1

13.2
11.6
11.4
19.1
22.1
20.2
22.3
33.0

Table 2

Comparison of Errors for Consumer and
Business Sectors
In billions of dollars
Period
1981:

Consumer
I .................................................13.2
M .................................................11.6
HI ................................ ................11.4
IV ................................ ................19.1

1982:

I ................................ ................22.1
II
III
IV

................20.2
................22.3
................33.0

Business

Total

—6.3
—5.0
-3 .7
-7 .4

6.9
6.6
7.7
11.7

—7.1

15.0

-4 .8
-6 .6
—6.8

15.4
15.7
26.2

Table 3

Predicted increases in Consumer Checkable
Deposits during 1982
In billions of dollars
Interest
rate
elasticity

Scale
variable*

Demand
deposits

Other
checkable
deposits!

Total
checkable
deposits

0.05 ..........
0.10 ..........
0.15 ..........

C
C
c

8.5
10.4
12.3

9.5
13.1
16.9

18.0
23.5
29.2

0.05 ..........
0.10 ...........
0.15 ..........

Dl
Dl
Dl

6.8
8.5
10.5

8.0
11.5
15.2

14.8
20.0
25.7

1.5

Actual increases
25.6
27.1

*C=:consumption expenditures, DI=disposable income.
fPrim arily NOW accounts.

FRBNY Quarterly Review/Summer 1983

been expected as a result of the fall in short-term rates
during 1982, an estimate of the opportunity-cost elas
ticity’s value in the consumer demand for checkable
deposits is needed. But, because consumers have
made extensive use of liquid, market-yielding savings
instruments for only a brief time, an estimate from
regression analysis of this elasticity in the current en
vironment could not be made directly. However, some
estimates are available for the period before 1973,
when passbook savings accounts and consumer time
deposits, while subject to interest rate ceilings, were
nonetheless the principal liquid savings vehicles. The
estimates are usually in the range of 0.15 to 0.40, and
the estimate obtained in the previous econometric
section of this article was around 0.25. Nevertheless, a
few preliminary calculations suggested that it would
not even be necessary to assume a value as large as
that to explain the bulge in consumer money holdings,
and the assumed values used here for sake of illustra
tion vary from 0.05 to 0.15, a fairly conservative range.
In this setting, to illustrate the possible effect of the

sharp drop in short-term interest rates on the con
sumer demand for checkable deposits, six sets of pre
dicted increases in the levels of demand deposits and
other checkable deposits were calculated and are pre
sented in Table 3. These sets of predicted increases
differ depending on (1) the proxy for transactions
employed (consumption expenditures or disposable in
come to which unitary elasticity in the demand func
tion was applied, consistent with the findings in the
econometric section) and (2) the assumed elasticity
(0.05, 0.10, or 0.15) applied to the opportunity cost of
holding a demand or NOW account deposit.
For example, in the top line of Table 3, an $8.5 billion
increase in demand deposits was predicted for 1982
from the $86.6 billion level of December 1981. Part of
this increase was due to a 7.7 percent rise over the
year in consumption expenditures, to which unitary
elasticity of demand was applied. The rest of the $8.5
billion increase was due to a fall in the opportunity
cost of holding a demand deposit, from 12.5 percent to
8.5 percent per year, to which in this case an elas-

Box 2: Opening of NOW Accounts during 1982
Survey results from a lim ited sam ple show that the aver
age balance in NOW (ne g o tia b le o rd e r of w ith d ra w a l)
and ATS (autom atic transfer service) accounts increased
about 9 percent from Novem ber 1981 to Novem ber 1982,
from $5,079 to $5,520. If it is assumed that these average
balance figures are representative fo r the nation as a
whole, then it is possible to construct estim ates of the
num ber of NOW and ATS accounts in existence by d iv id
ing the volum e of de p osits in these accounts by the
average balances held in them. The estim ates show that
the num ber of accounts, after grow ing very rapidly in
1981 when NOW accounts were introduced nationw ide,
increased another 22 percent in 1982. Thus, in e x p la in
ing the 33 percent increase in the d o lla r volum e of NOW
and ATS accounts from Novem ber 1981 to Novem ber 1982,
the increase in the num ber of accounts was about 2Vz
tim es m ore im portant than the increase in the size of the
average balance. The im portance of add itio na l NOW a c
counts still being opened in 1982 is that the M-1 data
w ould have been inflated du rin g that year, just as they
were in 1981 but to a lesser degree.
Roughly speaking, a little over 70 percent o r $18 b illio n
o f the $25 b illio n increase in NOW account balances a p
pears to be due to the grow th of the num ber of accounts.
Of that $18 b illion, the results from the e conom etric se c
tion suggest that $8 b illio n o r 44 percent cam e from o u t
side M -1, leaving about $10 b illio n or 56 percent com ing

FRBNY Quarterly Review/Summer 1983

Estimates on NOW and ATS Accounts
Total volume
(billions
of dollars)

Average
balance
(dollars)

Number of
accounts
(m illions)

November 1981 . . . .
February 1982 .........
May 1982 .................
August 1982 .............
November 1982 ___

75.2
83.4
87.4
91.8
100.1

5,079
5,156
5,154
5,206
5,520

14.81
16.18
16 96
17.63
18.13

November 1982 over
November 1981 (per
centage increase) . .

33.1

8.7

22.4

Period

Source: Board of Governors of Federal Reserve System.

from dem and deposits. The 44 percent com ing from o u t
side M-1 seems high in lig h t of previous experience w ith
NOW accounts and pro b a b ly should be viewed m ore as an
upper lim it.*
*For more detail on the earlier experience with NOW accounts,
see Joanna H. Frodin and Richard Startz, "The NOW Account
Experiment and the Demand for Money", Journal of Banking
and Finance (1982), pages 179-93. For 1981, the Board of
Governors’ staff estimated that about 25 percent of the growth
of NOW accounts came from outside M-1.

ticity value of 0.05 was applied. Similarly, other check
able deposits— primarily NOW accounts— were pre
dicted to increase $9.5 billion from the level of $78.4
billion as the result of the rise in consumption and the
fall in the opportunity cost of holding these deposits
from 7.25 percent to 3.25 percent per year. (In each
case, the same elasticity values were applied to other
checkable deposits as to demand deposits.) The pre
dicted increases in demand deposits and other check
able deposits together imply an increase in total
checkable deposits of $18.0 billion. The five other sets
of predicted increases shown in the table were ob
tained in the same manner.
By interpolating, it can be seen that the observed
increase in total checkable deposits is consistent with
that predicted when it is assumed that the opportunitycost elasticity value is about 0.13 and consumption
expenditures measure transactions, or when it is
assumed that the value of the opportunity-cost elas
ticity is about 0.16 and disposable income measures
transactions.9 While reasonable elasticities will explain
the increase in total checkable deposits held by the
consumer sector, the predicted increase in demand
deposits is considerably too high, and the predicted
increase in other checkable deposits is far too low.
If it is in fact correct to apply the same elasticity to
both NOWs and demand deposits, then these figures,
too, suggest that funds were switched from demand
deposits into NOWs as new accounts were opened
during 1982.
These calculations, however, do not incorporate the
estimate, reported in the previous section, of about $8
billion of funds deposited into the new NOW accounts
that came from outside M-1. Using the $8 billion esti
mate to adjust downward the increase in total check
able deposits leaves an increase of around $19 billion
to be explained by changes in the level of interest
rates and the volume of transactions. By interpolating
between the calculations shown in the table, an in
crease of $19 billion is consistent with an assumed
opportunity-cost elasticity of about 0.06 if consump
tion expenditures are used to measure transactions
or an assumed opportunity-cost elasticity of about
0.09 if disposable income measures transactions. As
would be expected, these elasticities are somewhat
smaller than those found consistent with the unad
justed increase in total checkable deposits. Looking
* Compared with the elasticities estimated in earlier studies using the
passbook rate (0.15 to 0.40), these figures appear rather small. How
ever, with respect to market rates, the consumer sector did not appear
to be very responsive until the introduction of liquid market-yielding
instruments such as MMMFs. As a result, consumers have become
more responsive to changes in market rates than in the past, but this
"responsiveness” is not yet so large as earlier estimates made with
respect to changes in the passbook rate.

next at the two components of total checkable de
posits on an adjusted basis: ( 1 ) if the estimated trans
fer of funds from demand deposits to new NOW ac
counts ($10 billion) is subtracted from NOWs and
added back into demand deposits and (2) if the $8
billion flow from outside M-1 into new NOW accounts
is subtracted from NOW accounts, then the adjusted
increases in demand deposits and other checkable
deposits are, respectively, $ 1 1 1/2 billion and $7 V2
billion.10 These adjusted figures are still somewhat
different from the predicted increases of about $8 bil
lion for demand deposits and about $10.5 billion for
other checkable deposits but are reasonably close. So,
whether or not explicit account is taken of the effect
of additional NOW accounts being opened in 1982,
even a rather small market rate response on the part
of the consumer sector would explain the increase in
that sector’s total checkable deposit holdings. How
ever, to explain the increases in the components,
adjustments for shifts of funds into new NOW accounts
are necessary.
As noted in the econometric section, to assign
much of the growth of M-1 during 1982 to a fall in
short-term rates implies that the new instruments
(MMMFs and NOWs) have made the consumer-sector
holdings of transactions balances much more respon
sive to market rate changes than in the past. If this
argument is in fact valid, then part of the reason why
an aggregate money demand equation— estimated
with data prior to 1979— underpredicts M-1 growth in
1982 is because the estimated market interest rate
elasticity was the combined response of the business
and consumer sectors covering a period when con
sumers did not use extensively either NOW accounts
or market-yielding alternatives to M-1 (Chart 2). The
continued opening of new accounts added to this ten
dency for the equation to underpredict.

Conclusions and implications for policy
In summary, what appears to be behind the large de
cline in the velocity of M-1 during 1982? First, whether
looking at the question from the perspective of sectoral
velocity or sectoral checkable-deposit-demand equa
tions, the buildup in money balances that caused the
reduction of M -I’s velocity was in the consumer sec
tor and concentrated in consumer NOW account hold
ings. But, because NOW accounts have been used
extensively for just a little more than two years, not
As shown in Box 2, the increase in the number of accounts explains
a little over 70 percent, or about $18 billion of the $25 billion increase
in NOW account deposits in 1982. If, as estimated in the econometric
section, $8 billion came from outside M-1, then about $10 billion was
transferred from demand deposit accounts, and the volume of demand
deposits would need to be adjusted by that amount.

FRBNY Quarterly Review/Summer 1983

Chart 4

N oninstitutional M M M Fs, S ix-m onth MMCs,
and M M DAs as a P ercen tag e of M -2

Chart 5

Changing C om position of C heckable D eposits
Sectors as percentage of total
Percent

Percent
40

1971 72

enough time has passed as yet to establish the degree
to which consumers view them as a savings instru
ment. Furthermore, for similar reasons, it is not pos
sible to determine what the demand elasticities of
consumer money holdings are, not only relative to
the rate paid on conventional time and savings ac
counts, but also with respect to the rates on marketyielding instruments (MMDAs and MMMFs) which
have been growing very rapidly as a percentage of
consumers’ liquid assets (Chart 4). Nevertheless, after
allowance is made for the consideration that consum
ers continued to open NOW accounts during 1982,
much of the increase in consumer money holdings
can be explained by using what would be considered,
even by very conservative standards, reasonable mar
ket interest rate elasticities for total money holdings
demanded by the consumer sector. (These elasticities
are considerably less than those estimated in earlier
studies for regulated time and savings accounts.)
Hence, one explanation for the rapid M-1 growth in
1982 is that these relatively new unregulated savings
instruments are, at least for the time being, increasing
the market interest rate sensitivity of M-1 in the sense
that consumers can more easily substitute in and out
of M-1 as market rates change.
But that explanation does not rule the others out.
It is thus difficult to anticipate what the relationship
between M-1 and the economy will be. The severity of
the recession may have temporarily increased con

FRBNY Quarterly Review/Summer 1983

sumers’ demand for liquid precautionary balances. This
leaves open the possibility of a sudden reversal at some
later date, causing velocity to rise sharply. It also in
creases the uncertainty about the degree to which M-1’s
response to movements in interest rates has changed
over the last few years. Moreover, even if consumers’
demand for money holdings has become more sensitive
to market rates over time, that is not the same as saying
that any past elasticity estimates are good guides to
the future. It appears that MMDAs, like MMMFs could
increase even further the sensitivity of consumer
money demand to interest rates, particularly since
they are covered by FDIC insurance.
On the other hand, the new Super NOW account,
because it is a component of M-1 that does not have
any limitations on the rate of interest that can be paid,
will tend to offset some of the added market interest
rate response for the consumer sector caused in re
cent years by the MMMFs and MMCs and just recently
by the MMDAs. Super NOWs could also result in some
further combining of savings and transactions bal
ances. This would be done to meet minimum balance
requirements and for the sake of having all liquid bal
ances conveniently in one place. The key point is that
not only is the composition of M-1 changing, that is,
becoming more and more consumer oriented, but
even the characteristics of the money holdings within
the consumer sector are changing— shifting from
noninterest-bearing to interest-bearing forms (Chart 5).

At the same time, new liquid alternatives for holding
narrow money are being offered to consumers. Thus,
M-1, in general, and the money holdings of the con
sumer sector, in particular, are likely to deviate from
past relationships for some time.
This, of course, raises serious questions for mone
tary policy. How much weight should M-1 have in the

policy process when its sectoral composition as well
as its responsiveness to movements in market interest
rates are changing? Should alternative approaches to
policy be tried because of the uncertainty of M-1’s in
terpretation? These are questions that the experience
of 1982 and early 1983 suggests will need to be ex
plored in considerable depth.

Lawrence J. Radecki and John Wenninger

FRBNY Quarterly Review/Summer 1983

Credit Cycles and the Pricing
of the Prime Rate
The prime rate— so named because it was the rate
banks offered business borrowers with the best credit
— long has been regarded as a key indicator of bor
rowing costs. But in recent years the significance of
the prime rate has diminished. To begin with, large
volumes of below-prime loans have been made. For in
stance, surveys show that during the second half of
1982, a period of falling interest rates, over three
quarters of the new short-term business loans were
made at rates below prime. Also, there have been times
when the prime appeared to be unusually high rela
tive to other interest rates. For example, during August
1982, the prime fell much more slowly than most money
market rates and the spread between the prime and
three-month certificate of deposit (CD) rates widened
to almost 4 percentage points.
In this article, we present evidence that the prime
has been set differently since the mid-1970s. During
the early 1970s the prime rate lagged a month or two
behind both upward and downward changes of other
money market rates. During the late 1970s and early
1980s, however, the prime rate movements lagged
more when rates were declining. Some people view
this situation as reflecting a noncompetitive prime. But
there are few cogent economic explanations of how
the U.S. banking market with thousands of institutions
could be generally noncompetitive.
We suggest that the reason for the prime’s asym
metrical adjustment is that the “competitiveness” of
the prime rate now varies with the state of loan de
mand. When loan demand is weak, individual banks
have less interest-sensitive loan demand and tend to
keep the prime high relative to market rates. During

FRBNY Quarterly Review/Summer 1983

such times, banks use pricing schemes other than the
prime to attract or to retain those customers who are
most sensitive to interest rates. In the future, if the
trend to nonprime pricing options continues, the prime
may move even less with market rates.

The prime rate in recent years
Until the late 1970s, the prime rate was considered the
measure of the cost of bank credit. Many commercial
and industrial loans were tied to the prime, and it was
often viewed by the public as an indicator of the over
all level and movement of interest rates. Since then,
many people have argued that the prime is no longer
an indicative rate. What has happened?
During the late 1970s and 1980s, the prime rate
deviated more from other money market rates than in
the early 1970s (Chart 1). Reflecting this new develop
ment, the correlation of the prime with most other inter
est rates fell after the late 1970s (Table 1).1 One explana
tion for this declining correspondence is the increased
volatility in interest rates. Since the prime rate changes
less frequently than market rates, the prime would di
verge more from other rates when the financial markets
are more volatile. However, casual observation indicates
that the spread between the prime and the commercial
paper rates was much higher in the late 1970s than in

1 Brian C. Gendreau, “When Is the Prime Rate Second Choice?” ,
Business Review (Federal Reserve Bank of Philadelphia, May/June
1983), argued that the prime rate has been adjusting faster in recent
years than in the early 1970s. However, our results suggest that the
faster speed of adjustment was accompanied by an overall decline
in the correlation between the prime and other money market rates.

the earlier period. If the increased fluctuation in in
terest rates was the only reason for the decreased
correlation between the prime and other money market
rates, the spread would be equally likely to decrease as
to increase, and the observed widening of the primecommercial paper rate spread should not occur. Thus,
volatility in interest rates cannot explain entirely the
increased deviations between the prime and other
money market rates.
The asymmetric adjustment of the prime rate

One peculiarity associated with this declining corre
spondence between the prime and other money mar
ket rates is the asymmetric adjustment of the prime
rate over an interest rate cycle. Since the mid-1970s,
the prime has tended to lag market rates more when
they were falling than when they were rising.
A typical adjustment path for the prime rate over a
hypothetical interest rate cycle can be derived from
statistical analysis of the period 1976-82 (Table 2). Dur
ing the upswing of an interest rate cycle, the prime
rate is adjusted upward rather quickly (Chart 2). For
example, if the three-month CD rate increases by
1 percent, the prime is raised by 62 basis points in the
first month so that the spread narrows temporarily by
38 basis points (Chart 3). By the second month, the

prime rate is realigned completely. When the CD rate
declines, however, the prime rate lags behind sub
stantially. Even after three months, the spread is still
16 basis points higher than its normal level.2
One explanation of the widening spread between
the prime and other money market rates when rates
are declining relates to the “ maturity” of the prime
relative to the maturity of other money market instru
ments. The prime rate can be changed by banks any
time and has no obvious maturity. In fact, the prime
can be regarded as a “ daily” rate while the CD rate
used in Charts 2 and 3 is clearly a rate on a ninetyday instrument. If daily market rates are expected to
decline over the next ninety days, then a ninety-day
rate, which embodies expectations of these lower
daily rates, will tend to be below the current daily
rate. Or, turning this around, the prime rate which is
a “ daily” rate should tend to be high relative to the
CD rate when rates are falling. Extending this argu
ment to periods when rates are rising rather than fall
ing, we would expect the prime rate to be low relative
to the CD rate. In other words, the spread should nar
row when rates are rising.
J Statistical tests show that the asymmetry in the adjustment path is
statistically significant at the 1 percent level.

Table 1

Coefficients of Correlation with the Prime Rate
July 23,1975October 3,1979

October 10,1979July 28,1982

July 23,1975July 28,1982

0.98
0.98
0.98
0.98
0.99
0.92

0.89
0.84
0.88
0.86
0.83
0.55

0.98
0.96
0.94
0.98
0.97
0.92

January 1972September 1979

October 1979July 1982

January 1972July 1982

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

0.92
0.72
0.94
0.94

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

0.93
0.74

0.91
0.87
0.90
0.88
0.85
0.57

0.97
0.92
0.97
0.97
0.97
0.92

Rate
Weekly data on:
.....................
.....................
.....................
.....................
.....................
.....................

Monthly data on:

* Weekly data for the commercial paper rate begin on April 12, 1978.

FRBNY Quarterly Review/Summer 1983

metrically across the credit cycle during the early
1970s than in the late 1970s and 1980s. During the
earlier period, the prime rate seemed to fall just as
fast as it rose.4

Table 2

Dependent Variable: Prime-RCD/(1-RR)

Variable

Equation (1)
January 1971December 1975

Constant . . .
X ............
X ( -1 ) . ...
x ( - 2) . ...
Y ............
Y ( -1 ) . ...
Y (-2 ) .
RR
RISK

0.32
-0 .5 2 *
- 0 .2 7 *
- 0 .2 6 *
- 0 .7 9 *
- 0 .2 4 *
-0 .1 1
-0 .1 4 *

R2
DW
P ............

0.58f
0.83
1.13
0.85

Equation (2)
January 1976December 1982

Equation (3)
January 1976December 1982

0.88*
-0 .4 0 *
- 0 .0 7
0.05
- 0 .6 0 *
- 0 .1 9 *
- 0 .1 6 *
-0 .1 0 *
0.53*

1.13*
- 0 .3 8 *
—
—
-0 .6 5 *
-0 .2 3 *
- 0 .1 6 *
- 0 .1 3 *
0.42*

0.94
2.12
0.61

0.93
2.14
0.57

* Statistically significant at 1 percent level,
t Statistically significant at 10 percent level.
RCD
X
Y
RR
RISK

= Three-month secondary market certificate of
deposit rates.
= ARCD when ARCD > 0; 0 otherwise.
= ARCD when ARCD < 0; 0 otherwise.
= Required reserve ratio on certificates of deposit
(including marginal reserve requirement).
= Difference between rates on BAA and AAA
corporate bonds.

To test whether the peculiar adjustment path of the
prime rate observed in Charts 2 and 3 is due to the
particular maturity of the prime, we also estimated
the movement of the prime rate relative to a daily
rate, the Federal funds rate. The estimation results
show the persistence of the asymmetry. The prime is
adjusted relatively fast when the funds rate is rising.
When the funds rate is falling, however, the prime
tends to lag behind.3 Therefore, the difference in rate
maturities cannot explain entirely the unusual be
havior of the prime rate.
Thus far, we have shown that during recent years
the prime rate has been adjusting asymmetrically over
an interest rate cycle. Did the prime rate exhibit the
same behavior in earlier years?
Applying the same kind of statistical analysis, we
found that the prime rate moved much more sym
3 This asymmetric adjustment is also statistically significant at the
1 percent level. Statistical results are available upon request.

FRBNY Quarterly Review/Summer 1983

Causes of the prime’s unusual behavior
In past years, many authors have investigated the
prime rate and its determination.5 Two competing
hypotheses have emerged on the setting of the prime
rate. They are the competitive and noncompetitive
approaches.
The competitive approach asserts that the costs of
searching and switching banks are not high enough
to give banks much leeway for noncompetitive pricing.
Rather, fluctuations in the spread between bank lend
ing rates and their cost of funds merely reflect
changes in the characteristics of the loans or the
services provided by the bank. In contrast, the non
competitive approach views search and information
costs as important factors in the pricing of bank
loans. By this argument, banks can price their loans
noncompetitively to some extent.
There are several problems, however, in treating
the prime as a rate which can diverge greatly from
other market rates for extended periods because of
noncompetitive behavior. First, it does not seem plau
sible that there can be an equilibrium in which bor
rowers pay noncompetitive prices in a nation where
there are 15,000 commercial banks. While the markets
in which these banks compete are segmented to some
degree, it is hard to believe that the barriers to entry
in other banks’ local markets are sufficiently high
to inhibit competitive behavior, at least in urban areas.
And, for many borrowers, there are adequate incen
tives to compare rates among banks and to respond to
persistent interest rate differentials. The second prob* The asymmetry is not statistically significant at the 5 percent level.
* For example: Paul Boltz and Tim Campbell, "Innovations in Bank
Loan Contracting: Recent Evidence” (Board of Governors of the
Federal Reserve System, Staff Economics Study No. 104), 1979;
William Dunkelberg and Jonathan Scott, “ Credit Conditions for Small
Business", mimeographed (National Federation of Independent Busi
ness), 1982; Gerald C. Fisher, The Prime: Myth and Reality (1982);
Gendreau (1983); Michael Goldberg, “ The Pricing of the Prime Rate” ,
Journal of Banking and Finance (June 1981), pages 277-96; Chris
topher James, “ An Analysis of Bank Loan Rate Indexation” , Journal of
Finance (June 1982), pages 809-25; Jeffrey D. Hanna, Bruce Brittain,
and Tran Q. Hung, “ Libor vs. Prime: The Internationalization of the U.S.
Loan Market", American Banker (June 5,1981); John P. Judd, "Com
petition Between the Commercial Paper Market and Commercial
Banks” , Economic Review (Federal Reserve Bank of San Francisco,
Winter 1979); John W. Lanza, "Criticism of the Prime Rate", The
Journal of Commercial Bank Lending (February 1973); Randall C.
Merris, "The Prime Rate", Business Conditions (Federal Reserve
Bank of Chicago, April 1975); Howard J. Poduska, “ The Prime Rate
and Other Pricing Considerations in Past, Present, and Future” ,
The Journal of Commercial Bank Lending (October 1978).

lem in positing a noncompetitive prime is the lack of
strong empirical evidence. Most of those who argue
for an oligopolistic banking industry provide sugges
tive rather than conclusive evidence.6
Cyclical monopolistic competition and the prime
While it seems unlikely that the banking system con
sistently behaves noncompetitively, there may be
forces which generate noncompetitive opportunities
occasionally. We hypothesize that the elasticity of
demand for loans from any particular bank varies with
economic conditions and can account for periods of
a relatively noncompetitive prime. There are times
when most businesses know market conditions and are
in contact with several banks. At other times, this will
not be true. With a significant portion of outstanding
loans still linked to the prime, by maintaining a higher
prime a bank can make greater profits on the loans
that remain with it. It must weigh these extra profits
on the loans it maintains against the loss of customers.7
When is the elasticity of loan demand low and when
is it high? Among small businesses, the most interestsensitive participants in the credit markets would tend
to be borrowers who are applying for new loans or
are seeking to establish a credit relationship with a
new lender. They already have gathered the materials
to prove their creditworthiness and as a matter of
course (or precaution) are in touch with several lend
ers. In this case, other things being equal, the bank
which offers the best deal wins their trade. Compari
son shopping across banks requires time and re
sources, however. If a small firm is not already in the
market for new loans, it may be reluctant to make the
effort to search out the cheapest loan rate.
Large firms, in contrast, generally have relationships
with several banks in addition to having access to the
commercial paper market. In fact, a 1981 survey re
ported that more than 75 percent of large companies
(Fortune’s top 500) deal extensively with five or more
banks.8 Since large companies typically have staffs to
keep constant track of credit market conditions, the
cost of the search for them may be no more than a
phone call in either phase of the business cycle.

Should one lender’s rate move grossly out of line, the
several banking relationships maintained by large
firms would allow them to begin shading their borrow
ings fairly rapidly toward other banks or the commer
cial paper market.
Another reason why a small firm may face difficulty
in developing a new banking relationship during down
turns is that banks have a problem in identifying the
source of its borrowing needs: Is the firm seeking a
new credit relation to expand and/or to avoid the per
ceived high spread charged by its previous lender,
as it claims, or has it been cut off by its old banker
because the firm may not survive? The firm ’s old banker
may be willing to provide credit because, in the course
of their relationship, he has acquired information on
the fundamental health of the firm. To the extent that
such information is difficult to provide to a new pro
spective lender who is unacquainted with the firm, the
firm will be tied to its old credit relationship. Banks
may be able to take advantage of these hurdles to
entering the loan market which certain borrowers face
during downswings. During upswings, however, these
hurdles would be much less significant and banks
would be forced to charge competitive rates.
Large firms do not face such problems to the same
degree. With several established banking relationships
and constant monitoring of their creditworthiness by

Chart 1

Spread between Prime and Commercial
Paper Rates*
Percent
7
6

5
4
3
2

« For example, Goldberg (1981) argued the current month’s prime
rate is affected by previous months’ CD rates. He suggested that this
is a sign of average cost pricing rather than marginal cost pricing,
which indicates oligopolistic behavior. However, his results may
reflect merely the difference in maturities between the three-month
CD and the prime rates. Thus, Goldberg’s results did not provide con
clusive evidence about the competitiveness of the banking industry.
7 Judd (1979) also argued that tying floating rate loans to the prime
might have reduced the incentives for banks to compete by lowering
spreads.
•Greenwich Research Associates, “ Large Corporate Banking 1981” ,
mimeographed, 1981.

0
-1

-2
1972 73

*T h irty-d a y dealer-placed commercial paper rate.

FRBNY Quarterly Review/Summer 1983

rating agencies and market analysts, both current and
potential lenders can draw distinctions between cycli
cal and secular weakness in the firm’s balance sheets.
Overall, then, information and search costs would
differ for large borrowers and small borrowers over a
credit cycle.
Because of the relative immobility of small borrowers
during downturns, individual banks may face different
elasticities of loan demand at different points in the
credit cycle. The elasticity of loan demand from each
individual bank is likely to be highest when total de
mand for new loans is strongest. This generally hap
pens later in an expansion, a time when interest rates
are generally rising, too. At such times the lost revenue
from discouraged new borrowers and disgruntled old
borrowers outweighs any additional revenue from
keeping a wide spread. Therefore, a bank would find
it in its best interests to charge a competitive spread.
At times when loan demand is weak, however, larger
total profits can be earned by keeping a high prime
and perhaps foregoing the few interest-sensitive cus
tomers. In addition, banks can limit the loss of custom
ers by lending at below-prime rates to particularly
interest rate-conscious borrowers when the prime rate
is high relative to market rates. Interest-sensitive bor

rowers can thus be charged market rates at any point
in the business cycle.
We, therefore, characterize the pricing of the prime
as being subject to cyclical noncompetitiveness. We
suspect that it is competitive during periods of stable
or increasing market rates but may be somewhat non
competitive when rates are falling.
This argument is supported by statistical evidence.
Recall that we found that the prime rate comes down
more slowly relative to market rates than it rises, in
dicating that banks charge higher spreads on primebased loans during downswings. However, our theory
also suggests that borrowers in the market for new
loans would be better able to obtain loan rates closely
tied to market rates, in contrast to those merely main
taining outstanding loans tied to the prime. Indeed, we
find that the interest rates charged on new commercial
and industrial loans do not show the same asymmetry
with respect to market rates.9 Although the rates on
new loans tend to lag behind the CD rate and move
down a bit slower than they move up, the difference
in the speed of adjustment is very small and not statis-

9 Statistical results are available upon request.

Chart 2

Chart 3

T y p ic a l A djustm ent Path of the Prim e Rate
in Response to CD Rate C h a n g e s *

A d ju s tm e n t P ath s of th e P rim e-C D R ate
S p re a d in R esponse to a 1 Percentage
P oint C h a n g e in th e T h re e -M o n th CD R a te *

Interest rate
(percent)
12.5Shaded area indicates delayed response of the
prime rate.
Prime rate

Spread
(basis points)
2 0 0 ----------------------------------------------------------------------When the CD rate falls at month 1, the prime lags
behind, raising the spread.

12.0

11.5

11.0

10.5
3-month
CD rate
1 0.0

But, when the CD rate rises, the prime adjusts much
more rapidly, and the "norm al” spread is restored in
one month.

9.5 I

4
Months

* Assumes the "n o rm a l” spread is 100 basis points.

FRBNY Quarterly Review/Summer 1983

Months
Assumes the "norm al” spread is 100 basis points.

tically significant. Of course, these data come from
a sample of borrowers who may not be typical of the
average loan seeker.10 Nonetheless, the results suggest
that those firms actively in the loan market may be
able to obtain market-related rates at any point in the
credit cycle, despite the increase in the prime-CD
spread during downturns.
Evidence on below-prime loans is also consistent
with the view that such pricing schemes enable banks
to retain interest-sensitive customers during periods
of a high prime-CD rate spread. If below-prime loans
are completely unrelated to the pricing of the prime,
then they should be neither more nor less prevalent
when the prime-CD spread changes. Statistical analysis,
however, indicates that below-prime lending is much
more common when rates are falling and the spread
is wide, suggesting that some customers move from
prime-based to below-prime loans when the prime is
out of line with market rates.11
Why did the behavior of the prime rate change?
While these arguments may explain why the prime ad
justs asymmetrically during the credit cycle, they do
not explain why the pricing of the prime changed in
the last decade. Earlier, we showed that during the
early 1970s there was little or no asymmetry in the
prime rate vis-a-vis market rates across the business
cycle. By the late 1970s, however, there was a pro
nounced asymmetry. Can these results be related to
the bank lending practices described above?
Perhaps the most striking change in the banking
system in the mid-1970s was the development of al
ternatives to domestic bank lending. The commercial
paper market grew rapidly, while U.S. domestic resi
dents also began to have better access to foreign
sources of funds (Chart 4). By most accounts, the devel
opment of these markets have made the U.S. banking
system on the whole more competitive now than in the
past. These pro-competitive developments may have
had a somewhat paradoxical effect on the prime rate,
however.
In the early 1970s, most floating rate loans were
also prime-based loans. Both the interest-sensitive
and relatively immobile borrowers were tied to the
prime, for the most part without other pricing options.
If an individual bank kept its prime too high, then
the interest-sensitive customers would leave for an10 The data are from the Survey on Terms of Bank Lending conducted
quarterly by the Federal Reserve System. The surveys include business
loans extended during the first full week of the middle of the month
of each quarter. The sample consists of both large and small
commercial banks.
n Statistical results are available upon request.

Chart 4

C om m ercial Paper and Foreign Borrowing
Billions of dollars
6 0 --------------------------------------------------------------------------------------------------------C o m m e rc ia l p aper
5 0 --------------------------------------------------------------------------------------4 0 ---------------------------------------------------------------------------------3 0 -------------------------------------------------------------------------

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

1 0 ---------------------

--------------

------------------

----------------------------

-----------------------

-----------------------------------------------------

pi 111111 11111 1111111 i I l l l l l l l l 11111111111ll LI llJ I ll 11 11111
3 5 0 --------------------------------------------------------------------------------------------------------T o tal fo re ig n funds raised by dom estic
300

n o n fin a n c ia l investors and bank

250

loans m ade by fo re ig n
jn
U nited S ta te s

banks

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

/ ------------------------------

1 5 0 ---------------------------------------------- —

-----------------------------------------------

-10 0 --------- -------------------------------------------------------------50 ------

--------------------------------------------------------------------------------------------

0 l m il ii l i M i H i i i i i h i i l i i i l i i i l i i i l m I m i i n l n i i i i i l
1970 71

Source: Flow of Funds statistics.

other bank or for the commercial paper market, which
was beginning a period of rapid expansion. Conse
quently, banks had to set their prime rate in line with
other market rates. Since the loan rates for both ratesensitive and rate-insensitive borrowers were gener
ally based on the prime, price discrimination between
the two classes of borrowers over a credit cycle was
more difficult.12
In the mid-1970s, new pricing options became more
common, as many borrowers began to have easier
access to the commercial paper and Euro-lending
markets and were no longer restricted to the prime.
Commercial banks desiring to retain such customers
12 Banks and their customers could negotiate different spreads on their
loans at different points in the credit cycle. However, such customer
by customer negotiation is an inefficient method for price discrimina
tion between broad classes of borrowers. Similarly, the two-tier prime
under the Committee on Interest and Dividends (CID) was monitored
closely by the CID, and banks were not able to use this as a vehicle
to take advantage of the difference in interest sensitivity between the
two classes of borrowers.

FRBNY Quarterly Review/Summer 1983

had to offer pricing schemes as attractive as the new
alternatives. By this interpretation, the function of
below-prime loans (or loans with pricing options that
the borrower may elect at certain times) partly served
to allow discrimination between borrowers. Less mo
bile borrowers remain tied to the prime when rates
come down and spreads increase, while the more
mobile borrowers shift to rates closely tied to market
rates. Thus, the change in the behavior of the prime
rate can be attributed to the declining average inter
est sensitivity of the prime-based borrowers since the
early 1970s.13

Other possible explanations for asymmetric
movements in the prime
Besides cyclical noncompetitiveness, there are other
possible reasons for the prime to move down more
slowly than up. One of them is a change in the relative
risk premium attached to nonfinancial business vis-dvis banks over a business cycle. In a recession, for
instance, interest rates tend to fall and corporate
financial positions tend to deteriorate. Thus, the seem
ingly high prime during periods of falling interest rates
may reflect the higher default risk of business loans.
In addition, the asymmetric movement of the prime
rate may be caused by a shift in the creditworthiness
of prime-based borrowers during downturns. Banks
may choose not to reclassify businesses and to raise
their loan rates relative to the prime. Instead, cus
tomers whose creditworthiness remains high are given
below-prime loans, while the prime is kept high rela
tive to market rates. Those businesses that remain
tied to the prime are then companies that require
a higher risk premium.
Also, the movement of the prime-CD rate spread
may be affected by government policies. Under the
Committee on Interest and Dividends (CID), banks
offered a lower prime to small businesses from April
1973 to May 1974. And, in 1980, the credit restraint
program placed limits on loan growth which may have
contributed to the unusually high prime rate during
that period.
To take account of these factors, we included sev
eral additional variables in our statistical analysis. The
spread between the rates on BAA- and AAA-rated cor
porate bonds was used to measure the higher default
risk of business lending. Additional impact from the
13 The contribution of the commercial paper market in attracting
interest-sensitive borrowers away from banks was also stressed
by Judd (1979).

shift in the creditworthiness of prime-based borrowers
was incorporated in our analysis by adding the busi
ness failure rate. Moreover, separate dummy variables
for the periods of the CID and the credit restraint pro
gram were included in our equations. None of these
variables, however, with the exception of the BAA-AAA
bond rate spread and the business failure rate, had
any significant effect on our estimates. Most impor
tantly, inclusion of these variables did not reduce the
asymmetry in the movement of the prime.14
Besides testing our hypothesis of cyclical noncom
petitiveness against alternative explanations, we also
conducted out-of-sample simulations to measure the
forecasting accuracy of our equation over the past
year. The simulation results indicate that our statistical
estimates track quite well the behavior of the prime-CD
rate spread from July 1982 to June 1983, accounting
for 1.3 percentage points of the 1.4 percentage points
narrowing in the spread.15 In the most recent month,
when the prime has been unchanged while market
rates were rising, our equation predicted about half
the actual narrowing in the spread.

Summary
There has been a major change in the behavior of
the prime rate. Since the mid-1970s, the prime rate has
moved asymmetrically over an interest rate cycle.
One explanation for this change is the development
of new forms of borrowing by large corporations. Since
the mid-1970s, many interest-sensitive borrowers were
given pricing options other than the prime. Those bor
rowers who remain tied to the prime may be less
responsive to their loan rates, unless they are in the
market for new loans. This may give banks occasional
opportunities to increase the spread.
Despite the temporary noncompetitive behavior of
bank lending, in the long run we would expect bank
loan rates increasingly to resemble other money mar
ket rates. For one thing, borrowers may demand
more pricing alternatives, which will safeguard them
against overpaying at times of falling interest rates.
Paradoxically, however, the fewer borrowers remaining
tied to the prime would be the least mobile, and the
slowness in the prime following other rates down may
become even more pronounced than it is now.
14 Statistical results are available upon request.
is The mean error and root mean square error for the out-of-sample
period of July 1982 to June 1983 was —0.01 and 0.33 percent, respec
tively, compared with the in-sample root mean square error of 0.23
percent for the period January 1976 to June 1982.

Marcelle Arak, A. Steven Englander, and
Eric M. P. Tang

FRBNY Quarterly Review/Summer 1983

Recovery without Accelerating
Inflation?

On both the wage and price side, inflation over the
past year was at its lowest level since 1967. The Em
ployment Cost Index increased only 6.4 percent in
1982, down from 9.8 percent in 1981 (Chart 1). And
consumer prices rose by only 3.9 percent in 1982,
down from 8.9 percent in the previous year. Moreover,
consumer prices have increased at only a 3 percent
annual rate thus far this year.
The dramatic price and wage slowdowns undoubt
edly reflect the recession at least to some degree, and
many analysts expect some reacceleration of prices in
late 1983 and 1984 as the economy recovers. The Blue
Chip consensus, for example, foresees 1984 consumer
price inflation at about 5 percent. But an examination
of the 1961-82 period suggests that there may be more
ground for optimism:
• Both casual observation and more rigorous sta
tistical analysis imply that the paths of real
economic growth and unemployment rates pro
jected by most analysts are unlikely to gener
ate an inflationary resurgence in the near term,
1983 or 1984.
• The immediate outlook in oil and crop markets
is for continued weakness and price modera
tion, although a major crop failure or oil shock
could rapidly push up inflation.
While the high level of unemployment is likely to
sustain slow growth of wages and prices in the near
term, the medium- to long-term outlook (1985-88) is less

certain. Nevertheless, economic relationships, found to
hold true in the past, suggest that wages in the mid1980s might not accelerate until the unemployment rate
falls below 6 percent. This would represent a more fa
vorable scenario than we have had recently when un
employment rates of 7 percent or so seem to have been
associated with a speedup in inflation.

Near-term inflation prospects
Many forecasters expect the recovery to be accom
panied by a rise in inflation in 1984. For example,
growth of the GNP deflator, the broadest measure of
price inflation, is expected by many observers to ac
celerate in 1984 by about 0.4-0.6 percentage point
(Table 1). Assumptions underlying these forecasts gen
erally include somewhat stronger commodities prices
and profit margins, a gradual tightening in labor mar
kets, and a declining dollar. Such forecasts may be
overly pessimistic about the resurgence in inflation,
however.
In the first few years of other recoveries inflation has
generally stayed flat or fallen (Table 2). Moreover, as
of this spring, most forecasters predicted a slower than
normal recovery for the next year or so. For example,
the Office of Management and Budget (OMB) projected
4.3 percent growth of GNP and the Blue Chip con
sensus projected 4.6 percent for the first two years of
the expansion.1 Yet, GNP growth averaged 5 percent
per year in the first two years of every postwar re1 Sources: OMB, April Update of the 1984 Budget; Blue Chip, Economic
Indicators ( May 1983).

FRBNY Quarterly Review/Summer 1983

Chart 1

P rivate N onfarm C o m p e n s a tio n
Employment cost index
Percent

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

covery, except for the short recovery from the 1980
recession, and the inflation rate generally declined.
Thus, casual observation of history suggests the possi
bility that disinflation will continue during the next
few years.
Recent wage bargains also bode well for the near
term. In 1982, collective bargaining settlements con
tained wage adjustments that were quite modest as
compared with recent years. As shown on Chart 2, the
average first-year increase of 3.8 percent was well
under half the increase in 1980 and 1981, and just
about equal to half the increase approved the last time
the two parties settled.2 Of course, part of this drop
was in distressed industries, as 43 percent of workers
received no increase. But the average for the remain
ing workers is still well below the previous year. Further,
the wage agreements are not simply front loaded, with
low increases in the first year only. The average in
crease over the life of the contract is 3.6 percent annu
ally, excluding cost-of-living adjustments (COLAs).
COLAs could add 2 percent or less in 1984, provided
1983 Consumer Price Index (CPI) growth remains in the
2 The statistics cited in this paragraph are published by the U.S.
Department of Labor, Major Collective Bargaining Settlements in
Private Industry, 1982 (January 1983).

FRBNY Quarterly Review/Summer 1983

forecasted 3-4 percent range.3 Thus, with a mean
duration of thirty-one months, the 1982 agreements and
similar ones negotiated in early 1983 appear to have
locked in moderate wage growth for these industries
for 1983 and 1984. Moreover, if these settlements re
flect the wage trends emerging in the nonunionized
sector, the next two years may bring a continuation
of wage disinflation.
More rigorous statistical analysis also supports the
view that wage growth will continue to fall or moderate
over the next eighteen months even as the recovery
progresses. In common with many earlier analyses, our
research suggests that the critical determinants of
wage inflation over the past twenty years have been
(1) the level of the unemployment rate and (2) inflation
expectations. This relationship of wage growth, infla
tion expectations, and the unemployment rate, which
is summarized by the model described in Box 1, has
been extremely stable and reliable over the past twenty
years.4 Moreover, the relationship explains a large pro
portion of what to many has been the surprisingly rapid
slowdown of wage inflation. The 4 percentage point de
cline in hourly compensation from 1980 to 1982 repre
sents the sharpest slowdown over a two-year period
since the 1940s. And when our estimated relationship,
which is based on the 1961-79 period, is applied to the
1980-82 period, it suggests a 4.3 percentage point re
duction of the growth of hourly compensation, very
close to the actual 4 percentage point drop.
Such results obviously do not guarantee that past
relationships will remain reliable, but they provide at
least some analytical basis for formulating a forecast
of the near-term outlook for wages. One way of as
sessing that outlook is to insert the Blue Chip con
sensus forecast of unemployment and price inflation
into our equation and then to calculate a forecast for
compensation growth. A projection done in this way
shows continued moderation in wage growth in 1983
and 1984 (Table 3). The growth of compensation per
man-hour would be 4-5 percent in each year. Despite
the expansion, high unemployment rates— about 9
percent in 1984—will continue to exert downward pres
sure on wage growth.
This forecasting approach provides only a rough
estimate of future compensation growth since it ig
nores the interdependence of wages and prices. In a
more complete model, the slower wage growth would
3 According to the Bureau of Labor Statistics, about 60 percent of the
workers are covered by COLAs that reimburse workers for approxi
mately 70 percent of CPI growth.
* For a more detailed discussion see Englander and Los, “ The Stability
of the Phillips Curve and Its Implications for the 1980s" (Federal
Reserve Bank of New York Research Paper No. 8303), February 1983.

contribute to lower price growth. (Note that the Blue
Chip consensus forecast has consumer price growth
accelerating from 3.2 percent in 1983 to 5.1 percent in
1984.) Then, since inflation expectations in our model
are measured by lagged price increases, compensa
tion growth could be even slower than the 4.2 percent
projection that uses the Blue Chip price inflation
assumptions.
One risk is that supply shocks may occur and quickly
rekindle expectations of rising inflation despite the
weakness in labor markets. Although employee com
pensation is the major cost faced by firms, many econ
omists believe that wages were not the primary cause
of the inflationary upswings of the mid- and late 1970s.
Instead, run-ups in the prices of food and oil contrib
uted the initial spark to the speedup of inflation, and
wages responded only with a lag. Again, in the 1980s
there is some risk that sudden run-ups in energy or
food prices or a steep depreciation of the dollar (which
would raise import prices) could cause workers to
press for higher wages.
However, there is currently little basis for projecting
such shocks over the next eighteen months. The supplydemand balances in food and energy suggest that food
and oil price increases will be moderate in the short
run (Table 4). For example, the CPI for food is expected
to rise by 3-4 percent in 1983 and possibly a bit more
in 1984. It now appears that it would take a major crop
failure, either here or abroad, to change that outlook
by much. Imported oil prices are expected to remain
flat over the remainder of 1983 and grow only slightly
in 1984.
The international value of the dollar— another key
factor in inflation— has continued to remain strong
despite many forecasters’ predictions of a decline. It
now appears that, if a depreciation of the dollar does
occur over the next eighteen months, it will not be large
enough to affect significantly the wage and price out

look. Data Resources Incorporated (DRI), for example,
sees the dollar falling by about 8 percent over 1983 and
1984. Such a decline in the dollar, on a trade-weighted
basis, would probably contribute less than 0.5 percent
age point to inflation in 1983 and perhaps 0.8 per
centage point in 1984.5 Since most of the Blue Chip
forecasts already have assumed some decline in the
dollar, it would take a very large drop to affect the
compensation growth projection in Table 3.
Will a declining unemployment rate result in a
speedup in wage growth?
The difference between compensation growth in 1984
of 5 to 6 percent that is projected by some other eco
nomic forecasters and our projection of about 4 per
cent is not large in absolute terms, given the vari
ability of the inflation rate over the last decade. But
whether or not compensation growth begins to speed
up so soon after the start of a recovery, as reflected
in the alternative forecasts, can have important im
plications for longer term inflation prospects. It is
unlikely that the rate of compensation growth would
increase in 1984 and then not change after that, un
less real growth of the economy slowed down signifi
cantly. If compensation growth were to accelerate in
1984, it would in all likelihood be followed by con
tinued escalation, assuming real economic growth
through 1984 and into 1985 were to continue at a
4-5 percent pace. Also, in the past, even after it
was clear that inflation had speeded up, forecasters
have generally underestimated the size of the subse
quent acceleration. If the predicted 1984 accelera
tion occurs, then forecasts of generally modest in-

5 For a more detailed discussion of the effects of a dollar devaluation
on consumer prices, see Joel L. Prakken, “ The Exchange Rate and
Domestic Inflation” , this Quarterly Review (Summer 1979),
pages 49-55.

Table 1

Alternative Inflation Forecasts
Four-quarter change in GNP deflator; in percent

Chase
Econometrics

Year
1983
1984

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

5.0

Congressional
Budget
Office

Data
Resources
Incorporated

Office of
Management
and Budget

Blue Chip
consensus

4.7
4.7

4.6
5.2

4.5
5.0

4.9
5.3

Sources: Chase Econometrics, U.S. Macroeconomic Forecast and Analysis (May 1983). Congressional Budget Office, Five-Year Economic
Assumptions (January 1983). Data Resources Incorporated, Review of the U.S. Economy (March 1983). Office of Management and Budget,
April Update of 1984 Budget. Blue Chip, Economic Indicators (May 1983).

FRBNY Quarterly Review/Summer 1983

Table 2

Chart 2

Does Inflation Accelerate in Early Stages
of Recovery?

M ean W a g e -R a te A d ju s tm e n t o ver Life of
C ontract in M a jo r C o lle c tiv e B arg ain in g
S e ttle m e n ts *

In percent

Annual rate
Trough of
recession

Real GNP
growth

Change in
inflation rate*

Percent
1 0 ---------------------------------------------------------------- -----------

First four quarters of recoveryt
1954-11 ........................... ................................ 7.4
1958-11 ........................... ................................ 8.4
1961-1 ............................. ................................ 7.0
1970-IV ......................... ................................ 4.7
1975-1 ............................. ................................ 6.7
1980-111 ........................... ................................3.2

0.5
0.9
1.3
—0.3
-5 .1
-0 .1

Second four quarters of recovery^
1954-11 ........................... ................................2 6
1958-11 ........................... ................................1.7
1961-1 ............................. ................................3.3
1970-IV ......................... ............................... 7.0
1975-1 ............................. ............................... 4.4

1.1
-1 .2
—0.3
-0 .4
-0 .8

* Excluding cost-of-livin'g adjustments (COLAs).
t First three months.

* Implicit GNP deflator.
fGrowth rate in the four quarters after the trough minus
growth rate in the four quarters before the trough.
^Growth rate in the second four quarters of recovery minus
growth rate in the first four quarters of recovery.

creases over the rest of the decade may be similarly
low. Thus, it is reasonable to raise the issue of
whether “ slow” or “ modest” acceleration in inflation
might quickly turn into rapidly rising wages and
prices.
Some analysts, looking at simple relationships be
tween wage growth and the unemployment rate, argue
that an acceleration in wage increases within the
next eighteen months is inevitable if the unemploy
ment rate declines. They argue that the decline in
the unemployment rate will result in tighter labor mar
kets that will lead to more rapid wage growth. Our
analysis suggests that this point of view is incom
plete.
A lower unemployment rate will mean a higher
rate of wage growth only if everything else is held
constant. Statistical analysis of past data suggests
that the trade-off at any given point in time t, looks
something like the line AB, shown in Chart 3.
Notice, if the unemployment rate at t were lower than
the one associated with point W, the rate of wage
growth would be higher. When moving between time
periods, however, everything else other than the un
employment rate does not remain constant. A critical
factor that can change between time periods is in-

FRBNY Quarterly Review/Summer 1983

Summary of Collective Bargaining Agreements
In percent

Basic wage increases

1982

1981

1980

Last time
1982
parties
bargained

Average first-year wage
increase (excluding
COLAs) ...............................

3.8$

9.8

8.3

7.9

Average annual increase
over life of contract
(excluding COLAs) ...........

3.6

7.9

6.5

6.3

1 1982: 43 percent of workers received no increase; average
increase for remainder was 7 percent; 25 percent of workers
received increases greater than 8 percent.
Source: U.S. Department of Labor, Bureau of Labor Statistics.

flation expectations. Statistical analysis also suggests
that, if inflation expectations decline, the trade-off line
for the period t + 1 will shift down to A'B' in Chart 3.
The movement between point W and point X in
Chart 3 is intended to illustrate our estimate of the
growth of compensation that is consistent with the
Blue Chip projection for the recovery. Moderating
inflation expectations, as measured by lagged infla
tion, can cause the unemployment-wage growth trade
off line to shift downward. (The 1982 and 1983 de-

clines in the inflation rate would be responsible for
this.) This shift is enough to compensate for the effect
of a decline in the unemployment rate, so that be
tween periods t and t + 1 the shift between point W
and point X results in the same rate of wage growth.
But a more rapid decline in the unemployment rate
could more than offset the effect of lower inflation
expectations. The shift would be between point W and
point Y, with the rate of wage growth increasing in
period t + 1 compared with period t. A less rapid de
cline in the unemployment rate would lead to a re
duction of wage growth.
Thus, while a decline in the unemployment rate
clearly contributes an upward thrust to the rate of
wage growth, it is possible for this to be offset by

the downward momentum of declining inflation expec
tations. Under the Blue Chip forecasts for prices and
for the unemployment rate, the unemployment rate
decline and the expectations effect exactly cancel each
other out in 1984, so that wage growth is the same as
in 1983.
Recently, many economic forecasts for 1983 and
1984 have been revised upward and projections of the
unemployment rate revised downward from the 9.3 per
cent rate for 1984 used in our calculation. However, it
is also possible that the inflation projection for 1984
implicit in the Blue Chip forecast is too high. Our re
search suggests that as long as the unemployment rate
remains high— above 7 percent in 1984 and above
6 percent in 1985 and beyond— the expectations effect

Box 1: Estimating the Inflation-Unemployment Trade-off
To m easure th e tra d e -o ff betw een u n e m p lo ym e nt and
in fla tio n , w e use th e e xp e cta tio n s-a u g m e n te d P h illip s
cu rve (EAP) in c o m b in a tio n w ith a sim p le p ric e equa
tio n . T he EAP cu rve re la te s the rate of ch a n ge in
co m p e n sa tio n p er m an -h o u r (CCOMP) to : (1) the un
em p lo ym e n t rate o f p rim e age m ales (25-54 years)
(URM25), as a m easure of la b o r m arket tig h tn e s s ;*
(2) a w e ig h te d ave ra g e of past in fla tio n rates as a
m easure of e x p e cte d p ric e in fla tio n (CPCE); (3) u pw ard
changes in th e p rim e age m ale un e m p lo ym e nt rate
(DURM25) to c a p tu re the co st of ce rta in frin g e and
severance b e n efits rece ive d by laid off w o rk e rs ; (4)
th e in crea se in e m p lo ye r so cia l s e cu rity c o n trib u tio n s
(ECSS), a co m p o n e n t o f h o u rly c o m p e n s a tio n ^ (5) th e
in crea se in the c iv ilia n la b o r fo rc e (CLHC) sin ce th e
ra p id in flu x o f w o rk e rs s h ifts th e d is trib u tio n of w o rk
ers to w a rd le s s -e x p e rie n ce d and le ss-skille d (and
th e re fo re , pre su m a b ly, to lo w e r paid) w o rke rs; and (6)
the share o f u n e m p lo ym e nt be n efits paid to w o rke rs
une m p lo ye d m ore than tw e n ty-six w eeks (S U R B 2 7 )4
*The prime age (24-54 years) male unemployment rate as a
measure of “ slack" in the labor market was suggested by
Phillip Cagan. See Phillip Cagan, “ The Reduction of Inflation by
Slack Demand” , in W. Fellner, (ed.), Contemporary Economic
Problems 1978 (Washington, D.C., 1978), pages 13-45.
fThe changes in employer social security contributions are
expressed as a percentage of compensation per hour. From this,
we subtract the increased contributions which occur as the
overall level of wages grows. The remainder represents the
effect of social security tax contributions in causing compen
sation growth to change.
^Extension of unemployment benefits may reduce the incentive
to search aggressively for new jobs, raising the unemployment
rate while damping the disinflationary effects of higher
unemployment.

A dum m y va ria b le , D1 a c c o u n ts fo r the re stra in in g
e ffe ct of th e p ric e free ze in 1971-1V and the rebound
a fte r the re la xin g o f the c o n tro ls in 1972-1.
T he e q u atio n e stim a te d by o rd in a ry least squares
(stan d a rd e rro rs prese n te d in p a re n th e sis) is:
CCO M P = 0 .92*C P C E - 0 .8 9*U R M 25 + 0.60*D U R M 25
(0.09)
(0.21)
(0.86)
+ 1 .0 6 *ECSS - 0 .4 5*C L H C
(0.24)
(0.13)
+ 4.15*S U R B 27 - 4.59*D1 + 6.23
(2.30)
(1.13)
(0.76)
P e rio d : 1961-1 to 1979-IV
R2 =
SEE =r
F (7,68) =
DW =

0.75
1.30
33.0
2.16

W e a p p lie d a se ries of re ce n tly d e ve lo pe d e c o n o m e tric
robustness te sts to th is EAP e q u a tio n . T he te sts s tro n g
ly su g g est th a t th is EAP cu rve is s u b je c t n e ith e r to
pe rm a n e n t n o r tra n s ito ry s to c h a s tic sh ifts n o r to p e r
m anent d e te rm in is tic sh ifts. A d d itio n a l e vid e n ce o f its
s ta b ility is p ro vid e d by th e e x c e lle n t o u t-o f-sa m p le
fo re c a s tin g a b ility of th is EAP cu rve in the 1980 s.§

§For more details, see A. Steven Englander and Cornells A. Los,
“ The Stability of the Phillips Curve and Its Implications for the
1980s” (Federal Reserve Bank of New York Research Paper
No. 8303), February 1983.

FRBNY Quarterly Review/Summer 1983

shown in Chart 3 will continue to exert a significant
downward thrust to wage growth. Whether this would
be sufficient to offset the effect of a more rapid decline
in the unemployment rate depends on how fast the
rate falls. We estimate that it is likely that wage growth
will hold steady or slow down further as long as the
unemployment rate declines by 1.5 percentage points
or less over the next six quarters from its secondquarter level of 10.1 percent. This is still a somewhat
steeper unemployment rate decline than is projected in
many of the recently revised forecasts for the economy.
Wage inflation over the long term
While falling unemployment during the next eighteen
months may not lead to rising inflation, for how long
can economic growth proceed before wage inflation
does begin to speed up? In recent years, it appears
that the unemployment rate could not fall below 7 per
cent without an upsurge of inflation. And, indeed, this
was the experience in 1978. Currently, many observers
feel that the “ natural” rate— the unemployment rate
consistent with no speedup in inflation— will remain
high through the 1980s.6 For example, in a talk given
in November 1982, Martin Feldstein, the Chairman
of the Council of Economic Advisers, suggested
that the natural rate of unemployment will remain at
6-7 percent or above and not drop significantly over
the balance of the decade unless programs such as
job retraining induce major structural changes in the
economy.
Estimates of the natural rate should be examined
carefully. The higher they are, the more severe are the
constraints on the economy’s ability to expand without
worsening inflation. However, the natural rate is not di
rectly observable; it must be inferred from estimates of
wage and price relationships. As such, it depends on all
the factors which underlie the inflation-unemployment
rate trade-off. All the issues have by no means been
settled, but both theoretical work and statistical analy
sis suggest that productivity growth, demographics,
and employer payroll taxes are linked to the trade-off.
In general, more rapid productivity growth lowers the
unemployment rate associated with nonaccelerating
wages. Conversely, more rapid labor force growth and
employer tax increases tend to raise the natural rate
of unemployment. (The interactions of these factors
are discussed in greater depth in Box 2.)
Analysis of the behavior of wages and prices sug
gests that the natural rate moved from about 4.5 per
cent in the early 1960s to over 7 percent in the mid- and
late 1970s (Table 5). The key factor in the rise in the

Table 3

Projected Compensation Growth, 1983-84
In percent
Underlying assumptions*
Civilian
unemployment
Consumer
ratef price growth
1983
1984

10.2
9.3

3.2
5.1

FRBNY Quarterly Review/Summer 1983

4.2
4.2

'B lue Chip, Economic Indicators (May 1983).
fAverage for year obtained by adding 0.2 to the
unemployment rate of all workers including military.

Table 4

Food and Energy Price Increases
Built into Current Forecasts
In percent
Projected price growth
from 1983-1 to 1984-1V
(compounded, annual rate)
Food at home
(CPI)
O ilf

Forecast
source

DRI ........................... ....................................4.2*
C h a s e ....................... ....................................5.8
OMB ......................... ....................................—
CBO ......................... ....................................4.9

—7.6
—0.7
—3.6
2.9

‘ Food and beverages.
fCrude oil— composite refiner acquisition cost.
Sources: Same as Table 1.

Table 5

The Natural Rate of Unemployment, 1961-82
In percent
1961-67

1968-73

1974-82

The increase in the natural rate of unemployment
Natural rate of unem ploym ent___

4.4

6.2

7.2

appears to have been caused primarily by
the decline in productivity
Productivity growth .........................

3.3

1.8

0.8

and a rapid upsurge in the labor force
Civilian labor force growth ...........

4 The technical appendix to this article discusses the calculation of the
natural rate.

Projected
compensation
growth

1.6

2.5

2.3

Chart 3

The In flatio n -U n e m p lo y m e n t T ra d e -o ff
during R ecovery
Wage
growth
Trade-off in
period t

High unemployment in period t
(point W) causes inflation
expectations to fall between
period t and period t+1....

But recovery can offset
the decline (point X) or even
produce an increase in inflation
(point Y).

Unemployment rate

natural rate appears to be the dramatic slowdown in
productivity growth over this period, although rapid
labor force growth, particularly in 1968-73, also con
tributed.
By projecting future trends in the major determinants
of the natural rate— productivity, demographics, social
security tax increases— we can estimate how low the
unemployment rate can fall in the 1980s without an
inflationary resurgence. Our benchmark assumptions
come from the Administration’s April 1983 scenario.
They forecast trend productivity growth of about 1.7
percent over 1983-88 and civilian labor force growth
of 1.6 percent.7 On the basis of these assumptions, we
estimate that the natural rate could fall close to 6 per
cent in the mid- to late 1980s, giving the economy

i The Administration scenario contains no social security tax projection.
We assume that employer social security contributions will rise with
inflation and according to legislated rate increases. At most, these
increases may contribute 0.2 percentage point to the natural rate.

some breathing room for expansion without worsening
inflationary pressures.
Of course, the actual path of inflation will depend on
the pace at which the unemployment rate is lowered.
But, under the Administration’s long-term growth sce
nario, the unemployment rate would fall by 0.8 percent
age point per year and would not dip below 6 percent
until 1988. In the absence of exogenous price shocks,
such a gradual recovery should not cause compensa
tion to accelerate until the end of the period. In short,
wages would not appear to be a major factor propelling
inflation over the next five years under the projections
of productivity, labor force, and unemployment made by
the Administration.
Long-range economic assumptions that accompany
the budget are often overly optimistic. If that is the case
for the Administration’s April assumptions, then a 6 per
cent estimate for the natural rate is too low. But it is
not obvious that overoptimism characterizes the Ad
ministration’s recent productivity assumptions. Much
research has been devoted to analysis of the causes
of reduced productivity growth in the mid-1970s. The
important factors appear to be a slowdown in the rate
of growth of capital per worker, changes in the age-sex
composition of the labor force, and the impact of
higher energy costs. While the contributions of these
factors are not known with certainty, several studies
have concluded that some combination of these fac
tors accounts for over half the decline in productivity
growth.8
The future outlook for capital formation has been
much improved by the Economic Recovery Tax Act,
although some economists believe that part of this is
countered by the prospects for large Federal budget
deficits. The teenagers and women who entered the
labor force in the late 1960s and 1970s will continue
to acquire experience over the next several years
and can be expected to contribute more to total out
put than in the past. And most energy forecasters
do not foresee another sharp run-up in oil prices, simi
lar to the 1973 and 1979 experiences, during the re
mainder of the decade. It is for these reasons that
those economists who have made long-range projec
tions expect productivity growth to average about 1.8
percent annually over the next several years, about
the same as the Administration.9 Their projections
8 J. R. Norsworthy, Michael J. Harper, and Kent Kunze, "The Slowdown
in Productivity Growth: Analysis of Some Contributing Factors” , in
Brookings Papers on Economic Activity (1979:2); Edward F. Denison,
Accounting for Slower Economic Growth (Brookings Institution, 1979);
Edward A. Hudson and Dale W. Jorgenson, "Energy Prices and the
U.S. Economy, 1972-1976", DRI Review of the U.S. Economy
(September 1978).
9 DRI, U.S. Long-Term Review (Spring 1983), Morgan Guaranty Survey
(April 1983), Chemical Bank U.S. Economic Outlook (May 10, 1983).

FRBNY Quarterly Review/Summer 1983

Box 2: Determinants of the Natural Rate of Unemployment
T he n a tura l rate o f u n e m p lo ym e n t is th e un e m p lo ym e nt
rate c o n s is te n t w ith no a c c e le ra tio n o r d e ce le ra tio n of
prices. T h is b o x exa m in e s som e of th e u n d e rlyin g
d e te rm in a n ts o f the n a tu ra l rate.

Productivity
In th e past, m any re se a rch e rs trie d to find a d ire c t
lin k fro m p ro d u c tiv ity to wages. In m ost cases the
e ffo rts w ere u n su ccessfu l o r u n c o n v in c in g .* H ow ever,
th e re is an in d ire c t lin k from p ro d u c tiv ity to w a ges via
u n it la b o r co sts. In th e long run, p rice g ro w th is m ainly
d e te rm in e d by th e g ro w th o f u n it la b o r costs, th e d if
fe re n c e betw een w a g e g ro w th and p ro d u c tiv ity g ro w th .
S h o rt-ru n c y c lic a l fa cto rs, p ric e sh o cks, and exch a ng e
rate flu c tu a tio n s can a lte r th is re la tio n sh ip fo r sh o rt
p e rio d s o f tim e, b u t th e y g e n e ra lly even o u t o ve r lo n g
e r in te rv a ls . To th e e x te n t th a t w age g ro w th e xce e ds
p ro d u c tiv ity g ro w th , u n it la b o r co sts rise and feed in to
p ric e in fla tio n . A c tu a l p ric e in fla tio n a ffe cts e x p e c te d
p ric e in fla tio n w h ich , in tu rn , a ffe cts w a g e g ro w th .
Thus, fa s te r p ro d u c tiv ity g ro w th in d ire c tly a ffe cts co m
pe n satio n g ro w th by lo w e rin g th e p rice in fla tio n w h ich
c o rre s p o n d s to any g iven rate o f w age in fla tio n .
The e ffe c t of p ro d u c tiv ity is ve ry p o w e rfu l by o u r
e s tim a te s. T he d e c lin e in p ro d u c tiv ity g ro w th fro m 3.3
p e rc e n t in 1961-67 to 0.8 p e rce n t in 1974-82 raised the
n a tura l rate by a b o u t 2.5 p e rce n ta g e p o in ts a c c o rd in g
to o u r c a lc u la tio n s . But th is m ay overstate the effe cts
som ew hat, sin c e p a rt o f the p ro d u c tiv ity d e c lin e un
d o u b te d ly re s u lts from c y c lic a l fa c to rs in th e 1974-82
p e rio d . N e ve rth e le ss, fe w analysts p la ce tre n d p ro
d u c tiv ity g ro w th in th e 1970s m uch above 1.1 p e rce n t,
w h ic h im p lie s a 2 p e rce n ta g e p oint in crea se in the
‘ Most researchers agree that trend productivity growth rather
than current productivity growth should affect wages. However,
few of the trend productivity measures have produced
statistically significant results.

for labor force growth are also similar to those of the
Administration. Moreover, in recent months, the pro
ductivity gains have surpassed any normal cyclical
upturn. Were this to continue, the prospects would be
for a natural rate of unemployment under 6 percent.
Of course, the reliability of all forecasts tends to
diminish the further out they are drawn. The likelihood
of unforeseen shocks increases as economic projec
tions are extended further into the future. Neverthe
less, it is important to realize that, in the absence of
such shocks, there may be considerably more room
for noninflationary economic expansion than is com
monly assumed by many analysts. It is possible that

FRBNY Quarterly Review/Summer 1983

n a tu ra l rate o f u n e m p lo ym e nt due to th e p ro d u c tiv ity
slo w d o w n .

Demographics
L a b o r fo rc e g ro w th a ffe cts th e in fla tio n -u n e m p lo ym e n t
tra d e -o ff in c o m p le x w ays. R apid la b o r fo rc e g ro w th
te n d s to im p ro ve th e m easured tra d e -o ff b e ca use new
w o rk e rs are g e n e ra lly y o u n g e r, in e xp e rie n ce d , and th u s
lo w e r p aid. T h is s h ifts th e d is trib u tio n o f w o rk e rs
to w a rd th o se at th e b o tto m o f th e age and e a rn in g s
sca le , causing a slo w d o w n in w age g ro w th and a d e
c lin e in th e n a tura l rate o f u n e m p lo ym e nt. H ow ever,
la b o r fo rce g ro w th also has o ffs e ttin g in d ire c t e ffe cts.
If new e n tra n ts are less p ro d u c tiv e b e cause of in e x
p e rie n ce , m ore rapid la b o r fo rc e g ro w th w ill te n d to
raise th e n a tu ra l rate by slo w in g p ro d u c tiv ity g ro w th .
Of co u rse , if w o rk e rs ’ w ages are d ire c tly p ro p o rtio n a l
to th e ir p ro d u c tiv ity , then th e tw o e ffe cts sh o u ld e x a c t
ly even out. H ow ever, o u r resu lts, w h ile te n tative , su g
g e st th a t on n e t m ore la b o r fo rc e g ro w th te n d s to
raise th e na tura l rate of une m p lo ym e nt.
O ne reason th a t ra p id la b o r fo rc e g ro w th m ay raise
th e n a tura l rate is th a t new w o rk e rs and o ld w o rk e rs
m ay n o t be p e rfe c t s u b stitu te s. W hen la b o r fo rc e
g ro w th ta ke s o ff ra p id ly, th e re m ay be a lim it to th e
e co n o m y’s a b ility to a b so rb the new w o rke rs, and som e
o f them m ay have to qu e ue te m p o ra rily as u n e m ployed,
w o rse n in g th e tra d e -o ff. Or, new e n tra n ts to th e la b o r
fo rc e m ay ta ke m ore tim e in th e ir se a rch fo r e m p lo y
m ent, again te n d in g to raise th e u n e m p lo ym e n t rate.
M ost analyses su g g est th a t th e la b o r fo rc e g ro w th
rate w ill fa ll o ff in th e 1980s, a lth o u g h a p o rtio n o f the
rece n t slo w d o w n p ro b a b ly stem s fro m the rece ssio n .
N e vertheless, o ve r th e n e xt fe w ye a rs the la b o r fo rce
w ill b ecom e m ore e xp e rie n ce d and th e e co n om y m ay
be b e tte r able to a b so rb a s lo w e r stream of new en
tra n ts than in th e 1970s.

the pattern of growth and inflation in the mid-1980s
may be closer to the 1960s model than the 1970s.
Summary
Based on the evidence of the past twenty years and
forecasts of real growth and unemployment for the
next five, the outlook for nonaccelerating wages and
prices is probably better now than at any time over
the past decade. In the short run, the unemployment
rate will probably be high enough to keep wage in
flation decreasing or flat. Over the medium to long
term, two factors should prevent a significant upturn
in inflation. First, if the recovery is gradual as ex-

Box 2: Determinants of the Natural Rate of Unemployment (continued)
Government policies
G o ve rn m e nt p ro g ra m s can a ffe ct the u n e m p lo ym e ntin fla tio n tra d e -o ff e ith e r d ire c tly o r in d ire c tly . D ire ct
e ffe c ts co m e fro m e m p lo y e r p a yro ll taxes, so cia l
s e c u rity being m ost im p o rta n t, a lth o u g h u n e m p lo ym e nt
in su ra n ce c o n trib u tio n s also m ay have som e effect. Our
re s u lts in d ic a te th a t e m p lo ye r so cia l s e c u rity ta x in
crea se s e n te r one fo r one in to co m p e n sa tio n — th a t is,
w o rk e rs do not seem to m itig a te th e ir w age de m a n d s
as a re s u lt o f e m p lo y e r p a yro ll ta x in crea se s. In the
past, such in cre a se s have had a sm all e ffe ct, raisin g
th e n a tura l rate by 0.1-0.2 p e rce n ta g e p o in ts. The rate
in cre a se s c u rre n tly s ch e d u le d fo r 1983-88 are som e
w h a t la rg e r than in re ce n t ye a rs b u t s h o u ld neve rth e
less c o n trib u te o n ly a b o u t 0.15 p e rce n ta g e p o in ts to
th e n a tura l rate.
A n o th e r p ro g ra m w h ich m ay a ffe ct the u n e m p lo ym e ntin fla tio n tra d e -o ff is the exte nsion o f u n e m p lo ym e nt
in su ra n ce benefits. Evidence fro m o ur s ta tis tic a l a n a ly
sis and o th e r s o u rc e s su g g ests th a t th e e xte nsion of
b e n efits m ay offse t a p o rtio n of the e ffe c t o f h ig h e r
u n e m p lo ym e nt on w age g ro w th .f In part, th is sim p ly
m ay re fle c t th e re q u ire m e n t th a t w o rk e rs rem ain in the
la b o r fo rc e to c o lle c t u n e m p lo ym e n t be n efits. E xte n sio n
also m ay reduce so m e w h a t the in ce n tive s to search fo r
w o rk e a rly d u rin g u n e m p lo ym e nt spells, raisin g the
average d u ra tio n o f u n e m p lo ym e nt and th u s the un
e m p lo ym e n t rate.
O ther p o lic ie s m ay have less d ire c t effects, p e rh a p s
w o rk in g th ro u g h som e o f th e fa c to rs d iscu sse d e a rlie r.
E asier im m ig ra tio n p o lic ie s w o u ld te n d to increase
la b o r fo rc e g ro w th , p ro b a b ly am ong re la tiv e ly in e xp e ri
e n ce d and less p ro d u c tiv e w o rke rs, raisin g the n atural
rate. But in ve stm e n t in c e n tive s in tro d u c e d in re ce n t
tFor example, see S. T. Marston, "The Impact of Unemployment
Insurance on Job Search” , Brookings Papers on Economic
Activity (1975-1 ).

pected, the unemployment rate will remain high relative
to its natural rate even several years into the recovery.
Second, it may take a lower unemployment rate than
in the 1970s to generate inflationary wage increases
because of renewed growth of labor productivity. If

ye a rs m ay push in th e o p p o s ite d ire c tio n as th e re
c o ve ry p icks up steam and c a p ita l p e r w o rk e r in
creases.
P ro te c tio n is t p o lic ie s w h ile a ttra c tiv e in th e s h o rt
term m ay w o rsen the in fla tio n u n e m p lo ym e n t tra d e -o ff.
By sh ie ld in g w e a k in d u strie s, d is c o u ra g in g in n o va tion ,
and d ive rtin g in ve stm e n t to w a rd less c o m p e titiv e s e c
to rs, lo n g -ru n p ro d u c tiv ity m ay su ffe r. M ore d ire c tly ,
d o m e stic p ric e s m ay s h ift u p w a rd if ch e a p e r fo re ig n
p ro d u c ts are b lo cke d fro m th e m arke t. P o te n tia lly off
se ttin g som e o f these e ffe cts are e ffic ie n c y g a in s from
running p la n ts at n e a re r to fu ll c a p a c ity . N evertheless,
o ver th e long te rm , th e losses from th e p ro te c tio n is t
p o lic ie s are lik e ly to o u tw e ig h th e be n efits.
M ore g e n e ra lly, th e e ffe c ts o f fo re ig n c o m p e titio n
m ay d iffe r in the s h o rt run fro m th e long run. A ra p id
upsu rg e o f im p orts, p a rtic u la rly if co n ce n tra te d in
s p e c ific in d u strie s, m ay in crea se s tru c tu ra l u n e m p lo y
m ent in these s e cto rs w ith o u t s ig n ific a n tly d a m p in g
w a g e agreem ents in the e co n om y o ve ra ll. T h is w o u ld
te m p o ra rily raise th e u n e m p lo ym e n t rate w h ic h c o r
resp o n d s to any path o f w a g e g ro w th . T he in fla tio n
e ffe ct m ay be m uted, how ever, because th e im p o rte d
g o o d s are lik e ly to be c h e a p e r than th e ir d o m e stic
co u n te rp a rts.
In co n tra st, th e lo n g e r te rm e ffe ct of fo re ig n co m
p e titio n m ay be to im p ro ve th e in fla tio n -u n e m p lo ym e n t
tra d e -o ff. As w o rk e rs m ove fro m th e in d u s trie s affe cte d
by fo re ig n c o m p e titio n to o th e r se cto rs, th e y sh o u ld
e xe rt a d o w n w a rd e ffe ct o n w age se ttle m e n ts in these
se cto rs. As such, th e net e ffe ct o f c o m p e titio n m ay be
to lo w e r w a g e g ro w th at any level o f u nem ploym ent.
M oreover, to th e e x te n t th a t the c o m p e titio n g ro w s
g ra d u a lly ra th e r than in a b u rst, th e in itia l stage o f
in crea se d s tru c tu ra l u n e m p lo ym e n t m ay be avoided
and the be n efits fro m a m ore p ro d u c tiv e a llo c a tio n of
reso u rce s w ill be o b se rve d sooner.

we avoid major exogenous price shocks in food and
raw materials markets and get improvements in pro
ductivity growth, the economy may finally pull itself
out of the stagflation in which it has been mired for
the last decade.

A. Steven Englander and Cornelis A. Los

FRBNY Quarterly Review/Summer 1983

Technical Appendix: Computation of the Natural Rate of Unemployment
The s h o rt-te rm b e h a vio r o f co m p e n sa tio n g ro w th is d e
s c rib e d by the e xp e cta tio n s augm ented P h illip s c u rv e :*

(1)

w t = p® -

but + cxt

w h e re w t is theg rate o f ch a n ge in c o m p e n sa tio n p e r
m an -h o u r and p t is th e e xp e cte d average rate o f p ric e
in fla tio n , u t is th e u n e m p lo ym e nt rate, and x t c a p tu re s
all a d d itio n a l e co n o m ic in flu e n ce s on co m p e n sa tio n
g ro w th . A second e q u atio n a llo w s in fla tio n e xp e cta tio n s
to be d e te rm in e d by a sim p le a d a p tive e xp e cta tio n s
schem e:

(3)

pt =

wt -

w h e re p t is th e rate o f ch a n ge o f p ric e s a nd q t is tre n d
p ro d u c tiv ity g ro w th . A p p ly in g th e d e fin itio n o f th e
n a tura l rate o f une m p lo ym e nt, b e in g th a t rate o f un
e m p lo ym e n t a t w h ich p ric e in fla tio n rem a in s co n sta n t,
th e n a tura l rate can be fo u nd as a fu n c tio n o f p ro d u c
tiv ity and o th e r real e co n o m ic fa c to rs . W hen e xp e cte d
in fla tio n eq u als a ctu al in fla tio n , w e have fro m e q u a tio n

(2):
(4)

p* = p * . , = p t .

S u b s titu tin g e q u a tio n (4) in to e q u a tio n (3) and th e n in to
e q u a tio n (1) re su lts in an e xp re ssio n fo r th e n a tu ra l
rate o f u n e m p lo ym e nt:
T he c u rre n t e x p e cte d average rate o f p ric e in fla tio n is
e q u al to th e e x p e cte d average rate o f p ric e in fla tio n
in th e p re v io u s p e rio d a d jv s te d by a fra c tio n o f th e
d iffe re n c e b etw een th is rate and th e a ctu a l rate in th e
p re v io u s p e rio d . P rice in fla tio n is d e te rm in e d by u n it
la b o r co s ts :

‘ This is, in very simplified form, the estimated equation of Box 1.

FRBNY Quarterly Review/Summer 1983

(5)

u t is= (c x t -

q t ) /b .

In o u r e stim a te d e q u a tio n th e c ru c ia l tra d e -o ff c o e ffi
c ie n t b has a va lu e eq u al to 0.89. N o tice th a t th e
n a tu ra l rate o f u n e m p lo ym e n t is n o t a c o n sta n t b u t is
n e g a tive ly relate d to p ro d u c tiv ity q t and p o s itiv e ly re
la te d to th e e c o n o m ic v a ria b le s re p re se n te d by x t
w h ic h te n d e d to raise w a g e g ro w th in e q u a tio n (1).

Federal Deficits and
Private Credit Demands
Economic Impact Analysis
One of the few areas of agreement among public
officials and economists alike is the belief that the
United States is facing deficits of unprecedented size
— in absolute terms and relative to the economy— over
the next several years. There are, of course, some
technical estimating differences among professionals,
but these are minuscule compared with wide differ
ences in the outlook for the deficit that existed a year
ago. The important questions now are what are the
chances that the projected deficits will be reduced
and, if they are not cut, what are the implications of
large deficits for monetary policy and ultimately for
the economy in general.
The analysis that follows is in three parts. First,
after a brief introductory discussion to put the mag
nitude of the future deficits into a historical and inter
national perspective, the factors that have led to the
dramatic shift in the outlook in the last few years are
reviewed. Next, the question of whether it is likely
that the economy can "grow out of the deficits” is
explored. At the end of these two parts, it will be
clear that the budget deficit is not likely to be reduced
very easily or very rapidly. This conclusion is the
motivating factor behind the final section which dis
cusses the implications of large deficits for monetary
policy and the economy.

Uncharted fiscal territory
As shown on Chart 1, the United States is moving
into uncharted fiscal territory. The deficit will equal
61/2 percent of gross national product in 1983, and
by 1985— three years into a recovery— it could still be
about 6 percent of GNP. Usually the deficit peaks
shortly after the end of a recession and then drops
by a significant amount. But that is not likely to be the
case in 1983 through 1985, under reasonable assump
tions about how the economy will perform.
While Chart 1 compares the projected deficits to
previous experience, Table 1 puts them into an inter
national perspective. As a percentage of GNP, pro
jected general government deficits for the United
States (the combined deficit or surplus of the Federal
and state and local sectors) are well in excess of the
1970-80 average for Japan, Germany, the United
Kingdom, and France. More important, the projec
tions of the general government deficit as a percent
age of net saving, 50 to 60 percent for the United
States in 1984 and 1985, is about double the highest
figure for Japan during the decade— 31 percent in
1978— and is above the highest figure for any of the
four countries, except the United Kingdom, during
their 1975 recession.

What is driving the widening gap?
The views expressed in this article are those of the author, James R.
Capra, formerly Manager of the Domestic Research Department, and
do not necessarily reflect those of the Federal Reserve Bank of
New York. The author would like to thank William Cohen for his help
on net interest estimates and Carl Palash for his work on estimates
of saving.

A few years ago, in the late 1970s, even the most
pessimistic of fiscal policy economists were not pro
jecting deficits of 6 percent of GNP, especially not
well into a recovery. What happened? Some argue
that the tax cut is responsible for the problem. Others

FRBNY Quarterly Review/Summer 1983

contend it is the defense buildup or uncontrolled non
defense spending. Still others say the recession put the
economy on a growth path so far below potential that
it will never fully recover. They argue that lower real
output and incomes, combined with disinflation, have
permanently eroded the revenue base, that is, nominal
incomes. It is important to explore the question of
what has caused the deficit to grow, if only to em
phasize that the problem is one that is not likely to
go away without some hard and difficult decisions
being made.
As shown on Chart 2, by 1985, revenues are pro
jected to be 18.7 percent of GNP and outlays 24.6
percent, for a deficit of 5.9 percent of GNP. Using
1980 as a reference point, a year when the deficit
was 2.3 percent of GNP, revenues are projected to
decline and outlays increase. The swing is 1.4 per
centage points for revenues and 2.2 percentage points
for outlays (Table 2). The defense increase (1.7 per
centage points) and higher government interest pay
ments (1.4 percentage points) more than account for
the spending increases. Nondefense outlays are pro

jected to decline as a percentage of GNP, although,
as will be shown later, there are both ups and downs
within this category.
Revenues
The 1.4 percentage point decline in Federal revenues
as a percentage of GNP is made up of reductions of
the corporate and individual income tax burden, offset
partially by the rise in social security taxes enacted
in the 1977 and 1983 Social Security Act Amend
ments (Table 3A). The second part of the table parti
tions the change in revenues, compared with 1980, into
recession-related changes and legislative changes.
The message of the table is that, although the recent
recession is a factor in the decline in revenues as a
percentage of GNP, it is far less important than the
legislative changes— in particular the Economic Re
covery Tax Act (ERTA).
A different way of looking at the revenue projec
tion is to ask if the decline was deliberate. This can
be done by comparing current projections of revenues

Table 1

General Government Deficits, 1970-80

Chart 1

Uncharted Fiscal Territory

Highest*

Average

Country

Budget deficit as a percentage of GNP
As a percentage of GDP or GNP
- 2 .1 7
-5 .5 (1 9 7 9 )
-5 .7 (1 9 7 5 )
- 1 .8 5
-4 .9 (1 9 7 6 )
- 2 .3 7
-2 .2 (1 9 7 5 )
-4 .2 (1 9 7 5 )

Percent

United K in g d o m .........
United S ta te s f...........

Projection for the United States:

1983 = —5.4
1984 = - 4 . 7
1985 = - 4 . 7

As a percentage of net private savings

United K in g d o m ...............
United Statesf .................
Projection for the United States:

-1 9 .6
-3 0 .2
- 1.8
-1 4 .8

-5 5 .9 (1 9 7 5 )
-7 0 .0 (1 9 7 5 )
-2 0 .2 (1 9 7 5 )
-52 .4 (1 97 5 )
1983 = -7 0 -8 0
1984 = -5 0 -6 0
1985 = -5 0 -6 0

Fiscal years
Years 1983, 1984, and 1985 are estimated, assuming
current services and real gross national product growth
of 1.7, 4.6, and 4.3 percent. Shaded areas represent
periods of recession, as defined by the National Bureau
of Economic Research.
Source for historical data: O ffice of Management and Budget

FRBNY Quarterly Review/Summer 1983

* Figures in parenthesis indicate year of highest deficit
for decade.
flncludes state and local governments.
^Average for 1975-80 was 24.8 percent.
Source: Organization for Economic Cooperation and
Development (June 1983).

Chart 2

Growing Gap in Share of GNP

Table 2

Federal receipts vs. outlays

How the Budget Changes after 1980

Percent

As a percentage of GNP

2 6 ---------------------------------------------------------------------------------------

Budget items

1980

1985*

Deficit .......................

-2 .3

-5 .9

Revenues

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

Outlays .....................
D e fe n s e .................
Interest .................
Nondefense ......... •

Change
(percentage
points)
-3 .6

20.1

18.7

-1 .4

22.4
4.8
2.0
15.6

24.6
6.5
3.4
14.7

+ 2 .2
+ 1.7
+ 1.4
-0 .9

Fiscal years
Projections for 1983, 1984, and 1985 are Federal Reserve
Bank of New York estimates.

‘ Current policy (current services) estimates.

Source for historical data: Office of Management and Budget.

Table 3

(A) Composition of Decline in Federal Revenues
As a percentage of GNP
Revenue source

1980

Individual income ...................................................................................
Corporate income ...................................................................................
Social insurance .....................................................................................
Other .........................................................................................................
Total

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

1985

Change

9.5
2.5
6.1
2.0

8.4
1.6
6.9
1.7

—1.0
—0.9
+ 0 .8
—0.3

20.1

18.7

-1 .4

(B) Factors Contributing to Change in Federal Revenues
As a percentage of GNP, 1985 compared with 1980

Revenue source

Total
change

Recession
related

Social
security
tax
increase

ERTA/
TEFRA*

Windfall
profit

Individual income ................................................................................... ..........—1.0
Corporate income ................................................................................... ..........—0.9
Social insurance ..................................................................................... ..........+ 0 .8
Other ....................................................................................................................—0.3

—0.2f
—0.4:}:
—
- 0 .2 §

—
—
+ 0 .8
—

—0.8
—0.5
—
-0 .2

—
—
—
+0.1

Total change ........................................................................................... ..........—1.4

—0.8

+ 0 .8

—1.6

+0.1

‘ Economic Recovery Tax Act and Tax Equity and Fiscal Responsibility Act.
fThe 1980 unemployment rate was 7.3 percent and real GNP was 4.0 percent below potential. For 1985, the unemployment rate is assumed
to average 8.9 percent and real GNP is projected to be 8.0 percent below potential. If the gap had remained the same, individual income taxes
as a share of GNP would have risen because of the progressive tax structure.
4:Profits before taxes (pre-accelerated cost recovery basis) as a share of GNP are projected to be 7.8 percent in 1985, compared with
9.5 percent in 1980. If the profits share had remained at 9.5 percent, corporate taxes as a percentage of GNP would have been larger.
§This change reflects the effect of lower interest rates (assumed to be related to the 1982 recession) on Federal Reserve earnings and
the effect of lower oil prices on windfall profit taxes.

FRBNY Quarterly Review/Summer 1983

Table 4

Table 5

How Individual-Corporate Income Taxes for
1985 Compare with What was Anticipated
When ERTA was Passed?

Where in the Budget will the GNP Share Decline?
Outlays as a percentage of GNP

As a percentage of GNP
Changes
ERTA e s tim a te .................................
Changes:
Economic changes .....................
^Revenue loss (revised estimate)
TEFRA ..........................................

Individual

Corporate

8.3

1.7

- 0 .6 *
+ 0 .4
+ 0 .3

—0.6f

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

+0.1

- 0 .1

Current estimate .............................

8.4

Subtotal

+ 0 .5

1.6

* —0.2 because of lower real GNP; —0.4 because of lower
inflation.
fThe corporate profits share of GNP (pre-accelerated cost
recovery basis) was assumed to be 9.0 percent at the time
ERTA was passed, compared with a current estimate
of 7.8 percent.
tThe Treasury and Joint Committee on Taxation revised their
estimates of the revenue effects of the tax cuts subsequent
to enactment.

with what public officials were told was going to hap
pen to 1985 individual and corporate income tax reve
nues when ERTA was passed. Recently, some have
argued that the deficit increase is larger than antici
pated two years ago because inflation is now forecast
to be so much lower than projected then, in the
summer of 1981, and because the real economy in
1985 is expected to be a lot farther below potential
than anticipated in the Administration’s economic sce
nario that was used at the time.1
Those who take this position tend to overestimate
the effect of the change in economic assumptions on
revenues as a share of GNP. Changing economic as
sumptions can drastically affect estimates of revenues
in billions of dollars, but the effect on the share of
GNP is much smaller in a proportional sense. A
weaker economy and lower inflation mean that both
GNP and revenues are lower. Whatever effect there
is on the revenue share of GNP is primarily the result
of the progressive or graduated character of individual
income tax rates. This causes individual income tax
revenues to fall by a somewhat greater percentage
than the fall in income. But the effect on the total
1 See the House Budget Committee Recommendations for the First
Concurrent Resolution (March 1983), page 72, for a discussion of the
disinflation point.

FRBNY Quarterly Review/Summer 1983

1980
Actual

Budget items
National defense

1985
Baseline
projection

1980-85
change

.........

4.8

6.5*

+ 1.7

Benefit payments:
Means tested ...........
tNonmeans tested . . .

2.2
8.8

2.1
9.6

- 0 .1
+ 0 .8

Grants to state and local
governments^ ...............

2.3

1.5

- 0 .8

Other Federal operations
and subsidies ...............

2.3

1.5

-0 .8

Net interest ...................

2.0

3.4

+ 1.4

22.4

24.6

+2.2

Total

‘ Assumes 5 percent real growth in 1984-85 budget authority
and pay raises of 4 percent in January of each year.
fSuch as social security and medicare benefit payments.
^Excludes grants for benefit payments for individuals.

revenue share of GNP is not very large, in part be
cause individual taxes will represent less than 50 per
cent of total revenues by 1985 and in part because
starting in 1985 the effect of inflation on the revenue
share of GNP is muted by the start of tax indexing.
Also ignored by those who suggest that revenues will
fall by more than anticipated is the fact that the Tax
Equity and Fiscal Responsibility Act (TEFRA) effec
tively took back some of the ERTA tax cuts, a political
development not anticipated in 1981. When the effects
of the economic and legislative changes since the
summer of 1981 are tabulated, as in Table 4, the results
for individual and corporate income taxes are that
the estimated share of GNP in 1985 is virtually un
changed from what was intended when ERTA was
passed. Individual income taxes for 1985, as a per
centage of GNP, are up Vio percentage point (8.4 per
cent compared with 8.3 percent) from what was
planned and corporate income taxes are down Vio (1.6
percent compared with 1.7 percent).
The conclusion to be drawn from this discussion of
the revenue side of the growing deficit is that the de
cline in revenues as a percentage of GNP is primarily
because of the 1981 tax cuts. The recession is a much
less important factor. And the projected decline, es
pecially in individual and corporate income taxes, is
about what was intended.

Outlays
It is clear that in an arithmetic sense defense and gov
ernment interest payments more than account for the
projected increase in outlays from 22.4 percent of GNP
in 1980 to 24.6 percent by 1985. Nondefense spending
as a percentage of GNP is projected to decline. But
this calculation masks the fact, shown in Table 5, that
the GNP share for nonmeans-tested benefit payments
such as social security and medicare increases sig
nificantly. At the same time, grants to state and local
governments and other Federal operations (primarily
Federal civilian agency pay) decline.
The size of the defense buildup is a familiar topic.
A relevant point that has not been made, though, is
that much of this buildup is already locked in. Thus,
although the estimates in Table 5 assume that real
growth of budget authority will be held to 5 percent
in 1984 and 1985, defense outlays as a percentage of
GNP will still rise significantly by 1985. Defense ex
penditures will rise even more if the cuts assumed in
the First Concurrent Resolution are not implemented
and budget authority growth in real terms is not held
to 5 percent. For example, if authority increases by as
much as suggested by the President, projected outlays
in 1985 as a percentage of GNP would be 0.4 to 0.5
percentage points higher than shown in Table 5.
Nonmeans-tested benefit payments are dominated by
social security cash payments— Old Age, Survivors,
and Disability Insurance— and medicare, which make
up almost three fourths of the category (Table 6). The
problem of future growth of entitlement and benefit
payments really boils down to these two programs.
They account for more than all the 1980-85 growth.
The other programs decline slightly, on balance, as a
percentage of GNP. An important point to note is that
medicare, as a percentage of GNP, is projected to grow
faster than social security cash payments. Its share of
GNP is projected to rise from 1.2 percent in 1980 to
2.0 percent in 1985. The figures in Table 6 imply that, if
spending for nonmeans-tested programs is to be
brought under control, social security cash payments
(which were just recently addressed in the Social Secu
rity Amendments of 1983) and medicare would probably
have to absorb a significant part of the cutback.
How do the projections for 1985 compare with the
Administration’s original budget plans of March 1981?
In March 1981, the Administration was seeking to
reduce outlays to 19.2 percent of GNP by 1985. The
baseline projection is now 24.6 percent (a difference
of 5.4 percentage points). The largest increases in the
projection since 1981 are due to rises in nonmeanstested benefit payments, rises in net interest, and the
failure to achieve an undistributed cut of over $40
billion (equivalent to 1 percent of GNP) that the Ad

ministration never ultimately proposed but which was
included in the March 1981 budget totals.
One reason why the projection has changed is that,
on balance, the budget cuts were smaller than the
President included in his plan— by 0.5 percentage
points as a percentage of GNP or 1.5 percentage
points if the Congressional reductions to the Presi
dent’s defense plan are not included. Most of the
change was the $40 billion undistributed cut. Excluding
that cut, the Congress actually passed nondefense
budget reductions about equal to what was proposed
in March 1981 although the distribution of the cuts was
somewhat different (Table 7). If defense is included, the
cuts exceeded the President’s proposal.
Automatic stabilizers, that is, higher than anticipated
unemployment benefits resulting from a higher than
projected unemployment rate, and higher interest pay
ments, resulting from higher rates and greater than
anticipated debt outstanding, are responsible for 1.9 of
the 5.4 percentage point change in the projection of
1985 outlays as a percentage of GNP. But the largest
element in the change is the fact that there is not
necessarily a full and automatic response of outlays
to a lower than anticipated nominal GNP. Lower infla
tion results in lower outlays for some, but not all,
programs. But even this occurs with an appreciable
lag. Lower real economic growth has no effect on
outlays aside from the automatic stabilizers just men
tioned. Thus, when nominal GNP falls, the denominator
of the spending-GNP ratio falls much more rapidly
than the numerator.

Table 6

What is the Composition of 1980-85 Growth
of Nonmeans-Tested Benefit Payments?
As a percentage of GNP

Benefit payments
Social security:
‘ Cash p a ym e n ts............
Medicare .......................
Civil service/military
retirement .........................
Unemployment
compensation ...................
Veterans benefits .............

1980

1985
baseline
projection

Change

4.6
1.2

5.1
2.0

+ 0 .5
+ 0 .8

1.0

1.1

+0.1

0.7
0.8

0.6
0.5
0.3

- 0 .1
-0 .3
-0 .2

8.8

9.6

+ 0 .8

*Old-Age, Survivors, and Disability Insurance.

FRBNY Quarterly Review/Summer 1983

The last column in the table is an attempt to account
for the unresponsiveness of outlays to lower nominal
GNP. It shows that, even if all the President’s proposals
had been enacted intact, lower nominal GNP, unaccom
panied by lower nominal outlays, would have raised
the GNP share for outlays by 3.0 percentage points.
To keep the outlay target at 19.2 percent of GNP, the
President would have had to propose successively
deeper cuts in nominal outlays as the projections for
real growth and inflation were lowered.
For outlays, then, the projected growth as a per
centage of GNP since 1980 is comprised of defense,
net interest, and nonmeans-tested benefit payments.

Grants and other operations have been reduced sig
nificantly, while the GNP share for means-tested bene
fits is projected to be virtually unchanged. The pro
jection for outlays as a sTiare of GNP in 1985 has
increased significantly since the President submitted
his March 1981 plan. This is primarily because pro
posals were not made nor was Congressional action
initiated that would lower nominal outlays by an amount
proportional to the loss in projected GNP. In an indirect
sense, recession and disinflation had more of an effect
on the President’s 1981 plan to cut the outlay share of
GNP than it did on his path for revenues.

Table 7

What Happened to the Administration’s Original Spending Plan for 1985?
Outlays in 1985 as a percentage of GNP

Budget items
National defense .....................................
Benefit payments:
Nonmeans te s te d .................................
Means tested ........................................
Grants ........................................................
Other operations and s u b s id ie s .............
Net in te re s t................................................
Undistributed cut .....................................
Total

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

March 1981
estimate

1985
baseline
projection

6.5

8.3
1.7
1.0
1.2
1.5
-1 .0

9.6
2.1
1.5
1.5
3.4
—

+ 1.3
+ 0 .4
+05
+ 0 .3
+ 1.9
+ 1.0

19.2

24.6

+ 5 .4

Change
—

Reasons for Change from 1981 Plan
Outlays in 1985 as a percentage of GNP

Budget items
National defense ..................................
Benefit payments:
Nonmeans tested .............................
Means tested ....................................
Grants ....................................................
Other operations and s u b s id ie s ........
Undistributed cut ..................................

Automatic
stabilizers*

Interest payments:
more
higher
debt
rates

Lower
GNP inflexible
outlays!

Total
change

Congressional
action/inaction

—

-1 .0

—

+ 1 .0

+ 1 .3
+ 0 .4
+ 0.5
+ 0 .3

-0 .2
+0.1
+ 0 .3
+0.1
—

+ 0 .2
—
—
—
—

—
—
—

—
—
—
—

+ 1 .3
+ 0 .3
+ 0 .2
+ 0 .2

+ 1.3

+ 0 .4

+ 0 .2

+ 1 .0

+ 1.2

—

-0 .2

+ 5 .4

+ 0 .5

+ 0.2

+ 1.3

+ 0 .4

+ 3 .0

'H igher than anticipated unemployment benefits resulting from a higher than projected unemployment rate.
fMeasures effect of lower GNP on outlays as a percentage of GNP if 1985 outlays, in nominal terms, were to equal the March 1981 target.

FRBNY Quarterly Review/Summer 1983

Will the economy grow out of the projected deficits
Recently, the suggestion has been made that the
economy will grow out of the projected deficits. The
reasoning is that higher incomes, resulting from more
economic growth, will boost tax revenues sufficiently
to wipe out a significant part of the deficits. To ex
amine this proposition more carefully, three alterna
tives were chosen to the basic economic scenario
used for the calculations in the previous section. Also,
the projections were extended through 1988.
Real GNP
Most forecasters have recently revised their projec
tions for 1984 in response to a faster than expected
expansion in production and employment in the sec
ond quarter of 1983. But the important question for
the long-run prospects for the deficit is what growth
to project for the extended period 1984-88.
The baseline economic scenario used here assumes
real GNP growth (year-over-year basis) of 4.6 percent
in fiscal 1984, 4.3 percent in 1985, and 3.8 percent in
each year 1986-88. Over the five-year period, 1984-88,
cumulative real GNP growth under these assumptions
would be 22.0 percent.
In the postwar era, there have in fact been selected
five-year periods over which more growth was
achieved. For example, in the five-year period ended
with 1966, real GNP grew by 30.2 percent. In the fiveyear period just after the war, ended with 1952, real
GNP grew by 27.7 percent. The momentum of growth
during these periods, together with the simple arith
metic of including at least two of the years from these
peak growth spurts in the calculation of moving aver
ages for five-year periods, meant that the periods
ended in 1963, 1965, 1967, 1968, 1969, and 1953, 1954,
and 1955 also show ed g ro w th above the 22 percent as
sumed in the baseline economic assumptions (Table 8).
But, if the years affected by the two postwar growth
spurts are disregarded, the next highest five-year
period is the one ended in 1980— the recovery from
the 1974 recession. Five-year growth was only 19.7
percent, lower than assumed for 1984-88. In fact, there
was not one five-year period ended in the 1970s when
cumulative growth was as high as 20 percent.
In economics, historical precedent is not proof. Yet
it does temper our judgment of what is likely. Clearly,
a growth spurt comparable to 1962-66 is possible, but
it does not appear likely. The Administration, in its
January budget document, lists several reasons why
such rapid growth probably w ill not occur. For one
thing they suggest that since capacity utilization is
now much lower than it was at the start of the earlier
period, a comparable surge in fixed investment will
probably not happen— especially at current levels

ft' " . '
Table 8

i l l W SM:

Cumulative Real GNP Growth over
Five-Year Periods
Year designates final year of period; in percent
Cumulative
five-year
growth

Year
1952
1953
1954
1955

.........
___
........
....

27 7
27.3
25 2
22 9

1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970

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

___
___
___

13.8
9.2
172

___

127

___
___
___
....
___

21 4
261
30.2
26.4
27.1

___

168

1972
1973
1974
1975

___

173

___

146

18.7

1977 ...........................................................................
1979
1980
1981
1982

of real interest rates. They also mention that finan
cial difficulties faced by many lesser developed coun
tries will be a drag on future U.S. exports.
More fundamentally, over extended periods of time
it is best to think about the growth of real GNP as
the sum of the growth of employment and labor pro
ductivity. In the five-year period ended with 1966,
real GNP growth averaged 5.4 percent per year. Civil
ian employment grew by 2.0 percent per year (2.6 per
cent in the nonagricultural sector) and productivity
by 3.3 percent. In the five-year period ending in 1988,
real GNP— according to the baseline economic as
sumptions— would grow by about 4.1 percent per
year, with civilian employment growing by 2.5 percent
annually and productivity by 1.7 percent. (Average
weekly hours are assumed to continue their long-run
secular decline, falling 0.2 percentage points.)
The big difference between economic performance
in the early sixties and the projection for the mid-

FRBNY Quarterly Review/Summer 1983

Table 9

Alternative Economic Assumptions
Fiscal year over fiscal year growth rates; in percent

Fiscal
year
1984
1985
1986
1987
1988

(Baseline)
Real
GNP
GNP deflator
................... 4.6
................... 4.3
...................3.8
................... 3.8
................... 3.8

4.0
4.0
4.0
4.0
4.0

Path A (1962-66)*
Real
GNP
GNP
deflator
6.0
6.0
5.5
5.0
4.6

5.5
6.5
7.5
7.5
7.5

Path B (1948-52)*
Real
GNP
GNP
deflator
6.0
5.7
5.0
4.5
3.9

5.5
6.5
7.0
7.0
7.0

Path C (1976-80)*
Real
GNP
GNP
deflator
4.5
3.4
3.4
3.4
3.4

3.9
3.9
3.8
3.8
3.7

‘ Real GNP growth was made, on average, the same as in the period identified. Inflation that is consistent with that growth was then
estimated. Inflation was not made the same as in the period identified, since labor force, productivity, and energy price outlooks are
now much different.

eighties is productivity. As low as the projection for
productivity is, it still is significantly better than the
performance of the past five years. In 1982, the level
of output per man-hour in the nonfarm business sector
averaged exactly what it did in 1977— no growth in
five years. While it is unlikely that the experience of
the last five years will be repeated, neither is it prob
able that an explosion in productivity will occur and
then be sustained for five years. The factors contrib
uting to the slowdown in productivity growth are not
likely to change dramatically overnight.2 It is true that
in the first quarter of 1983, productivity did grow at a
4.8 percent annual rate. But a one- or two-quarter
jump in productivity at the start of a recovery, before
workers are rehired, is normal. In fact, 4.8 percent is
well below the average of 7.9 percent for the first
quarter of postwar recoveries. Thus, it does not appear
reasonable to use the first-quarter numbers to argue
that the long-range productivity assumptions are too
low.
The growth of 2.5 percent annually in employment
under the baseline economic assumptions would be
sufficient to reduce the unemployment rate to 6 percent
by the end of the period, assuming labor force growth
of about 1.7 percent per year. In the 1962-66 period, the
labor force grew by 1.5 percent per year, while em
ployment was growing by 2.0 percent. Thus employ
ment growth in the 1984-88 period under the baseline
2 J. R. Norsworthy, Michael J. Harper, and Kent Kunze, “ The Slowdown
in Productivity Growth, Analysis of Some Contributing Factors” in
Brookings Papers on Economic Activity (1979:2); Edward F. Denison,
Accounting for Slower Economic Growth (Brookings Institution, 1979);
Edward A. Hudson and Dale W. Jorgenson, “ Energy Prices and the
U.S. Economy, 1972-1976” , DRI Review (September 1978).

FRBNY Quarterly Review/Summer 1983

assumptions is assumed to be even faster, relative to
labor force growth, than in 1962-66.
A repeat of the 1962-66 growth spurt, while tech
nically possible, is not likely, although estimates of
the effects of such a recovery on the deficit will be
presented. But, first, it is necessary to state the infla
tion rates that are assumed to go with alternative rates
of real GNP growth.
Inflation
The baseline economic assumptions project inflation,
as measured by the GNP deflator, to average about
4 percent annually. The projections assume an ab
sence of food or oil price shocks— about the only
assumption that can be made— but it is clear that
these could change the outlook considerably. From
a more fundamental economic standpoint, the char
acter of the recovery that is projected implies that
not until 1988 would the economy approach “ potential”
— the level of GNP above which most economists be
lieve that inflation will accelerate. Thus, under the
baseline real GNP forecast, inflation would remain
moderate throughout the period.3
If the economy were to grow at the 1962-66 pace,
accelerating inflation would probably reassert itself
more quickly. By 1986, real GNP would be in excess

3 For this analysis, potential GNP is defined as the level of real GNP
when the unemployment rate is 6 percent. The question of whether
inflation is likely to accelerate under a growth path similar to the
baseline scenario used here is explored in some detail in the article by
Steven Englander and Cornelis Los elsewhere in this Quarterly Review.
Their conclusion is that an acceleration is not likely until the unem
ployment rate falls below 6 percent unless exogenous food or energy
price shocks occur.

of potential GNP. The resulting faster inflation would
improve the deficit outlook. Revenues, which tend to
respond fully and immediately to higher inflation,
would increase by more than outlays, which respond
only partially to more inflation and with a lag. An
acceleration of inflation would reduce the likelihood
of sustaining rapid real growth, so that in a sense a
high growth-high inflation scenario might not be feasi
ble. Nevertheless, for illustrative purposes, the next
section includes estimates of current services deficits
under two such economic scenarios. Also included
are estimates of current services deficits if the econ
omy were to recover at the 1976-80 pace, with real
growth averaging 3.6 percent annually over the next
five years.
Budget deficits under alternative economic paths
Three alternatives to the baseline economic scenario
were selected for use in calculating projected budget
deficits. The three paths— A, B, and C— correspond to
average annual growth of 5.4 percent, equivalent to the
experience of 1962-66, 5.0 percent (1948-52), and 3.6
percent (1976-80). In all the paths, growth is assumed to
be more rapid at first and to decline gradually. For ex
ample, under path A, real GNP growth is 6.0 percent in
both fiscal years 1984 and 1985 (Table 9).
For inflation, a gradually widening discrepancy be
tween the inflation rate in the baseline projection and
the alternative paths is assumed. The process might
not be that gradual if inflation expectations were to
anticipate rapidly accelerating price increases.
Interest rates tend to be sensitive to the current and
anticipated inflation rate. For the calculations of interest
on the public debt, it was assumed that the gap be
tween the inflation rates in the baseline and the rates
in the alternative paths would be fully transmitted to
interest rates. Thus, the rates on new Treasury financ
ing would be 3.5 percentage points higher in 1988
under path A than under the baseline.
The baseline deficit projection grows from about
$220 billion in fiscal year 1984 to $300 billion by 1988
(Table 10). There is no question that more rapid GNP
growth, like the record growth in 1962-66, would alter
the outlook. But the improvement is not so great or
so rapid as might be expected. Specifically, under
path A, the current services deficit would decline to
about $180 billion by 1985 and to $150 billion by 1988.
The estimates contain four separate effects of the
economy on the budget:
• Higher revenues because of higher real GNP
and higher prices ($215 billion in 1988).
• Lower outlays for unemployment compensation,
food stamps, and welfare ($10 billion in 1988).

Table 10

Alternative Deficit Projections
By fiscal year; in billions of dollars

Fiscal
year
1984
1985
1986
1987
1988

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

Baseline

Under
path A
(1962-66)
growth
rate

Under
path B
(1948-52)
growth
rate

Under
path C
(1976-80)
growth
rate

-2 2 2
-2 2 5
-2 4 3
—276
-3 0 0

-2 0 0
-1 8 0
-1 6 5
— 165
-1 5 0

-2 0 0
-1 8 0
-1 7 5
-1 7 5
-1 8 5

—222
-2 3 5
-2 6 0
—300
—330

• Higher outlays for indexed entitlements be
cause of higher inflation ($60 billion in 1988).
• Lower interest outlays because of lower debt
outstanding as a result of deficits being smaller
than in the baseline ($45 billion in 1988).
• Higher interest outlays because of higher inter
est rates on Treasury debt as a result of higher
inflation ($60 billion in 1988).4
It is important to note that, if by some chance the
rate of inflation were not to accelerate even though
real GNP were growing at a record pace, the deficits
would be larger than under path A. There would be no
effect on indexed entitlements or on the interest rates
for Treasury debt, but revenues would not grow as
much because nominal income would be lower than
under path A. The 1988 deficit would be about $185
billion under this hypothetical rapid growth-low infla
tion scenario, compared with $150 billion under path A.
Under path B, the 1948-52 growth scenario, the deficit
would hover around $180 billion throughout the period.
Finally, under path C, a recovery similar to that of the
1976-80 period, the deficit would be even larger than
in the baseline— about $330 billion in 1988. The
year-by-year estimates for all three paths are sum
marized in Table 10.
As a percentage of GNP, deficits under the three
paths contrast more sharply with the baseline figures.
For example, the 1988 deficit of $300 billion for the
baseline would be 6.3 percent of GNP. The $150 billion
deficit under the record growth of path A would be 2.6
4 This includes about $50 billion from higher rates and $10 billion
because financing the higher rates caused more debt to be created.

FRBNY Quarterly Review/Summer 1983

percent of GNP— substantially more modest, but still
well above the postwar average of 0.9 percent and
the average of 1.6 percent between 1965 and 1980.
(If faster real growth were for some reason not accom
panied by more rapid inflation, the deficit would be
3.2 percent of GNP in 1988.) Under path B, the 1988
deficit would be 3.1 percent of GNP. The path C
deficit, which reflects slower economic growth and
lower inflation, would be 7.1 percent of GNP in 1988.
Overall, analysis of budget trends reveals that ex
plicit policy actions like the tax cut, institutional con
straints like the failure of nominal outlays automatically
to respond very much or very quickly to disinflation,
and public support for social security, medicare, and
a stronger defense appear to imply that large deficits
could be a part of the economic landscape for the
foreseeable future. More rapid GNP growth could im
prove the outlook somewhat, but even with record
growth over the 1984-88 period the deficit would still
be about $150 billion by 1988 and the GNP share would
be large by historical standards. If substantial deficits
are likely under almost all circumstances, barring a
major switch in public policy, what are the implications
for monetary policy and the economy?

Implications for monetary policy
On the surface, it is not entirely clear what the large
deficit projections for the future mean for monetary
policy. In the United States, there is no precedent for
deficits that do not drop significantly (at least as a
percentage of GNP) within six to twelve months after the
end of a recession. In addition, even if the current def
icit outlook were not unique, the historical relationship
between deficits and monetary policy— at least as mea
sured by M-1 growth— is ambiguous. The econometric
results on this subject are as contradictory as any in
the literature with the possible exception of the work
on the relationship between social security and saving
behavior. Chart 3 exemplifies this. Between the mid1950s and 1974, money growth and deficits appear to
track quite well, but between 1974 and 1980 there ap
pears to be little relationship— possibly because the
Federal Reserve was paying more attention to targeting
the money stock or possibly because financial inno
vation was distorting the meaning of M-1 growth rates.
Money is not the only important economic variable
that does not show a strong historical correspondence
or correlation with deficits. The Secretary of the Trea
sury recently reiterated what many academicians re-

Chart 3

The D eficit as a Percentage of GNP and M-1 Growth *
P ercent
4.5

4.0
3.5
3 .0
2.5

2.0
1.5

1.0
.5

0
-.5
-

1.0
1952
♦S h ad ed

areas represent periods of recession, as defined by the National Bureau of Economic Research.

S e rie s a re norm alized by dividing

by the mean of each series.

FRBNY Quarterly Review/Summer 1983

82 83

ported throughout the 1970s— namely, that deficits
have historically not been high at the same time inter
est rates and inflation rates were high. But this lack of
historical or statistical correspondence by no means
proves there is no relationship between deficits and
these other variables. It may mean that the deficits
were not big enough to make a difference, or that other
policies or economic events were working to offset the
effects. To evaluate the potential effects of the large
projected deficits on the economy, simple correlation
analysis is insufficient. Some model or view of how the
economy works is an essential first step. Next is a fore
cast of the outlook for the economy, together with some
assumption about how public policy (especially mone
tary policy) will respond or choose not to respond to
the deficits.
The near term
Ironically, one of the factors contributing to what many
thought would be the slow pace of the current re
covery is the relative weakness of the fiscal stimulus.
This does not mean that the level of deficit is small.
The important thing to focus on, from the standpoint
of fiscal stimulus, is the change or swing in the deficit.
As shown in Table 11, the increment to the defict in
1983 (as a percentage of GNP) is less than one half of
that in the first year of the 1975-76 recovery.5
A useful way of summarizing fiscal-monetary policy
interactions is the graphical framework of IS-LM
curves. The position of the IS curve, which is the
locus of combinations of interest rates and output that
correspond to equilibrium in the markets for goods
and services (output market), is determined by, among
other things, government expenditures and taxes. The
position of the LM curve, which is the locus of inter
est rate-output combinations consistent with equi
librium in the money market, is determined by, among
other things, monetary policy.
With the fiscal policy-induced shift in the IS curve
in late 1982 and 1983 being relatively small, because
the fiscal year 1983 deficit as a percentage of GNP
grew by only 1.7 percentage points, the movement in
the IS curve was rather modest— as shown in the
first drawing in Chart 4. Thus, the only other shortrun change that would induce an increase in output
was an LM curve shift.6 Between late summer and
mid-December 1982, reserve pressures were eased

s This is not to say that over a more extended period the budget will
not be more stimulative than in the past. It will be, as exemplified
by the second recovery year comparison in Table 11.
«The LM curve on Chart 4 is drawn as a nearly horizontal line.
This would appear to be appropriate for short periods of time. Over the
long term, the curve is more nearly vertical.

Table 11

Fiscal Policy Comparison, 1974-76 vs. 1982-84*
As a percentage of GNP
1974 1975 1976

1982 1983 1984

Revenues ................. 20.4 18.8 19.5
Expenditures ........... 21.2 23.4 22.6
D e fic it....................... - 0 . 8 —4.6 - 3 . 2

Budget item

20.1 18.5 18.3
24.9 25.0 24.7
- 4 . 8 —6.5 —6.4

Change in deficit as a percentage of GNP
First recovery year
1974-75
1982-83

Increase of 3.8 percentage points
Increase of 1.7 percentage points

Second recovery year
1975-76
1983-84

Decrease of 1.4 percentage points
Decrease of 0.1 percentage points

‘ Estimates are for year before the start of recovery, first
recovery year, and second recovery year. Thus, the figures for
1974 represent deficits and GNP for 1974-11 through 1975-1.
Figures for 1982 represent 1982-1 through 1982-IV.

and the discount rate was cut seven separate times,
falling from 12 percent in early July to 8.5 percent on
December 15. Short-term rates fell and long-term
rates followed them. Yields on thirty-year Treasury
bonds fell from 13.92 in late June to 10.54 in Decem
ber. The LM curve shifted down, as graphically shown
in the second drawing in Chart 4.
Up to this point in the analysis, deficits would ap
pear to be relatively unimportant to the recovery. In
fact, it could be argued that cutting the 1983 or 1984
deficit might reduce demand (shift the IS curve down)
and, without an offsetting monetary policy change (LM
curve shift), such a move toward fiscal restraint would
slow the recovery.
However, there is at least one way in which deficits
may in fact endanger the recovery by maintaining high
nominal and real intermediate- and long-term interest
rates even in the face of a monetary policy designed
to facilitate recovery through moderate levels of short
term rates. For many purposes the interest rates of
fundamental importance to spending decisions are
intermediate- and long-term rates. Open market oper
ations and discount rate cuts, however, directly affect
only short-term rates. There is no guarantee that long
term rates will follow. They usually do, but not always.
In December, for example, after the most recent dis
count rate cut, long-term rates did not follow and, in
fact, backed up a bit. There are numerous explana
tions for this. A commonly held view is that the mar
ket had already anticipated the discount rate cut and

FRBNY Quarterly Review/Summer 1983

Chart 4

N ear-term IS-LM E quilibrium

( 2)

( 1)

(3 )

Chart 5

Long-term IS-LM E quilibrium

( 2)

( 1)

(3 )

FRBNY Quarterly Review/Summer 1983

did not expect any additional ones for a while, and so
the cut was already built into rates. But, looking be
yond this reasoning, some explanation is required for
the expectation that additional discount rate cuts were
not forthcoming. One hypothesis is that money growth
was expected to accelerate. Another hypothesis is
that the market or the Federal Reserve or both may
have believed that for a time a limit had been
reached as to what monetary policy could do to stimu
late the economy. A reasonable case could have been
made that further monetary accommodation, while
further lowering short-term rates for a time, at best
would have had no effect on long-term rates and at
worst could have caused them to increase, shifting the
LM curve up, as shown in the third drawing on Chart 4.
Deficits are one of the reasons, although not neces
sarily the only reason, for what may be constraints on
the ability of monetary policy to reduce intermediateand long-term rates. The explanations given for
continued high real and nominal intermediate- and
long-term rates include the following:
• Projections of future deficits are holding up
real rates as investors believe that ultimately,
after recovery is under way, fiscal and mone
tary policies will clash.
• Future deficits undermine the market’s confi
dence in monetary policy’s ability to remain
on its anti-inflationary course over the long
run. Thus, they affect the inflation premium,
based on expected inflation, that is built into
long-term rates.
• Finally, the uncertainty premium in rates is
probably increased because of expected high
deficits, since the high level of rates— adjusted
for current inflation— increases the risk of fi
nancial failure.
In short, what is argued is that from the standpoint
of long-term investors large deficits in the midst of a
prolonged economic recovery mean one of two things.
Either a noninflationary monetary policy will lead to a
confrontation between public' and private credit de
mands that will drive up real interest rates or the
Federal Reserve will ultimately accommodate, inflate
the money stock, and the economy along with it. Thus
nominal rates will rise.
Are there any facts to back up these hypotheses or
does the unprecedented size of projected deficts mean
we cannot use past experience and conventional analy
sis at all? In the first three years of recovery from the
1974-75 recession, the recession most like our recent

one in depth and duration, public borrowing (that is,
Federal and state and local government borrowing)
was 46.2 percent (1975), 30.8 percent (1976), and 21.6
percent (1977) of the net funds raised in the credit and
equity markets by domestic nonfinancial sectors and
by foreigners who borrowed and issued equity in the
United States. The private percentage was the mirror
image of these figures— 53.8 percent, 69.2 percent, and
78.4 percent. One signal of possible future credit mar
ket pressures induced by a clash between monetary
policy and deficits would be if government borrowing,
as a percentage of total credit, were not to decline
during recovery as in the past. For example, Federal
Reserve policies could restrict the growth of total
credit. And, since the Federal Government will never
be crowded out of the market, the private sector
would have to adjust. The market mechanism for this
would be higher interest rates.
In early 1983, when the Federal Reserve set its target
range for growth of the monetary aggregates, it also
estimated an associated range for the growth of the
level of domestic nonfinancial credit. A range of 8 V2
percent to 11V2 percent growth for 1983 was estimated
to be consistent with the targets for monetary growth.
Even though the M-1 target was recently revised, the
associated range for domestic nonfinancial credit was
left unchanged. In addition, Chairman Volcker sug
gested that the range would in all likelihood be
lowered by V2 percentage point, to an 8 to 11 per
cent band, for 1984. Under a noninflationary monetary
policy and in the absence of major future institutional
shifts in the financial sector, it is reasonable to extrap
olate the 8 to 11 percent band into 1985. (Some might
even argue that the band should be lowered.) The ele
ments of funds raised in the financial markets that
are not part of this credit aggregate— corporate equity
issues and foreign debt and equity issues— have been
included in a projection of total funds raised in
1983-85 (Table 12). (The funds raised through these
vehicles are projected to grow by a significant amount
in 1983, reflecting the surge in stock issues in early
1983, and then to decline somewhat in 1984 and 1985.)
The view of many in the credit markets that prob
lems lie ahead if the deficits turn out as projected ap
pears to be justified (Table 12). Funds available for the
private sector— business, households, and foreigners—
would be only about 40 percent or less of the total in
each year, 1983-85, if total funds raised were held to
the low end of the range. This would imply credit market
pressures in each year, since private credit and equity
comprised much higher fractions of the total— 53.8
percent, 69.2 percent, 78.4 percent— in the 1975-77
recovery years. Even under the more expansionary
policy, where domestic nonfinancial credit was to grow

FRBNY Quarterly Review/Summer 1983

at 1 1 V2 percent in 1983 and 11 percent in both 1984
and 1985, funds available for the private sector would
be about 55 percent of total funds raised in the credit
and equity markets in 1983-85. In this case, the restric
tions on credit growth implied by the monetary targets
would not appear to be a problem in 1983— which
probably has been the case so far this year— but
would become an increasingly serious problem in
1984 and 1985.
The estimates in Table 12 should not be viewed as
a flow-of-funds forecast but simply a first-order calcula
tion to determine whether on the surface the large
future deficits appear consistent with growth of private
credit that might be expected in a recovery. If this initial
calculation were closer to prior experience, that is, if

the government share were calculated to be 20 to 30
percent of the total, for example, instead of 40 to 60
percent, it might be argued that second-order effects
would make it possible for the government deficit to
be financed with only minor repercussions for interest
rates.
One of these second-order effects is net foreign
investment. Clearly, both the government and the
private sector could draw on foreign capital flows.
In 1977, for example, foreigners purchased $31.5 bil
lion of U.S. Government securities, equal to about
55 percent of new issues. Over the 1983-85 period,
slightly higher interest rates might induce future for
eign purchases of securities, but it is hard to see this
being enough to finance a large percentage of a

Table 12

Funds Raised in the Credit and Equity Markets
By calendar year

Calendar
year
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982

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

Total
funds
raised
in credit
markets'k
(billions
of
dollars)

Federal financing
% Of
total
Billions
funds
of
raised
dollars
4.1
6.1
39.8
25.2
17.0
13.4
9.3
19.9
21.5
36.6

8.3
11.8
85.4
69.0
56.8
53.7
37.4
79.2
87.4
161.3

201.7
193.9
214.4
273.5
334.3
401.7
402.0
397.1
406.9
440.7

State and municipal
financing
% of
Billions
total
of
funds
dollars
raised
13.2
15.5
13.7
15.2
15.4
19.1
20.2
27.3
22.3
45.8

Nonfinancial
business
% of
total
Billions
funds
of
raised
dollars
96.4
98.0
51.6
80.2
110.9
126.3
146.9
143.9
149.5
128.5

6.5
8.0
6.4
5.6
4.6
4.8
5.0
6.9
5.5
10.4

47.8
50.5
24.1
29.3
33.2
31.5
36.5
36.2
36.7
29.2

Households
% of
Billions
total
of
funds
dollars
raised
77.7
53.9
52.1
89.5
137.3
169.3
176.5
117.5
120.4
88.5

Billions
of
dollars

38.5
27.8
24.3
32.7
41.1
42.1
43.9
29.6
29.6
20.1

6.1
14.8
11.5
19.6
13.9
33.2
21.0
29.3
27.3
16.6

Foreign
% of
total
funds
raised
3.0
7.6
5.4
7.2
4.2
8.3
5.2
7.4
6.7
3.8

Projection

Calendar
year
1983 .............
1984 .............
1985 .............

Total funds raisedf
8-81/2 %
11-11 y2%
scenario
scenario
(billions of dollars)
447
447
471

Public-sector borrowing
Federal
State-local
(billions of dollars)

589
616
673

214
237
243

45
43
46

‘ Includes nonfinancial foreign borrowing and new equity issues,
t Assumes 8V2-11V2 percent range for 1983 and 8-11 percent range for 1984 and 1985.
^Business, households, and foreign.

FRBNY Quarterly Review/Summer 1983

Public percentage of total
8-8i/2%
11 -11 y2 %
scenario
scenario
(percent)
(percent)
57.9
62.6
61.3

44.0
45.4
42.9

Private percentage
of total (residual)t
8-81/2 %
11-11 Vs %
scenario
scenario
(percent)
(percent)
42.1
37.1
38.7

56.0
54.6
57.1

$225 billion deficit unless interest rates and the dollar
rise appreciably.
Another second-order effect is that, with somewhat
higher interest rates, the personal saving rate might
increase. That would mean credit could grow more
rapidly not because the economy was expanding
faster (as would be the case with a constant saving
rate) but because of a rise in the desire to save on
the part of individuals. The statistical evidence on the
relationship between interest rates and the personal
saving rate is not very convincing, however.
Foreign capital flows and a change in personal sav
ing rates are just two of the second-order effects
that could reduce the upward pressure that large
deficits exert on interest rates. There may be others.
But, even under complete flow-of-funds forecasts,
second-order effects are insufficient to counter the
unprecedented size of the projected deficits.7 Thus,
returning to the initial hypothesis, it does appear
reasonable to conclude that the prospects of large
Federal deficits has served as a constraint on the
ability of monetary policy to reduce intermediate- and
long-term interest rates by actions that result in lower
short-term rates.
One attempt to quantify the effect of the deficits
on current interest rates has concluded that, because
the financial markets foresee an endless stream of
$200 billion budget deficits, corporate bond yields are
160 basis points higher than they would be if the
expectation were for a series of $100 billion deficits.
The econometric equation, formulated by Allen Sinai,
shows that over the last few years, the outlook for
deficits has become an important variable in the de
termination of long-term interest rates.8 The precise
estimate made by Sinai may be subject to some ques
tion, since large deficits are only a recent phenome
non and there is more uncertainty attached to an
estimate obtained with just a few data points. But the
magnitude of the estimated effect lends support to
those who argue that large projected deficits are
keeping long-term rates higher than they would other
wise be, limiting the ability of monetary policy to
induce recovery, and ultimately slowing down the
recovery.

1 Cary Leahey and Allen Sinai, "Funds Raised in U.S. Financial Markets:
An Econometric Study” , Data Resources Incorporated, Review of the
U.S. Economy (May 1983).
* Allen Sinai, "Deficits, Capital Markets, and the Economy” , Testimony
for the House Subcommittee on Telecommunications, Consumer
Protection, and Finance (April 14, 1983). This research differs from
previous econometric work where the effect of deficits on rates appears
at best to be ambiguous. Sinai used forward or projected deficits in
his equation rather than previous or lagged deficits.

Table 13

Saving as a Percentage of GNP
By calendar year
1961
to
1970

1971
to
1980

1985
projection

Gross private s a v in g ...............

16.4
4.7
11.7

16.9
4.9
12.0

17.5
4.0
13.5

Total use of s a v in g .................

16.4

16.9

17.5

0.5
0.5

1.9
-0 .9

5.9
-2 .6

Equals:
Amount available for gross
private investm ents...................

15.4

15.9

14.2

Addendum:
Capital consumption allowance

8.4

9.9

11.0

Amount available for net
new private investments........

7.0

6.0

3.2

Item

Less:
Financing the Federal deficit ..

‘ Includes net foreign investment and state and local deficits.

The long term
The long-term and near-term effects of deficits are
related. The analysis just completed has suggested
that the expectation of future interest rate pressures
may be keeping current long-term rates high. But
there is another sense in which some argue that
deficits are a long-term problem.
For the longer term, a reasonable case can be made
for the proposition that the growth of the money stock
is the critical variable in the determination of the level
of nominal GNP. In other words, the LM curve, when
the analysis is done in nominal terms, is nearly vertical
(Chart 5 on page 40). Once a money growth-nominal
GNP path is determined, it can be argued that fiscal
policy will affect the mix of GNP— both in terms of
its real-inflation composition and its relative shares of
consumption, investment, government purchases, and
exports.
An expansive long-run fiscal policy, given the current
composition of the budget, appears to mean a GNP
more heavily weighted toward consumption and de
fense expenditures than toward investment in plant and
equipment. By 1985— three years into a recovery— the
deficit under current policies would be about 6 percent
of GNP. Under what may be generous assumptions for
personal and business saving, this would mean that
net saving available for new private investment— as a

FRBNY Quarterly Review/Summer 1983

share of GNP— would be about one half the average
of the 1960s and 1970s (Table 13).
No one knows for sure the precise magnitude of
the effect of capital formation on productivity growth.
One analysis estimates that in the period 1948-73,
when output per man-hour grew by an average of 2.9
percent per year, productivity growth stemming from
capital formation was about 0.75 percent per year. In
the subsequent period, 1973-78, when productivity
growth slowed to 1.2 percent per year, the contribu
tion of capital formation was only 0.21 percent, con
tributing a considerable amount to the productivity
slowdown.9 Somewhat different estimates of the effect
of capital formation have been made by other schol
ars, using different measures of capital, labor, and
output. But the results all show that capital formation
does have an important positive effect on productivity
growth.
One of the significant implications of large deficits
and weak capital formation is that the real-inflation
mix of GNP in the long term (under a given set of
monetary targets) may be more heavily weighted toward
inflation. Thus, the long-term problem with large def
icits, aside from the anticipated interest rate pres
sures, is that the deficits may ultimately have an un
favorable effect on the composition of GNP.

Conclusion
The analysis presented here has attempted to delin
eate the forces that have contributed to the rise in the

9 Norsworthy, Harper, and Kunze, op. cit.

Federal budget deficits projected for the 1980s and to
put the effects of large projected deficits into a broader
economic perspective. The tax cut is clearly one reason
for the increase in deficit, but, even if it were not for
that, decisions to increase the real resources for de
fense and the relentless growth of medicare and social
security would have caused the expenditure-revenue
gap to widen. More rapid economic growth and faster
inflation could narrow the projected gap somewhat, but
even under record GNP growth for 1984-88 the pro
jection is for deficits well in excess of those experi
enced on average during the postwar period.
It is reasonable to conclude that, from the short-run
perspective, anticipation of large Federal deficits has re
duced the effectiveness of monetary policy. Certainly,
Federal Reserve actions can lead to lower or higher
short-term interest rates. But analysis of projected defi
cits and private demands on the credit markets clearly
lends support to market fears of either a monetary-fiscal
policy clash in 1984 or 1985 or an inflationary monetary
policy if such a clash is avoided. And there is evidence
that these fears would be an important factor that could
prevent long-term rates from falling very much even if
the Federal Reserve were to take actions to reduce
short-term interest rates.
From the long-term perspective, while monetary pol
icy can have an important effect on the level of nominal
GNP, it can do much less to affect the composition.
Under reasonable assumptions about the future growth
of GNP, projected deficits of $200-250 billion in 1984-85
would result in saving available for capital formation
that would be very much below the experience of the
1960s and 1970s, with negative consequences for longrun productivity growth.

James R. Capra

FRBNY Quarterly Review/Summer 1983

February-April 1983 Interim Report
(This report was released to the Congress
and to the press on June 9,1983.)

Treasury and Federal Reserve
Foreign Exchange Operations

During the February-April period under review, the
decline in global economic activity appeared to have
ended, but questions remained about the breadth and
scope of recovery and the prospects for a resumption
in growth of world trade. Demand for oil remained
weak and oil prices softened to the point of challeng
ing the ability of OPEC (Organization of Petroleum
Exporting Countries) to set production quotas and
price differentials and thereby effectively to limit price
declines. Meanwhile, persistent concern about the
divergence of economic performances within Europe
generated a major speculative attack against the ex
change rate relationships within the European Mone
tary System (EMS). This speculation prompted the
heaviest central bank intervention in support of the
EMS rate structure in the four-year history of the EMS
before the rates were realigned on March 21.
As the exchange markets reacted to the cross
currents of these developments, the dollar generally
held steady against most currencies. On balance, be
tween end-January and end-April the dollar was little
changed against the German mark and narrowly mixed
vis-k-vis other currencies. Although trading below its
highs of late 1982 against the major foreign curren
cies, the dollar remained well above its lows reached
immediately preceding the reporting period, in Janu
ary 1983. This firm performance was contrary to the

A report by Sam Y. Cross. Mr. Cross is Executive Vice President
in charge of the Foreign Group of the Federal Reserve Bank of
New York and Manager of Foreign Operations for the System Open
Market Account.

forecasts of the many experts and market observers
who were anticipating a significant further easing of
the dollar through early 1983.
The dollar’s firmer than expected tone first emerged
in response to definite signs that recession in the
United States was giving way to a significant recovery.
However, for a period after mid-February, those initial
signs of a strong industrial upturn were superseded
by later indications that the expansion was likely to
be more moderately paced, confined largely to in
creased activity in a few sectors of the economy and to
a turnaround in inventory investment. Thus, some skep
ticism reappeared that the recovery would prove dura
ble in the face of continued high real interest rates.
Nevertheless, the economic outlook remained more
promising for the United States than for most other
industrialized countries. Moreover, shortly after the
President’s State of the Union and budget messages,
the Administration’s economic advisers were suggest
ing that the projections for real output growth for
1983, then estimated at 1.4 percent, should be re
vised strongly upward. By comparison, European offi
cials forecast little or no growth of Continental econ
omies, and Japan’s forecast growth rate of 3.4 percent
for fiscal 1983-84 looked modest as compared with
that country’s presumed potential.
The dollar was sustained in the market as a number
of concerns subsided that had weighed against the
currency during the late fall and early winter. In par
ticular, the fear that economic recovery would neces
sarily be accompanied by a rekindling of inflation
tended to dissipate as prospects for substantial gains

FRBNY Quarterly Review/Summer 1983

in productivity improved. Market observers also be
came less concerned about cost pressures from basic
materials, as expectations grew of a substantial re
duction of world oil prices. The U.S. trade account
turned out to be in smaller deficit during the first
quarter than had generally been expected, and the
deficit even narrowed somewhat from that recorded
in the last three months of 1982. This result reflected
a sharp drop in the oil import bill, which was expected
to be largely temporary and was associated with re
duced demand in response to the relatively warm

winter and liquidation of inventories in anticipation of
lower prices later. Market forecasts of a very large
U.S. current account deficit for the year as a whole
were not significantly revised. Nevertheless, the tem
porary respite from monthly releases of large deficit
figures seemed to defuse what had been an important
negative factor for the dollar previously, so that con
siderations of relative trade and current account per
formances received little attention in the exchange
markets during this period.
The exchange markets were also influenced at times

Table 1

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

Bank drawing on
Federal Reserve System
Bank of M e x ic o .................................
‘ Bank for International Settlements
(against German marks) .................

Outstanding
January 1,
1982

1982
I

1982
II

1982
III

-0-

(+ 8 0 0 .0
{ - 6 0 0 .0

-0-

1982
IV

1983
I

1983
April

Outstanding
April 30,
1983

( + 1,400.0
{ — 900.0

-2 1 7 .4

-4 8 2 .6

-0-

(+ 1 2 4 .0
j —124.0

-0-

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 2

Drawings and Repayments by the Bank of Mexico under Special Swap Arrangements
In millions of dollars; drawings ( + ) or repayments ( — )
Outstanding
January 1,
1982

1982
I

1982
II

Federal Reserve special facility
for $325 million .................................

U.S. Treasury special facility
for $600 m illio n .................................

*
*

Drawings on
U.S. Treasury special temporary
facility for $1,000 m illio n .................

Outstanding
April 30,
1983

1982
III

1982
IV

1983
I

1983
April

825.0
825.0

•

C+
*

89.8
43.8

+211.2

67.8

-0-

325.0

f + 166.8
{ — 81.3

+392.2

+ 122.3

-0-

600.0

(+1,081.6
950.0

+603.5

+ 190.0

-0-

925.0

Drawings on special combined
credit facility:

Total ..................................................

Data are on a value-date basis. Because of rounding, figures may not add to totals.
*Not applicable.

FRBNY Quarterly Review/Summer 1983

might be better able to meet the objectives of their
stabilization programs. In fact, short-term rates held
steady through April, and the Federal Reserve kept its
discount rate at the 8 V2 percent level established in
December. But long-term rates did continue to ease,
moving down in two stages— first during February
and again in April. It appears that, as long-term rates
eased, substantial amounts of funds were moved into
the United States by investors hoping to realize fur
ther capital gains. At the same time, real interest rates
remained relatively high, and foreign investment was

by shifting assessments of the prospects for dollar
interest rates. During February the improving scenario
for inflation, together with the prospect for only a
moderate recovery, gave a lift to U.S. credit markets,
and long-term interest rates began to turn down. In
this environment, market operators considered the
possibility that the Federal Reserve would not resist
a decline in short-term interest rates and might lower
its discount rate, both to lend support to the recov
ery at home and to help foster an international eco
nomic climate in which heavily indebted countries

Table 3

Drawings and Repayments by the Central Bank of Brazil under Special Swap Arrangements
with the U.S. Treasury
In millions of dollars; drawings ( + ) or repayments ( — )
Outstanding
January 1,
1982

1982
I

1982
II

1982
III

1982
IV

1983
I

1983
April

Outstanding
April 30,
1983

$500 m illio n ...............................

♦

$280 million ...............................
$450 m illio n ...............................

*
*

— 280.0
— 450.0

*
*

$250 million ...............................

500.0
500.0
280.0
450.0
250.0
104.2

*
*

145.8

♦

f+
1 -

200.0
200.0
200.0
200.0

•

Drawings on
U.S. Treasury
special facilities for

$200 m illio n ...............................

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

$200 m illio n ...............................

Total ............................................

+
+

P
*

( + 1,480.0
604.2

( + 400.0
{ -1 ,2 7 5 .8

Data are on a value-date basis.
*Not applicable.

Table 4

U.S. Treasury Securities, Foreign Currency Denominated
In millions of dollars equivalent at Treasury book value; issues ( + ) or redemptions ( —)

Issues

Amount of
commitments
January 1,
1982

1982
I

1982
II

1982
III

1982
IV

1983
I

Amount of
commitments
1983
April 30,
April
1983

Public series:
Germany .........................

Total ...............................

-0-

-4 5 1 .0

-1 ,2 3 1 .9

-6 6 4 .1

-0-

-0*

1,275.2

-0-

-4 5 8 .5

-0-

-4 5 1 .0

-1,2 3 1 .9

-6 6 4 .1

-4 5 8 .5

-0-

1,275.2

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

FRBNY Quarterly Review/Summer 1983

Table 5

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

Period

Federal
Reserve

United States Treasury
Exchange
Stabilization
General
Fund
account

February 1 through
April 30, 1983 ...............

-0-

Valuation profits and
losses on outstanding
assets and liabilities
as of April 30, 1983 ___

—578.1

-9 5 1 .3

+360.9

Data are on a value-date basis.

attracted also by the bullish U.S. stock market, con
tinuing safe-haven considerations, and the apparently
better growth prospects in the United States than
abroad.
In addition, the dollar frequently became caught up
in developments primarily involving European curren
cies, particularly the events surrounding the realign
ment on March 21 of parities in the EMS. From early
February, sentiment became increasingly favorable
toward the German mark, which strengthened against
other European currencies as well as the dollar, as
market participants speculated first about the out
come of coming national elections in Germany and
then about the likelihood that a long-anticipated re
alignment of EMS parities would take place shortly
thereafter. Speculative buying of German marks and
Dutch guilders, both considered virtually certain to
be revalued in any restructuring of the EMS, inten
sified while the weaker currencies in the European
joint float, including particularly the French and Bel
gian francs, came on offer. The French franc, after
having been maintained around the middle of the
EMS band for some weeks, was allowed to drop to
its mandatory lower intervention point after March 6
and, subsequently, Euro-French franc interest rates
soared to unprecedented levels. The Belgian author
ities, also faced with intensifying pressures, imposed
stringent new foreign exchange controls. With specu
lation against these two currencies becoming prohib
itively expensive, positioning in favor of the stronger
EMS currencies increasingly took the form of sales
of non-EMS currencies, including the dollar. At the

FRBNY Quarterly Review/Summer 1983

same time, official intervention to defend the EMS
parities, while primarily conducted in European cur
rencies, also involved substantial sales of dollars by
the central banks whose currencies were weak within
the system. EMS-related sales by both private and
official parties thus contributed to a tendency of the
dollar to decline moderately during the first three
weeks of March, particularly against the German mark.
The reversal of these flows after the March 21 realign
ment similarly contributed to the dollar’s subsequent
recovery.
By April, as the new quarter opened and many of
the reflows into dollars associated with the recent
EMS realignment were completed, exchange market
activity settled down to a subdued pace, and the
dollar traded in a relatively narrow range. Some un
certainty was generated by the persistent divergence
between the dollar’s apparent firmness and the still
widely held view that the medium-term trend of the
dollar would be downward because of the outlook for
interest rates and current accounts. Adding to the un
certainty were concerns that trade protectionist pres
sures might be deepening in response to two years of
declining world growth. In this context, talk spread
among market participants that the major industrial
countries might be preparing a coordinated interven
tion effort— now that the intervention study commis
sioned at last year’s summit meeting had been com
pleted and on speculation that exchange rates would
be a major point of discussion at the Williamsburg
summit. By late April, however, expectations of sub
stantial changes in official intervention policy faded,
and on April 29 the intervention study was released
by the summit ministers, accompanied by a statement
on intervention and related matters. But, in the cau
tious atmosphere that had prevailed during much of
April, market professionals were prepared to sell dol
lars, thereby stemming any marked upward movement
of the dollar, while commercial participants often were
substantial buyers when the dollar eased. As a result,
the dollar market was well balanced. There was a
marked change in the dollar only against the pound
sterling which, in an environment of stabilizing oil
prices, recovered nearly 7 percent from an earlier de
cline.
By the close of the period the dollar traded at
DM2.4615 in terms of the German mark and ¥237.80
against the yen, some V2 percent and 1 percent re
spectively below the levels of three months earlier.
Against the pound sterling, the dollar ended the period
down nearly 3 percent as compared with three months
earlier, while it increased by 2 percent against the
Swiss franc. In terms of a trade-weighted average,
the dollar rose by about 1 percent to close the period

only slightly below the historically high levels it had
reached in November 1982. The U.S. authorities did
not intervene in the exchange markets during the
period under review.
In other operations during the three-month period,
the U.S. monetary authorities continued to provide
credits to Mexico and Brazil. At the same time, both
countries made repayments on earlier bridging credits
provided by the U.S. monetary authorities as they drew
on other financing arrangements.
As discussed in the previous report, both the Fed
eral Reserve and the U.S. Treasury’s Exchange Stabi
lization Fund had provided credits to Mexico during
1982-83. Funding was provided through the Bank of
Mexico’s regular swap facility of $700 million with the
Federal Reserve, and also through special swap facil
ities in cooperation with other central banks through
the Bank for International Settlements (BIS). In Febru
ary, Mexico drew the remaining portion of the special
facility, receiving $44.25 million from the Treasury and
$25.75 million from the Federal Reserve. As of April 30,
drawings of $325 million and $600 million were out
standing from the Federal Reserve and the Treasury,
respectively, representing the entire $925 million avail
able under the U.S. portion of the multilateral swap
facility. On February 28, the Bank of Mexico fully re
paid the remaining $373 million outstanding on its
swap line under the Federal Reserve’s regular recipro
cal currency arrangement, which had been drawn last
August before other arrangements had been put in
place. Thus, on balance, during this three-month pe
riod, Mexico reduced its net outstanding borrowing
from the Federal Reserve and the Treasury under
these facilities by $303.0 million.
The Central Bank of Brazil repaid on February 1
$280 million of the $730 million outstanding on facili
ties made available to it earlier by the Treasury. The
remaining $450 million facility was repaid on March 3.
On February 28, the Treasury agreed to provide Brazil
with two additional swap facilities of $200 million each
in anticipation of Brazil’s drawings under the com
pensatory financing facility and extended Fund fa
cility of the International Monetary Fund. These swaps

were drawn on February 28 and March 3 and were
repaid by March 11. Thus, at that point Brazil had
repaid in full all Treasury swaps made available to it
since October 1982.
In April, the Bank for International Settlements, act
ing with the support of the U.S. Treasury and the
monetary authorities in other countries, agreed to
participate in an international financial support pack
age for Yugoslavia. The Treasury, through the Ex
change Stabilization Fund, as part of the liquiditysupport arrangement for the BIS provided by the
participating monetary authorities agreed to be substi
tuted for the BIS for $75 million in the unlikely event
of delayed repayment by Yugoslavia.
In the period from February through April, the Fed
eral Reserve and the Treasury realized no profits or
losses from exchange transactions. As of April 30,
cumulative bookkeeping or valuation losses on out
standing foreign currency balances were $578.1 million
for the Federal Reserve and $951.3 million for the
Treasury Exchange Stabilization Fund, while the Trea
sury general account showed valuation gains of $360.9
million related to outstanding issues of securities de
nominated in foreign currencies. These valuation gains
and losses represent the decrease in the dollar value
of outstanding currency assets and liabilities valued
at end-of-period exchange rates, compared with the
rates prevailing at the time the foreign currencies
were acquired.
The Federal Reserve and the Treasury have invested
foreign currency balances they had acquired in the
market as a result of their foreign exchange operations
in a variety of investments that yield market-related
rates of return and have a high degree of quality and
liquidity. Under the authority provided by the Mone
tary Control Act of 1980, the Federal Reserve had
invested some of its own foreign currency resources
and those held under warehousing agreements with
the Treasury in securities issued by foreign govern
ments. As of April 30, the Federal Reserve’s holdings
of such securities were equivalent to $1,509 million.
In addition, the Treasury directly held the equivalent
of $2,589 million in these securities as of end-April.

FRBNY Quarterly Review/Summer 1983

NEW PUBLICATIONS
The Federal Reserve Bank of New York is pleased to
announce the recent publication of:
Foreign Exchange Markets in the United States
by Roger M. Kubarych, Senior Vice President.
This 52-page book explores the foreign exchange mar
ket’s structure, the types of trade and how they are
executed, commercial bank trading decisions, the eco
nomic factors that help determine exchange rates, and
the dynamics of rate movements. This revised volume
highlights the main changes that have taken place
since 1978 when the first edition was published.
This publication is free. The Bank reserves the right
to limit bulk orders.

Central Banking Views on Monetary Targeting
edited by Paul Meek.
This 140-page volume is a collection of papers pre
sented by central bank representatives from nine coun
tries at a May 1982 meeting at the Federal Reserve
Bank of New York. The papers indicate many common
central bank concerns about monetary targeting in
recent years. This book is intended for economists.
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FRBNY Quarterly Review/Summer 1983

PUBLICATIONS ALSO AVAILABLE FROM
THE NEW YORK FED
U.S. Monetary Policy and Financial Markets by Paul
Meek, Vice President and Monetary Adviser, is a com
prehensive review of the formulation and execution of
monetary policy. Published in late 1982, this 192-page
book examines open market operations with primary
emphasis on the post-October 1979 period. The finan
cial institutions and markets within which the Federal
Reserve operates are also described.
This book is intended primarily for economists, seri
ous economic students, bankers, participants in the
financial markets, and other “ Fed watchers” .
Single copies are available free of charge. Additional
copies are $4 each for shipments in the United States.
However, reasonable quantities are available free of
charge for classroom use. Such orders will be sent
only to U.S. college or university addresses. For addi
tional copies mailed to those outside the United States
the charge is $9, and foreign residents must pay in U.S.
dollars with a check or money order drawn on a U.S.
bank or its foreign branch.

Selected Papers of Allan Sproul is a representative
selection of the published and unpublished writing of
the third chief executive officer of the Federal Reserve
Bank of New York. This 254-page book includes a bio
graphical essay by Lawrence S. Ritter, Professor of
Finance at New York University, who edited the vol
ume.
A single copy is available free.

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FRBNY Quarterly Review/Summer 1983

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FRBNY Quarterly Review/Summer 1983

Full text of Economic Policy Review (Federal Reserve Bank of New York) : Summer 1983, Vol. 8, No. 2

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