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Federal
Reserve Bank of
NewYbrk

Quarterly Review

Summer 1984

Volume 9 No. 2

Financial Innovation— A Complex
Problem Even in a Simple Framework

Targeting in a Dynamic Model

Potential Output Growth and the
Long-Term Inflation Outlook

Financing the U.S. Current Account
Deficit

Did Financial Markets in 1983 Point
to Recession?

Recent Trends in the U.S. Foreign
Exchange Market

Nuclear Power Plant Construction:
Paying the Bill

In Brief
Economic Capsules

Treasury and Federal Reserve
Foreign Exchange Operations

Financial Innovation—
A Complex Problem
Even in a Simple Framework
Deregulation of financial markets and financial innovations
have caused a great deal of discussion on how to imple
ment monetary policy during a period of time when the
structure of the economy is rapidly changing. In particular,
the decline in M-1’s velocity in late 1982 and early 1983
raised questions about what effects innovations and regu
latory change were having on M-1 ’s interpretation and per
formance. This question of what unstable economic rela
tionships mean for monetary policy is not a new issue, of
course, but was a key consideration of the “rules-versusdiscretionary-policy” debate some 25 years ago. At that
time, Jacob Viner argued:1
Even if there are a single end, a single authority, and a
single means, but the end is a quantity of some kind
which is a function of several variables, all of which are
important and are in unstable relation to each other,
there will be no fixed rule available which will be both
practicable and appropriate to its objective.
The purpose of this article is to show in terms of a very
simple model the broad range of problems that innovations
and deregulation could cause for monetary policy. The case
will be made that the effects of innovations and deregulation
on the economy are very difficult to spell out, even if a very
simple model of the economy is used. This, of course,
makes one wonder what can be said about the effects of
innovations on our highly complex economy.
’ Jacob Viner, “ The Necessary and Desirable Range of Discretion to be
Allowed to a Monetary Authority" Leland B. Yeager (ed.). In Search of a
Monetary Constitution, Harvard University Press (1962), page 247.

The framework for illustrating the effects of innovations
in this paper is the basic IS-LM model (Table 1). This model,
as used here, consists of three equations: (1) an equation
that relates consumption and investment expenditures to the
level of interest rates, (2) an equation that relates the pub
lic’s demand for money to income and interest rates, and
(3) an equation relating the supply of money to the quantity
of reserves provided by the Federal Reserve and the level
of interest rates. These three equations, in turn, can be
solved so that it is possible to see the effects innovations
can have on economic relationships.
Much discussion has already taken place on the question
of whether the interest responsiveness of the demand for
M-1 has been or will be increasing or decreasing as a result
of innovations and deregulation. On the one hand, con
sumers now have highly liquid, market-rate yielding alter
natives to M-1 such as money funds and money market
deposit accounts. These could increase the interest elasticity
of the demand for M-1 in the sense that it is easier than
before for the consumer to manage transactions balances.
On the other hand, one component of M-1— Super-NOW
accounts— already pays an unregulated rate of interest, and
this deregulation could continue in the future. These
developments might reduce M-1’s interest responsiveness
because the yield on M-1 will vary with market rates.
Therefore, the net effect of all these changes on M-1’s
interest elasticity at any point in time remains highly
uncertain. Nonetheless, since the interest elasticity of the
demand for M-1 is a factor that determines how responsive
M-1 will be to changes in the supply of reserves, how it
changes over time is important for monetary policy.
In this paper, an attempt is made to go beyond just the

FRBNY Quarterly Review/Summer 1984 1

question of what a declining money demand interest elas
ticity means for the relationship between M-1 and the supply
of reserves. It will be argued that the interest responsive
ness of expenditures and/or the income elasticity of money
demand might also change as a result of innovations, and
these changes could also have important implications for
the Federal Reserve’s ability to control M-1. Hence, it is not
possible to say for certain whether the responsiveness of
M-1 to changes in the supply of reserves will become
greater or smaller on balance as a result of innovations
because many, possibly offsetting, changes could be
occurring simultaneously. In other words, both the predict
ability and stability of the relationship between M-1 and the
supply of reserves could deteriorate considerably, thereby
greatly complicating monetary policy.
Moreover, the Federal Reserve’s ability to control its
intermediate target— M-1— is not the only problem caused
by innovations. For example, the arithmetic of the IS-LM
model suggests that a declining money demand interest
elasticity, along with changes in the other parameters, could
also affect in an unpredictable way the responsiveness of
GNP to changes in the supply of reserves and M-1. The
primary point is that changes in these elasticities could alter
several of the key relationships in the economy and not just
the relationship between the supply of reserves and M-1.
Moreover, changes in these elasticities mean that income
might become more or less sensitive to shocks coming from
either the real or monetary side which could also affect the
basic decision of whether it would be in theory better to
target M-1 or interest rates.2
Innovations and the IS-LM Model
The primary problem in illustrating the effects of innovations
using the basic IS-LM model shown in Table 1 is that the
results are often ambiguous. In presenting the potential
effects of innovation below, we begin with the most common
view, but then also make the case that the effects of inno
vations, particularly in the shorter run, could differ from this
more conventional view. We then proceed to show that even
if the more conventional view is taken, innovations are still
difficult to analyze even in the simple IS-LM model because
they have the potential for causing changes in many
dimensions simultaneously.
In terms of the basic IS-LM model, innovations and de
regulation that result in a larger portion of bank assets and
liabilities (including M-1 deposits) paying market-related rates
of interest could contribute to three changes in the economy.
• They could reduce the interest elasticity of money
demand (“ a” in the model) because the return on
2See, for example, William Poole "Optimal Choice of Monetary Policy
Instruments in a Simple Stochastic Model", Quarterly Journal of
Economics (May 1970).

2 FRBNY Quarterly Review/Summer 1984

money will move with market rates. Background: Even
though transactions balances at some point in time will
perhaps pay a market-related rate of interest, the gap
between the rate on transactions balances and market
instruments will still widen as market rates increase
because of the reserve requirements on transactions
balances. Thus, it could be argued on the one hand that
the interest elasticity of money demand for transactions
purposes will be reduced but not eliminated. On the
other hand, it could also be argued that the public will
tend to hold, particularly at low rates of interest, both
savings and transactions balances in M-1 but that the
savings component will be much more sensitive to
changes in rate spreads than has been the case in the
past when only transactions balances were held in
M-1. On balance, of course, it is not dear what the net
effect will be on the M-1 interest elasticity of having
transactions deposits bear a market-related rate of
interest. Thus far, with the introduction of fixed-rate
conventional NOW accounts, the experience seems to
have been that the interest elasticity of money demand
has been increased not reduced. This is in part because
a given change in market rates will produce a larger
percentage change in the spread between market rates
and NOW accounts than in the spread between market
rates and the zero rate on demand deposits. It also
appears that money funds and money market deposit
accounts have made consumer money demand more
responsive to changes in market rates because it is now
easier for consumers to earn market rates and manage
their cash balances more effectively.3
• They could increase the interest elasticity of expendi
tures (“ c” in the model) because more loans will be
on a floating (variable rate) basis. Background: With
fixed rate loans, when rates rise only the prospective
borrower is affected, whereas with variable rate loans
all borrowers would be affected— hence a greater
expenditure elasticity. However, if variable-rate borrowers
in some sense expect to pay some average rate, not
the initial rate, over some longer period of time, then
an increase in floating rates, unless it changes the
assumed average, would not affect the expenditures of
previous borrowers. Moreover, with floating rates not
even the prospective borrower would postpone spending
until rates dropped because his borrowing costs will
automatically fall as rates decline and he will pay the
average rate “just like everyone else”. So the effects
of variable rates on the expenditures elasticity are not
clear on balance. It could also be argued that in a
^ r more on this topic, see Lawrence J. Radecki and John Wenninger,
“ Shifts in Money Demand: Consumers Versus Business” this Quarterly
Review (Summer 1983), pages 1-11.

deregulated environment the effects of changes in
interest rates will be larger because (1) no sectors of
the economy are insulated from rate increases by ceil
ings on the deposits that are used to fund them, and
(2) a given percentage change in rates will be trans
m itted more quickly through a more com petitive
economy. Moreover, if the effect of deregulation is to
make the general level of interest rates higher and
therefore interest costs a higher proportion of total costs,
then spending might become more sensitive to a given
percentage change in rates.4 All in all, the effects of
innovations and deregulation on the expenditures
elasticity is still an open question. Already, we have
seen how complicated assessing the effects of changes
in the financial system on this parameter can be without
even asking such questions as whether the develop
ment of markets for financial futures could insulate
spending from changes in interest rates.
• They could possibly increase the income elasticity of
money demand (“ b ” in the model). Since M-1 deposits
will earn about the same rate of interest as savings
accounts, consumers might place in M-1 as income
grows funds that they would otherwise have placed in
savings accounts. Background: Here again, it is difficult
4For a detailed argument along these lines, see M.A. Akhtar, “ Financial
Innovations and Their Implications for Monetary Policy: An International
Perspective”, Bank for International Settlements Economic Papers,
Number 9 (December 1983).

Table 1

Basic IS-LM Model
(1) Y
= ~cr + X
(2) M-1 = - a r + bY + Z
(3) M-1 = R/m + dr + K

=
=
=
=
=
=
=
m=
a, b, c, d =
M-1
r
Y
Z
X
R
K

narrow money stock
the interest rate
income
money demand shift
autonomous expenditures
non borrowed reserves
money supply shift
reserve ratio
structural parameters

Reduced Form Multipliers
R

c
c
......... %
a + d + bc
m(a + d + bc)

Z
c
a + d + bc

m(a + d + bc)

a + d + bc

Even though it is difficult to know for certain what the
effects of innovation will be, for the sake of illustration from
Table 1 it is assumed that when the transition to a dereg
ulated economy has been completed the interest elasticity
of money demand (a) will have declined, the interest elas
ticity of expenditures (c) will have increased, and the income
elasticity of money demand (b) will have increased. Will
these three developments (individually and collectively) make
income (Y), the interest rate (r), and the narrow money
stock (M-1)— the endogenous variables in Table 1— more or
less sensitive to exogenous changes in reserves (R), money
demand shifts (Z), money supply shifts (K), or changes in
autonomous expenditures (X)?5
Table 2 provides a partial answer to this question on a
case by case basis. Case 1 deals with the interest elasticity
of money demand while Case 2 and Case 3, respectively,
deal with changes in the interest elasticity of aggregate
demand and the income elasticity of money demand. We
will first analyze the effects and implications of innovations
on the individual elasticities and then turn to what happens
on balance as a result of all the changes. The only elasticity
in the model that is assumed not to change because of
innovations is the interest elasticity of the money supply
function (d). It has a positive interest elasticity in this very
simple model because banks borrow more reserves from
the Federal Reserve as market rates rise. However, since
it has been suggested that this elasticity could be reduced,
if not effectively made equal to zero, by having the discount
rate move with market rates, this proposal will also be briefly
examined in the context of this simple model. The effects
of reducing d on the multipliers is shown in Case 4, while
in Case 5 the combined effects of reducing both the money

X
+

a+ d
a + d + bc
b
a + d + bc

bd
a + bc
d
a + bc
------------------+
® ■ +- f --------------- +
-+f
'
m(a + d + bc)
a + d + bc
a + d + bc
a + d + bc

to know for certain whether the elasticity will increase
or decrease on balance. It would depend upon the
degree to which and where transactions and savings
accounts are combined and upon the relative income
elasticities of transactions and savings deposits. It is
entirely possible that consumers also have been com
bining some savings and transactions balances in other
instruments as well, such as money funds or money
market deposit accounts. Hence, although the direction
of change is unclear, the potential exists for this elas
ticity also to change.

5For the ease of illustration, it is assumed that X, R. Z. and K are not
correlated with one another. Moreover, in a simple model like this, there
is no room for innovations to affect the speed of adjustment of the
endogenous variables to exogenous disturbances, or to make a dynamic
system stable or unstable over time. Rather, the intent of this article is to
show how difficult it is to evaluate the effects of innovations even before
more complex models, with perhaps even additional variables included,
are incorporated. In this article, innovations are viewed as affecting key
parameters or elasticities in the model Innovations, of course, could also
'shift the functions." that is. cause Z. or K to change.

FRBNY Quarterly Review/Summer 1984

demand and supply elasticities to zero in absolute value
are shown.6

Case 1
Case 1 shows the effects on the multipliers when the
interest elasticity of money demand declines. The results
indicate that for the most part the endogenous variables (in
9 of the 12 cases) become more sensitive to changes in
the exogenous variables. The important exception, of
course, is that the money stock becomes less sensitive to
changes in the supply of reserves. But since interest rates
become more sensitive, some analysts have been con
cerned that larger swings in interest rates will be required
to control M-1.7 At the same time, the Federal Reserve’s
ability to control M-1 is deteriorating in other dimensions as
well as the interest elasticity of money demand declines
because M-1 is becoming more sensitive to exogenous
shifts in the demand for money and autonomous expend
itures (bottom row of Case 1). Thus, a given shock could
cause a larger deviation of M-1 from target, and the Federal
Reserve might need to allow larger deviations of M-1 from
target or make larger adjustments to the M-1 target as a
result.
However, the “ ultimate objective” income becomes more
sensitive to changes in the supply of reserves at the same
time M-1 becomes less sensitive. Thus, we end up with a
situation in which M-1 is less sensitive to changes in the
supply of reserves, while income and interest rates are more
sensitive. Nevertheless, a given desired path for GNP will
still be associated with the same interest rate movements
as in the past because the ratio of r to Y does not depend
on the money demand interest elasticity for any given level
of reserves, but rather only on the interest elasticity of
expenditures (Table 1). In a sense, whether monetary policy
on balance will be encumbered by a declining money
demand interest elasticity depends on how one views the
way the Federal Reserve operates. If the view is taken that
the Federal Reserve tries to control M-1, while avoiding
large swings in interest rates, then a declining money

6lt is also possible to view the interest elasticity of the supply function
declining for other reasons as well. In a more deregulated environment, it
could be argued that the quantity of money and credit supplied by
banks would not depend upon the interest rate level, but rather on the
desired spread between the interest rate on loans and cost of funds.
Hence, with regard to the level of rates, the supply of money function
interest elasticity would become more, if not completely, inelastic. Since
this effect in terms of the level of rates works in the same direction as
indexing the discount rate to market rates, it did not seem necessary to
create a separate case for it. For more discussion on the subject of the
supply of money or credit in a deregulated environment, see Albert
Wojnilower, "The Central Role of Credit Crunches in Recent Financial
History”, Brooking Papers on Economic Activity II (1980).
7For more on this topic, see Richard G. Davis, “ Monetary Targeting in a
Zero Balance World” Proceedings of Asilomar Conference on Interest
Rate Deregulation and Monetary Policy, sponsored by the Federal
Reserve Bank of San Francisco (November 1982).

FRBNY Quarterly Review/Summer 1984

demand interest elasticity is undesirable because correcting
a given deviation of money from target will require a larger
change in interest rates. If, on the other hand, the view is
taken that the Federal Reserve does not care about M-1
for its own sake, but only attempts to control it in order to
achieve a GNP objective, then the concern about M-1
control and interest rate stability is less important because
the same interest rate movements as in the past will be
required to obtain a desired level of GNR Monetary policy
is still complicated by a declining money demand interest

Table 2

Effect of Innovations on Reduced Form Multipliers
In absolute value
Case 1: Reduced Money Demand Interest E lasticity

Y ........
r ..........
M-1.....

R
Larger
Larger
Smaller

K
Larger
Larger
Smaller

Z
Larger
Larger
Larger

X
Smaller
Larger
Larger

Case 2: Increased Expenditures Interest E lasticity

Y ........
r .........
M-1
.

R
Larger
Smaller
Larger

K
Larger
Smaller
Larger

Z
Larger
Smaller
Smaller

X
Smaller
Smaller
Smaller

Case 3: Increased M oney Demand Incom e E lasticity

Y ........
r ..........
M-1.....

R
Smaller
Smaller
Larger

K
Smaller
Smaller
Larger

Z
Smaller
Smaller
Smaller

X
Smaller
Larger
Larger

Case 4: Reduced Money S upply Interest E lasticity

Y ........
r .........
M-1....

R
Larger
Larger
Larger

K
Larger
Larger
Larger

Z
Larger
Larger
Smaller

X
Smaller
Larger
Smaller

Case 5:* Money Demand and S upply Interest E lasticities - 0
R
Larger
( + l/m b)

K
Larger
( + 1/b)

Z
Larger
( - 1 /b )

X
Smaller
(o)

r ..........

Larger
(-1 /m b c )

Larger
( - 1 /b c )

Larger
(+ 1 /b c )

Larger
(+ 1/c)

M-1.....

Larger
( + 1/m)

Larger
(1)

Smaller
(o)

Y ........

*The resulting multipliers are also shown in this case for ease of
comparison to those in Table 1.

elasticity, however, because GNP would become more
susceptible to monetary disturbances (Table 2).
If disturbances from the monetary side are a source of
instability in the economy, then a declining money demand
interest elasticity will make income more sensitive to mon
etary shocks unless the Federal Reserve adjusts its mon
etary targets when these disturbances occur or uses interest
rate targets instead. As a matter of fact, if the result of a
declining money demand interest elasticity is to make
income more sensitive to monetary shocks than to real
sector shocks, then in theory it might be better for the
Federal Reserve to target an interest rate rather than the
money stock. The results from the top row of Table 2 sug
gest that a declining money demand interest elasticity
reduces the sensitivity of income to real sector disturbances
at the same time it increases the sensitivity of income to
monetary shocks. So it is entirely possible that interest rate
targets might turn out to be better than M-1 targets.8
Another question could also be asked: even if it becomes
less desirable in some sense for the Federal Reserve to
target M-1 as the interest elasticity of money demand
declines, is M-1 still a reliable indicator of Y? From Table 1 it
can be seen that for a given supply of reserves, the ratio
of Y to M-1 equals c/(a + bc). As “a” decreases, therefore,
velocity increases and M-1 is not as good a proxy for Y
during the transition period to a deregulated economy. In
other words, a given change in Y will be associated with
a smaller change in M-1 than in the past. This means that
changes in the interest elasticity of the demand for M-1 not
only can affect the Federal Reserve’s ability to control M-1
but also can affect the value of M-1 as an indicator of what
is happening in the economy. Moreover, not only will
changes in the supply of reserves have different relative

•James Tobin, in a recent lecture, reached much the same conclusion:
“ Monetarist policy has made the LM curve more vertical in recent years.
Structural changes are working in the same direction. Deregulation is
allowing deposits to bear market-determined interest rates, which will
move up or down with the rates depository institutions can earn on their
assets. Thus the demand for deposits, however sensitive to the
differential between open market rates and deposit rates, will be much
less sensitive to the general level of rates. In short, this reform itself is
making the economy’s natural LM curve much steeper If the pre-reform
M-r rule was optimal by Poole criteria, it is no longer optimal. The rule
should be changed in the accommodative direction— the more so if, as
seems likely, the reform also increases the volatility of money demand.
This seems likely because, once the two rates are so close, depositors
will be less precise and prompt in moving funds between moneys and
near-moneys.” See James Tobin, “ Monetary Policy: Rules, Targets, and
Shocks", Journal of Money, Credit, and Banking, Volume 15, Number 4
(November 1983), page 514.
John Hicks makes a similar argument: “ What I mean by a credit
economy is one that contains no money that does not bear interest; so
that the key instrument of monetary control must be the rate of interest,
or the interest rates. Actual economies, as we have seen, are tending in
that direction; so it need not surprise us to find that much can be
learned about actual money by considering the pure type" See John
Hicks “The Foundations of Monetary Theory” Money, Interest and
Wages— Collected Essays on Economic Theory, Volume 2, Harvard
University Press (1983), page 266.

effects on M-1 and Y than in the past because of a
declining money demand elasticity, but so will changes in
the other exogenous variables as well— making velocity
quite unpredictable. A declining money demand interest
elasticity changes not only the relationships between the
exogenous variables and the endogenous variables but also
the relative movements in the endogenous variables during
the transition to a deregulated financial system. In this case,
the ratio of Y to M was altered, raising questions about
M-1 ’s value as a target or as an indicator.
Cases 1 and 4 combined—Case 5
The final point to keep in mind from Case 1 is that even
if the money demand interest elasticity goes to zero, that
does not mean that the Federal Reserve loses all control
over M-1.9 As long as there are reserve requirements on
M-1 (or a stable “desired demand” for reserves as a func
tion of transactions deposits), there will be a link between
M-1 and the supply of reserves. This can be seen most
readily from the bottom row of Case 5 in Table 2. Even if
the interest elasticity of M-1 demand goes to zero, and even
if there was some sort of reform of the discount window
so that the money supply function had an effective interest
elasticity of zero (d = o in Table 1), all that would do is
change the multiplier between reserves and M-1 to 1/m,
where m is the reserve ratio. In other words, we end up
with the simplest textbook money supply function (compare
the relationships in the bottom row of Case 5 in Table 2 to
the bottom row of Table 1).10
And in this extreme case, (a = d = o), it could be argued
that the Federal Reserve’s control of M-1 would be greatly
improved for basically two reasons. First, money demand
shifts and shifts in autonomous expenditures would have no
effect on M-1 under these circumstances (last two terms in
the bottom row of Case 5 in Table 2 become equal to zero).
The effects of these variables would show up as larger
movements in interest rates (center row of Case 5). Second,
it could also be argued from this extreme case (a = d = o)
that changes in other parameters (b and c to be discussed
later in the context of innovations changing them) no longer
would affect the relationship between the supply of reserves
and M-1 since this relationship depends now only on the
reserve ratio. So in that sense the “money multiplier” would
•For the interest elasticity of M-1 demand to become zero, not only would
the rate of interest on M-1 balances need to move with market rates, but
the Federal Reserve would also need to pay a market rate of return on
reserve balances as well. In this article, we are ignoring the currency
component of M-1 which does not earn interest.
10Case 4 shows just the effects of reducing the money supply interest
elasticity (d). With respect to the impacts of the exogenous variables on
r and X a reduced money supply interest elasticity reinforces the effects
of a reduced money demand elasticity. With respect to the effects on
M-1, they tend to offset one another (compare Case 4 to Case 1).
However, in the extreme case, a = d = o, the effects of the money supply
elasticity on the M-1 multipliers dominate (see bottom row of Case 5).

FRBNY Quarterly Review/Summer 1984 5

be more predictable since innovations that might affect these
other parameters would no longer affect the relationship
between reserves and M-1.11
But again, there are complications that may or may not
make this a desirable outcome. Clearly, if one takes the
view that (1) controlling M-1 is the only objective the Federal
Reserve should have, and (2) the demand for M-1 is
becoming highly interest inelastic, then reforming the dis
count window, which provides interest elasticity in the supply
function for M-1, would be an important goal. Obviously
setting d = o by having the discount rate move with market
rates, or by making it a “true penalty” rate, would be ways
of tightening monetary control in the sense outlined above.
But what are some of the other consequences of setting
d = o? Income becomes more sensitive to shifts in the
supply of and the demand for M-1 (top row of Case 5). At
the same time, however, income becomes less sensitive to
changes in autonom ous expenditures, with the impact
equalling zero if both a and d = o (top row of Case 5).
Hence, the end result could well be to make income more
sensitive to shocks from the monetary side than from the
real side. This could argue for interest rate targeting rather
than M-1 targeting, assuming that the magnitudes of the
disturbances themselves are not also changed. Ironically, the
very changes in the structure that might make M-1 highly
controllable might also be the ones that alter the relative
importance of the disturbance terms from the real and
monetary sides in such a way that interest rate targets
would be preferable to M-1 targets.12
The question could also be asked whether M-1 would
have any meaning or could be defined if transactions bal
ances earned a market rate of interest and the Federal
Reserve paid a market rate on reserves. Clearly, many socalled “cash management practices” would stop and M-1
would contain liquid investments as well as transactions
balances. Banks might also allow limited checking privileges
on other accounts as well, and M-1 would lose all the

"Moreover, if a = d = o then the multiplier between autonomous
expenditures and income also becomes zero (top row of Case 5). In
other words, fiscal policy has no impact on income, while monetary
policy, as measured by the supply of reserves, has a larger impact
Hence, the elasticities also matter in some sense for the relative
effectiveness of monetary and fiscal policy, which was often raised as an
issue in the late 1960s. For a more detailed discussion of this, see
Warren L. Smith, "A Neo-Keynesian View of Monetary Policy”, Controlling
Monetary Aggregates, Federal Reserve Bank of Boston (June 1969).

12James Tobin recently expressed some similar concerns. "A number of
'reforms' have been proposed to limit variability in the money multipliers
connecting the monetary base or unborrowed reserves to intermediate
aggregates. These include indexation of the discount rate to market
interest rates and payment of a similarly indexed rate on reserves. They
are objectionable on the ground that they, like the deregulation of deposit
interest, enhance the volatility of interest rates and the vulnerability of
business activity to purely financial shocks" See James Tobin, op. cit.,
page 515.

FRBNY Quarterly Review/Summer 1984

Table 3

Effects of Innovations on the Economy
Overall changes in relationships from Table 2

Case’
(variable)

Changes in
Supply of
Reserves (R)

1(V)
2 {Y ). .
3 (Y ).
4(Y)

Money
Supply
Function
Shifts (K)

Larger
Larger
Smaller
Larger

i(r)
2(r) ........
3(r)
..
4(r) . .

Larger
Smaller
Smaller
Larger

1(M-1) ....
2(M-1) ...
3(M-1)
4(M-1)

Smaller
Larger
Larger
Larger

Money
Demand
Function
Shifts (Z)

Larger
Larger
Smaller
Larger

Larger
Smaller
Smaller
Larger

Larger
Smaller
Smaller
Smaller

Changes in
Autonomous
Expenditures
(X)

Smaller
Smaller
Smaller
Smaller

Larger
Smaller
Larger
Larger

Larger
Smaller
Larger
Smaller

'Case 1 = Effects of the demand for M-1 becoming less sensitive to
changes in interest rates.
Case 2 - Effects of aggregate demand becoming more sensitive to
changes in interest rates.
Case 3 = Effects of the demand for M-1 becoming more sensitive
to changes in income.
Case 4 = Effects of the supply of M-1 becoming less sensitive to
changes in interest rates.

uniqueness currently attributed to it by regulation. Thus, it
might not be possible to specify an “ LM schedule” in terms
of M-1 as has been done in this paper. Under these cir
cumstances, some analysts would argue that the Federal
Reserve would have little choice but to use interest rate
targets.13 Hence, while this extreme case serves as an
interesting theoretical exercise in some ways, it is not clear
that it could ever exist in practice.

Cases 2 and 3
Next, we turn briefly to the effects of innovations on the
remaining elasticities in the model. In Case 2 in Table 2,
where the interest elasticity of expenditures increases, and
in Case 3 where the income elasticity of money demand
increases, the results suggest that the effects, for the most
part, would be to reduce the multipliers (Table 2). Here, as
was the result in Case 1, the important exception is the
relationship between M-1 and the supply of reserves. The
money stock becomes more sensitive to changes in
reserves, while the interest rate becomes less sensitive—
13See John Hicks, op. cit., for a detailed discussion.

the opposite of what happened in Case 1. Moreover, in
Case 1 the effect of a declining money demand interest
elasticity was to increase the sensitivity of M-1 to money
demand shifts and changes in autonomous expenditures.
From Cases 2, 3 and 4, however, it can be seen that these
effects could be offset or even reversed. (Table 3 contains
a different arrangement of the first four cases from Table
2 that is easier to use for some of these overall compari
sons.) Hence, whether innovations will reduce the Federal
Reserve’s ability to control money on balance after all these
different elasticities change is an open (perhaps empirical)
question.
Moreover, the impacts of innovations in Cases 2 and 3
could offset the effects of a declining money demand
interest elasticity in other dimensions as well. For example,
in Case 3 an increasing money demand income elasticity
would make income less sensitive to shocks coming from
the monetary sector. This could offset the added sensitivity
of income to monetary disturbances caused by a declining
money demand interest elasticity. In turn, this would also
affect the question of whether in theory it is better to target
M-1 or interest rates.
This is not the only instance in which the results become
ambiguous. Nor is it necessary to have changes in all four
elasticities for ambiguous results to occur. For example, in
Case 1 in Table 3 the direction of change on all 12 multi
pliers is clear. If Cases 1 and 2 are combined, the effect
on only four of the 12 multipliers remains unambiguous; and
if Cases 1, 2 and 3 are combined, only the effect on one
multiplier is still clear (upper right hand corner of Table 3).
In any case, the simple model still shows that innovation
increases the uncertainty about what the underlying eco
nomic relationships in fact are, making policy much more
difficult. And with many relationships in the economy
changing at the same time, it is not even possible to say
that the Federal Reserve would be better off targeting
interest rates instead of M-1.
Table 4 contains a summary of the changes that argue
for interest rate targeting versus money supply targeting. In
Table 4, the top four rows of Table 3 are reclassified in
terms of whether or not the larger or smaller multipliers
argue for money supply targeting (MST) or interest rate
targeting (IRT). If the result was one that made income
more (less) sensitive to shocks from the monetary sector,
then the underlying change in the financial structure was
classified as one that argued for interest rate targets (money
supply targets). On the other hand, if the underlying change
made income more (less) sensitive to changes in autono
mous expenditures, then the result was classified as
favoring money supply targeting (interest rate targeting). In
10 of the 12 instances, the changes corresponding to Cases
1 through 4 would argue for interest rate targets. But that
in and of itself does not make a case for interest rate tar
geting. In terms of looking at the results down all four cases

in each cell, two out of the three overall effects are ambig
uous since some changes within the individual cell favor
interest rate targets, while others favor money supply tar
gets. The only result that is clear-cut is the one on the far
right-hand side. All of the changes make income less sen
sitive to shifts in autonomous expenditures. If the net effect
in the other two cells is not to change the sensitivity of
income to shocks from the monetary sector from what it had
been before, then the results in the far right-hand cell might
be interpreted as giving more weight than before to the
argument for interest rate targets. However, given all the
uncertainties in assessing in which direction these various
elasticities will change as a result of innovations, a great
deal of caution should be taken in drawing any policy
implications from Table 4.

Conclusion
In sum, the analysis presented here essentially takes us
back to the point made in the citation from Jacob Viner at
the onset of this article. If the relationships between key
variables are changing, then it simply is not practical for
policy to focus in some mechanical way on any single var
iable, whether it be M-1, GNP, interest rates, or even
reserves themselves. A change in a structural parameter in
one equation has the potential for changing the relationships
among many (or possibly all the) other variables. From even
a very simple model it can be seen that innovations and
deregulation can have far-reaching implications for the

Table 4

Effects of Innovations on the M-1 Versus Interest
Rate Targeting Question*

Casef
(variable)

Changes in
Supply of
Reserves (R)

1(Y)...........
2 (Y )..........
3{Y )..........
4 (Y )...........

t
*
%
t

Money
Supply
Function
Shifts <K)

Money
Demand
Function
Shifts (Z)

Changes in
Autonomous
Expenditures
(X)

IRT
IRT
MST
IRT

IRT
IRT
IRT
IRT

IRT§
IRT
MST|j
IRT

'Assuming that the ultimate objective is to stabilize income (Y).
fCase 1 = Effects of the demand for M-1 becoming less sensitive to
changes in interest rates.
Case 2 = Effects of aggregate demand becoming more sensitive to
changes in interest rates.
Case 3 = Effects of the demand for M-1 becoming more sensitive
to changes in income.
Case 4 = Effects of the supply of M-1 becoming less sensitive to
changes in interest rates.
tN o t applicable.
§A change that favors interest rate targeting.
||A change that favors money supply targeting.

FRBNY Quarterly Review/Summer 1984

relationships between key variables, and that makes fixed
rules for policy very unattractive regardless in terms of which
variable they are formulated.
The main conclusions of this article that remind us of the
citation from Jacob Viner are as follows:
• The effects of financial innovations, even in the simplest
of models, are next to impossible to sort out. This raises
questions about what we can say about the effects of
these innovations in terms of the complex economy we
have in reality.
• One reason it is difficult to assess the effects of inno
vations even in simple models is because even for a
given parameter— such as the interest elasticity of the
demand for M-1— some changes seem to be increasing
it, while others seem to be working to reduce it. This
is particularly true during the transition phase to a de
regulated financial system. Hence, it is difficult to know,
for example, whether the net effect will be to increase
or reduce the responsiveness of M-1 to changes in the
supply of reserves at any point in time.
• But even if it was possible to ascertain that a declining
money demand interest elasticity was causing M-1 to
become less sensitive to changes in the supply of
reserves, that would only be one effect of this declining
elasticity. Monetary control could also be complicated by
the consideration that M-1 would become more sensitive
to shifts in the money demand function and changes
in autonomous expenditures.
• Moreover, a declining money demand interest elasticity

could also affect how responsive income would be to
exogenous shocks such as money demand shifts or
changes in autonomous expenditures. This, of course,
could affect the fundamental question of whether the
Federal Reserve should target M-1 or interest rates if
GNP is viewed as its ultimate objective.
• If the demand for M-1 does become interest inelastic
as a result of innovations, then reform of the discount
window that would make the supply of money function
unresponsive to interest rates movements would
become attractive to some analysts because the supply
function would more closely approximate the simple
“money multiplier” model. However, such a change
would also affect other relationships in the economy,
and it is not clear on balance that it would be a worth
while reform.
• The problem is further complicated in that the money
demand and supply interest elasticities are not the only
parameters that might be affected by innovations.
Depending upon which other parameters are affected
and the direction in which they are changed, the effects
on the economy from changes in the money supply and
demand elasticities could be offset or enlarged.
• Not only do changes in these elasticities raise questions
about what impact changes in supply of reserves will
have on M-1, but they also have the potential for
affecting the ratio of income to M-1, perhaps reducing
the usefulness of M-1 as an indicator of what is hap
pening to income during the transition to a deregulated
economy.

John Wenninger

8 FRBNY Quarterly Review/Summer 1984

Targeting in a Dynamic Model

Support for monetary targeting is eroding. Many economists
and government officials express increasing concern that
monetary targeting destabilizes both the financial and real
sectors of the economy. Unnecessary volatility in the money
supply, interest rates, and the levels of income and
employment, they argue, comes from attempting to target
money too rigidly. The sharp swings in the economy during
the three-year period following the change in the Federal
Reserve’s operating procedures in October 1979 are cited
frequently, although the second oil price shock and the credit
control program certainly contributed to the increased vol
atility. Moreover, they view the much smoother performance
of the economy since late 1982 as a telling development.
Around that time, the Federal Open Market Committee
(FOMC) reduced its emphasis on M-1 relative to the broader
monetary aggregates; and in view of rapid institutional
change, it adopted a more flexible approach to achieving
the objectives for the aggregates.
As support for monetary targeting wanes, the search for
an alternative approach to policymaking intensifies. Many
agree that the Federal Reserve should have targets or
numerical objectives of some kind. Targets communicate to
the public the long-run direction of monetary policy and
provide Congress with some basis to assess FOMC deci
sions. Against this background, some economists (among
them James Tobin and Robert Gordon) have advocated
nominal GNP targeting.1 They claim adopting this strategy
will lead to better achievement of the ultimate objectives of
monetary policy.
’ James Tobin, "Monetary Policy: Rules, Targets, and Shocks” Journal of
Money, Credit, and Banking (November 1983), pages 506-18; and Robert
J. Gordon, “ Using Monetary Control to Dampen the Business Cycle: A
New Set of First Principles” National Bureau of Economic Research
Working Paper, Number 1210.

This paper investigates the properties of both monetary
targeting and nominal GNP targeting. The first issue to be
covered is whether adhering rigidly to monetary targets does
indeed lead to unnecessary volatility in the financial and real
sectors of the economy. Perhaps the monetary targets and
the ultimate objectives of policy are actually best achieved
by attempting less rigid control. Currently, these matters are
particularly relevant. With the implementation of contem
poraneous reserve requirements and the more normal
behavior of M-1 ’s velocity recently, some may feel that this
year offers an opportune time to return to tighter monetary
targeting.
The second issue is the effectiveness of nominal GNP
targeting versus monetary targeting. How well do the two
policy strategies stabilize nominal income around desired
levels? If GNP targeting can be shown to be more effective,
then the strategy advocated by Tobin and Gordon has a
firmer foundation.
Throughout the article, the issues are examined by using
the most compact model of the economy possible. Never
theless, the model’s framework is kept versatile enough to
study the consequences of alternative approaches to mon
etary policy in a dynamic setting— the primary purpose of
this article. But many of the practical and institutional con
straints that surround both monetary targeting and nominal
GNP targeting are left aside.2
The first section shows that a monetary target is best
achieved over time by gradually offsetting deviations from
2For a discussion of some of the practical problems with monetary
targeting and nominal GNP targeting, see the articles by John Wenninger
(page 1) and Douglas M. Woodham (page 16) in this issue. Also see
Anthony M. Solomon, “ Unresolved Issues in Monetary Policy", this
Quarterly Review (Spring 1984), pages 1-6; and John B. Carlson,
“ Nominal Income Targeting", Federal Reserve Bank of Cleveland
Economic Commentary (May 21, 1984).

FRBNY Quarterly Review/Summer 1984 9

target. And the second section goes on to show that mod
eration in pursuing a monetary target will also contribute to
lower volatility in interest rates and nominal income. But this
raises a question about the usefulness of monetary targeting
in stabilizing income in the longer run. In the last section,
the strategy of reacting to movements in income emerges
as more effective than monetary targeting in stabilizing the
level of nominal income. This turns out to be the case for
this particular model, even when the demand for money
is stable and no financial innovation or deregulation is
occurring.3
The volatility of money and the interest rate under
monetary targeting
To begin, consider a simple version of the monetary sector,
separate from the rest of the macroeconomy. Two relation
ships comprise it: the demand for money and a policy for
mula. The demand for money is based on a transactions
motive for holding money. The total volume of money
demanded by households and firms is determined primarily
by the levels of income and the interest rate. Furthermore,
it is assumed that households and firms take some time to
adjust their holdings to changes in income and the interest
rate. Simple one-period lags are specified in the demandfor-money function to reflect this. (Longer and more complex
lag patterns could be used, but at the cost of greatly com
plicating the mathematics underlying the analysis.) This
means that the current values of income and the interest
rate and their previous period’s values jointly determine the
quantity of money demanded. Because the relationship is
presumed not to hold exactly, a random disturbance term
is included, representing all other factors in the demand for
money. The disturbance term satisfies all the usual
assumptions. So, the demand for money can be written as:
(1) M(t) = a - br(t) - cr(t-1) + dY(t) + eY(t-1) + v(t)
where:
M = actual money supply,
r = the interest rate,
Y = nominal income,
v = a random disturbance term, and
t denotes the time period.
(b, c, d, and e > o)
The policy formula attempts to succinctly represent the
essence of decision-making while following a strategy of
monetary targeting. The formula used here states that in
order to achieve the target the interest rate is moved
upward when the money supply is above target, and
downward when it is below target. The movement in the
interest rate is in proportion to the deviation of the actual
^The article by John Wenninger in this issue addresses the problems for
monetary policy created by financial innovation and deregulation.

10 FRBNY Quarterly Review/Summer 1984

money supply from the target.4 The deviation is measured
over the interval from the previous FOMC meeting to the
present one.5 The new level of the interest rate is then to
be maintained until the time of the next meeting. So, the
policy formula can be written as:
(2) [r(t) - r(t-1)] = X[M(t-1) - M*]
where:
M* = the targeted level of the money supply.
The change in the level of the interest rate, [r(t) - r(t-1)],
is related to the discrepancy between actual and targeted
money, [M(t-1) - M*], by the coefficient X. It measures the
strength of the response to deviations from target. For
example, suppose the FOMC sets the value of X at 2.00
(and the money supply is measured in billions of dollars).
Then the interest rate is moved 2 percentage points for
every billion dollars the money supply is away from target.
Implicit in this representation of policymaking is the
assumption that the FOMC— with its 12 members, each
possessing his or her own views on monetary economics—
can reach a consensus on how strong the response to
deviations from the monetary target should be. The value
of X reflects this consensus. Now, assuming that the true
value of the coefficient b in equation 1 (the short-run
response of money demand to the interest rate) is 0.10, the
FOMC, by setting X equal to 2.00, would actually be
attempting to correct 20 percent of a deviation from target
immediately. Each FOMC member, however, may not esti
mate the coefficient b to be exactly 0.10. So, each FOMC
member could believe that setting X at 2.00 means that
something other than 20 percent immediate correction is
being sought.
In general, setting X equal to (1/b), whatever the value
of b is, implies that, in reality, immediate correction of
deviations is sought, although individual FOMC members
may think differently. A value of X between zero and (1/b)
means that partial correction is attempted in the upcoming
period. In other words, the time horizon over which the
money supply is to be brought back to target is somewhere
4A similar representation of monetary targeting was used by Jared Enzler
and Lewis Johnson, “ Cycles Resulting from Monetary Targeting" in New
Monetary Control Procedures, Federal Reserve staff study, Volume 1,
Board of Governors of the Federal Reserve System Washington, D.C.
(1981), page 3.
5The policy formula contains the previous period’s, and not the current
period’s observation on the money supply. The assumption then is that
the FOMC reacts to observed, rather than anticipated changes in money
at the time of each meeting. The erratic nature of the monetary data, as
well as the difficulty of accurately projecting the money stock, suggests
that this is a reasonable assumption. If the current period’s observation
is incorporated instead, many of the results obtained in the analysis are
reversed. Furthermore, equation 2 should not be construed as a
representation of monetary targeting with a nonborrowed reserve target
at the tactics level. In that setting, there is some immediate response to
a deviation from target.

beyond the upcoming period; the smaller the value of \, the
longer the horizon.
If these two equations are combined, they can be used
to derive the long-run volatility (or asymptotic variance) of
the money supply about its target, and correspondingly, the
interest rate about its level that is consistent with the mon
etary target.6 These values, of course, depend on (1) the
interest rate elasticity and lag structure of money demand
and (2) the particular value selected for the coefficient \.
®The use of the asymptotic variance to measure the effectiveness of
stabilization policies was developed in E. Phillip Howery, “ Stabilization
Policy in Linear Stochastic Systems’! Review of Economics and Statistics
(August 1967), pages 404-11.

V o l at i li t y of the Mo n e y Su p p l y versus
S t r en g t h of t h e Pol icy Response
L o n g -ru n v o la tility
o f the m o ney s u p p ly *
10

^C ase 1

C ase 2

i
10

i
I
!

1
i

20
30
40
50
60
70
80
S tre n g th o f the p o lic y re s p o n s e
(P e rc e n t a tte m p te d c o r re c tio n )

100

V ol a t i l i t y of the I n t e r es t Rate versus
S t r e n g t h of the Pol icy R e s po n s e
L o n g -ru n v o la tility
of the in te r e s t r a t e *
3 0 0 ---------------------------------------------------------------------------------- ;
250C ase 2j
200-

S tre n g th o f the p o lic y re s p o n s e
(P e rc e n t a tte m p te d c o rre c tio n )
* M e a s u re d by the a s y m p to tic varia nce.

There will be, though, a value of \ that minimizes the var
iance of the money supply for a prespecified demand for
money. This minimum variance implies that the money
supply is being kept, on average, as close to the target as
possible.
Rather than presenting at this point the algebraic solution
for the value of X that produces the tightest effective control
over money, two specific examples will be drawn. The two
examples differ in terms of the speed with which individuals
and firms adjust their money holdings to interest rate
changes. In the first example, two-thirds of the total
adjustment in money holdings to a change in the interest
rate occurs immediately; that is, in the same time period
that the interest rate changes. (Or, b = 0.10 and c = 0.05
in the money-demand equation 1.) In the second example,
the adjustment takes place less rapidly, occurring almost
equally in the current and the following period (b = 0.08
and c = 0.07).7
The two examples are used to show the relationships
between, on the one side, the strength of the policy
response, and on the other, the long-run variances of the
money supply and the interest rate. The relationships are
plotted in the diagram; the strength of the policy response
is varied from 0 to 100 percent attempted correction in the
upcoming period. In the upper panel of the chart, monetary
targeting appears most accurate in the first example when
the response is to attempt to eliminate 69 percent of the
deviation in the upcoming period; in the second example,
46 percent. Clearly, in neither case is the money supply kept
closest on average to target by attempting to eliminate
deviations from target entirely in the next period.
In general terms, the presence of lagged interest rate
effects on the volume of money demanded explains why
attempts to immediately correct deviations from target do
not produce the greatest effective control. If the interest rate
is moved upward to correct an overshoot in money com
pletely in the upcoming period, the lagged effect of the
interest rate change would push the money supply below
target in the following period.8 Thus, attempting to correct
deviations too quickly only increases the volatility of the
money supply and is ultimately counterproductive. Con
versely, attempting to correct deviations from target grad
ually— in other words, over an appropriately long horizon—
can lead to greater success on average in keeping the
money supply close to target. In fact, as long as there is
partial adjustment in the same period in which the interest
rate moves, complete immediate correction will be less than
optimal.
The lower panel in the chart shows that the asymptotic
variance of the interest rate increases exponentially as the
7lf b < c, the model exhibits undampened (explosive) cycles.
8That is, unless the disturbance term takes on a large positive value in
the upcoming period.

FRBNY Quarterly Review/Summer 1984

strength of the policy response increases.9 This agrees with
the widespread view that in order to smooth the course of
the money supply, the interest rate must fluctuate widely.
In this situation, uncertainty over the relative size of the
current and lagged interest rate effects on the demand for
money would lead policymakers to respond conservatively
to money supply deviations. To illustrate with the second
example, the money supply is kept closest to target by
attempting to eliminate 46 percent of the observed deviation
in the upcoming period. If this is done, the asymptotic var
iance of the interest rate is about 48 times the variance of
the disturbance term attached to the demand for money. If
the policy response is strengthened with the intention of
eliminating 64 percent of the observed deviation immediately,
interest rate volatility roughly doubles. Conversely, if the
policy response is weakened to 32 percent, interest rate
volatility drops off to 24 times the variance attached to
money demand.
With these figures in mind, suppose it is somewhat
uncertain how quickly the public adjusts its money holdings.
Policymakers are then unsure as to how quickly to bring
money back to target. Obviously, it would be advantageous
for them to err on the low side in determining the speed
with which the money supply is brought back to target.
The effect of adding the real sector to the model
The model used in the previous section represented just the
monetary sector. The real sector was omitted, as mentioned
earlier, to keep the mathematics relatively simple. But to
understand the basis for nominal GNP targeting and then
compare its performance with that of monetary targeting, the
real sector must also be part of the model. Incorporating
the real sector modifies the two major results regarding
monetary targeting. The results now reflect the impact of
the monetary sector on the real sector and vice versa, but
they are not fundamentally changed.
Let us add to the monetary sector a version of the widely
used multiplier-accelerator model. There are two behavioral
relationships in this model. First, consumption spending
depends solely on income. Second, investment spending
responds to the interest rate and to changes in the level
of output. Neither relationship is assumed to hold exactly;
random disturbance terms are included. Thus, the real
sector can be represented as:
(3) C(t) = f + gY(t) + u,(t)
(4) l(t) = h - jr(t) + k[Y(t-1) - Y(t-2)] + u2(t)

■This result appears to be the analogue in a stochastic model to the
problem of "instrument instability” in a deterministic model, identified first
by Holbrook. See Robert S. Holbrook, “ Optimal Economic Policy and the
Problem of Instrument Instability", American Economic Review (March
1972), pages 57-65.

12 FRBNY Quarterly Review/Summer 1984

where:
C = nominal consumption,
I = nominal investment, and
u, and u2 are disturbance terms.
(0 < g and k < 1; j > 0)
By combining these two equations with the income identity,
we obtain the “ IS curve”, equation 5:
(5) (1-g)Y(t) - kY(t-1) + kY(t-2) = (f+h) - jr(t) + u(t)
Adding the real sector expands the model from two
equations to three: the demand for money and the policy
formula, plus the IS equation. Now the monetary sector
affects the real side of the economy, which in turn feeds
back on the monetary side. So, a change in the interest
rate affects the demand for money directly by changing the
opportunity cost of holding money. But a change in the
interest rate also affects money demand indirectly by its
impact on spending and income, the other key element in
money demand.
Note also that the lagged effects present in the model
have been increased substantially. Earlier, only the lagged
effect of the interest rate on money demand was relevant;
now the lagged income effect on money demand is also
relevant. Furthermore, the real sector has an important
lagged effect: aggregate demand is in part determined by
the level of income one and two periods earlier, due to the
accelerator mechanism. All together, the dynamic structure
of the expanded model is much more complex than that of
the original model.
Including the real sector, however, does not materially
change either the analysis or the thrust of the results. This
is demonstrated algebraically in the appendix. The two
principal results, however, must be modified to reflect the
connections between the monetary and real sectors. The
results are changed to the following:
• Keeping the money supply as close, on average, as
possible to target still requires seeking partial, and not
complete, correction in the current period. But, the per
centage correction that accomplishes this is now deter
mined by the elasticities and the lag structures in both
the demand for money and the aggregate demand for
goods and services.
• As the strength of the policy response to deviations from
target increases, the long-run volatility of both the interest
rate and income rises exponentially. This is because they
play parallel roles: income and the interest rate jointly
determine the quantity of money demanded. And appro
priate movements in the levels of income and the interest
rate are the means employed to keep the money supply
close to its target.

The second result, modified now to reflect the real sector,
has important implications. As the policy response is
increased until the greatest attainable stability in the money
supply is achieved, the volatility of income and the interest
rate increases. This means, as it did earlier, that uncertainty
over the structure of the economy would make policymakers
prefer bringing the money supply back to target too slowly
rather than too quickly. But the motive here is concern about
unnecessary fluctuations in income and employment, not
just fluctuations in interest rates.
Moreover, adopting strict monetary targeting could, in fact,
be self-defeating if the intent were to stabilize income. To
hit a money supply target, the interest rate and income must
be maneuvered so that random disturbances shocking the
system have a minimal impact on the money supply. That
is, the process of targeting money insulates the money
supply from shocks to the economy, with income and the
interest rate bearing the brunt of the shocks. Taking this line
of thinking one step further, it may be that, in order to sta
bilize income, policy should respond to deviations of income,
not money, from target. The money supply, in other words,
should be the “shock absorber” instead of income.
Monetary targeting versus focusing directly on income
Now bearing the larger model in mind, let us compare how
well targeting money stabilizes income with how well
focusing on income itself stabilizes income. To simulate
monetary targeting, the system must contain three equa
tions: the IS curve, the demand for money, and a policy
formula oriented to deviations of the money supply from its
target. 1o simulate nominal GNP targeting, the system must
consist of the IS curve and a policy formula relating changes
in the interest rate to movements in income itself. The
interest rate changes can be made relative to the deviation
of income (Y) from its target (Y*), which would be repre
sented as:10
(6a) [r(t) - r(t-1)] = p[Y(t-1) - Y*]
Or instead, the interest rate changes could be made relative
to the observed changes in income, which would mean the
formula would be written as:11
(6b) [r(t) - r(t-1)] = 7[V(t-1) - Y(t-2)]
’ “ National income accounts data are compiled quarterly, whereas the time
period in the model is one half of a quarter. So, if the model were made
operational, GNP data would have to be interpolated. Considering the
volume of data on the real economy released monthly, and the fact that
monthly estimates of GNP are made in the private sector, the task could
be performed.
11The policy formulas are examples of proportional and derivative control in
the Phillips framework for stabilization policy. See A. W. Phillips,
“ Stabilization Policy in a Closed Economy" Economic Journal (June
1954), pages 290-323.

To simplify the comparisons between nominal GNP tar
geting and monetary targeting, consider two cases: first, all
disturbances are in the monetary sector; second, all dis
turbances are in the real sector.12 In the first case, focusing
on income itself must be a superior strategy to monetary
targeting. If all shocks originate in the monetary sector,
aggregate demand is perfectly stable. Therefore, if policy
focuses on income, it will be left undisturbed after coming
to rest at the target level. But focusing on the money supply
requires movements in the interest rate to keep it on target.
These movements in the interest rate will in turn cause
income to fluctuate, at times moving far away from the
target. Thus, GNP targeting is preferred to monetary tar
geting.
This finding could have been expected on the basis of
Poole’s work with a static model.13 He shows that the money
supply is inferior to the interest rate as an intermediate
target when the monetary sector (or LM curve) is the source
of instability in the economy, not the real sector (IS curve).
In the other polar case, where all disturbances originate
in the real sector, a simulation exercise must be conducted
to compare the long-run volatility of income under the three
policy formulas. Starting from equilibrium, the model was
simulated for 250 periods. Under GNP targeting, a search
was conducted for the value of the policy parameters ((3 or
7 in equations 6a and 6b) that minimized the variance of
income. Under monetary targeting, the search was for the
value of the policy parameter (\ in equation 2) that mini
mized the variance of the money supply, and the corre
sponding variance of income was noted.
The simulations show, surprisingly, that monetary targeting
was less effective, although only slightly less so, than either
version of GNP targeting. The fact that monetary targeting
is ranked below the other two strategies, even by a slight
amount, is decisive. This polar case, in which all shocks
originate in the economy’s real sector, is where monetary
targeting is supposed to be most effective. Moreover, the
differences in the ranking of the strategies could probably
be substantially widened either by altering the model’s
structure or by selecting different values for some key
parameters. In any event, the two polar cases together
indicate that over the entire spectrum a monetary targeting
strategy is outperformed by a strategy of concentrating on
the economy itself.
12Because the policy strategies are evaluated on their ability to stabilize
nominal GNR “ supply-side" or “ price" shocks are not considered. If the
strategies are evaluated in terms of real output and inflation, the
aggregate supply of goods and services must be incorporated in the
model. See Gordon H. Sellon, Jr. and Ronald L. Teigen, “The Choice of
Short-Run Targets for Monetary Policy" Federal Reserve Bank of Kansas
City Economic Review (April 1981), pages 3-16.
13William Poole, “ Optimal Choice of Monetary Policy Instruments in a
Simple Stochastic Macro Model”, Quarterly Journal of Economics (May
1970), pages 197-216.

FRBNY Quarterly Review/Summer 1984 13

Identifying the source of inefficiency in monetary targeting
Considering the results of the simulations, there must be a
source of inefficiency intrinsic to monetary targeting in
addition to the one Benjamin Friedman identified. He argued
that “the intermediate-target procedure for monetary policy,
based on the money stock, is in general an inefficient
means of processing the information contained in obser
vations on the money stock.” 14 More specifically, monetary
targeting implicitly attributes all money supply surprises to
the disturbance term in the real sector, which is generally
not believed to be true. But in the case of the simulations
conducted here, it is true. All disturbances in the simulations
are by design in the real sector and monetary targeting is
still inefficient.
The extra source of inefficiency apparently lies in the
lagged interest rate and income effects in the demand for
money. With GNP targeting, the demand for money does
not enter into the determination of income. But naturally, with
monetary targeting it does, and consequently its presence
introduces more lagged effects into the system. Since
lagged effects create substantial difficulties in stabilizing any
system, monetary targeting turns out to be inefficient relative
to GNP targeting even when all disturbances are on the real
side. If there are no lagged effects in the demand for
money, this particular source of inefficiency in monetary
targeting disappears; the inefficiency Friedman identified
remains, however.
While the simulations point to GNP targeting’s relative
efficiency, they conceal a complication. Economists believe
that interest rate movements have virtually no impact on
14Ber»jamin M. Friedman, “The Inefficiency of Short-Run Monetary Targets
for Monetary Policy" Brookings Papers on Economic Activity II (1977),
page 318.

aggregate demand in the very short run. The effect first
becomes noticeable perhaps three months later. In contrast,
interest rate changes do have a discernible impact on
money supply growth in the very short run. Thus, policy
makers would see their actions having an effect sooner on
the money supply than on nominal GNP.
Summary
This paper examined the properties of monetary targeting
in a compact model of the macroeconomy. The first con
clusion is that a monetary target is most effectively achieved
by returning the money supply gradually to its target fol
lowing a deviation. Attempts to bring the money supply back
to target too rapidly cause unnecessary volatility in the
money supply, interest rates, and the level of income.
Hence, it is not just concern about volatility in rates that
argues for a gradualistic approach, but unnecessary volatility
in GNP itself.
The second conclusion is that, in principle, monetary
policy could more effectively stabilize nominal income by
focusing on the economy directly instead of on a monetary
aggregate. Moreover, this is true even when the demand
for money is stable and no financial innovation is occurring.
This finding lends support to the argument for shifting the
focus of monetary policy from the monetary aggregates to
the performance of the economy. But, of course, the results
of this analysis are limited by the particular model used,
which does not incorporate some potentially significant
factors, such as expectations. In other words, different
models can yield different results. But even more impor
tantly, a comprehensive evaluation of monetary targeting and
GNP targeting would also take into account several practical
and institutional considerations.
Lawrence J. Radecki

14 FRBNY Quarterly Review/Summer 1984

Asymtotic Variance
In the first section of the paper, the monetary sector is sep
arated from the rest of the macroeconomy. Equations 1 and
2 can be solved to obtain the final-form equations for the
money supply and the interest rate.
(1A) M(t) + (Xb-1 )M(t-1) + XcM(t-2) =
(b + c)M* + v(t) - v(t-1)
(2A) r(t) + (Xb-1)r(t-1) + Xcr(t-2) = (a-M*) + Xv(t-1)
The asymptotic variances of the money supply, sM2, and the
interest rate, s 2, are shown in equations 3A and 4A.
(1 + Xc) 2sv2

(3A) sM2 =

(1 - Xc) [(1 + Xc)2 - (Xb - 1)2]
(4A) sr2 =

(1 + kc) k % 2_________________
(1 - Xc) [(1 + xc)2 - (Xb - 1)2]

In the second section of the paper, the real sector, rep
resented by equation 5, is joined to the monetary sector.
Combining this IS curve with equations 1 and 2 yields finalform equations for the money supply, income, and the
interest rate, equations 5A, 6A, and 7A, respectively.
(5A) AM(t) + BM(t-1) + CM(t-2) + DM(t-3) + EM(t-4) =
Fm + GM(t)
(6A) AY(t) + BY(t-1) + CY(t-2) + DY (t-3) + EY(t-4) =
Fy + GY(t)
(7A) Ar(t) + Br(t-1) + Cr(t-2) + Dr (t-3) + Er(t-4) *
Fr + Gr(t)
where:
A =
B=
C =
D =
E=
FM =
Fy =
Fr =
GM(t) =

1-g
[(1-g)(Xb-1) - k + Xdj]
[(l-g)xc - k(xb-1) + k + xej]
[k(Xb-1) - xck]
Xck
X[(1-g)(b + c) + j(d + e)]M*
X[(b + c)(f + h) - j(a-M*)]
X[(d + e)(f + h) + (1-g)(a-M*)]
dw(t) + (e-d)w(t-1) - ew(t-2) + (1-g)v(t) (1-g + k)v(t-1) + 2kv(t-2) - kv(t-3)

GY(t) = w(t) - (1-Xb)w(t-1) + Xcw(t-2) - Xjv(t)
Gr(t) = Xdw(t-1) + Xew(t-2) - X(1-g)v(t-1) +
Xkv(t-2) - Xkv(t-3)
There are two features of these equations to be noted: all
three equations, by necessity, have the same autoregressive
structure: and the three equations differ in their composite
disturbances.
It is anticipated that, if the expressions for the asymptotic
variance were available, essentially the same results would
be found for this fourth-order system of three variables as
were found for the second-order system of two variables.
These results, modified to take account of the addition of
the real sector, would be that:
• There is a value of X between zero and (1-g)/[b(1-g) +
dj] that minimizes sM2, the asymptotic variance of the
money supply. In the expanded system, [b(1-g) + dj]/
(1-g) is equal to the contemporaneous impact on the
money supply brought about by a fall in the interest rate
of one percentage point. It is the combined effect that
the interest rate has on the demand for money directly
and indirectly, via a change in income. The value (1-g)/
[b(1 -g) + dj] sets the value of x corresponding to 100
percent elimination of deviations in the upcoming period.
• As X increases, the asymptotic variance of both the
interest rate and income rises exponentially. This is
because the parameter X appears in the composite
disturbance terms of these two variables. (See Gy(t) and
Gr(t) in equations 6A and 7A.) Thus, the solutions for
the asymptotic variance will have X2 in the numerator,
just as it appeared in the solution for the asymptotic
variance of the interest rate in the smaller system,
equation 4A.
The last point has an important implication. As the policy
response is increased until the greatest attainable stability
in the money supply is achieved, the volatility of the other
endogenous variables increases at an explosive rate. In other
words, as X is increased until sM2 is minimized, sY2 and s 2
are growing exponentially.

FRBNY Quarterly Review/Summer 1984

Potential Output Growth and
the Long-Term Inflation Outlook

The rapid growth in real GNP and in domestic demand
during this expansion has led to concern about a resur
gence in inflation. If the economy continues to expand at
a quick pace, some analysts suggest, it may soon run into
a capacity constraint. Further increases in the demand for
goods and services would then raise the inflation rate, with
little or no increase in real output.
Historically, the effect of demand pressures on the inflation
rate has been captured well by unemployment rate move
ments. An important factor in the inflation outlook is the
rapidly closing gap between the unemployment rate and the
natural rate— the unemployment rate consistent with stable
inflation. This gap has proved to be a useful indicator of
demand pressures since movements in the gap have had
a stable and predictable impact on the rate of inflation.1 At
present, most estimates of the natural rate fall somewhere
between 6 and 7 percent; thus, the current unemployment
rate is somewhat above the midpoint of this range. Once
the unemployment rate reaches the natural rate, if the
economy can then be stabilized there, a pickup in inflation
may be prevented.
To operate at the natural rate, real GNP needs to grow
at what is called its potential or capacity growth rate. Growth
in potential output, as discussed below, is fundamentally
equal to trend growth in productivity, the labor force, and
average weekly hours. As such, it represents the rate of
growth in the economy’s long-run ability to produce goods
and services. If the economy expands at the same rate as
potential, there is no systematic pressure on the unem’ 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 Number 8303 (February 1983).

16 FRBNY Quarterly Review/Summer 1984

ployment rate to rise or fall. Thus, when actual output is
growing in line with potential and the unemployment rate
is equal to the natural rate, an important source of pressure
on the inflation rate is eliminated.
This article examines the behavior of potential output over
the past twenty-five years. Growth in potential output from
1974 to 1983 was found to be approximately 3.1 percent,
down significantly compared to the years 1960 to 1973. An
analysis of likely trends in the determinants of potential
output suggests that it could continue to expand approxi
mately three percent a year over the next decade.
Since 1974, however, the link between output growth and
changes in the unemployment rate has become more var
iable. Consequently, deviations in output growth from its
potential are no longer as reliable an indicator of movements
in the unemployment rate. The inflationary consequences
of an expanding economy, therefore, are more uncertain
today than before 1974. This greater uncertainty, moreover,
suggests caution in moving to a nominal GNP target for
monetary policy that some economists have suggested in
recent years.
What is potential output?
Generally speaking, potential output measures what the
economy can produce at full employment. Throughout the
1960s, the Council of Economic Advisors defined potential
output to . equal the amount of goods and services the
economy could produce with a 4 percent unemployment
rate. In the late 1960s and early 1970s, however, it became
increasingly clear that while it might be possible for the
economy to operate with 4 percent unemployment, it would
conflict with another policy goal— price stability.
For most purposes, the relevant measure of potential

output equals the amount of goods and services the
economy can produce when operating at the natural rate.
Potential output is tied to the natural rate since movements
in the unemployment rate away from the natural rate have
proved to be an important determinant of whether the
inflation rate will rise or fall. Note, however, that even if the
economy is growing at its long-run potential rate, in the short
run, the unemployment rate need not equal the natural rate.
Some analysts have suggested that a natural rate of
capacity utilization also exists and that deviations in capacity
from its natural rate serve as a reliable indicator of inflation.
But if there is a natural rate of capacity utilization, it, like
the natural rate of unemployment, does not appear to have
remained constant over the past twenty years. In the midto late-1960s, for example, the manufacturing sector reached
rates of capacity utilization in the high eighties before con
sumer prices accelerated. In the mid- to late-1970s, in
contrast, inflation accelerated when the manufacturing sector
was operating at only about 80 percent of capacity.
Perhaps more importantly, movements in capacity utili
zation tend to mirror movements in the unemployment rate;
the two series have a correlation coefficient close to - 0.9.
Thus, after accounting for movements in the unemployment
rate, movements in capacity may not improve our ability to
track inflation. This, however, is an empirical question
beyond the scope of this paper.
Measurement of potential output
A number of techniques have been used to measure growth
in potential output; two of them are employed in this article.
The simplest and most direct method is to ascertain the
growth in real GNP that historically has been associated
with a stable unemployment rate. The equations estimated
for this purpose are presented in Box 1. An alternative
approach, which analyzes growth in productivity, average
weekly hours, and the labor force, is discussed below. A
third approach, not used in this paper, involves estimating
a production function for the economy and determining the
factor input levels consistent with full employment.2
Econometric or statistical approach
Based upon the statistical relationship between movements
in real GNP and the unemployment rate, the rate of growth
in potential output over the period 1974 to 1983 was found
2For recent analyses along this line see, among others, Jeffrey M. Perloff
and Michael L. Wachter, "A Production Function-Nonaccelerating Inflation
Approach to Potential Output: Is Measured Potential Output Too High?’’, in
Karl Brunner and Allan H. Meltzer, eds., Three Aspects of Policy and
Policymaking: Knowledge, Data, and Institutions, Carnegie-Rochester
Conference Series on Public Policy, Volume 10 (1979), pages 113-163,
and John A. Tatom, “ Potential Output and the Recent Productivity
Decline” Federal Reserve Bank of St. Louis Review (January 1982),
pages 3-16. A number of objections, however, have been raised about
this method. See, for example, the comments on the Perloff and Wachter
paper. Estimates of potential output made by Tatom are discussed later
in this article.

to be 3.1 percent. This rate of expansion, however, was less
than the 3.9 percent growth in potential that characterized
the period from 1960 to 1973.
The chart illustrates the reduction in capacity growth by
plotting the estimated long-run relationship between real
GNP growth and changes in the unemployment rate. As can
be seen in the chart, the GNP growth rate consistent with
a stable unemployment rate decreased beginning in 1974.
The decline in potential output growth meant that after
1973 the economy could no longer expand as fast as in
the previous decade and still maintain a stable inflation rate
over the longer term. Yet perceptions of potential growth
changed slowly. As a result, the growth rates which had
been built into people's expectations may have become
highly inflationary.
A second, and perhaps more significant new finding in
this article is that beginning in the mid-1970s, the link
between output growth and the unemployment rate became
more uncertain.3 This implies that the range of likely
movements in the unemployment rate associated with any
rate of real GNP growth became much wider. For example,
the unemployment rate rise in 1975 and drop in 1983 were
larger (in absolute terms) than the statistical relationship
predicted. In the earlier period, on the other hand, the
relationship predicted unemployment rate changes much
more accurately. Thus significant movements in the unem
ployment rate, that do not reflect the underlying strength or
weakness of the economy, are now more likely to occur.
Over time, these errors will tend to cancel each other out.
However, over the course of six months to a year, large
movements in the unemployment rate, unrelated to GNP,
can occur.
Historically, compensation growth has moved in fairly close
tandem with unemployment rate movements. The more
tenuous link between GNP growth and the unemployment
rate, then, serves to loosen the link between GNP growth
and inflation. Thus the inflationary consequences of eco
nomic expansion are more uncertain today then before
1974, primarily because unemployment rate movements
cannot be predicted as accurately from GNP growth.
The increased variability in the GNP/unemployment rate
relationship suggests that a significant decline or increase
in inflation over the short run may occur even when the
economy is expanding at the same rate as its long-run
potential. Consequently, successfully implementing economic
policies aimed at stabilizing the unemployment and inflation
rates may be more difficult. For policy-makers, this means
distinguishing what may be only “blips” in the unemployment
and inflation rates from movements which truly reflect the
economy’s underlying strength or weakness.

3Not only did the growth rate of potential output change, but the residual
standard error rose 75 percent as well.

FRBNY Quarterly Review/Summer 1984 17

Box 1: Estimating the Unemployment/Real Output Relationship
The relationship between real GNP growth and unem
ployment rate changes was estimated using data from 1960I to 1983-IV Based upon a number of tests for structural
stability, the data were consistent with real GNP having a
different impact on the unemployment rate beginning in
1974.*
In light of this, the data were split into two groups— 1960-1
to 1974-1 and 1974-11 to 1983-IV Several models were esti
mated for each subperiod to identify the relationship between
the unemployment rate and real GNR The best equation for
each subperiod was:
1960-1 to 1974-1
(A.1) DU, = .260 - .183 gnp,* - .090 gnp,.,* + .312 DU,.,
(6.18)
(-7 .2 6 )
(-2.60)
(3.17)
R2 = .70
a = .16
Durbin’s-H = -.6 3
*For details, see Douglas M. Woodham, “ The Changing
Relationship Between Unemployment and Real GNP in the United
States” Federal Resen/e Bank of New York Research Paper
(forthcoming), revised.

1974-11 to 1983-IV
(A.2) DU, = .329 - .285 gnp* - .142 gnp,.,*
(6.44)
(-7 .0 5 )
(-3 .5 8 )
R2 = .73
a = .28
DW = 1.71
where DU equals the change in the unemployment rate and
gnp* equals (GNP, - GNP^/GNP,., times 100. Both equa
tions were estimated by ordinary least-squares (t-statistics
are in parentheses).
The rate of growth in potential output equals the rate of
growth in real GNP associated with a stable unemployment
rate. This growth rate can be calculated for the period 1974II to 1983-IV as follows: set the left hand side of equation
(A.2) to zero and find the constant rate of growth in GNP
that solves the equation. The solution is .77 percent. This
corresponds to 3.1 percent growth when expressed at a
compound annual rate.
Growth in potential over the earlier period can be calcu
lated in a similar manner. Besides setting the current value
of DU equal to zero, however, the lagged value of the
change in the unemployment rate must also be set equal
to zero.

Box 2: Decomposing Growth in Potential Output
Movements in real GNP can be decomposed into move
ments in productivity (P), average hours worked (AHW), the
proportion of people employed (1-U), and the labor force (LF)
using the equation reported in the section on an alternative
approach to measuring potential output. A problem arises,
however, in using the conventional measures of P AHW, (1U), and LF in this equation since they are not measured on
the same basis.* The most widely used measure of pro
ductivity equals output per hour produced by all employees
in the nonfarm business sector while average hours worked
is generally reported as the average workweek of production
workers in the nonfarm sector.
Furthermore, the employment series used to calculate both
of these variables is based upon data from the Bureau of
Labor Statistics’ payroll survey. The unemployment rate and
labor force variables, on the other hand, are based upon
employment numbers generated from the Bureau of Labor
Statistics’ household survey. These surveys sometimes give
very different estimates of the number of jobs being created
in the economy. This was particularly true in 1983.
The fact that P, AHW, (1-U), and LF are measured on
different bases can be accounted for by noting that:
GNP

GNP
NFGNP

* NFGNP
HOURS

* HOURS

PR0DH0URS

PR0DH0URS * WORKERS * EMPLOY * LF
WORKERS

EMPLOY

AHW

LF
(1-U)

*The approach employed here owes much to Peter K. Clark, "A
Kalman Filtering Approach to the Estimation of Potential GNP",
unpublished manuscript, Yale University (November 1983)

FRBNY Quarterly Review/Summer 1984

where;
NFGNP = nonfarm private sector output,
HOURS= total hours of all employees in the nonfarm
private sector,
PRODHOURS= t0ta| hours of production workers in the
nonfarm private sector,
WORKERS = production workers in the nonfarm private
sector.
EMPLOY = total employment
LF = civilian labor force.
The first ratio compares real GNP to the value of all goods
and services produced in the nonfarm business sector. The
second ratio equals the conventional measure of productivity
while the third ratio provides a link between productivity and
the conventional measure of average hours worked. The fifth
ratio links different employment variables from the household
and payroll series, while the last two ratios equal, respec
tively, one minus the civilian unemployment rate and the
civilian labor force.
This equation implies that the underlying rate of trend
growth in real GNP can be decomposed into the underlying
rates of trend growth in the conventional measures of P,
AHW, and LF, along with growth in the various “ linking”
variables. Cyclically adjusted trend growth in P AHW, and
LF are reported in Table 1 along with the sum of the
underlying rates of trend growth in the “linking” variables.

An alternative approach to measuring potential output
The estimates of potential growth presented above were
derived implicitly from statistical analysis of the relationship
between unemployment rate changes and real GNP growth.
Another approach is to estimate the growth in potential by
measuring trend growth in productivity, average weekly
hours, and the labor force. This method both confirms the
earlier statistical analysis and provides insight into the fun
damental factors that have changed potential output growth.
Underlying the alternative approach is the following
identity, relating real GNP growth to the sources of economic
growth:

GNP =

GNP
total hours
worked

total hours
worked
employment

employment
labor force

labor force.

The first ratio measures labor productivity, the second
average weekly hours, and the third is equal to one minus
the unemployment rate.
This equation implies that GNP growth in any quarter is
identically equal to the sum of growth in labor productivity,
average weekly hours, the proportion of workers employed,
and the labor force. Suppose the unemployment rate were
set equal to a pre-specified value, such as the natural rate.
Then, the economy’s underlying rate of growth— the rate of
growth in potential— would equal the sum of the underlying
rates of growth in labor productivity, average hours worked,
and the labor force. Table 1 presents these growth rates
for different time periods.
Calculating trend growth in these variables requires some
care. The equation presented above is an identity, and, as
such, the product of productivity, average hours worked, etc.,
has to equal real GNR This necessitates choosing the input
variables carefully since the conventional measures of these
variables are calculated using somewhat different bases.
Accordingly, compositional changes in employment and
output have to be accounted for, as noted in Box 2.
From 1960 to 1973, potential output was expanding at a
3.9 percent annual rate. Most of this growth came from
rapid advances in labor productivity. Trend growth in the
civilian labor force of 2.0 percent was also an important
factor.4

4The growth accounting framework used here provides a convenient way
of summarizing how the sources of economic growth have changed over
time. A mistaken impression may arise, however, that an acceleration or
deceleration in one source of economic growth will unequivocably lead
to a change in potential growth. This is not true since the behavior of
each source of growth can affect the evolution of the others. A rapid
influx of inexperienced workers, for example, may boost labor force
growth; however, it will also tend to depress productivity. The trend
behavior of each source of economic growth, then, should not be viewed
as being independent of the others.

Taken together, the expansion in productivity and the labor
force suggest that potential output was growing at a 4.4
percent annual rate. However, average hours worked by
production workers in the nonfarm private sector was falling
a cyclically-adjusted 0.5 percent. This lowered the rate of
growth in potential output to 3.9 percent.
Beginning in 1974, growth in potential output fell to 3.1
percent. Two disparate factors led to this change: a rise in
labor force growth and a slowdown in productivity growth.
First, from 1974 to 1983, cyclically-adjusted trend growth
in the civilian labor force rose to 2.5 percent from 2.0 per
cent. The accelerated growth stemmed from a sharp rise
in labor force participation. From 1974 to 1983, labor force
participation— the ratio of the civilian labor force to the
working age population— expanded at an annual rate of 0.7
percent (adjusted for cyclical variation). This is more than
three times the growth rate from 1960 to 1973 (Table 2).
The pickup in participation rates was largely the result of
more women entering the labor force.
Second, faster growth in the labor force, which by itself
would have increased growth in potential, was offset by a
decline in the rate of expansion in labor productivity. Several
factors contributed to the productivity slowdown. Sharp
increases in energy prices, a decline in capital investment
relative to employment growth, and a change in the com
position of the work force that accompanied the surge in
the labor force are some of the more frequently cited fac
tors. A complete explanation for the slowdown, however, has
eluded researchers.
Taken together, the productivity slowdown that began in
1974 more than offset the rise in labor force growth over
the same period. The result has been a noticeable decline
in the economy’s capacity to produce goods and services.
Comparison with other studies
The analysis presented above suggests that potential output
has been growing about 3.1 percent a year since the mid1970s, down sharply from 3.9 percent. Statistical analysis
also implies that the link between GNP growth and the
unemployment rate became weaker after 1973. Both the
large size of the estimated drop in potential growth— 0.8
percent per year— and the more uncertain link of GNP
growth to unemployment after 1974 are results which are
new in this paper.
Table 3 shows the growth rates for three potential output
series constructed by the Council of Economic Advisors, by
John Tatom, and by Peter Clark. Over the period 1960 to
1973, only one series had potential expanding 3.9 percent
a year while the other two grew a bit slower. Also, from
1974 to 1983, all three series grew faster than 3.1 percent.
Since the three studies used different methods and time
periods to calculate potential, it is not surprising that they
produced somewhat different point estimates.
While the point estimates may differ, the work presented

FRBNY Quarterly Review/Summer 1984 19

Table 1

Decomposition of Growth in Potential Output
Cyclically adjusted trend growth, in percent

Period
1960-73 .
1974-83 . .

Produc
tivity*
2.4
0.9

Average
weekly
hoursf
- 0 .5
- 0 .5

Civilian
labor
force

Rate of
Compo growth in
sitional
potential
output
changes^

2.0
2.5

0.0
0.2

3.9
3.1

'O utput per hour in the nonfarm private sector.
fHours worked per week by production workers in the private nonfarm
sector
^Explained in Box 2.
The trend growth rates were estimated by regressing the natural log
of each variable on a constant and time trend. To account for cyclical
variation, the current and one lagged value of the unemployment
rate were added into each regression Annualized rates of growth
are reported in the Table.
Trend growth in average weekly hours and some of the variables
that go into the “compositional change” variable are based on data
beginning in 1964
The productivity, average weekly hours, and civilian labor force trend
growth rates are based on Bureau of Labor Statistics data

in this paper, unlike the other studies, suggests that a sharp
decline in the economy’s capacity to produce goods and
services occurred in the mid-1970s.5 A reasonable lower
bound on the^decline is 0.5 percentage point, while a 0.8
percentage point fall is an upper limit. The actual decline,
which we can never know with certainty, is probably closer
to the upper limit than the lower one.
A reduction of this size implies that a significant loss of
output can accumulate in a short period of time. For
example, suppose the economy were to grow over the next
five years at its earlier 3.9 percent potential growth rate,
rather than at our current estimate of 3.1 percent per year.
Real GNP in 1988 would be $71 billion more— almost 5
percent of real GNP— a very significant difference over a
short period of time.
Another finding of this study that was not stressed in
earlier work is the more uncertain link between output and
unemployment since 1974. The 1979 Annual Report of the
Council of Economic Advisors alluded to an apparent
decline in the reliability of the relationship between output

5A revised, yet unpublished, potential output series developed by John
Tatom suggests that potential output growth fell about 0.7 percentage
point in the mid-1970s. The “ middle-expansion” trend real GNP series
presented in a table in Frank de Leeuw and Thomas M. Holloway,
"Cyclical Adjustment of the Federal Budget and Federal Debt" Survey of
Current Business, Volume 63, Number 12 (December 1983), page 29.
also supports the view that a major change in productive capacity
occurred around 1974

FRBNY Quarterly Review/Summer 1984

and employment that began in 1973.6 The forecasting
errors, however, were attributed to an incorrect estimate of
growth in potential GNP The work presented here suggests
that even after allowing for a shift in the rate of potential
growth, the relationship between real GNP and unemploy
ment became more uncertain.

The outlook for growth in potential
An analysis of likely trends in productivity, average hours
worked, and the labor force can be used to project tenta
tively the rate at which potential output may expand over
the next 10 years. Such calculations, although highly
speculative, help to illuminate the likely sources of eco
nomic growth.
Over the next decade, both the civilian labor force and
labor productivity will probably behave very differently
compared with the 1970s. However, in contrast to the earlier
period, the changes are likely to offset each other, leaving
growth in potential output at about 3 percent.
The Bureau of Labor Statistics projects that the civilian
labor force will only grow by about 1.2 percent on average
from 1985 to 1995, compared with 2.5 percent growth for
1974 to 1983. A decline in the growth rate of both the
working age population and labor force participation are
responsible for the slowdown.7
If trend behavior in productivity and average hours worked
were not to change over the next decade, slower labor force
growth would push the rate of growth in potential down to
approximately 2.0 percent. Trend growth in productivity,
however, will probably not remain at the depressed 197483 rate of 0.9 percent for a number of reasons.
First, the entry of the baby-boom generation into the labor
force and the rise in labor force participation of women
increased the number of relatively inexperienced and
unskilled workers seeking employment in the 1970s. This
change in the composition of the labor force contributed
significantly to the productivity slowdown. As these workers
gain experience and develop new skills, productivity is likely
to advance at a faster rate over the next decade than in
the 1970s.
Second, the sharp rebound in business fixed investment
in this recovery, if continued, is likely to increase productivity
growth. Furthermore, expenditures on “ high-tech” capital
goods0 have been growing rapidly since the mid-1970s,
6See pages 73-4 of the Council's 1979 Report.
H'hese projections are based upon data discussed in Howard N.
Fullerton, Jr. and John Tschetter, "The 1995 Labor Force: A Second
Look" Monthly Labor Review (November 1983), pages 3-10.
8ln 1976. for example, expenditures on "high-tech" capital goods—
scientific and engineering instruments, photographic and communication
equipment, and office and store machinery— were equal to 26.5 percent
of expenditures on producers' durable equipment. By 1983, the share
had risen 80 percent to 47.7 percent.

leading to an ever larger share of total equipment expen
ditures going to high-tech goods. This change in the com
position of expenditures may also help to boost productivity
growth.
Finally, energy price growth— regarded by many analysts
as a key factor in the productivity slowdown— is expected
to be moderate in the 1980s. Indeed, over the past two and
a half years energy prices have generally been either
declining or showing no change. Thus they are not likely
to act as a further drag on productivity growth, barring
another round of energy price shocks.
These factors, taken together, suggest that over the next
ten years productivity is likely to expand faster than the
0.9 percent trend growth which occurred after the first oil
shock. Forecasts of long-term productivity growth of about
2 percent, for example, have been made by a number of
economists.9
Such a substantial pickup in productivity growth would
largely offset the decline in labor force growth projected by
the Bureau of Labor Statistics. If these forecasts are correct,
then, the rate of growth in potential output over the next
decade would essentially remain at approximately 3 percent.
The labor force and productivity projections may, of course,
prove to be incorrect. However, until there is evidence that
these forecasts are wide of the mark, projections of three
percent growth in potential seem reasonable. Therefore,
both this analysis and the statistical analysis presented
earlier suggest that once the unemployment rate is at the
natural rate, real growth of approximately 3 percent will help
avoid a long-term rise in inflation.

The near-term outlook for unemployment
The alternative approach confirms the potential growth
estimate obtained from the statistically-based method. This
suggests that the statistically-based method may indeed be
helpful in analyzing short-term unemployment rate move
ments. However, in so doing, one should recall the second
implication of the statistical analysis: forecasts of unem
ployment rate movements based on GNP growth are not
as reliable today as they once were. Therefore, the impact
of GNP growth on the unemployment rate, and in turn the
inflation rate, is much less certain.
As a benchmark for our projections, we use the Blue Chip
consensus forecast of June 1984, which calls for fourth
quarter to fourth quarter growth of approximately 4.8 percent
in 1984 and 2.8 percent in 1985. If these forecasts prove
to be correct, further reductions in the unemployment rate
are likely in 1984, albeit at a slower pace than in 1983,
since real GNP will be growing faster than potential. In
1985, however, the unemploym ent rate is not likely to

•See Chase Econometrics, U.S. Macroeconomic Long-Term Forecasts
(October 1983), page A.4 and Data Resources, Inc., U.S. Long-Term
Review (Summer 1983) page 1.9.

decline very much, since the economy will be expanding
at approximately the same rate as potential output.
Will the decline in the unemployment rate that may occur
in 1984 bring the unemployment rate down to the natural
rate? The rates of real output growth needed over various
time intervals to reduce the unemployment rate by one or
more percentage points are shown in Table 4. Real growth
at an annual rate of approximately 7 percent over two years,
for example, is associated with a three percentage point
decline in the unemployment rate. As a rule of thumb, for
every percentage point by which real GNP growth exceeds
3 percent, the unemployment rate declines about 0.4 per
centage point over a year.10
The numbers in Table 4, which are based on the historical
relationship between real output and the unemployment rate,
imply that the unemployment rate will probably not fall below
the natural rate this year. The June unemployment rate, at
7.1 percent, was about 0.6 percentage point above the
midpoint of natural rate estimates. Historical relations sug
gest that a reduction in the unemployment rate of this size
10ln their 1984 Report, the Council of Economic Advisors projected that real
GNP would expand on average 4.2 percent from 1984 to 1989. This rate of
expansion exceeds the estimate of potential growth presented in this paper
by about one percentage point. The Council has the unemployment rate
falling on average 0.4 percentage point a year to 5.7 percent in 1989, a
drop consistent with our estimate of potential output growth.

E s t i ma t e d L on g- r u n Re l a t i on s h i p B e tw e e n
C h a n g e s in the U n e m p l o y m e n t Ra t e and
Real GNP Gr owt h
F o u rth -q u a rte r to fo u rth -q u a rte r
P e rce n ta g e p o in ts
3. 1%

3 9%

•
1975

! ^

1960-1973
P e rio d
/
1974-1983
Period

•
1983
I

I
I
3
4
Real grow th

I
5

I
6

FRBNY Quarterly Review/Summer 1984

I
7

would require real GNP growth of approximately 4.6 percent
for one year. Growth of this magnitude, while possible, is
stronger than most forecasts. The economy, then, may well
be operating somewhat above the natural rate at the year-

Table 2

Decomposition of Growth in the
Civilian Labor Force

Conclusions and policy implications

In percent
Trend rate of growth
1974-83
1960-73

Demographic factors
Civilian labor fo rc e ...........................
Working age population*.................
Labor force participationt...............

2.0
1.7
0.2

2.5
1.7
0.7

*AII noninstitutionalized civilians 16 years old and over.
tT he ratio of the civilian labor force to the working age population.
The data were obtained from the Bureau of Labor Statistics. See
Table 1 for an explanation of how the growth rates were calculated.
Since the working age population depends upon past fertility rates
and life e x p e c ta n c y , ra th e r than the busin ess c y c le , the
unemployment rate was not included in the working age population
regressions.

Table 3

A Comparison of Estimates of Growth
in Potential Output
In percent

Period
1960-73........
1974-83.......
1984-89

Council of
Economic
Advisors
3.7+
3.34:
4.2(3.1)§

Tatom*
3.9
3.4

C larkf
3.6
3.4

This
study
3.9
3.1
3.1

*See John Tatom, op. cit. The grow th rates were estim ated by
regressing the natural log of Tatom's potential output series on a
constant and time trend. The growth rate for 1974 to 1983 is based
on data ending in 1981-111.
tRevised estimates based on Peter K. Clark, op. cit. The growth rates,
which are based on annual data, equal the average rate of growth
over the stipulated interval. The growth rate for 1974 to 1983 is
based on data ending in 1982.
4:1981 Annual Report of the Council of Economic Advisors. The growth
rates were estimated by regressing the natural log of the Council's
potential output series on a constant and time trend. The growth rate
for 1974 to 1983 is based on data ending in 1980-IV.
§1984 Annual Report of the Council of Economic Advisors. The first
number equals the average rate of growth in the Administration's
real GNP forecast. See Table 6-11, page 197 in the Council’s Report.
The number in parentheses refers to the Council’s estimate of trend
GNP growth from 1970 to 1989.
||Not available.

FRBNY Quarterly Review/Summer 1984

end, although it may approach the natural rate sometime
in 1985.
A final note of caution is in order here. The natural rate
is not known with certainty. Changes in trend productivity
growth or shifts in labor bargaining relationships may alter
the natural rate. Thus, it is important to monitor wage and
price inflation carefully as we approach the range of esti
mated natural rates.

The economy’s potential growth rate— the long-run rate
compatible with stable inflation— appears to be about three
percent. Real GNP growth above three percent would ulti
mately drive the unemployment rate below its natural rate,
eventually reviving inflationary pressures. This rate of growth
in potential is lower than the 3.9 percent rate that char
acterized the 1960s and early 1970s.
Particularly significant is the finding that the link between
the unemployment rate and real GNP is more uncertain
today. Given any rate of growth in real GNP, the range of
likely movements in the unemployment rate is larger now
than before 1974.
What does this uncertainty mean for our understanding
of inflation and real growth? The relationship between
inflation and unemployment has remained fairly tight over
the past twenty years. But the weakened link between
unemployment and real output, by extension, loosens the
link between inflation and output. We therefore face more
uncertainty today regarding the inflationary consequences
of economic growth than in the 1960s and early 1970s.
Suppose, for example, that the economy is expanding at
the same rate as its long-run potential and that the unem
ployment rate is initially at the natural rate. Shocks to the
unemployment rate, unrelated to GNP growth, can cause
temporary, yet significant, upticks or declines in inflation. This
has been particularly true since 1974.
Notwithstanding these difficulties, the rate of growth in
potential GNP is a useful measure of the longer-term ability
of the economy to produce goods and services. Sustained
growth in excess of 3 percent is likely to induce an over
heating of the economy, which would revive inflationary
pressures. Thus, despite the greater uncertainty in the
unemployment/real output relationship in the post-1973
economy, it is important that policy aim at bringing economic
growth toward its long run potential of about 3 percent.
However, arguing that economic policy should be con
sistent with growth in potential does not imply that we
should move all the way to nominal GNP targeting, as some
analysts have suggested. In fact, hitting nominal GNP tar
gets presents many of the same problems as hitting mon
etary targets. Targeting nominal income requires setting
goals for both real output growth and price inflation, which
add up to nominal GNP growth. Our estimated three percent
growth in potential provides a long-term anchor on which

to focus the real growth component. But this estimate would
have to be carefully monitored. As we have seen, a shift
in the rate of capacity growth— similar in many ways to a
shift in money demand— occurred in 1974, but it took a long
while before the shift was detected. Such undetected shifts

Table 4

Relationship Between Unemployment Rate
Movements and GNP Growth
Real Grow th (in percent)
needed to reduce unem ploym ent rate by;
Over a period of
1 ye a r......................
2 yea rs....................
3 yea rs....................

1 point

2 points

3 points

5.5
4.3
3.9

8.0
5.5
4.7

10.5
6.8
5.5

These numbers were derived using equation (A.2) reported in Box
1. They were obtained by solving the equation for the constant rate
of growth in real output that would reduce the unemployment rate
by one, two, or three percentage points over the stipulated time
interval. The growth rates are expressed at an annual rate.

would greatly reduce the benefits from nominal GNP tar
geting.
Finally, our finding of a weakened link between output and
unemployment (and therefore inflation) implies that the
economy is now more prone to large, albeit possibly tem
porary, departures from a nominal income target over a
policy-making horizon of, say, a year. Consequently, even
if real GNP were to expand along its potential path, a wide
range of inflation rates and, thus, deviations from a nominal
income target, are possible over a period of several quar
ters, again posing problems analogous to those associated
with interpreting the monetary aggregates.11 More generally,
a given rate of nominal income growth may be difficult to
interpret, since its inflation and real growth components may
differ greatly from those expected in setting the nominal
income target. Such issues raise questions about the
practicality of targeting nominal GNR

"Suppose, for example, that the economy is proceeding along its potential
path and that the nominal income target is 8 percent (composed of 3
percent real growth and 5 percent inflation). Unexpected movements in
the unemployment rate (as large as plus or minus a half a percentage
point in any quarter) could yield inflation rates of 4 to 6 percent over the
course of a year. If policymakers attempt to offset what may be
essentially random movements in inflation, they run some risk of inducing
unnecessary fluctuations in the economy.

Douglas M. Woodham

FRBNY Quarterly Review/Summer 1984

Financing the U.S. Current
Account Deficit
Over the past two years, the U.S. current account— the
broadest measure of a country’s international trade in goods
and services— has moved into heavy deficit. That deficit is
continuing to grow rapidly.
The sharp rise in the deficit— from roughly $10 billion in
1982 to about $40 billion last year, and to an estimated $80100 billion per year this year and next— has understandably
raised many questions about whether and, if so, how deficits
of these magnitudes can be financed.
This article has three purposes:
• To review the simple analytics of current account
financing that apply to any country;
• To compare the pattern of financing for recent U.S.
deficits with past financing patterns of this country and
other industrial countries; and
• To suggest how the financing pattern might change
under a few plausible scenarios (but not predictions)
about the future.
It’s worth anticipating a few of the main conclusions:
(1) To ask whether a current account deficit can be
financed is basically the wrong question. If a current account
deficit can’t be financed, it can’t be incurred in the first
place. The real question is under what financial market
conditions and with what mix of relative interest rates and
exchange rates will the financing be forthcoming.
(2) The United States does have financing options that
This article is essentially the product of a team effort, and the author has
drawn heavily on the expertise and energies of Chris Cumming and
Dorothy Christelow of the Industrial Economies Division along with Paul
Bennett, Robert McCauley, and Fred Marki of the International Financial
Markets Division.

24 FRBNY Quarterly Review/Summer 1984

virtually no other country has because of the dollar’s unique
international role as the principal currency that foreign official
monetary institutions hold in their reserves. But during the
past two years, when the current account deficit has been
rising rapidly, the United States hasn’t been relying on
financing of the type ordinarily associated with the dollar’s
special role— increases in official reserves. Instead, the
deficit has primarily been financed through the U.S. banking
system, by drawing in essentially private short-term funds
from abroad, and by various unrecorded capital inflows.
(3) There is no necessary point at which the U.S. current
account deficit can no longer be readily financed; in that
sense, the present pattern of financing is, at least in prin
ciple, sustainable.
(4) But there is ample precedent in practice to support
the view that the present financing pattern, with its heavy
reliance on foreign acquisition of short-term dollar assets,
is obviously vulnerable to shifts in how foreign investors
perceive U.S. inflation trends and prospects for movements
in dollar exchange rates. Moreover, an important part of the
recent financing pattern is foreign-trade-related, an incidental
by-product of the rapid surge in U.S. imports. As U.S. import
growth slows, this incidental financing must also tend to
decelerate.
(5) Even so, an abrupt shift in financing patterns is hardly
likely to force the United States to suffer a sudden, sharp
cutback of imports— the usual adjustment other countries
make in the face of obstacles to financing large current
account deficits.
Methods of Current Account Financing
There are many channels through which current account
deficits may be financed. Generally, they are distinguished
according to who provides the financing and what type of
instrument is involved. Six distinctions are natural:

• between the private sector and government;
• between domestic residents or institutions and foreign
residents or institutions;
• between banks and other institutions;
• between short-term instruments and long-term instru
ments;
• between local currency instruments (e.g., dollars for the
United States, yen for Japan) and foreign currency
instruments (e.g. yen, marks, or Swiss francs for the
United States); and
• between changes in existing asset holdings and
changes in levels of debt.
A couple of examples illustrate how these distinctions
work:
1. A U.S. domestic private sector company sells a factory
it owns in France, converts the French francs it gets
into dollars and uses the proceeds in its U.S. domestic
operations. That transaction will (inadvertently) help
finance a U.S. current account deficit.
2. A Latin American government-owned development
bank borrows dollars from private commercial banks
in London for six months. It lends those dollars to the
domestic telephone company to enable it to finance
a shipment of switching equipment. That will help the
Latin American country finance its current account
deficit.
The problem with applying this framework is that it leads
to literally dozens of possible combinations, even without
bringing in the role of international organizations like the
International Monetary Fund (IMF) or the World Bank.
What’s necessary then is to simplify the analysis in a way
which is instructive and which fits well with the data avail
able in published balance-of-payments statistics.
The most useful starting point is to separate private from
official capital flows and identify the main components of
each. Private flows incorporate:
• Net flows through the banking system. These flows
represent changes in bank assets and liabilities with
respect to the rest of the world. To finance a deficit,
either external assets must be reduced or liabilities to
foreigners must be increased.
• Net direct investment. When foreigners bring in funds
to establish businesses in domestic markets, acquire
existing domestic companies or commercial real estate,
or add to their current holdings, the result is inflows
which offset part of a current account deficit. Alterna

tively, domestic companies can reduce their ownership
stake in operations abroad, as in the first example
above.
• Other private capital. This category includes net port
folio investment, that is, the difference between net
purchases of domestic stocks and bonds by foreign
investors and net purchases (or sales) of foreign
securities by domestic investors. It also includes sup
pliers’ credits (usually short-term, but sometimes long
term) to finance foreign trade, other than those trade
credits granted by the banking system.1
It’s illuminating to analyze private capital movements in
the following way: Some of these flows are best thought
of as incidental financing, because they are essentially a
by-product of trade decisions by exporters and importers.
Normally, those decisions depend on the relative strength
of demand in different national markets. So, for example,
when U.S. market demand is strong and exporters abroad
are eager to bolster sales, because of weak demand else
where, sales to the United States can be routinely financed
by the exporter or the exporter’s bank. The financing is
incidental in the sense that without the underlying trade
transaction the financing (and the associated capital inflow)
wouldn’t have happened. In other words, the current account
deficit would have been smaller, but the capital account
surplus would have been smaller, too.
By contrast, most other private capital flows are best
thought of as incentive-driven. They reflect the more or less
continuous management of portfolios by international
investors and of balance sheets by domestic companies.
That process is highly sensitive to such factors as relative
interest rates, exchange rates, stock market trends, property
values, and commodity price developments. Flows of funds
through the banking system, while primarily involving short
term funds, are also incentive-driven. They often respond
to even very slight differences in interest rates between, say,
the U.S. domestic money market and the Eurodollar market.
Eventually, even incidental financing flows become incentivedriven as exporters abroad shift their focus from generating
new sales to managing the revenues that they earn from
those sales.
The second broad category, official flows of funds, is
made up of two important elements. First is the change in
official reserves. Drawing down official reserves is an
important source of current account financing in many
countries for short periods of time. The other, main element
is the change in official borrowing abroad. The borrowing—
by the central government, the central bank, or certain
’ Borrowing abroad by domestic nonfinancial companies to raise funds to
use at home is tricky to categorize. Sometimes it appears in direct
investment, and sometimes in the "other” category, depending on the
specifics of the transaction.

FRBNY Quarterly Review/Summer 1984 25

another, virtually all countries, including the United States,
have undertaken foreign exchange operations that directly
or indirectly provided current account financing.
To conclude this discussion of the analytics of current
account financing, it’s important to be aware of the major
impediments to applying these basic concepts to the real
world. In principle, all capital account items must sum up
to a surplus that exactly equals the current account deficit.
In reality, data collection is incomplete, partly because of
actions taken to avoid official reporting requirements. The
difference between the reported current account balance
and the reported capital account balance is labeled errors
and omissions.2 For the United States, it has been a large,

public sector enterprises— can be from private commercial
banks, from other governments, or from international
organizations like the IMF or World Bank.
The concepts of incidental and incentive-driven financing
are often applicable to official, as well as private, financing
flows. To the extent that public sector enterprises (a public
power company is a good example) are able to finance
imports by suppliers’ credits from the foreign exporter, inci
dental financing of the current account occurs. As for
incentive-driven flows, public sector enterprises can choose
to seek funding abroad because it appears to be cheaper
than domestic borrowing. When the decision to borrow
abroad is arrived at by the same sort of financial analysis
as a private firm might go through, the resulting capital
inflow can be described as incentive-driven.
But most official financing is policy-related. It is under
taken to avoid the exchange rate and interest rate conse
quences that would arise if the current account deficit
financing had to be left to the private sector. Policy-related
financing mechanisms take a variety of forms. They range
from discretionary exchange market intervention (and,
therefore, discretionary use of reserves), to government
directives telling public sector enterprises to borrow abroad
regardless of the economic costs or risks, all the way to
structural adjustment programs with the IMF providing official
balance-of-payments credits to the country. At one time or

2Some analysts feel that a sizable portion of U.S. errors and omissions
reflects unreported current earnings on international trade in services
and unreported interest and dividends. Federal Reserve Bank of New
York economists feel that they reflect mainly unrecorded capital flows for
two reasons:
First, comparing data for the countries paying for international services
with relevant data for the United States and other industrial countries
suggests that the under-reporting problem is considerably greater for the
other industrial countries than for the United States.
Second, U.S. errors and omissions tend to follow a pattern: They show
large and growing inflows when relatively well-reported banking system
transactions show a net outflow and when relatively less well-reported
direct and securities investments are increasing. By contrast, when the
well-reported banking flows turn around, while less well-reported direct
and securities investments diminish, errors and omissions usually
diminish too.
The conclusion: errors and omissions behave like capital flows.

Table 1

Decomposition of the U.S. Balance of Payments
In billions of dollars: seasonally adjusted annual rates (+ is an inflow; - is an outflow)
1974

1975

1977

1978

1979

1980

1981

1982

1983

1984-1

6.3

1.9

18.1

4.2

-14 .5

-1 5 .4

-1 .0

1.9

-9 .2

-4 1 .6

-1 9 .4

Net private capital ..................... . -1 1 .4

-2 0 8

— 15.1

-1 8 .2

-1 4 .3

18.4

- 5 .2

-2 .1

16.9

42.4

24.9

-4 5 .1

23.7

9.4

6.4

- 1 .3

Balance on current account
Net bank .................................. .

- 3 .5

-1 2 .9

-1 0 .4

-4 .7

-1 7 .5

6.4

-3 6.1

-4 2 .0

Net direct investm ent............. .

- 4 .3

-1 1 .6

- 7 .6

-8 .2

- 8 .2

-1 3 .3

- 2 .3

13.5

Other private capital net ...... .

- 2 .2

-2 .2

-7 .7

- 3 .3

- 1 .2

-0 .1

8.2

4.1

9.6

3.0

3.2

Errors and omissions ............. .

- 1 .5

5.9

10.5

-2 .0

12.5

25.4

24.9

22.2

32.9

9.3

13.5

9.4
*
’

2.7
*
*

10.9
*
*

32.7
28.5
4.2

29.8
28.9
0.9

-1 8 .5
-2 1 .0
2.5

2.2
-6 .1
8.3

- 5 .3
-1 2 .5
7.2

- 7 .8
- 5 .3
- 2 .5

- 0 .9
11.1
-1 2 .0

- 5 .5
- 1 .3
- 4 .2

U.S. assets .............................. .
Industrial countries .............
Other ....................................

-1 .1
*
*

-4 .3
*
*

- 6 .8
*
*

-4 .1
- 0 .2
- 3 .9

- 3 .9
- 5 .5
1.6

- 4 .9
0.2
-5 .1

-1 3 .3
- 7 .0
- 6 .3

-1 0 .3
- 1 .0
- 9 .3

-1 1 .1
1.2
-1 2 .3

- 6 .2
1.0
- 7 .2

- 2 .6
- 0 .4
- 2 .2

U.S. liabilities ..........................
Industrial countries .............
Opec ....................................
Other ....................................

10.5
*
*
*

7.0
*
*
*

17.7
*
*
*

36.8
28.8
6.4
1.5

33.7
34.3
-1 .1
0.1

-1 3 .7
-2 1.1
5.5
1.9

15.5
0.9
12.8
1.8

5.0
-1 1 .5
13.1
3.4

3.3
- 6 .5
7.3
2.5

5.3
10.1
- 8 .6
3.8

- 2 .9
- 0 .9
- 2 .5
0.5

SDR allocations ..........................

1.1

1.2

1.1

Net official ...................................
Industrial countries .................
Other ........................................

’ Not available.
Source: U.S. Department of Commerce.

1976

FRBNY Quarterly Review/Summer 1984

19.6

and highly variable, component of the balance-of-payments
statistics. In this article, errors and omissions are treated
as unrecorded private and official capital flows because they
appear to fluctuate over time more like capital flows than
like current account transactions. But admittedly, by their
very nature errors and omissions cannot be specified with
certainty.
How have U.S. current account deficits been financed?
Past financing patterns
In only one other time period besides the present did the
United States have a substantial current account deficit:
1977 and 1978, when the deficits added up to about $30
billion. The statistics show (Table 1) that those deficits were
financed very differently from the current ones. In 1977 and
1978, the balancing item was a very substantial inflow
reflecting net official transactions: purchases of dollars
through foreign exchange market intervention by the central
banks of the main industrial countries. The official inflow also
reflected actions the U.S. authorities took to support the
dollar.
In contrast, net private capital movements were entirely
adverse in every single category during 1977-78: Banking
transactions yielded an outflow of over $20 billion. Net direct
investment produced an outflow of over $16 billion. Secu
rities transactions of various types yielded an outflow of
nearly $5 billion. The only inflows came from unrecorded
net positive errors and omissions. That is, not only did the
United States not finance its current account through private
capital inflows, but it even had to finance private capital
outflows. For 1982 to the present, the pattern is completely
different.
Recent current account financing patterns
The United States began to run a current account deficit
in 1982. Unfortunately, for that year, the sources of offsetting
financing cannot be identified. The $9.2 billion current
account deficit, together with large net official capital out
flows and an enormous $45 billion outflow through the
banking system, was essentially offset by huge unrecorded
capital flows. To be sure, sizable private capital inflows were
identifiable. Foreigners bought, on balance, substantial
quantities of stocks and bonds; foreign companies made
substantial direct investments. But far greater amounts of
flows went unrecorded. In other words, errors and omis
sions, amounting to $33 billion, financed the current account
deficit and a lot besides.
Last year, the financing pattern of the enlarged $41.6
billion current account deficit was very different. Flows into
the U.S. stock and bond market continued. Moderate
amounts of net inward direct investment also continued. But
by far the most important element was a new one: a mas
sive switch in the direction of banking transactions between
the Eurodollar market and the domestic money markets.

That swing— from a $45 billion outflow through the banking
system in 1982 to $24 billion inflow in 1983— accounted for
more than half the total financing of the 1983 deficit. In other
words, the banking sector provided far more of an increase
in financing than the increase in the current account deficit
alone required. This turnaround is all the more impressive
considering that there had been net outflows through the
banking system for every year but one over the past
decade, resulting in a cumulative outflow of nearly $170
billion since 1974.
First quarter 1984 statistics are also available. The current
account deficit of $19.4 billion was again financed impor
tantly by net bank inflows amounting to $9.4 billion.
Reported securities transactions yielded a net inflow of $3.3
billion. By contrast, official capital movements produced a
net outflow of $5.5 billion; net direct investment swung to
a $1.3 billion outflow. The balancing item, errors and omis
sions, turned out to be an inflow of $13.5 billion.3
What components of bank assets and liabilities have
changed to produce this large-scale swing?
Banks make international financial transactions for their
own portfolios and, as fiduciaries, for their customers. For
instance, U.S. money market mutual funds invest in the
Eurodollar market and hold the physical instruments with a
U.S. bank. Changes in these holdings are reported by the
custodian bank as part of the balance-of-payments data
collected by the U.S. Treasury. The largest part of the
movement between 1982 and 1983 came through changes
to the banks’ own portfolios. New claims on foreigners
(mainly new loans to foreign enterprises, governments, and
banks) dropped precipitously at a time when the buildup of
foreign deposits in U.S. banks remained fairly strong.
Some background on these asset-liability developments
might be helpful. Banks located in the United States (and
that includes U.S. agencies, branches, and subsidiaries of
foreign banks, too) build up their external assets in three
ways. First, they lend money to their own branches abroad,
who in turn lend the money to foreign banks, companies,
and governments. Second, U.S. banks also build up claims
on unaffiliated banks abroad when, for example, a New York
bank lends funds to a German bank subsidiary in Luxem
bourg— a typical transaction in the Eurodollar market. Finally,
banks lend money from their domestic offices, including their
recently established International Banking Facilities (IBFs),
to foreign customers. All of these transactions represent
capital outflows. By contrast, banks build up their external
liabilities by taking deposits from banks and other foreigners.
That buildup represents a capital inflow.
In 1982, banks located in the United States increased
3That's for the time being. Some of the as yet unrecorded inflows may
reflect borrowing abroad by U.S. companies from non-U.S. banks and it
is conceivable that data on these transactions will be reported, at least
in part, in due course.

FRBNY Quarterly Review/Summer 1984 27

Table 2

Net Private Bank Flows
In billions of dollars (+ is an inflow; -

is an outflow)

Flows

1974

1977

1978

1979

Net bank ........................................ ...
Net dollar .................................... ...

-1 0 .4

- 4 .7

-1 7 .5

-1 0 .4

- 4 .0

-1 8.1

Net own dollar ....................... ...

-1 2 .2

-1 0 .4

-4 .1

-1 3.1
-1 0 .2
-2 .9

-2 0 .1
— 16.7
- 3 .4

12.7
10.6
2.1

0.9
- 0 .7
1.6

1981

1982

6.4

-3 6 .1

-4 2 .0

-4 5 .1

23.7

9.4

5.8

-3 5 .9

-3 9 .9

-4 3 .7

23.6

14.9

-1 6 .8

14.0

-3 0 .6

-3 4 .9

-4 0 .4

16.9

14.9

-1 0 .2
- 8 .8
- 1 .4

-3 3 .4
-2 3 .4
-1 0 .0

-1 8 .4
- 6 .3
-1 2.1

-3 8 .6
-2 6 .9
-1 1 .8

-7 4 .3
-5 1 .6
-2 2 .7

-1 04.1
-7 7 .3
-2 6 .8

-3 2 .0
— 18.1
-1 3 .9

4.1
2.1
2.0

9.7
7.1
2.6

6.1
4:5
1.5

16.6
15.3
1.3

32.4
30.7
1.7

8.1
7.2
0.9

39.4
33.8
5.5

63.7
45.1
18.6

48.9
35.5
13.3

10.8
8.2
2.6

- 0 .2

0.1

- 1 .3

- 8 .2

- 5 .3

- 5 .0

- 3 .3

6.7

- 0 .4

-0 .4

- 0 .2

-0 .4

- 0 .2

0.5

- 0 .3

- 1 .0

-1 .1

- 0 .5

- 0 .2

1.5

-0 .1

0.2

- 0 .3

0.8

0.1

-1 .1

- 0 .3

0.6

-5 .4

1976

- 3 .5

-1 2 .9

- 4 .6

-1 2 .4

- 4 .7

Own dollar claims .............. ... -1 7 .4
1) On banks ................... ... -1 1 .9
2) On other foreigners ... ... - 5 .5
Own dollar lia b ilitie s........... ...
1) To banks ..................... ...
2) To other foreigners ....
Net custody dollar claim ......
Net foreign currency ................. ...
Residual ...........................................

1983

1984-1

1980

1975

Source: U.S. Treasury and U.S. Department of Commerce. Figures prior to April 1978 are FRBNY staff estimates based on data with different categories
than shown here.

their claims on foreigners by more than $100 billion. Around
half of this was an increase in claims on unaffiliated banks,
principally those operating in the Eurodollar market. On the
other side of the balance sheet, banks’ external liabilities
to foreigners increased by a substantial $64 billion. Never
theless, the net changes in bank assets and liabilities pro
duced a capital outflow of some $40 billion.
In 1983, the pattern was quite different. The increase in
bank liabilities to foreign customers slowed a little, to just
under $50 billion. But new claims on foreigners shrank
across the board, especially new claims on unaffiliated
banks, which fell to virtually zero. Overall, these movements
produced a capital inflow of $17 billion last year.
A large shift in banks’ custody accounts reinforced the shift
in their own portfolios. Transactions for customers produced
a net outflow of around $3 billion in 1982 but a net inflow of
nearly $7 billion in 1983. Most of that swing represented a
reduction of custody claims (for example, a reduction in Euro
dollar CDs held in custody by banks located in the United
States on behalf of money market funds).
What caused the turnaround in banking flows?
Mainly, the pace of economic recovery in the United
States— and the associated demand for public and private
sector credit— made U.S. credit markets taut relative to the
Eurodollar market. So, relatively ample liquidity in the
Eurodollar market offered the U.S. banking system a com
paratively inexpensive source of short-term funding to sup
port domestic credit expansion. The key incentive for this
was that interest rates within the United States, notably on
instruments such as negotiable CDs, have tended to move

FRBNY Quarterly Review/Summer 1984

upward compared to rates in the Eurodollar market. The
direction of banking system flows corresponds fairly closely
to this interest rate relationship.
Therefore, the question of why the banking flows shifted
so much becomes one of why the Eurodollar m arket
became so liquid. That answer is more complex.
To begin with, part of the ample liquidity stems from world
exporters (to a great extent, Asian exporters) depositing
large amounts of dollars earned from the spiraling U.S. trade
deficit. This activity constitutes incidental financing of the
current account deficit, as discussed earlier.
But incidental financing is a short-term phenomenon. The
true question is why exporters have decided to stay in dol
lars rather than convert export earnings into local currency
or into other major currencies. The answer is that they
perceived a strong incentive to remain in dollar investments,
albeit of short-term maturities. Relative interest rates on
dollar-denominated assets remained attractive, both in
nominal and in real terms throughout 1983 and into this
year. That relative yield advantage has been a clear moti
vation for remaining in short-term dollar assets.
Yet, clearly, there was a reluctance to invest earnings in
longer-term U.S. securities or equities. Views on the course
of dollar exchange rates conflicted. Predictions were frequently
made that dollar exchange rates would decline as a result of
burgeoning U.S. current account deficits. But as time went on,
and these predictions failed to be realized, expectations about
dollar exchange rates came to be increasingly influenced by
factors other than current account considerations. In short, the
placement of dollar earnings in short-term deposits reflected
a positive attitude toward short-term yields and dollar exchange

rates prospects but a more “wait-and-see” attitude toward
longer-term developments.
Another major reason why the Eurodollar market re
mained so liquid was that the pace of economic expansion
in Europe lagged behind that of the United States. Ac
cordingly, credit demands were weaker there than here. In
fact, as expansion got underway in countries such as Ger
many, some companies tended to use improved cash flows
to repay short-term debt rather than to borrow. This not only
relieved pressure on their own domestic credit markets but
on the Eurocurrency markets as well.
Current account deficit financing in other industrial
countries
The contrast between the two U.S. experiences shows how
different current account financing can be. It depends inti
mately on the attitudes and expectations of private investors
and private companies. To put the U.S. experience into
perspective, it is also useful to compare it with that of other
major industrial countries. Here, perhaps the most interest
ing distinction— apart from private versus official flows
— is between how much of a country’s current account
financing is in its own currency and how much is in other
currencies.
With that distinction in mind, the clearest lesson from
experience is that the United States has been singularly
able to finance its current account deficits in its own cur
rency, drawing in either private or official capital flows. In
fact, in the case of the United States, what foreign currencydenominated movements there have been generally have
been outflows— net direct investment abroad and acquisition
of foreign currency-denominated securities. Foreign currencydenominated inflows have been rare, most notably the
issues of what have become known as Carter bonds during
the dollar support program of 1978-79.
Going through recent episodes in other countries, it’s
apparent that both Germany and Japan, the two countries
whose currencies are widely held in official foreign exchange
reserves, have been able to finance current account deficits
partly in local currency— but not to the extent the United
States has (Table 3). France has been able to finance a
moderate portion of its current account deficits in French
francs, but on a much smaller relative scale than Germany
and Japan. On the far side of the spectrum, countries like
Italy and Denmark, which have gone through prolonged
periods of current account deficit and whose currencies are
not held in international reserves, have mainly financed their
current account deficits in foreign currencies. (That is true
for nearly all nonindustrial countries, too.)
The other feature differing considerably among countries
is the role of each country’s banking system in financing
current account deficits (Table 4).
In the United States, half the time inflows through the
banks have offset current account deficits; for the other half,

outflows through the banks have magnified the financing
requirement. For the other major industrial countries, banks
have usually, but not always, generated net inflows. In
almost half the cases of large deficits, banking inflows have
accounted for an important share of current account
financing. There’s no way of knowing what portion was
incentive-driven or what part was in response to government
measures or other encouragement. But it’s worth noting that
in several cases (the U.K. in 1973, Italy in 1976 and 1980,
and France in 1980) banking inflows mitigated the need for
official financing. By comparison, when banking flows
swelled financing requirements in these other countries, as
in the United States during 1978, official financing often
needed to be substantial.
Outlook for continuing inflows
What’s unique about the current account financing pattern
of the United States is that no other country in memory has
managed to finance deficits on the order of 2 to 3 percent
of GNP on a continuing basis— and in its own currency.
There are certainly many cases of large deficits that have
been financed, even for extended periods. But those were
financed in foreign currencies, so the exchange risk was
borne by the deficit country itself, not by the foreign saver.
In the case of the U.S. financing pattern, however, the
exchange risk is mainly being absorbed by foreign investors.
Therefore, the willingness to keep taking additional foreign
exchange risk is the key for the future current account
financing pattern. And that directly relates to expectations
about the dollar. The size of the impending current account
deficit is by now pretty well known, with only some modest
disagreements among various experts on its precise mag
nitude. The continuation of a deficit on an order of $80-100
billion would not occasion any surprise in the markets.
What would be a source of surprise? A number of
potential shocks could have a serious impact on confidence:
• First, a sudden rise in U.S. inflation to well above cur
rent rates;
• Second, a major adverse reassessment by foreign
investors of the medium to longer-term consequences
of the likely course of U.S. fiscal and monetary policies;
• Third, a sharp improvement in investment opportunities
outside the United States, that is, a relative rise in the
real rate of return on foreign currency assets; and
• Fourth, some major relaxation of political and economic
uncertainties in several regions of the world, since
those tensions have contributed to shifts of capital to
the United States for safety motives.
Any of these factors could easily discourage foreign

FRBNY Quarterly Review/Summer 1984 29

investments in dollar assets. But the dynamics of the sub
sequent outcome are paradoxical. That’s because an abrupt
deterioration of intended capital movements almost certainly
would be associated, ex post, with the same magnitude or
larger— but certainly not smaller—actual capital flows into
the United States.
The reason is that in the very short term the current
account deficit is more or less fixed. It responds to current
and lagged income growth in the U.S. and abroad as well
as to past exchange rates and price trends. So, there is
very little scope for adjustment in the size of the current
account deficit over the course of a few weeks or even a
few months. It takes a number of quarters for even a rel
atively substantial depreciation of a currency to pay off in
a meaningful improvement in a current account deficit. And
what’s worse, to the extent that some trade is denominated
in foreign currencies (which it is, to a limited extent, for U.S.
imports) there would be a small adverse valuation effect.
This would make the current account deficit even larger right
away, were the dollar to go down and raise the cost of
buying foreign currency
Therefore, in the short term, the current account is as
large as or larger than it was before the erosion in foreign
investment intentions. This means that to compensate actual
capital inflows must be as large as or larger than before.
And on the assumption that there is no substantial change
in official flows, for instance through a stepped-up pace of

Table 3

Current Account Deficits 1975-82:
Shares Financed by Domestic Currency Flows
75 percent
or more

25 percent to
75 percent

less than
25 percent

United States

1977
1978
1982

•
*
*

*
*
*

Germany ...............

1979
*

1980
1981

Japan ....................

1975
1980

*
*

1979
*

Country

1975

1976

France ...................

1980
1977

1976
*

1981
1982

Italy .......................

*
*
*
*

1975
*
*
*

1976
1980
1981
1982

Denmark ...............

1975

1976-82

United Kingdom

*Not applicable.
Source: Estimated from International Monetary Fund. Balance of
Payments Statistics Yearbook, Volume 34, Part I (1983).

FRBNY Quarterly Review/Summer 1984

foreign exchange intervention, those inflows would have to
come from the private sector.4
How is the capital inflow sustained even in the face of a
hypothesized sharp decline in foreign investment intentions?
The answer is that exchange rates, and interest rate dif
ferentials, and profit opportunities more generally between
the U.S. and abroad must move in such a way as to make
new investors willing to step in (and uncertain investors
willing to stay in) to a greater extent than existing investors
in dollar assets are moving out. Normally, that can only
happen if the movements in exchange rates and/or interest
rate differentials are substantial. Enough of a fall in the
currency is needed to convince at least some investors that
the sharp movement was overdone and that the next
movement in the dollar could only be upward. Therefore,
they would be willing to acquire dollar assets that other
foreigners are selling and that are being generated by the
ongoing trade deficit.
Alternatively, the exchange rate movement may be rel
atively small but then the shift in interest rate differentials
would have to be relatively large. An intended shift, for
example, from Eurodollar deposits to Euro-Deutsche mark
deposits, reflecting the change in investor perceptions, if
substantial enough in size, could lead to a downward
movement in Euro-Deutsche mark deposit rates and an
upward movement in Eurodollar rates. If the monetary
authorities do not take steps to inhibit the effects of those
movements on domestic money markets and, therefore,
domestic interest rates in Germany and the United States,
the movement in interest rate differentials would be able to
counter the shift in investment intentions and reinstate
favorable incentives for other investors to move back into
dollar assets.
In sum, the exchange rate must move enough to give at
least some international investors reason to believe that the
next movement will be upward; or interest rate differentials
and profit opportunities must move enough to reinstate
incentives for purchasing and holding dollar assets; or some
combination of both must happen.
The problem is how much, empirically, those movements
have to be. A further question is whether the resulting
configuration of interest rates and exchange rates is likely
to become part of a chain of subsequent rate adjustments—
a kind of ratchet effect or cascading of rates. The best
example of that scenario is when the sharp downward
movement in the exchange rate leads to a new and far
more pessimistic view of the inflation potential, touching off
speculation in commodity, real estate, and other asset
markets. The inflationary consequences of that activity
could perpetuate the erosion of confidence and require
further sharp interest rate or exchange rate adjustments
4Any other assumption would be unfair because it would change the
character of the analysis.

Table 4

Financing of Large Current Account Deficits in Major Foreign Industrial Countries
Current Account Deficit

Sources of Finance as Percent of Total Financing

Country

Year

$ billions

As %
of GNP

Banks

Public sector
borrowing

Official
reserve
assets
(net)

France ............................

1974
1976
1980
1981
1982

- 3 .5
-3 .4
- 4 .2
- 4 .8
-1 2 .1

- 1 .3
- 1 .0
- 0 .6
-0 .8 *
-2 .2 *

9.6
-4 0 .0
86.2
116.9
-2 1 .3

17.5
7.2
15.4
34.5
30.0

1.7
84.4
— 157.1
79.1
30.2

71.2
48.4
155.5
-1 3 0 .5
61.1

Germany .......................

1979
1980
1981

- 6 .2
-1 6 .0
-5 .7

- 0 .8
- 2 .0
- 0 .8

192.9
-3 3 .8
-6 7 .7

20.0
111.5
161.8

57.3
64.8
48.6

-1 7 0 .2
-4 2 .5
-4 2 .7

Italy ................................

1973
1974
1976
1980
1981
1982

-2 .5
-8 .1
- 2 .9
-9 .8
- 8 .6
- 5 .8

- 1 .6
- 4 .7
- 1 .5
- 2 .5
- 2 .5
- 1 .7

2.2 f
9 .3 t
109.0t
81.5 f
— 17.Of
- 39.8f

40.0
452
18.7
37.2
56.9
37.8

-1 6 .5
13.5
-6 4 .9
- 9 .5
4.9
80.5

74.3
32.0
37.2
- 9 .2
55.2
21.5

United Kingdom ..........

1973
1974
1975

- 2 .4
-7 .7
- 3 .5

- 1 .3
- 3 .9
- 1 .5

138.6
24.8
24.7

5.5
52.6
13.9

-2 2 .5
- 3 .3
41.8

-2 1 .6
25.9
19.6

Japan .............................

1974
1979
1980

- 4 .7
- 8 .8
-1 0 .8

- 1 .0
- 0 .9
- 1 .0

167.8
-3 .9
119.3

21.4
11.0
60.8

-2 6 .3
151.2
-4 7 .0

-6 2 .9
-5 8 .3
-3 3 .1

Other

'Percent of GDP GNP estimates not yet available.
tShort-term only.
Sources: Estimated from IMF Balance of Payment Statistics and International Financial Statistics.

later on in order to attract the necessary capital inflow.
To conclude, the U.S. current account deficit— and the
likelihood it will continue indefinitely— raises a valid concern
about future private-sector financing. In principal, the pattern
can be sustained, so long as sufficient interest rate,
exchange rate, and profit incentives, along with an essential
underpinning of market confidence, are maintained. But this

is uncharted territory. No other country has financed such
a large deficit in the private capital markets for so long in
its own currency. All old capital inflows have to be retained;
there is no room for any net diversification out of the dollar
by existing holders. And new capital inflows of $80-100
billion a year must be attracted for some time to come. The
challenge of securing such financing is imposing.

Roger M. Kuba^ych

FRBNY Quarterly Review/Summer 1984

Did Financial Markets in 1983
Point to Recession?

In the second half of 1983, the financial sector sent con
flicting signals of the economy’s future course. M-1 growth
slowed sharply, suggesting that the economy would also
slow substantially, if not fall into recession. But interest rates
were only modestly higher than in January 1983, indicating
little change in financial market conditions. Because real
GNP expanded vigorously over the first two quarters of
1984, considerable interest has developed in why M-1
pointed in the wrong direction and, more generally, in how
reliable M-1 is as an indicator of turning points in the busi
ness cycle.
In this paper, we review how in the past money and
interest rates have both provided fairly clear signs of
recession, when their behavior is evaluated properly. We
show, according to a criterion developed by William Poole,
that the deceleration in M-1 last year— before and after the
data revisions— was not as large as those associated with
past recessions.1 By year-end, however, it had become
sufficiently large to suggest the high likelihood of an immi
nent economic downturn. We also show that, in contrast,
the rise in interest rates in 1983 was far less steep than
usual before past recessions.
Why did the money supply give a false signal? Before
each of the past four downturns, the deceleration in M-1
was connected to rising interest rates, according to a wellestablished money demand equation. For 1983, the slow’ William Poole, "The Relationship of Monetary Decelerations to Business
Cycle Peaks: Another Look at the Evidence", The Journal of Finance
(June 1975), pages 697-712.

32 FRBNY Quarterly Review/Summer 1984

down in M-1 can be explained in two ways, neither of which
should have caused concern about the economy. First,
slower money growth reflected the response of money
demand to the leveling off of interest rates after their rapid
decline in the second half of 1982. Alternatively, it reflected
a downward shift in money demand.
Last year’s experience underscores a point often made:
exclusive reliance on M-1 for policy purposes is too narrow
a focus. Our results imply that, at the very least, movements
in interest rates should be examined to corroborate that
slower money supply growth points to an imminent reces
sion. More generally, we believe that it is useful to look at
many economic variables, financial and nonfinancial, in the
framework of a model when forecasting the economy.
Monetary slowdowns and recessions
Growth of the narrowly defined money supply, M-1, mod
erated considerably in the second half of 1983. Over the
last two quarters of 1983 M-1 rose at a 7.2 percent annual
rate, compared with its 12.4 percent annualized advance
over the first two quarters. The slowdown was even more
pronounced according to data reported during the course
of 1983, which did not incorporate subsequent benchmark
revisions and updated seasonal adjustment factors. Prior to
these revisions, M-1 growth was measured to be 13.3 per
cent in the first half of the year and 5.5 percent in the
second half, the sharpest deceleration in the post-war
period. But even after the revisions, the 5.2 percentage point
drop was among the steepest decelerations.
Although last year’s slowdown was exceptional, concerns

about the economy may not have been warranted. As is
well-known, monthly and quarterly changes in M-1 are quite
“ noisy”, and frequently have little to do with the overall
economy. For example, 1962 and 1973 saw sharp onequarter decelerations of about three percentage points. Only
the later slowdown was soon followed by recession.
Moreover, evaluating movements in the monetary aggre
gates without some well-defined criterion or rule is highly
discretionary and can be done to “fit” a particular “story”.
Indeed, choosing two intervals to compute first the accel
eration and then the deceleration in M-1 can become quite
arbitrary, as the experience of 1979-80 illustrates. The twoquarter growth rate of M-1 spiked in the third quarter of
1979. When the subsequent deceleration (which occurred
just prior to the 1980 recession) is measured from that
spike, it is comparable to those observed before earlier
economic downturns. But when the deceleration is mea
sured from any of the other quarters of 1979, it is only
modest. So, we need an objective way to determine the
significance of a monetary slowdown.
Such an approach was developed by William Poole. He
compared the level of M-1 with the extrapolated value of
its most recent highest trend, as measured over a prede
termined interval. In particular, for each month in the 1914
to 1972 period he calculated the trend in M-1 over the
previous twenty-four months. Then, after determining the
highest trend between two successive cyclical troughs, he
computed the shortfall in M-1 from that trend, extrapolated
twelve months beyond the cyclical peak (chart). Using this
calculation, Poole found that with few exceptions M-1 fell
below trend by at least 3 to 4 percent around a peak in
the business cycle. He also judged the finding to be valid
for M-2. He concluded that “ ...an NBER [National Bureau
of Economic Research] business cycle peak will be identified
within plus or minus 5 months of the month of significant
deceleration.” 2 As we will discuss later, this means that the
condition may not be met until after the onset of recession.
We apply Poole’s technique to the past four recessions
to see whether the pattern he observed has continued. Of
course, recent financial innovation and deregulation might
have altered the relationship between monetary decelera
tions and turning points in terms of either size or timing.
Still, the results are generally consistent. Specifically, sig
nificant monetary slowdowns occurred around the cyclical
peaks in 1973 and 1980. This was not quite the case,
however, in 1981 (Table 1, right-hand column). But this may
be because the 1981-82 recession followed the 1980
recession so closely and depressed the estimated twentyfour month trend. Estimating the trend over a twelve-month

^William Poole, page 712. Further work with this approach was done by
Bryon Higgins, “ Money Growth and Business Cycles", Federal Reserve
Bank of Kansas City Monthly Review (April 1979).

I l lustration of P o o l e ’s Pr o c e d u r e
for I d e n t i f y i n g S i g n i f i c a n t
Mo n e ta r y D e c e l e r a t i o n s

M o n th s

N ote: The lo g a rith m o f th e m o n e y su p p ly is
p lo tte d on th e v e r tic a l a x is . T h is m eans tha t
the d is ta n c e b e tw e e n the e x tra p o la tio n o f the
tre n d and the actu al m oney s u p p ly m e a s u re s
the size of the s h o rtfa ll as a p e rc e n ta g e of
the tre n d le ve l.

Table 1

Monetary Decelerations in the Vicinity of Recessions
In percent

Greatest Shortfall in M-1 Relative to Its Peak Established Trend*
Peak in the
business eyelet
December 1969.......................
November 1973.......................
January 1980 ..........................
July 1 9 8 1 .................................
1983
As
As
As

Deceleration
of 12/83, original data .
of 12/83, revised data .
of 3/84. revised data . .

Trend measured
over 12 Months
7.6
9.2
4.5
6.8

Trend measured
over 24 months

(1/71)
(4/75)
(5/80)
(7/82)

5.4 (12/70)*
6.2 (4/75)§
4.1 (5/80)//
1.7 (7/82)

4.5
3.7
5.0

1.7
11
f

'Dates in parentheses refer to the month in which the greatest
shortfall occurred.
fA s classified by the National Bureau of Economic Research.
^Became significant in December 1969 according to Poole's three
percent rule.
§Became significant in July 1974 according to Poole's three
percent rule.
//Became significant in April 1980 according to Poole's three
percent rule.
fCannot be computed; the peak trend rate has not yet been
reached.

FRBNY Quarterly Review/Summer 1984

interval removes the effect of the 1980 recession and
reveals a marked deceleration in M-1 during 1981 (Table 1,
left-hand column).3
How should a shortfall in M-1 relative to a twelve-month
trend be evaluated? Surely, the measured peak rate of
growth tends to be more rapid as the time span over which
it is calculated shrinks. Thus, it is not surprising that, when
money growth tapers off, the deceleration looks even more
dramatic relative to a shorter trend. But Poole never deter
mined how great the shortfall from a twelve-month trend
must be to have the same significance as a three percent
shortfall from a twenty-four month trend. But note that in
1967 there was a 2.7 percent decline from the twenty-four
month trend and a 4.5 percent decline from the twelve
month trend; that year the economy was either on the brink
of recession, or went into a very mild recession. (The NBER
did not identify 1967 as a recession.) Using the borderline
case of 1967 as a benchmark, we project that a decline
from the twelve-month trend on the order of five to six
percent would be as significant as a three percent decline
from the twenty-four month trend.
Poole’s technique helps put the 1983 deceleration into
perspective. According to the initially reported data, the
highest twenty-four month trend occurred between October
1981 and October 1983 and stood at an annual rate of 9.7
^The shortfall from both the twelve and twenty-four month trends would be
greater if an adjustment was made to offset the effects of the
introduction of NOW accounts nationwide in 1981.

Table 2

The Extent of the Monetary Deceleration at the
Time of the Onset of the Recession
In percent

Shortfall in M-1 Relative to Its Peak Established Trend
Peak in the
business cycle*
December 1969................
November 1973.................
January 1980.....................
July 1981............................

Trend measured
over 12 months

Trend measured
over 24 months

4.6
2.9

3.5
1.4
0.9

1.1
2.0

0.0

1967 Deceleration
As of 1/67.............................

4.5

2.7

1983
As
As
As

4.5
3.7
5.0

1.7
t
t

Deceleration
of 12/83, original data...
of 12/83 revised data....
of 3/84, revised data ..

*As classified by the National Bureau of Economic Research.
tC annot be computed; the peak trend rate is rising as of March.

FRBNY Quarterly Review/Summer 1984

percent, substantially faster than the 5.5 percent rate in the
second half of last year. By the end of 1983, M-1 was 1.7
percent below the extrapolated level of the trend, just over
halfway to meeting Poole’s criterion for significant deceler
ation. By this test, forecasts of a 1984 recession based on
the M-1 deceleration were premature.4 And after the data
revisions, the peak trend growth was rising into early 1984,
and therefore, no shortfall could even be measured.
But looking at the 1983 deceleration relative to the twelve
month trend may be more meaningful, for a similar reason
as in 1981. Specifically, measuring the trend over a shorter
interval reduces the influence of a nearby recession; in this
instance, the 1981-82 recession. Before the data revisions,
the highest twelve-month trend was 12.8 percent, spanning
July 1982 to July 1983. The shortfall from this trend reg
istered 4.5 percent in December. The data revisions less
ened the decline to 3.7 percent in December; but by March
1984, it registered 5.0 percent. In terms of the twelve-month
trend, then, the M-1 shortfall seemed to approach, but not
reach, a significant decline of five to six percent.

M-1 as a leading indicator
Poole’s approach confirms that monetary decelerations and
recessions in the past were closely linked. His results,
however, do not substantiate the leading indicator properties
of M-1.5 In fact, his findings dispute claims that M-1 is a
useful forecasting tool. As Poole shows for the 1914-72
period, decelerations in M-1 typically become significant
somewhere inside of six months before or after the cyclical
peak. In fact, for the nine cyclical peaks he covered, the
decelerations become significant before the turning point
four times, and after the turning point five times. For none
of the three recessions since Poole’s study did the decel
erations become signficant until after the economy had
already turned downward.
To further investigate M-1’s leading indicator properties,
we measure the size of the shortfalls at the time of each
of the past four cyclical peaks. In 1973 and 1980, the
decline from the twenty-four month trend was around 1
percent to 1 1/2 percent in the month when the economy
turned downward; and in 1981, no decline occurred (Table
2). Even though the slowdowns were much greater relative
to the twelve-month trend, they do not approach the mag
nitude of the 1967 slowdown, which was associated with a
near recession. In sum, relying on M-1 (relative to its highest
prior twelve-month or twenty-four month trend) as a leading
indicator may be quite risky.
4The introduction of the Money Market Deposit account in December 1982
distorted the growth of M-2 and M-3 in early 1983. Hence, the broader
aggregates could not be used to confirm or dispute the information
contained in M-1.
5The growth rate of M-1 is classified a leading indicator by the
Department of Commerce, but it is not a component of the composite
index of leading indicators.

Nevertheless, the pattern in M-1 growth prior to the onset
of the past four recessions offers a way to evaluate the
most recent experience. The deceleration in 1983 (according
to the initially reported data) was larger than most that
occurred before past recessions. Even using the revised
data, the shortfall relative to the twelve-month trend (as of
December 1983 or March 1984) looks large.
Because the deceleration in M-1 did not meet Poole’s
criterion, deciding whether it implied a recession had to be
based on judgement (or some test other than Poole’s). It
was possible that a subsequent boost in M-1 could very well
offset the shortfall and prevent this criterion from ever
becoming satisfied. When forecasting the economy, however,
the risk of giving a false alarm must be weighed against
the risk of waiting too late to sound a warning. In this light,
if M-1 was the only indicator, the slowdown in M-1 growth
certainly looked ominous and probably justified forecasting
an economic downturn during the first half of 1984.6 In
restrospect, even if the revised M-1 data had been known
last year, the deceleration relative to the twelve-month trend
was so sharp that it might have raised concern. In any case,
especially because the deceleration’s size was not decisive,
corroborating evidence from other sources should have been
sought. As we will show, other developments in financial
markets did not support forecasting an impending recession.

Interest rates and the onset of recessions
Besides the volume of money, an important piece of finan
cial data is the level of interest rates. In judging whether
developments in financial markets indicate a near-term
recession, it seems eminently reasonable to pay attention
to interest rates as well as the money supply, particularly
when their signals differ, as in 1983.7 In essence, a price
variable as well as a quantity variable should be considered.
To evaluate last year’s rise in rates, we begin by calcu
lating the percent (or relative) change in the nominal com
mercial paper rate over the last four quarters of each
expansion in the postwar period. The rise in the paper rate
before past recessions has not been of uniform magnitude,
tending to be greater since the late 1960s (Table 3, column
1). Specifically, the commercial paper rate rose two to four
times more steeply in the later period. Over the last three
quarters of 1983, it climbed about 10 percent. While this is
close to some of the increases in the 1950s, that decade
may not provide a good standard for evaluating the recent
rise.
Financial deregulation and innovation, as well as wider

Table 3

Behavior of Interest Rates over Four Quarters
Before Recession
Percent change Percentage point
in nominal
change in real
commercial
commercial
paper rate
paper rate’

Start of
recession
1949-1 .
1953-111
1957-IV
1960-111
1970-1 .
1974-1 .
1980-11.
1981 -IV

.
.
.
.
.
.
.
.

1983 (l-IV)

.
.
.
.
.
.
.
.

Percent
change in
real cost of
capital

38.1
12.9
17.9
13.1
44.6
68.5
43.5
72.0

t
0.6
1.0
0.8
2.2
0.8
3.3
7.5

11.3
2.4
3.5
3.8
11.7
16.6
13.8
14.6

10.0

0.5

- 4 .7

"Figures are the average of four estimates of the change in the
120-day real commercial paper rate. Each estimate of the real
rate subtracts a different proxy for inflation expectations from the
nominal commercial paper rate. These proxies are the change in
the fixed weight GNP deflator in the contemporaneous quarter
(before 1960 the implicit GNP deflator was used), the change in
the fixed weight GNP deflator over the previous four quarters,
University of Michigan survey data on price expectations over the
subsequent twelve months, and the Livingston survey data on
price expectations over the subsequent three months.
fN ot available.

swings in inflation, would certainly seem to be important
considerations in analyzing interest rate behavior.8 The
raising and eventual elimination of the ceiling on CD rates,
the growth of the Eurodollar market, and the greater diver
sity of bank liabilities, all reduced the role of credit rationing
at times when financial conditions tightened. Consequently,
sharper movements in interest rates were needed to restrain
the demand for goods and services. But it is also possible
that aggregate demand reacted more quickly and strongly
to a given percent rise in interest rates when rates reached
high levels.9 Nevertheless, most analyses suggest that the
interest elasticity of demand has not yet increased to a
significant extent. For our purposes, the upshot is that the
behavior of short-term rates since the late 1960s is probably
more relevant than that of earlier periods in evaluating the
recent rise in interest rates. Using this comparison, then,

6To determine whether this was so within a framework based on statistical
theory, the technique developed by Neftgi could be applied. See Salih N.
Neftgi, “ Optimal Prediction of Cyclical Downturns’! Journal of Economic
Dynamics and Control (1982), pages 225-41

8See Richard G. Davis, "Credit Market Restraints and the Functioning of
Monetary Policy" Federal Reserve Bank of New York Research Paper
Number 8015 (September 1980): Donald D. Hester, “ Innovations and
Monetary Control”, Brookings Papers on Economic Activity I (1981); Albert
M. Wojnilower. “ The Central Role of Credit Crunches in Recent Financial
History” Brookings Papers on Economic Activity II (1980).

H'he Federal funds rate is classified as a leading indicator of business
cycle peaks; the Treasury bill rate a coincident indicator of peaks. The
commercial paper rate is not classified.

9See M. Akbar Akhtar. Financial Innovations and Their Implications for
Monetary Policy: An International Perspective. Bank for International
Settlements Economic Papers Number 9 (December 1983).

FRBNY Quarterly Review/Summer 1984

the ten percent advance of the nominal commercial paper
rate in 1983 was clearly quite small, and indeed, almost
trivial.

Real interest rates
From our estimates, real short-term rates also did not rise
enough last year to suggest an imminent recession. Real
rates, of course, are unobservable; their proper measure
ment has long been debated without ever being settled. For
this reason, we present an average of several different
estimated changes in the real commercial paper rate for
each pre-recession period. But because these estimates are
occasionally negative, or positive and close to zero, we
cannot always calculate in a meaningful way the percent
change. Consequently, we examine their percentage point
(or absolute) changes over the four quarters before each
recession.
In comparison to these changes, the rise in the real paper
rate in 1983 was relatively small (Table 3, column 2). We
estimate that this rate climbed by less than one percentage
point last year, from between 31/2 and 41/2 percent in the
first quarter of 1983 to between 4 and 5 percent in the
fourth quarter of 1983. Among the recent experiences, only
the modest advance in 1973 approached this increase. That
period, however, involved a jump in oil prices and restrictive
fiscal policy; it may not be an appropriate episode to com
pare with 1983. The increases in the real paper rate before
the other recessions since the late 1960s were between four
and fifteen times greater than the rise in 1983. Overall, it
would seem reasonable to conclude that, from an historical
perspective, the behavior of short-term interest rates—
nominal and real— in 1983 did not point to a near-term
recession.
The same was true of real long-term rates. Long-term
rates can be measured by the real cost of capital, a
weighted average of the corporate bond rate adjusted for
inflation expectations and the dividend-price ratio.10 The real
cost of capital fell during most of 1983; by the fourth quarter
it stood about five percent below its level of three quarters
earlier (Table 3, column 3). But it had climbed sharply before
each recession since 1969. Thus, real long-term rates
confirmed the information in short-term rates: financial
markets were not appreciably tighter in the second half of
last year.
Still another sign of stable financial conditions came from
domestic nonfinancial sector debt, the credit aggregate first
monitored by the Federal Reserve in 1983. Its growth was
virtually the same in the two halves of the year, 10.6 percent
versus 10.5 percent, at annual rates.

10See Patrick J. Corcoran and Leonard G. Sahling, “The Cost of Capital:
How High Is It?”, this Quarterly Review (Summer 1982), page 23: Patrick
J. Corcoran, "The Cost of Capital: An Update" this Quarterly Review
(Autumn 1983), page 23.

FRBNY Quarterly Review/Summer 1984

Money demand: the connection between money, interest
rates and the economy
There is good reason to doubt the import of a slowdown
in M-1 growth when nominal interest rates are fairly con
stant. M-1 and interest rates, in principle, are not inde
pendent. Specifically, the demand for money represents a
direct connection between short-term interest rates and the
money supply. When interest rates rise, the quantity of
money demanded tends to fall, everything else held con
stant, because alternatives to holding money become more
attractive. The coincidence of rising interest rates and slower
M-1 growth around the onset of past recessions most likely
reflected in part this connection. Individually, they indicated
the same fundam ental change toward tighter financial
markets.
We demonstrate the link between decelerations in M-1
and rises in interest rates by simulating the demand for
money— represented by a well-established, widely-used
equation of the transactions demand for money— over the
intervals before the past four recessions.11 This is done with
and without the actual increase in interest rates; all other
determinants of money demand follow their historical paths.
The difference between the two sets of simulations brings
out the role interest rates played in the observed slowdowns
of M-1 growth.
The simulations indicate that, before the 1970 and 1974
recessions, the rise in short-term rates contributed sub
stantially to the decelerations in M-1 growth (Table 4). For
example, just before the 1974 recession the rate of increase

11This equation was analyzed extensively by Stephen M. Goldfeld, "The
Demand for Money Revisited", in Brookings Papers on Economic Activity
III (1973), pages 576-638.

Table 4

The Effect of Rising Interest Rates on the Growth
of M-1 before the 1970 and 1974 Recessions
In percent

Growth Rates of M-1

Period
1969-1 to 1970-1......
1973-1 to 1974-1......
1979-11 to 1980-11....
1980-IV to 1981-IV...

Actual

Simulated
with actual
interest
rates

3.0
5.4
4.3
5.1

3.6
6.3
7.4
9.3

Simulated
with Actual over
constant
previous
interest
four
rates
quarters
6.4
8.2
8.5
10.7

Source: Federal Reserve Bank of New York staff estimates.

8.3
8.5
7.7
7.4

in M-1 would have been 1.9 percentage points faster had
interest rates not risen in 1973. Thus, the deceleration in
M-1 growth from 8.5 percent (over the four quarters ending
1973-1) to 5.4 percent (over the four quarters ending 1974-1)
can be explained mostly as a consequence of the run-up
in rates. Either the money supply or interest rates then
would have provided a correct reading on changing devel
opments in the financial markets in 1973.
Unfortunately, similar demonstrations for the 1980 and
1981-82 recessions are not so clear-cut; the demand-formoney equation tracks the actual money stock poorly over
the 1980-82 period. The effects of financial innovation,
deregulation of bank deposits, the credit control program,
and volatility throughout the economy combine to undermine
the equation’s performance. But none of these developments
severs the interest rate/money demand connection; if
interest rates had not risen prior to these later recessions,
money growth would have been faster. Allowing for the
overprediction of money growth in 1980-82, we can compare
the simulated growth rates of M-1 with actual and constant
interest rates. Around the onset of the 1980 recession, a
third of the monetary deceleration can be attributed to rising
interest rates; before the 1981 recession, over a half.
Let us now turn our attention to 1983. First, let us assume
that the response of money demand to changes in interest
rates (and its other determinants) has a mean lag of three
to six months, the typical estimate obtained in econometric
studies covering the past ten years or so.12 In other words,
one half of the adjustment in the quantity of money
demanded by firms and households as a result of a change
in interest rates takes place in three to six months.
Combining this estimate with the observed pattern in
short-term rates since mid-1982 produces an explanation for
M-1 growth in 1983. Short-term rates fell sharply during the
third and fourth quarters of 1982, into January of 1983.
Taking the time lag into account, more rapid money growth
could be expected to begin in the fourth quarter of 1982
and continue into the second quarter of 1983. Then money
growth should have slackened as the effect of falling inter
est rates wore off. The modest rise in rates over the
remainder of 1983 would also have tended to depress
M-1 growth.
12See Flint Brayton, Terry Farr, and Richard Porter, “Alternative Money
Demand Specifications and Recent Growth in M-1”, Washington, D.C.:
Board of Governors of the Federal Reserve System, Division of Research
and Statistics, Econometric and Computer Applications Section (May
1983); John P Judd and Rose McElhattan, “The Behavior of Money and
The Economy in 1982-83", Federal Reserve Bank of San Francisco
Economic Review (Summer 1983).

If interest rates in 1982-83 cannot satisfactorily explain
the behavior of the money supply, the alternative is, natu
rally, that the large swing in M-1 growth was due to shifts
in the demand for money. In particular, extraordinary factors
(for example, precautionary demands for liquidity on the part
of households) may have shifted money demand upward
in the first half of last year and downward in the second
half. But such a downward shift— a fall in the demand for
liquidity— would not seem likely to harm economic activity.
Under either explanation, then, behavior of M-1 last year
did not represent a fundamental market development with
adverse implications for the economy.
Conclusion
The failure of M-1 to correctly signal the economy’s direction
in the first half of 1984 can be related to unresolved issues
in monetary policy. Of course, the extent to which monetary
authorities should focus on the money supply in formulating
policy has been debated for many years. The most avid
proponents of the money supply argue that it should be the
sole input to policy deliberations. Other analysts argue that
taking account of additional economic indicators, besides the
money supply, would generally lead to better policy deci
sions. Some Federal Open Market Committee members
have acknowledged in their public remarks the usefulness
of targeting monetary aggregates, but at the same time
stressed that they need a broader and more flexible
approach to policy making.
Our analysis lends support to the view that monetary
policy should be formulated in a broad framework. The
episode we examined demonstrates that focusing exclusively
on just one variable, M-1 in this instance, can be mis
leading. Moreover, it is probably not the only such occasion
in the recent past. We believe, for example, that the growth
of M-1 in 1975-77 seriously understated the expansionary
forces building in the economy, which contributed to the
acceleration of inflation in 1978 and 1979.
But note that there are also occasions when forecasts
based on a wide range of variables will not be better than
a projection based exclusively on M-1. There are several
reasons why an economic forecast can be far from the
mark, only some of which could have been foreseen. Also
note that the behavior of the monetary aggregates may
provide information on the economy’s course and should not
be ignored. Nevertheless, we believe that, in general,
weighing the import of various economic indicators will
substantially reduce the risk of errors such as forecasting
recession in early 1984.

Carl J. Palash and Lawrence J. Radecki

FRBNY Quarterly Review/Summer 1984 37

Recent Itends in the U.S.
Foreign Exchange Market

The U.S. foreign exchange market continued to expand in
the early 1980s, although not nearly as rapidly as in pre
vious years. The Federal Reserve Bank of New York’s latest
survey of foreign exchange turnover shows that trading
volume increased to $33.5 billion per day in April 1983, a
rise of 43 percent from the $23.4 billion recorded in March
1980. By contrast, during the previous three years the
volume of foreign exchange transactions multiplied nearly
fivefold, from about $5 billion per day in April 1977.
Slower growth is not surprising, considering how rapidly
the market expanded in the late 1970s. Most of the changes
that helped synchronize U.S. market practices with those
in other major financial centers, and sharply boosted activity,
had been completed by 1980. Also, the recent increase in
turnover is measured from a much higher base level than
was true for the 1977-80 period.1
Developments in the early 1980s had varying effects on
the foreign exchange activity of major classes of market
participants. On the one hand, financial deregulation in the
United States fostered a sharp increase in foreign exchange

’ Seasonal factors also may have played a role. In the United States both
April 1983 and March 1980 had 21 business days. But several financial
centers overseas were closed for the Good Friday and Easter Monday
holidays during April, probably reducing transactions from what they
otherwise might have been, even though the New York market was open
on those days. Turnover in April 1983 was also diminished because
European countries moved to daylight-saving time in late March, about
one month ahead of the United States. This decreased by one hour for
most business days in April the time when European and U.S. foreign
exchange markets were open simultaneously. In addition, turnover in April
1983 may have been reduced because market participants normally
advance some transactions from April into March in order to adjust
balance sheets prior to the quarter-end.

38 FRBNY Quarterly Review/Summer 1984

trading by nonbank financial institutions looking for additional
income or ways to complement traditional lines of business.
Meanwhile, Japan, one of the world’s major financial cen
ters, relaxed its foreign exchange controls, as had the
United Kingdom about a year earlier. Together, these
changes created greater potential for capital flows through
the diversification of international portfolios and generated
increased demand for foreign exchange services.
But some developments limited activity. The worldwide
recession and global debt crisis slowed or actually reduced
world trade volumes and probably depressed corporate
foreign exchange transactions related to trade-end foreign
earnings flows. In addition, following major changes in for
eign exchange accounting rules, many U.S. multinational
companies felt less need to hedge accounting exposure.
This, too, diminished corporate activity in the exchanges.
The rapidly changing situation affected not only banks’
customers but also the banks themselves. The world debt
crisis, new regulatory requirements, heightened competition,
and pressure on earnings all led bank management to
reassess foreign exchange operations. As a result, many
institutions altered their approach to the market.
This article, based on in-depth conversations with market
participants and the Federal Reserve Bank of New York’s
1983 survey of foreign exchange activity in the United
States, examines how major segments of the U.S. foreign
exchange market reacted. The first section looks at nonbank
institutions, both financial and nonfinancial. The second
examines commercial banks and their behavior. Third, the
various changes in currency shares are discussed. The final
section considers how various aspects of market concen
tration have changed.

The Foreign Exchange Activity of Nonbank Institutions
Nonbank institutions more than doubled their total purchases
and sales of foreign currency, to $83.8 billion in April 1983
from $35.4 billion in March 1980 (Table 1). (This excludes
arbitrage members of the International Monetary Market
(IMM).) In March 1980, activity by nonfinancial entities was
about four times that of financial institutions. But by early
1983 trading volume by the two groups was roughly equal.
Overall activity (spot, swaps, and outright forwards) by
nonfinancial institutions rose nearly 47 percent from $28
billion to $41.1 billion. Growth in transactions by nonbank
financial entities was far more rapid, rising nearly sixfold to
$42.6 billion from $7.4 billion.

Table 1

Summary of Foreign Exchange Transactions
by Nonbank Institutions
In billions of U.S. dollars

March 1980

April 1983

90 banks

119 banks

10.8
4.3
15.1

22.2
21.4
43.6

6.7
2.0
8.7

10.1
17.5
27.6

10.5
1.1
6.3
17.8

8.8
3.7
3.3
15.8

Nonfinancial institutions..................... ...........
Financial institutions............................ ...........
International Monetary M arket..........

28.0
7.4
6.3

41.1
42.6
3.3

Grand Total...................................... ...........

35.4

83.8

(Excluding International Monetary Market)
Grand Total...................................... ...........
(Including International Monetary Market)

41.6

87.0

Type of Transaction

Spot
Nonfinancial institutions..................... ...........
Financial institutions............................ ...........
Subtotal................................................

Swaps

Financial institutions
Especially noteworthy is the surge in activity by nonbank
financial institutions, a category including securities and
brokerage firms, commodities houses, and insurance com
panies. As deregulation of the U.S. financial system dimin
ished differences among various financial industries, non
bank financial institutions moved to establish a presence in
areas once dominated by banks. In particular, many com
mitted themselves to a more active role in foreign exchange.
Many nonbank financial institutions also benefited when
the United Kingdom and Japan eased foreign exchange
restrictions on capital flows in 1979 and 1980, respectively.
In many commercial banks, trade-related transactions tend
to generate a large portion of customer business. But certain
nonbank financial entities with a long-standing involvement
in the securities business naturally benefited when inter
national investors had greater opportunity to diversify their
portfolios by investing abroad.
While generalizing is difficult because firms emphasize
different areas, many nonbank financial institutions have
become involved in one or more of the following activities:
• Providing foreign exchange services to portfolio inves
tors and borrowers in the United States and abroad.
Package deals, which accommodate customers’ foreign
exchange needs stemming from underlying securities
transactions, have become increasingly prevalent.2
• Meeting corporate foreign exchange needs related to
takeovers and acquisitions of foreign entities.

Nonfinancial institutions..................... ...........
Financial institutions............................ ...........
Subtotal................................................

Outright Forwards
Nonfinancial institutions..................... ...........
Financial institutions............................ ...........
International Monetary M arket......... ...........
Subtotal................................................ ...........

Total Transactions

Source: Federal Resen/e Bank of New York’s Foreign Exchange
Turnover Surveys (March 1980 and April 1983).
Because of rounding, figures may not add to totals.

together borrowers and/or investors with different cur
rency interests.3
• Arbitraging to profit from price discrepancies that occur
between the interbank market and the IMM, where
foreign currency futures are traded.4
• Positioning in size on the IMM to speculate on currency

• Using long-term foreign currency swaps to bring

2For example, fully-hedged commercial paper programs are available to
foreign borrowers who wish to raise funds in the U.S. market, but avoid
exchange rate risk. A foreign company thus can obtain financing in its
home currency while fixing in home-currency terms future principal and
interest payments. Not all borrowers and investors choose to obtain
foreign exchange cover immediately. Instead they hope to lower effective
borrowing costs or augment investment returns through subsequent
favorable exchange rate movements.

3Suppose, for example, that a U.S. investment bank has arranged for a
dollar-denominated private placement by a Japanese financial institution
with a U.S. financial entity. A long-term dollar/yen swap would provide
the Japanese institution with yen funds, while also hedging the dollardenominated principal payment. Interest payments also could be
hedged. Meanwhile, the U.S. institution has a dollar-denominated asset.
A rbitra ge entails a comparison of futures prices with outright forward
prices for the same maturity in the interbank market, or with the spot or
"cash" rate for that currency. Profits are made by buying a currency
where it is relatively "cheap" and selling where it is relatively "dear”.

FRBNY Quarterly Review/Summer 1984

movements, both for customers and for their own accounts.5
• Positioning in the foreign exchange swap market. Swap
positions are based on expectations about interest rate
movements between two currencies. There is interest
rate risk but no exchange rate risk since the same
amount of foreign currency has simultaneously been
bought and sold.
• Offering foreign exchange options contracts to cus
tomers.
Several nonbank financial institutions have actually
established full-fledged trading operations with professional
dealing staffs to support their increased commitment to
foreign exchange. Some occasionally make markets but
normally do not quote rates consistently or maintain recip
rocal trading relationships with commercial banks. They
conduct their foreign exchange transactions through banks,
brokers, and sometimes the IMM.
Nonfinancial Institutions
Two factors largely explain the more moderate growth of
foreign exchange activity by nonfinancial institutions. First,
in the early 1980s the world economy and trade were
depressed. Second, foreign exchange accounting proce
dures governing corporations’ international business changed
significantly.
In December 1981, the Financial Accounting Standards
Board adopted a set of new rules (FASB 52), replacing
those in effect since early 1976. One of the most important
changes, from the corporate viewpoint, was that balance
sheet translation gains or losses produced by exchange rate
changes were to be reflected in a separate component of
stockholders’ equity, rather than in current earnings, as
before.6 Following this, many U.S. corporations felt less
compelled to protect themselves against wide swings in
earnings by hedging balance sheet exposure with outright
forward contracts.7 Instead, senior management focused
*For example, commodities houses that manage investment funds for
clients have shifted a portion of their portfolios into foreign exchange and
applied the same charting techniques and technical analysis used for
years to trade commodities. Some participants also apply the techniques
of spread trading to foreign currencies, hoping to take advantage of
distortions .in historical price relationships between two currencies, or
between a currency and some other financial instrument or commodity. If,
for example, the price of Swiss franc futures rises relative to that of
German mark futures, above a level that normally has prevailed, a
spread trader might purchase mark futures and sell Swiss franc futures,
speculating that the price ratio will move back into line.
•Translation gains or losses stem from an exposed position on the balance
sheet, that is, from a mismatch between those foreign-currencydenominated assets and liabilities which must be translated into U.S.
dollars at exchange rates prevailing on the date of the balance sheet.
7For a more detailed description of how U.S. companies have reacted to
FASB 52, see the author's "FASB 52: Corporate Response and Related
Exchange Market Effects", this Quarterly Review (Winter 1983-84), page 69.

40 FRBNY Quarterly Review/Summer 1984

more intensely on transaction and/or economic exposure,
accelerating a trend which was already emerging.8
At the same time corporations appear to have become
increasingly sophisticated in foreign exchange risk man
agement and hedging strategies. In response to volatile
exchange rates, some firms modified their trading tech
niques. Rather than using an outright forward, they now
frequently engage in a spot transaction, followed by a swap.
The end result is the same, but in a fast-moving market a
spot price often can be obtained more quickly from banks
than an outright forward price. The spot contract is done
promptly to eliminate exchange rate risk. The swap can be
done more leisurely because swap rates normally are less
volatile than spot rates. Indeed, commercial banks normally
use this technique to offset outright forward transactions
done for customers.
Beyond this, some large multinational companies have
established their own trading operations to manage their
foreign exchange exposures more aggressively and profit
ably. Such firms frequently trade actively on an intraday and
day-to-day basis, and at times position aggressively to
benefit from favorable short-term movements in exchange
rates. This can lead to a heavy volume of both spot and
swap transactions, with the latter used to roll over positions
coming due. Some corporations reportedly will even quote
prices on occasion, although probably only when they have
a natural interest in doing the business.
The turnover survey reflects these changes. Outright
forward transactions by nonfinancial institutions declined 16
percent to $8.8 billion in April 1983 from $10.5 billion in
March 1980. Meanwhile, their spot activity more than dou
bled to $22.2 billion from $10.8 billion, and swap transac
tions rose about 50 percent to $10.1 billion from $6.7 billion.
The impact of changing conditions on commercial
banks and their response
The international debt crisis and growing list of problem
loans at home, especially in the energy sector, led to
mounting concern within commercial banks over creditwor
thiness. Also, the Federal Reserve’s new requirement that
large U.S. banks maintain primary capital at a level equiv
alent to at least 5 percent of total assets focused attention
on the adequacy of bank capital. Meanwhile, heightened
competition and rising costs prompted more emphasis on
improving earnings from foreign exchange operations.
For these reasons bank management began to reassess
the risks and costs of active interbank trading and posi
tioning, and to adopt a more cautious attitude toward
increasing the size of balance sheets. Consequently, many
major trading banks have made important changes in their
approach to the foreign exchange market. Banks now are
generally more conscious of costs, and more attentive to
•See Patricia A. Revey, "Evolution and Growth of the United States Foreign
Exchange Market”, this Quarterly Review (Autumn 1981), pages 32-44.

risk-return characteristics of foreign exchange activities and
indeed their entire spectrum of products and services. They
have increasingly considered how foreign exchange activities
affect the size, risk characteristics, and maturity and cur
rency structure of the balance sheet, as well as the potential
role of exchange operations in overall asset-liability man
agement.
Reassessment of risks and rewards in foreign exchange
trading
Around the turn of the decade, many large trading banks
adopted a high-volume style of “ in-and-out” spot trading.9
Positions were put on and unwound in hours and minutes
rather than days or weeks, as traders pursued earnings over
a relatively short time period. Banks did this to reduce
exchange rate exposure risks to more acceptable levels in
an environment where exchange rates were highly variable
and difficult to predict, making long-term positioning risky.
Some banks have continued this strategy. But others, amid
growing concern over creditworthiness and the size of bal
ance sheets, became increasingly unwilling to incur the risk
accompanying the large credit lines needed to support
heavy intraday trading.10
In addition, profit opportunities diminished progressively
as more and more banks adopted a similar trading style.
With banks trading increasingly on signals provided by
technical models and with advances in communication
reducing the information lag, traders often found themselves
reacting at the same time and in a similar way.
Other factors also eroded banks’ earnings from foreign
exchange operations. Competition was intensifying for cor
porate business, which was expanding more slowly than
before. Banks were competing more aggressively, through
both narrower spreads on bid/offer quotes and expanded
corporate advisory services. And beyond this, new institu
tions continued to enter the market. The number of domestic
banking institutions in the latest turnover survey increased
by 11 to 59 between March 1980 and April 1983. The
number of foreign banks in the United States included in
the survey climbed from 42 to 60." In addition, nonbank
financial institutions were providing more foreign exchange
services.
Meanwhile, the cost of running a foreign exchange
operation was growing rapidly. Rising costs can be traced
to several factors, including the banks’ high-volum e
approach to trading. Rapid “ in-and-out” trading required
costly back office support systems, particularly computer
9For a more complete description of this development, see Patricia A.
Revey, op. cit.
10Along with the risk of outright losses from failure of counterparties to
meet contract terms, heavy intraday trading increases the risk of
potential payment errors.
11The Federal Reserve believes its survey includes banks that account for
the bulk of foreign exchange transactions in the United States

time, and a bigger clerical staff as banks struggled to
process, efficiently and accurately, a large number of
transactions. Moreover, this trading strategy put a premium
on quick access to timely information about a wide variety
of financial data as well as fast-breaking economic, political,
and social developments throughout the world. Therefore,
many banks acquired expensive new information services
and communications facilities.
Heightened competitive conditions also raised costs.
Scrambling for customer business, many banks had estab
lished or expanded their corporate advisory services around
the turn of the decade to increase, or at least maintain,
market shares. In addition, the proliferation of trading in the
late seventies, along with continued entry of new institutions,
spread trading talent thin and pushed salaries of profes
sional dealers rapidly higher. Meanwhile, rents and utility
charges were also rising.

Table 2

Foreign Exchange Turnover in the
Interbank Market
In billions of U.S. dollars

Type of Transaction

March 1980

April 1983

90 banks

119 banks

62.4
75.5
162.5
300.4

93.8
81.1
224.2
399.2

*
*
*

22.5
51.7
130.2
204.4

Spot
Direct with banks in U.S.................
Direct with banks a b road...............
Through brokers...............................
Subtotal................ .............................

Swaps
Direct with banks in U.S.................
Direct with banks a b road ...............
Through brokers...............................
Subtotal..............................................

137.8

Outright Forwards
Direct with banks in U.S.................
Direct with banks a b ro a d ...............
Through brokers...............................
Subtotal..............................................

*
*
*
11.6

3.1
3.7
4.6
11.4

*
*
*

119.4
136.5
359.1

449.7

615.0

Total Transactions
Direct with banks in U.S.................
Direct with banks a b ro a d ...............
Through brokers...............................

Grand Total
*Not available.

Source: Federal Reserve Bank of New York s Foreign Exchange
Turnover Surveys (March 1980 and April 1983).
Because of rounding, figures may not add to totals.

FRBNY Quarterly Review/Summer 1984

Changes in approach to positioning and spot foreign
exchange trading
Pressure on earnings and risk considerations led some
active trading banks to question the wisdom of conducting
rapid “in-and-out” transactions to benefit from short-term
movements in exchange rates. Now banks are generally
less willing to do volume for its own sake, and have reduced
active short-term position-taking. A few banks have begun
emphasizing a more strategic approach, positioning on
longer-term exchange rate expectations. Many have reas
sessed their role in making markets and chosen a lower,
more conservative profile in the interbank market. Banks are
less inclined to deal directly and quote two-way prices,
particularly for certain currencies or at certain times of the
day, and are less enthusiastic about maintaining a consistent
posture with respect to reciprocity. Reflecting a more
defensive attitude, banks have carefully reviewed credit lines
and in some cases cut them back.12
Consequently, relationships between trading banks have
become increasingly strained. This process has tended to
feed on itself, with growing complaints about lack of liquidity,
deteriorating trading conditions, and the difficulty of getting
business done in the New York afternoon after European
centers have closed.
The greater reluctance to pursue rapid intraday spot
trading and deal directly is reflected to some degree in the
April 1983 survey. Table 2 shows that the share of spot
transactions in total interbank activity slipped nearly 2 per
centage points to 64.9 percent between March 1980 and
April 1983. Meanwhile, the portion of interbank spot turnover
accounted for by direct transactions between U.S. banks
and between U.S. banks and banks abroad, declined to
43.8 percent from 45.9 percent.13 Although the changes are
modest, these trends seem to have continued since the
survey.
Banks less enthusiastic about direct dealing have had
greater recourse to foreign exchange brokers. The propor
tion of interbank spot transactions done through brokers
increased to 56.2 percent in April 1983, from 54.1 percent
three years before. While fees can be considerable, some
banks feel that dealing through brokers is cost-effective
because it reduces the size and expense of a full-time
professional dealing staff. Using brokers also enables
business to be done when banks shrink back from dealing
directly. And a bank can control its positions better, since
there is no obligation to reciprocate. Brokers generally
handle standard amounts in each currency (typically $3 or
$5 million equivalent) and discourage smaller, odd-sized
12The large turnover in chief dealers over the last year or two may in part
reflect the banks’ changing attitudes.
13Swap and outright forward transactions done directly by banks with other
banks were not separately classified in the March 1980 survey, so the
only comparison possible is for spot turnover.

42 FRBNY Quarterly Review/Summer 1984

deals, so the average size per deal tends to be larger.14
Increased emphasis on other areas of trading
Major banks have also turned more to some other areas
of trading thought to improve profits on a cost- and/or riskadjusted basis. These include:
• Foreign exchange futures. Many banks are, or are
considering becoming, more heavily involved in trading
on the IMM, either through their own subsidiary or
through brokers there, to profit from relatively riskless
arbitrage opportunities. Some are actively quoting prices
to other market participants who also are arbitraging
between the futures and interbank markets (Box 1).
• Foreign currency swaps. The use of swaps as part of
banks’ normal funding and lending activities has
increased. A bank needing dollar financing to fund
dollar loans, for example, can borrow dollars directly
or borrow one of several foreign currencies and swap
the proceeds into dollars if that is cheaper. The bank
has no exchange rate risk, and matches a dollar asset
with a dollar liability. Bank management has encour
aged closer communication between Eurocurrency
traders and foreign exchange swap dealers to facilitate
this activity.
• Foreign exchange swap positioning. This is regarded
as more conservative than spot positioning since
interest rate differentials typically do not move as rap
idly or as much as spot exchange rates. Accordingly,
less time and effort is required to monitor swap posi
tions. Many major banks now give more attention to
swap trading and, in some cases, make swaps a
trader’s sole responsibility. Only a few years ago, a
single trader often was responsible for both spot and
swap transactions. The turnover statistics show a
moderate increase in the relative importance of swap
transactions in interbank trading to 33.2 percent in April
1983 from 30.6 percent in March 1980.
• Cross-currency trading.'5 In part, these transactions
accommodate customer demands. Additionally, some
banks may now see cross-currency positioning as less
risky than positioning directly in the dollar, since most
cross rates have been less volatile and more predict
able than dollar rates in recent years. Some banks also
engage in cross-currency positioning to protect them
selves against unfavorable movements in dollar
,4The average deal size was greater for transactions reported by brokers
than for those reported by banking institutions for every currency but the
German mark.
15ln a cross-currency transaction a foreign currency is purchased or sold
directly against another foreign currency rather than against the dollar.

exchange rates. This is especially true when a position
in a widely traded currency, like the German mark, can
be used to hedge a position in a currency for which
cover is more difficult to arrange.16 Cross-currency
16lf a bank filled a customer order to buy Dutch guilders against dollars, it
might prefer to cover its resulting long-dollar, short-guilder position. But
this could be difficult since the dollar-guilder market in New York is often
thin, especially in the late afternoon. Thus, the bank might purchase
German marks against dollars, effectively leaving it with a long-mark,
short-guilder position. Should the dollar decline, losses on the dollarguilder position would be compensated for by gains on the dollar-mark
contract, as long as the mark-guilder cross rate remained stable.

activity, reported for the first time in the latest survey,
totalled $1.5 billion. This probably understates such
transactions since some banks had problems isolating
them from their records. Moreover, cross-currency
positioning reportedly picked up in late 1983 and early
1984, with substantial interest shown in sterling/mark,
mark/yen, and sterling/yen.
Development and marketing of new products
Heightened competitive conditions, along with the desire to
enhance earnings, encouraged many large U.S. trading

Box 1: The Changing Role of the Foreign Currency Futures Market
Trading of foreign currency futures, the bulk of which occurs
on the IMM in Chicago, has grown rapidly in recent years.
In fact, between March 1980 and April 1983 average daily
turnover in the major foreign currencies there grew over
twice as rapidly as adjusted total turnover, from $1.1 billion
to $2.3 billion equivalent. By April 1983, turnover on the IMM
had reached nearly 10 percent of adjusted total turnover, up
from 6.7 percent three years earlier. Growth in trading of
Swiss franc and Japanese yen futures was particularly dra
matic, leading to an IMM to total turnover ratio of nearly 25
percent and 12 percent, respectively.
Commercial banks have contributed significantly to this
expansion. In addition to their arbitrage activities, many
banks now regard the IMM as another source of liquidity for
the foreign exchange market. It enables them to conduct
business and alter trading positions when the interbank
market is inactive and thin. Moreover, closer contact with the
IMM provides important information. Many participants in the
futures market rely on the same charting techniques and
technical analysis to predict exchange rate movements. The
widespread use of this approach can generate similar
behavior which in turn sometimes causes sharp, short-term

price movements that spill over into the interbank market.
Since banks see the IMM as a potential force in moving
exchange rates, especially when the interbank market is thin,
they have felt compelled to adopt a more active presence
there. This helps them keep abreast of developments and
make judgements about their own position-taking. For April
1983, banking institutions reported that foreign exchange
futures contracts with organized exchanges totalled almost
$2 billion.
More active trading by banks and other institutions has had
several related consequences. The futures market has
become more closely integrated with the interbank market
in foreign exchange. Arbitrage opportunities have therefore
diminished and exchange rates in the two markets have
remained in line to a greater extent and more consistently
than before. Consequently, the role of the IMM’s “Class B”
members, a special class of clearing member authorized to
do only arbitrage transactions, has shrunk. Between March
1980 and April 1983, their activity dropped by nearly onehalf, from $6.3 billion to $3.3 billion. The share of commercial
banks' total customer business accounted for by arbitrage
members dwindled from 15 percent to onfy 4 percent.

Comparison of Growth in Turnover on the IMM and in Total Turnover
Daily averages in millions of dollars equivalent

March 1980
Currency
German m a rk ....................................
Swiss fra n c ........................................
Japanese y en....................................
Sterling........................................
Canadian dollar.........................
Total..............................................

IMM
turnover

Total
turnover*

April 1983

IM M/total
(percent)

IMM
turnover

Total
turnover*

IMM/total
(percent)

193
179
67
288
326

5.375
1,826
1,742
4.230
2,535

3.6
9.8
3.8
6.8
12.9

347
793
639
241
248

8,004
3,239
5,434
4,395
2,246

4.3
24.5
11.8
5.5
11.0

1,053

15,708

6.7

2,268

23,318

‘ Adjusted for double-counting of interbank transactions.
Source: IMM turnover based on International Monetary Market, IMM Foreign Exchange Daily Information Bulletin, various issues. Adjusted total turnover
based on Federal Reserve Bank of New York’s Foreign Exchange Turnover Surveys (March 1980 and April 1983).

FRBNY Quarterly Review/Summer 1984

banks to develop new products to attract more customer
business. This is especially evident in two areas— long-dated
foreign currency transactions and foreign exchange options.
Some banks have extended the maturity dates for which
they will do foreign exchange swaps and outright forwards,
often at the behest of their customers who are naturally
interested in such arrangements. Many sophisticated mul
tinational companies and other entities now routinely scour
the world’s capital markets to locate relatively inexpensive
funds and minimize overall financing costs. Long-dated
swaps, some reportedly extending well beyond ten years,
facilitate the search since with them a company can transfer
medium- and long-term borrowings from one currency to
another on a fully hedged basis. The opportunity to hedge
through long-dated transactions is also welcomed by large
institutional investors who hold foreign assets to diversify
risks internationally and improve overall performance.
Long-dated transactions are riskier for banks than shorterterm ones, owing both to the time element and the greater
difficulty of offsetting such deals.17 But clearly, institutions
actively marketing these services believe the income earned
adequately compensates for the additional risk. Not all
banks reason this way, however. Some arrange long-term
deals only at a customer’s request, while others will get
involved only if they can offset the transaction with another
bank or customer. The market for long-term foreign
exchange transactions reportedly is still small relative to total
turnover. Nonetheless, it is growing and could become more
important as banks gain experience in pricing and in dealing
with the risks.
Recently some banks began to offer custom-made foreign
exchange options contracts to their customers.18 Over-thecounter options, as these sometimes are called, and foreign
exchange options traded on organized exchanges in the
United States are relatively new but could assume an
important role in the market.19
Foreign exchange options can be useful in managing
foreign exchange risk. For a fixed fee (the premium), the
customer essentially purchases an insurance policy, and
transfers the risk of adverse exchange rate movements onto
the bank writing the option contract. Options limit the cus
tomer’s downside risk, but leave open the potential for
theoretically unlimited upside gains.
Banks writing foreign exchange options contracts take on
17The long-term swap market is less liquid than both the spot and short
term swap markets.
18An options contract provides the right— but not the obligation— to
purchase (call) or sell (put) an agreed-upon amount of foreign currency
at a specified price (strike price) on or before the maturity date of the
contract.
’ •Trading in sterling options contracts began on the Philadelphia Stock
Exchange on December 10, 1982, and over the next two months the
exchange added options contracts in Japanese yen, Swiss francs,
German marks, and Canadian dollars. Also, option contracts on German
mark futures began trading on the IMM early this year

44 FRBNY Quarterly Review/Summer 1984

significant risk. They do not know their ultimate exposure
until the holder exercises the option. Accordingly, much time
and effort must be spent monitoring the relationship between
the contract’s strike price and the spot price in the interbank
market.20
Banks tend to build into the premium price the heavy risk
of writing foreign exchange options contracts. So, although
corporations have expressed considerable interest, the
actual volume of business so far seems to have been fairly
limited.
Currency Shares
The main shift in currency shares was a dramatic rise in
the Japanese yen’s relative importance, largely offset by
declines in sterling and the Canadian dollar. The chart
shows that the Japanese yen became the second most
actively traded currency, accounting for 22.0 percent of total
turnover. Three years earlier the yen was fourth, with a 10.2
percent share. Trading in German marks remained the most
active, accounting for 32.5 percent of all transactions, very
close to March 1980’s figure of 31.7 percent.
The doubling of the yen's share largely reflects Japan’s
relaxation, in December 1980, of foreign exchange restric
tions on capital transactions.21 The new law increased for
eign access to Japanese markets and liberalized transac
tions abroad by Japanese residents.
By most accounts, two-way capital flows between resi
dents of Japan and the rest of the world have risen sharply
in recent years, with an accompanying increase in foreign
exchange transactions.22 Although gross data for all capital
flows in and out of Japan are not readily available, their
magnitude is suggested by total transactions related to
foreign portfolio investments by Japanese residents, and
portfolio investments in Japan by nonresidents. Since 1980,
such purchases and sales of stocks and bonds have more
than doubled to $171.8 billion in 1983 from $72.6 billion.23
Over the same period, Japan’s share of world trade also
grew from 7.1 percent to 8.1 percent.24
“ Banks have devised computer programs to help manage these
exposures. Ratioed hedging techniques often are used. They call for
covering a certain fraction of the option in the interbank spot market,
depending on the gap between the strike price and spot rate. Some
banks also try to offset options contracts on the IMM or in Philadelphia,
although this is relatively new since no options contracts with organized
exchanges were reported in the turnover survey. Moreover, it can be
difficult, as these options markets are still rather thin.
^The new Foreign Exchange law ratified and accelerated moves toward
relaxation that had been gradually occurring since the early 1970s. See
Japan Economic Institute Report, "Capital Market Liberalization in Japan"
Number 10A (March 9, 1984).
“ The growth in capital transactions also may help explain why swaps
account for a larger proportion of yen turnover than is true for other key
currencies. Swaps are frequently used to fund investment and lending
activities.
“ Based on data provided by the Japanese authorities.
“ International Monetary Fund, International Financial Statistics (June 1984).

D is trib u tio n of F o re ig n Exchange T u rn o v e r by C urren cy

M a rc h 19 80

A p ril 1 9 83

B e c a u s e o f rounding, fig u re s do n o t add to 100 p e rc e n t.
S ource:

Data based on F e deral R eserve Bank of New Y o rk ’s F oreign E xchan ge T u rn o ve r S urve ys (M a rch 1980 and A p ril 1983).

With activity in the yen picking up, many banks began
placing more emphasis on trading the currency, replacing
junior traders with more senior, experienced personnel who
were given larger position limits and generated a larger
volume of transactions. The recent agreement between
Japan and the United States to further open Japanese
financial markets and make the yen more of an international
currency is likely to increase the yen’s share of overall
turnover even more.

Concentration in the Foreign Exchange Market
Changing conditions in the foreign exchanges had varying
effects on concentration, depending on which aspect is
examined. The following discussion looks at concentration
from several perspectives.
• The overall market. Measured by the share of total
turnover accounted for by the ten most active trading
banks, overall concentration changed little. It rose
slightly to 39.9 percent in April 1983 from 39.2 percent
in March 1980.
• Individual currency markets. Of the major foreign cur
rencies, only trading in the German mark became less
concentrated, as the share of the ten most active banks
declined from 47.4 percent to 41.1 percent. Concen

tration in the pound sterling, Japanese yen, and Swiss
franc markets rose. Meanwhile, trading in the less
active currencies became less concentrated; even so,
these markets remained more concentrated than most
of those in the major currencies.
• Total turnover accounted for by foreign banks. Foreign
banks in the United States continued to enjoy a sig
nificant presence in the U.S. foreign exchange market.
Indeed, in April 1983, they comprised fully one-half of
the turnover survey’s bank respondents, compared with
46.7 percent in March 1980; they also accounted for
43.5 percent of total turnover, up from 39 percent three
years earlier.
• H om e-currency trading accounted for by foreign
banks. Foreign banks accounted for an important share
of activity in their hom e-currencies in April 1983,
ranging from 16 percent for trading in sterling to 45
percent for the French franc (Table 3A). The market
share of home-currency trading of foreign banks from
Canada, Japan, and Switzerland rose appreciably from
March 1980; but the share of German mark trading
accounted for by banks from Germany declined.
• Foreign banks’ specialization in home-currencies.

FRBNY Quarterly Review/Summer 1984

Box 2: Comparison of Foreign Exchange Turnover in Selected Markets
Comparing foreign exchange activity in different markets is
limited by the lack of published data. However, turnover
statistics on the Tokyo, Canadian, and Singapore markets
allow activity in those markets to be compared with that in
the U.S. market. The Table shows foreign exchange turnover
in April 1983 for the United States, Tokyo, Canada, and
Singapore. The data are adjusted to eliminate double
counting of interbank transactions within, but not between,
markets.

Tokyo*
Total adjusted turnover of $249 billion in the Tokyo market
was less than half of adjusted turnover in the U.S. market
of $544 billion during April 1983. However, yen turnover in
Tokyo ($229 billion) was twice as large as in the United
States ($114 billion), accounting for about 92 percent of total
activity, compared with about 21 percent in the United States.
As in Canada and Singapore, virtually all foreign exchange
trading is conducted against the U.S. dollar. Banks’ trans
actions through brokers accounted for about 49 percent of
interbank activity in Tokyo, somewhat lower than the 57
percent in the United States. Unlike brokers in the United
States, brokers in Japan currently are not allowed to arrange
transactions between domestic banks and banks abroad.t
Customer transactions comprised 26 percent of total Tokyo
'Foreign exchange trading also takes place in Osaka, where
activity is estimated to be about 2 percent of that in Tokyo.
"•■This will change soon. Beginning August 1, 1984 for nonyen
transactions and early next year for yen transactions, brokers in
Japan may accept bids and offers from banks abroad.

turnover, considerably more than the 16 percent in the United
States.

Canada
The volume of foreign exchange transactions in Canada
totalled $102 billion in April 1983, about 19 percent of
adjusted total turnover in the United States. In the Canadian
market, activity in the Canadian dollar was nearly two-thirds
larger than in the U.S. market, accounting for about 76
percent of total turnover there, compared with about 8.5
percent in the United States. In addition, a larger share of
interbank transactions by Canadian banks was done through
brokers (68 percent) than was true for U.S. banks (57 per
cent). Customer business accounted for 26 percent of total
turnover in Canada, compared with 16 percent in the United
States.

Singapore
Total adjusted foreign exchange turnover in Singapore
amounted to $123 billion in April 1983, about 23 percent of
activity in the U.S. market. The share of overall activity
accounted for by the Singapore dollar was about 18 percent.
The portion of interbank turnover conducted through brokers
is not known, since these transactions are included in the
figures showing direct transactions. Customer transactions
accounted for 4 percent of all activity in the Singapore
market, significantly less than in the United States, Tokyo,
and Canada. However, the relative importance of customer
business in Singapore is probably understated, since trans
actions by Singapore banks with nonbanks outside Singapore
are included in transactions done with banks abroad.

Foreign Exchange Turnover in Selected Markets for April 1983*
In billions of U.S. dollars

Total
turnover

Turnover in
Japanese
Yen

36
3
12
21
11

183

167

—

92
90§
65

84
82§
62

249

Total
turnover

Turnover in
Japanese
Yen

Turnover in
Canadian
Dollars

Interbank.....................................
Direct with domestic banks...
Direct with banks a b ro a d .....
Through brokers.....................
C ustom er.....................................

456
60
136
260
87

95
14
25
56
19

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

544

114

Transactions

Canada

Singapore

Total
turnover

Turnover in
Canadian
Dollars

Turnover in
Singapore
Dollars

75
3
21
51
27

52
3
14
35
26

118
27f
911 *
5

102

123

Tokyo

United States

229

Total
turnover

—

18
m
7t:
—

'Data adjusted to eliminate double-counting of interbank transactions,
flncludes transactions done through brokers.
^Includes transactions with banks and nonbanks outside Singapore.
§lncludes only transactions involving two domestic banks. Brokers in Japan currently are not permitted to arrange transactions with banks abroad.
Source: Data based on foreign exchange turnover surveys conducted by the Federal Reserve Bank of New York, Bank of Canada, and Monetary
Authority of Singapore. Data on the Tokyo market are estimates based on information provided by the Japanese authorities and other market participants.
Adjustments to eliminate double-counting in Singapore's and Japan’s data were done by the Federal Reserve Bank of New York.
Because of rounding, figures may not add to totals.

FRBNY Quarterly Review/Summer 1984

Table 3A

Market Share of Home-Currency Trading
of Foreign Banks in the United States
In percent

March 1980
Number of
banks

Market
share

G e rm a n y .................................. 8
United Kingdom. . .
4
C a n a d a ..................................... 5
J a p a n ....................... ................. 9
S w itze rla n d ............. ................. 3
France....................... ................. 6

24.2
16.5
14.4
27.0
20.8
46.7

Country of origin

April 1983
Number of
banks
11
5
5
13
4
9

Market
share
19.5
15.6
24 3
31 4
28 5
45 2

Table 3B

Relative Importance of Home-Currency Trading
in Total Activity of Foreign Banks
in the United States
In percent

March 1980
Country of Origin

Number of
Banks

G e rm a n y ................
United Kingdom. . .
C a n a d a ....................
J a p a n .......................
S w itze rland.............
France.......................

8
4
5
9
3
6

Share of
Activity
89.9
52,8
46.5
69.8
51.9
42.2

April 1983
Number of
Banks

Share of
Activity

11
5
5
13
4
9

85.6
37.8
38 1
86.6
49.7
34,4

Source: Data based on Federal Reserve Bank of New York's Foreign
Exchange Turnover Surveys (March 1980 and April 1983)

Home-currency transactions comprised a large share
of the total activity of foreign banks, extending from
about 34 percent for French banks to 86 percent for
German and Japanese banks. But except for Japanese
banks, the relative importance of home-currency trading
in total activity declined, in some cases substantially,
from three years before (Table 3B).

Conclusion
Overall, growth in foreign exchange turnover in the United
States slowed significantly in the early 1980s, compared with
its rapid pace in the late 1970s. But this was not true for
all major classes of market participants, whose experiences
differed widely
• Nonbank financial institutions greatly expanded their
foreign exchange activities. Deregulation of the U.S.

financial system encouraged them to become more
active in meeting customers’ foreign exchange needs
previously handled by commercial banks. In addition,
firms in the securities industry naturally benefited when
the United Kingdom and Japan eased controls on
capital movements, since that increased opportunities
to diversify portfolios internationally and led to greater
demand for foreign exchange services.
• Activity of nonbank nonfinancial institutions grew much
more moderately. Global recession and the debt pay
ment crisis depressed world trade volumes and thus
the need for foreign exchange transactions. At the
same time, new foreign exchange accounting rules
prompted many U.S. multinational corporations to
reduce, or end altogether, certain foreign exchange
activities designed to hedge balance sheet exposures.
• Heightened competition, rising costs, and concern over
creditworthiness and the size of balance sheets led
many commercial banks to reassess their foreign
exchange activities. Some became more reluctant to
pursue a high-volume, rapid “ in-and-out” trading style,
to deal directly, or to make markets. To improve earn
ings, many placed increased emphasis on other areas
of trading and began offering new products to attract
customer business.
Assessing prospects for future growth in foreign exchange
transactions is difficult. All things considered, a recurrence
of the explosive growth in the late seventies seems unlikely.
More probable is that the more moderate pace of recent
years will continue. As economic recovery spreads, world
trade volumes should pick up; creating a greater need for
foreign exchange transactions. In addition, ample scope for
greater diversification of investment portfolios, together with
planned further reductions of restrictions on capital move
ments in and out of Japan, suggest that foreign exchange
activity related to capital flows will continue to expand.
Less clear, however, is whether the change in corporate
balance sheet hedging practices is permanent. To some
extent, companies are still sorting out the full implications
of the new foreign exchange accounting rules. The answer
may depend on the course of the U.S. dollar. Should the
dollar continue to strengthen, many firms would experi
ence balance sheet translation losses. At some point the
impact of cumulative losses on equity might prompt them
to renew balance sheet hedging, to forestall a negative
reaction by analysts and stockholders. Likew ise, the
decision by some major trading banks to step back from
the high-volume approach to foreign exchange trading
may also be mercurial.
Michael D. Andrews

FRBNY Quarterly Review/Summer 1984

Nuclear Power Plant
Construction: Paying the Bill

Over the next few years U.S. electric utilities will be asking
for revenue increases to pay the cost of building some 50
nuclear power plants which are currently under construction
(Table 1). Eighty-five billion dollars has been spent on these
projects so far and, according to data provided by the util
ities, an additional $45 billion will be needed to complete
them. These revenue requests will, if granted, result in
electricity rate hikes of unprecedented magnitude: a total
increase in utilities’ revenues of roughly $25 billion, or about
20 percent of 1982 levels would eventually be required. If
requested rate increases are severely limited by the reg
ulators, the financial condition of many of the utilities with
nuclear construction projects would be further impaired.
Because of the way most states regulate electric utility
rates, the cost of constructing these plants has not yet been
reflected in the electricity bills of customers. Instead, funds
have been borrowed and raised through stock offerings.
Only after the plants begin producing commercial power do
customers begin to reimburse the utilities in cash for the
costs incurred in building the plants, along with a competitive
return on stockholders’ investment. In addition, typical reg
ulatory practice heavily loads the cost to consumers of new
generating facilities in the first few years that the plant is
in operation. In many affected areas all of this could mean
jumps in customers’ electricity bills upwards of 50 percent
as soon as the plants begin commercial operation.
The sudden rate hikes that accompany the opening of
nuclear plants (a phenomenon often called “rate shock”) are

The authors would like to thank Alfred Kahn, Charles Komanoff, Kemm
Farney, and Robert Crow for their comments on an earlier draft. We are
also grateful to Julie Rappaport for her assistance. Any remaining errors
are our own.

48 FRBNY Quarterly Review/Summer 1984

likely to be especially unpopular, not only because of the
unusually large size of the hikes, but also because in most
cases neither more electrical power nor additional generating
capacity is needed right now. In fact, in all but a few specific
regions, such as New England, the United States has an
excess of electrical-generating capacity.
Although at present it may look as if many new nuclear
plants were poor investments, it is not certain that the
construction of those plants that are eventually completed
will appear to have been a bad idea in retrospect ten or
twenty years from now. Demand for electrical power has
recently started to escalate as economic growth rates have
risen, and the replacement of imported petroleum and acid
rain-generating coal as power plant fuels could produce
substantial political, environmental, and economic benefits.
For the present, though, several utilities face serious dif
ficulties. There has already been a huge default in the case
of the Washington Public Power Supply System (WPPSS).
And currently, a number of investor-owned utilities— the Long
Island Lighting Company (Lilco), Public Service of New
Hampshire, Consumers Power of Michigan, and Public
Service of Indiana, among others— have serious financial
problems.
The purpose of this article is to describe and measure
the nationwide scope of a problem that has generally been
discussed on a case by case basis, without sufficient regard
to the interrelation of the issues involved.
The origins: demand growth declines while project
costs escalate
Industry standards typically call for electrical utilities to
maintain maximum generating capacity between 15 and 22
percent above projected peak load demand. If we take 18

percent as the average requirement, in the early 1970s,
when most of the nuclear plants currently under construction
were planned, there was no slack capacity in the aggregate
by this standard (Chart 1). At the same time, fossil fuel
prices were also increasing at unprecedented rates; real
crude oil prices quadrupled between 1970 and 1980 and
anthracite coal prices roughly doubled.1 Under the circum
stances nuclear power looked like a good bet to all but a
few observers. Government agencies actively encouraged
utilities to invest in nuclear plants, and opposition was not
widespread.
In the mid 1970s, the growth in demand for electricity
slowed markedly (Chart 1). In fact, some industry projections
10 years ago overstated the need for capacity in 1983 by
nearly 50 percent.2 As a result, the new capacity brought
on line during the 1970s has allayed immediate concerns
with most utilities’ ability to meet peak load demand.
Moreover, fossil fuel prices have stabilized; real anthracite
coal prices actually decreased by about six percent between
1980 and 1982.3
In addition, the 1979 incident at Three Mile Island raised
concerns with the safety of nuclear plant operations. The
regulations issued by the Nuclear Regulatory Commission
to address the safety issue have contributed substantially
to increasing both the cost of plant construction and the time
needed to complete the projects.
Finally, over the past several years, the cost of capital
to utilities has risen markedly. This not only increased the
direct construction cost of the plants, but also exacerbated
the cost consequences of delay.
As a result of all of these changes, building nuclear
generating plants has apparently not turned out to be as
good an investment as originally expected. In fact, current
estimates of the completion costs of plants now under
construction are as much as ten times as high as the levels
originally forecasted when the projects were initiated. Faced
with cost escalations of this magnitude, U.S. utilities have
cancelled 33 of the 39 new nuclear plants ordered since
1974. No new nuclear plants have been ordered since
1978.4

nuclear construction projects. While utilities in most parts
of the country are privately owned, the industry is subject
to far-reaching government influence, particularly on the
state level. State governments have granted particular util
ities the exclusive right to serve specific geographical areas.
In return for this distribution monopoly, however, state gov
ernments retain the right to approve or disapprove utilities’
proposed electricity rates. Another important characteristic
of the organization of the electrical utility industry is its
extensive vertical integration. A few utilities do not sell power
directly to final consumers but only to other utilities; and a
few firms act only as retailers of power produced by others.
But for the most part utilities produce at their own plants
most or all of the power they sell directly to final consumers.
The issues raised by nuclear plant construction and the
range of possible resolutions are, in large part, determined
by this combination of distribution monopoly, rate regulation,
and vertical integration.
In most states electrical rates are set by governmental
bodies called public service commissions or public utilities
boards. These regulatory agencies typically allow rates high
enough to meet the costs utilities incur in purchasing fuel
and in operating and maintaining their generating plants and
transmission facilities. In addition, utilities are allowed to

C h a rt 1

Uni t e d S t a t e s El e c t r i c a l G e n e r a t i n g
C a p a c i t y and S u m m e r Peak Load
D e m a n d plus 18 Percent
M illio n s o f k ilo w a tts
700

600

450
400

3Annual Energy Review, op. cit
4The Atomic Industrial Forum, “ Historical Profile of U.S. Nuclear Power
Development" (January 1984).

C apa city

500

Market structure and rate regulation

2For example, the National Electric Reliability Council estimate of electricity
demand in 1983 made in 1974 was about 750 million kilowatts,
compared with the actual 450 million.

55 0

The organization of the electrical utility industry is unique
in several respects, and its particular market structure will
exert a major influence on the ultimate impact of current
^ .S . Department of Energy, Energy Information Administration, Annual
Energy Review.

650

350

3 0 0 1970

^ C a p a c ity if all n u c le a r p la n ts u n der c o n s tru c tio n
w e re on line.
t P re lim in a ry .
S ource:

E dison E le c tric In s titu te .

FRBNY Quarterly Review/Summer 1984

Accounting for Construction Work in Progress
In most states utilities may not begin to pass the cost of
plant construction onto customers before commercial oper
ation begins. In the terminology used by utilities and their
regulators, the value of construction work in progress (CWIP)
is not typically included in the “rate base”— the aggregate
value of the plants whose cost utilities are allowed to recover
from their customers. Some states do allow utilities to begin
recovering a part of the value of CWIP before plants open,
but most do not.
The exclusion of CWIP from the rate base creates a
financing problem for utilities, especially given how long it
takes to build large generating facilities. Most investors would
be unwilling to advance funds to a utility for building a plant
in the expectation of not receiving any return for a period
of up to ten years. Therefore, to aid power companies in
raising construction funds, most regulatory commissions allow
utilities to include on their income statements a special item
called “Allowance for Funds Used During Construction”
(AFUDC). Regulators and accountants allow utilities to report
a noncash income item equal to the interest paid that year
on debt incurred to build the plant and a competitive return
on stockholders’ equity in the plant.
The utility does not actually receive cash income in that
amount, but with AFUDC included in its financial statement
the firm is considered creditworthy enough to continue raising
money in capital markets. In other words, by allowing utilities
to report AFUDC income, regulators are in effect providing
some assurance to potential investors that the utility will even
tually be able to recover the funds spent on the construction
project with a return retroactive to when the funds were raised.

collect enough from their customers to service any bonded
debt incurred to build plant or purchase equipment and to
pay stockholders a competitive rate of return on their equity
in the company.
A crucial feature of public utility regulation is that utilities
are typically not allowed to recover from their customers the
cost of building new plants until those plants begin gen
erating electricity for sale (box). This regulatory practice
leads to sudden, large rate hikes for utilities bringing
expensive projects into commercial operation.
It is very difficult to predict accurately the utility revenue
increase or electricity rate hike which will accompany the
opening of specific nuclear plants. The cost of capital is
different to different utilities, and different regulators allow
different returns on stockholders’ equity. Some of the plants
may never be completed. In the states that allow utilities
to begin recovering the cost of new plants before com
mercial operation, part of the required revenue increase may
already have been implemented. Many relevant figures may

FRBNY Quarterly Review/Summer 1984

Under ordinary circumstances, once the plant is completed
the utility is allowed to begin recovering from its ratepayers
the entire cost of building the plant, including both direct
expenditures and all accumulated funds used during
construction.
Another common regulatory practice is to base rate
decisions on the book value of the firm's assets. Over
time, therefore, as the book value of a plant is depre
ciated, the revenue return allowed on each asset
declines. Therefore, as any plant ages, the amount
consumers must pay as a return on capital investment
declines. This means that a large proportion of the total
investment in any new plant is charged to the consumers
in the first few years of operation. Inflation magnifies the
effect of this "front loading” in real terms. First, inflation
raises interest rates in general and therefore the rate of
return utilities are permitted to earn. Second, with infla
tion, the real value of the payment stream (which is fixed
in nominal terms) is depressed by greater amounts each
year.
For all of these reasons, a large part of the impact of
an expensive new plant’s completion is felt by consumers
all at once when the plant goes into service. Given how
long it has taken to build those nuclear plants currently
under construction and how high capital costs have been
over the last ten years, the practices of deferring rate
hikes until commercial operation commences and of
“ front loading” the capital costs has resulted in the
potential for huge additions to utilities’ rate bases and
consequent "rate shock.”

change by the time the plants finally go into service.5 Finally,
regulators, legislatures or the courts may not allow the
utilities to recover the full costs of construction on any one
of a number of grounds.
These qualifications notwithstanding, the rough estimates
in Table 2 provide a consistent basis for aggregation and
comparison across utilities and regions. The required rev
enue increases in the first year of operation (Table 2,
column 4) represent the sum of the following costs:6
5For example, the Department of Energy forecasts 5.4 percent growth of
electricity sales in 1984. See Energy Information Administration, Short
Term Energy Outlook (June 1984). Demand growth raises the revenue
increases required (as more operation and fuel costs are incurred) but
lowers the required rate hikes per kilowatt hour (as fixed costs are
spread over more kilowatt hours).
6Table 2 reports revenue increases only for the 60 investor-owned utilities
with shares of one or more nuclear plants under construction. These
utilities collectively own about two-thirds of the aggregate nuclear
capacity under construction. The rest is owned by private cooperatives
and governmental agencies.

• operations, maintenance, and fuel costs of two cents
per kilowatt hour produced, assuming the plant oper
ates 65 percent of the hours in a year,
• capital costs of an amount sufficient to service a
mortgage with initial principal equal to the cost of the
plant at completion over 30 years at 14 percent
interest, and
• annual charges of 6 percent of the cost of the plant
at completion to account for depreciation and taxes.7
This estimate of additional revenue requirements is
expressed as a percentage of the utility’s revenues for 1983
electric utility operations. It is important to emphasize that
these estimates are for the first year of operation only. A
large share of the utility revenues associated with a specific
plant is computed as a proportion of the capital value of
the facility. As the plant is depreciated, this portion of rev
enues will decline.
There are a few utilities with nuclear construction work
in progress which will not require very large r$te increases
to meet their share of the obligations incurred in building
a plant. However, the (weighted) average percentage rev
enue increase of some 35 percent for these utilities is more
than twice as large as the average 15 percent increase in
nominal revenues experienced by all U.S. electrical utilities
between 1970 and 1980.8 And in some cases, the required
increase is extremely large, exceeding 50 percent for 14
utilities.
The revenue increases associated with completion of
nuclear plants will probably be mitigated by the relatively
low operations, maintenance, and fuel costs at nuclear
plants. Much of the new nuclear capacity that comes on line
will initially be used to replace older oil and coal fired plants.
Operations and maintenance costs for the older plants,
especially the oil fired ones, are much higher than for
nuclear plants. Therefore, as nuclear capacity replaces oil
and coal fired capacity, the average variable cost of pro
ducing electricity will probably decrease.
The fifth column of Table 2 reports the net increases of
revenue required, assuming all of the electricity produced
by each nuclear plant replaces power produced currently
at the utility’s average 1983 costs for operations, mainte
nance, and fuel. In the cases of the utilities with the highest
variable cost of production— generally in the oil-burning
northeast— the eventual savings could be substantial. In fact,
HTie results are mildly sensitive to these assumptions. Allowing the total
rate of return to vary from 18 percent to 22 percent, and allowing the
operating factor to vary from 55 percent to 70 percent yielded estimates
of total revenue increases ranging from $20 billion to $25 billion. The
results reported in the table lie in the middle of that range.
•U.S. Federal Power Commission (1970); U.S. Energy Information
Administration, Statistics of Privately Owned Electric Utilities (1980).

the savings could be even greater than those shown in
Table 2, because these estimates are based on average
production costs for all plants, but utilities can be expected
to replace their highest variable cost facilities first.
It should also be noted that the expected percentage
revenue increases listed in Table 2 will not translate directly
into electricity rate increases. How much rates per kilowatt
hour do increase will depend on how many kilowatt hours
are sold. The demand for electricity could very well increase
substantially over the next few years, along with the growth
of GNP. A few years’ real growth of 3 percent would wipe
out most of the present excess capacity if no additional
plants are completed.9 To the extent that each utility
increases the sale of electrical energy, part of the revenue
increase would be covered by these sales.
In another way, however, a given initial rate increase might
understate the long term economic and financial impact of
nuclear plant completion. The experience of the 1970s
suggests that consumers will respond to the likely initial
electricity rate increases by conserving electricity and by
increasing their own production of electricity. (Under current
federal law, in fact, utilities are required to purchase excess
electricity produced by their customers.) Reductions in
nuclear utilities’ sales would lead to further rate hikes, to
provide enough revenues to meet fixed costs.
Aggregate and regional economic effects
For the national economy, the impact of the rate increases
expected upon completion of nuclear construction work in
progress would generally be moderate. A $25 billion shift
from utilities’ customers to investors in nuclear utilities would
probably not have substantial macroeconomic conse
quences, but such a transfer might have significant distri
butional effects. The average price of electricity per kilowatt
hour nationwide would increase substantially. Thus, elec
tricity-intensive industries with large investments in fixed
plants, such as ferro-alloy and aluminum smelting and
petrochemicals, would suffer the most.
In specific regions of the country the effects on economic
development may be greater. While 23 states are not seri
ously affected directly, in 13 others revenue increases could
exceed one percent of state personal income (Chart 2). By
this standard, the most severe problems appear to be
concentrated in northern New England and in the Ohio and
Mississippi Valleys. Some regions which could be affected
by large rate increases are not shaded in Chart 2 because
the local nuclear plants are being constructed by govern
ment-owned utilities or public authorities (notably the Pacific
Northwest).
There are, of course, differences in the impact of nuclear
plants within states (Table 2, columns 6 and 7). In New \brk
9ln Chart 1, for example, the excess reserves according to the 18 percent
standard was about 13 percent in 1983.

FRBNY Quarterly Review/Summer 1984 51

State, for example, Long Island has a severe problem while
New York City is unlikely to be directly affected.

The regulatory response
Under normal circumstances action on rate increases by
public utilities boards is fairly routine. Utilities document the
need for a rate increase, consumer advocates present their
arguments, and the board members vote to award the utility
an increase they see justified by the economic and financial
circumstances.
However, any request for an unusually large rate increase
would ordinarily be subject to special scrutiny by regulators
and extensive judicial review. And in the cases of nuclear
plants, because of the controversies surrounding nuclear
power and because the capacity is not immediately needed,
the attention paid to the regulatory proceedings will be

especially intense. The rules under which these regulatory
agencies operate provide some grounds for extraordinary
actions by public service commissions.
First, many states do not allow utilities to recover the cost
of constructing plants that are abandoned before completion.
For example, Washington State utilities entered into con
tracts with the Washington Public Power Supply System to
pay for the construction of WPPSS power plants whether
they operate or not. But the courts voided these contracts,
ruling that the utilities had no right to commit themselves
to pay for power never received. Firms with expensive
construction work in progress in states that do not allow
recovery of investment in incomplete projects have sub
stantial incentive to finish their projects, even if the electricity
is not presently needed or when the completed plant would
not be an economical generating facility.

Table 1

U.S. Nuclear Plant Construction Projects as of January 1,1984
(All estimates are as of March 31, 1984 unless otherwise noted.)
Estimated
Final Cost
(thousands)

Percent
Complete

Status/Estimated Date of
Commercial Operation

3,076,208
f
-p .o /o .u u u
2,077,600
1,465,500

78
77
57
70
54

1986
1989

Byron 1 ....................................................... ................ 1,120
Byron 2 ....................................................... ................ 1,120
Callaway 1 ................................................. ................ 1,188
Carroll County 1 ........................................................ 1,120
Carroll County 2 ........................................................ 1,120

2,200,000
1,535,700
2,850,000
*
*

93
67
99
0
0

1985
1986
Low power license
On order
On order

Catawba 1 .................................................

1,145

1,800,000

1985

Catawba 2 .................................................

1,145

2,100,000

1987

Clinton 1 .....................................................
Comanche Peak 1 f ..................................
Comanche Peak 2 | ..................................

950
1,150
1,150

2,867,982
1,945,000
1,945,000

83
97
65

1986
1985
1986

North Carolina Elec.
Membership Corp.
North Carolina Municipal
Power Agency
Illinois Power Co.
Texas Utilities
Texas Utilities

Diablo Canyon 2 ........................................
Fermi 2 .......................................................
Grand G u l f f ...............................................
Hartsville A-14 : ............................................
Hartsville A -2 t ............................................

1,106
1,093
1,250
1,205
1,205

2,219,500
3,071,258
3,000,000
/ k 7 ^ nnn
t '
'

96
98
100
44

1985
1984
1984
Indefinitely suspended
Indefinitely suspended

Pacific G&E
Detroit Edison
Middle South
TVA
TVA

Hope Creek ................................................
Limerick 1 .................................................
Limerick 2 .................................................
Marble Hill 1 ..............................................
Marble Hill 2 ..............................................

1,067
1,065
1,065
1,130
1,130

3,780,000
2,657,000
3,766,000
3,009,156
2,061.482

85
94
31
56
35

1986
1985
1990
Indefinitely suspended
Indefinitely suspended

Public Service E&G
Philadelphia Elect.
Philadelphia Elect.
PS. Indiana
PS. Indiana

Midland 1 f .................................................
Midland 2 t ..................................................
Millstone 3 ..................................................
Nine Mile Point 2 ........................................
Palo Verde 1 ..............................................

492
818
1,159
1,080
1,304

f . .„ n nm
I ’
’
3,538,500
5,100,000
1,905,694

84
84
75
99

Cancelled
Indefinitely suspended
1986
1986
1985

Consumers Power
Consumers Power
Conn. Light & Power
Niagara Mohawk
Arizona Public Service

Plant
Beaver Valley 2 ..........................................
Bellefonte 1 ...............................................
Bellefonte 2 ................................................
Braidwood 1 ..............................................
Braidwood 2 ..............................................

Capacity
(megawatts)
852
1,235
1,235
1,120
1,120

FRBNY Quarterly Review/Summer 1984

1991

1986
1987

Principal Owner
Ohio Edison
TVA
TVA
Commonwealth Edison
Commonwealth Edison
Commonwealth Edison
Commonwealth Edison
Union Electric Co.
Commonwealth Edison
Commonwealth Edison

Even when plants are completed, rate increases sufficient
to pay back all costs of construction may not be automatic.
Some states, such as New York and Ohio, allow utilities to
recover only those costs of construction which were “ pru
dently” incurred. Under this regulatory provision the state
public service commission has the right to conduct detailed
investigations into the history of each construction project
and to judge whether any “mistakes” that might have been
made could reasonably have been foreseen and avoided
by the utility’s management. For example,10 under this
principle the staff of the New York State Public Service
Commission has concluded that up to $1.6 billion of the
$4.1 billion cost of constructing the Shoreham nuclear facility
10State of New York, Department of Public Service, Investigation of the
Shoreham Nuclear Power Station: Executive Summary Testimony
(February 1984).

had been imprudently incurred. The Commission itself has
not ruled on the staff’s recommendation, but if it accepts
this finding Lilco could have to absorb a business loss of
that magnitude.
In fact, regulatory law offers a number of mechanisms for
opponents to challenge almost any utility’s case for almost
any rate increase. In some states, for example, the public
service commission may deny rate increases to utilities to
pay for plants whose capacity is not needed to meet
demand. And some public service commissions, those of
New York and Connecticut, for example, have placed limits
on the total construction costs for specific plants which will
be reimbursed through rate increases.
Consumers cannot be certain of being able to find legal
grounds for avoiding any rate increase; utilities have
recourse to the courts for protection from arbitrary actions

Table 1

U.S. Nuclear Plant Construction Projects as of January 1,1984

(continued)

(All estimates are as of March 31, 1984 unless otherwise noted.)

Plant

Capacity
(megawatts)

Estimated
Final Cost
(thousands)

Percent
Complete

Status/Estimated Date of
Commercial Operation

Principal Owner

1986
1987
Indefinitely suspended
1988
1985

Arizona Public Service
Arizona Public Service
Cleveland Elec. Ilium.
Cleveland Elec. Ilium.
Gulf States Utilities

Cancelled
Indefinitely suspended
1987
1986

Gulf States Utilities
PS. New Hampshire
PS. New Hampshire
Carolina P&L
Long Isl. Lighting

1987

Palo Verde 2 ................................
Palo Verde 3 ................................
Perry 1 ..........................................
Perry 2 ..........................................
River Bend 1 ................................

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

1,304
1,304
1,205
1,205
934

1,330,563
1,463,743
2,651,300
2,461,700
2,473,643

99
88
94
44
86

River Bend 2 ................................
Seabrook 1 f ................................
Seabrook 2 f ................................
Shearon Harris 1 ...........................
S h oreham ......................................

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

934
1,198
1,198
915
854

2,539,900
2,709,100
2,830,298
4,100,000

89
29
85
99

South Texas Proj. 1f ..................................
South Texas Proj. 2 f ..................................
Susquehanna 2 ................................ ........
Vogtle 1 ............................................ ........
Vogtle 2 ............................................

1,250
1,250
1,011
1,100
1,100

Waterford 3 ..............................
Watts Bar 1 ..............................
Watts Bar 2 ...............................
Wolf C reekf ..............................
WPPSS 1 t ................................

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

1,151
1,165
1,165
1,150
1,266

WPPSS 3 t .................................................
Yellow Creek 1 t ........................................
Yellow Creek 2$ ........................................
Zimmer 1 ...................................................

1,242
1,285
1,285
810

Total for all plants

59,286

50
18
99
65
22

Low power license
1987
1988

Houston L&P
Houston L&P
Pennsylvania P&L
Georgia Power
Georgia Power

2,900,000
3,460,209

100
97
63
91
60

1984
1985
1986
1985
Indefinitely suspended

Middle South
TVA
TVA
Kansas G&E
WPPSS

3,809,203
f „ „ , , - nm
I ’
'
3,100,000

50
33
33
85

Indefinitely suspended
Indefinitely suspended
Indefinitely suspended
Converted to coal

WPPSS
TVA
TVA
Cincinnati G&E

{7,411,006
2,159,000
3,722,379
1,475,671
2,649,200
j3,505,000

135,338,495

‘ Not available.
t1983 Estimates.
^1982 Estimates.
Source: Federal Energy Regulatory Commission, individual utilities, and the Atomic Industrial Forum.

FRBNY Quarterly Review/Summer 1984

by state regulators. However, rate increases to pay for very
expensive and apparently unneeded capacity cannot be
considered automatic. Most of the large rate increases
associated with the completion of nuclear plants currently
under construction will probably come under very conten
tious challenge before regulatory commissions, in state
legislatures and executive chambers and before state and
federal courts.

Financial consequences and capital market responses
Any possibility that previously expected rate increases may

be slow in coming or may not come at all threatens the
financial health of some of the utilities with nuclear con
struction work in progress. It is difficult to say exactly how
much of a loss any given utility could bear because the tax
treatment of such write-offs complicates matters consider
ably. However, if a utility has less than 100 percent of its
owners’ equity invested in a nuclear project, then the senior
creditors of the firm, if not necessarily the stockholders,
would probably be protected, even if the full book value of
the nuclear project had to be written off as a loss. When
the book value of nuclear construction work in progress

Table 2

Investor Owned Utilities with Nuclear Construction Work in Progress*

First Year
Required
Revenue
Increase
(percent)

Revenue
Increase.
Net
Operating
Savings
(percent)

Current
Revenues
per Kwh
(cents)

First Year
First Year
Net
Net
Revenue
Revenue
Increase:
Increase % Personal
per Capita
Income
(percent)^
(dollars ) t

Plant
Completion
Cost
(millions)

Expen
ditures
Remaining
(percent)

Arizona Public Service Co...............................
Atlantic City Electric Co...................................
Bangor Hydro-Electric Co
Canal Electric Co. (MA, Rl)
Carolina Power & Light Co (NC. SC)

1.368
189
115
184
2.372

4
15
42
42
15

84
26
96
196
68

46
9
35
27
34

25
5
22
19
28

68
88
64
50
53

200
24
149
10
144

19
0.2
18
0 1
18

Central Hudson Gas & .Electric Corp (NY)
Central Maine Power Co.............
Central Power & Light Co (TX)
Central Vermont Public Service Corp
Cincinnati Gas & Electric Co

459
403
1.868
144
1.442

25
36
66
31
15

70
62
90
71
59

25
22
47
25
39

19
16
33
17
33

78
59
67
59
56

91
103
432
63
172

09
12
43
0 7
16

Cleveland Electric Illuminating Co
Columbus & Southern.Ohio Electric Co
Commonwealth Edison Co (IL)
Connecticut Light & Power Co........................
Consumers Power Co (Ml)
.......................

2.344
787
7.279
2.071
4.430

28
15
27
19
16

55
71
95
75
97

49
27
47
37
69

32
23
15
22
57

72
53
76
82
58

268
124
271
160
222

23
13
22
12
20

The Dayton Power and Light Co
Detroit Edison Co
Duke Power Co (NC. SC)
Duquesne Light Co. (PA)
El Paso Electric Co

871
2 457
975
1.127
743

15
2
16
28
4

58
70
49
56
164

30
26
11
35
73

24
19
9
23
23

65
66
45
73
8 1

178
116
101
159
457

18
10
10
14
60

Fitchburg Gas and Electric Light Co (MA)
Georgia Power Co
Gulf States Utilities Co. (TX. LA)
Houston Lighting & Power Co.
Illinois Power Co

47
2.376
1.732
2.283
2.294

42
48
14
66
17

88
59
102
37
119

41
22
31
15
69

17
17
26
11
57

84
5 1
48
64
53

6
129
299
174
304

0 1
1.4
28
13
3 1

0
8
105
116
143

13
16
56
79
78

-2
-2
39
60
49

53
57
63
54
109

87
62
232
540
251

09
06
20
4 7
19

129
146
137
92

60
49
32
24

43
40
23
18

57
46
55
55

218
266
37
66

28
29
04
07

Interstate Power Co (IA. IL)
...........
lowa-lllinois Gas and Electric C o.................
Kansas City Power & Light Co (KS. MO)
Kansas Gas and Electric Co
Long Island Lighting Co.

1 363
1.363
5.018

100
100
9
9
5

Maine Public Service Co
Middle South Utilities. Inc (MS. LA. AR)
Montaup Electric Co (MA. Rl)
.......
New England Power Co (MA)

79
5.349
294
951

42
0
30
30

FRBNY Quarterly Review/Summer 1984

§
§

Nuclear
Exposure
(percent)t

exceeds 100 percent of equity, both stockholders and
bondholders would be exposed to losses. Based on data
for 1983 there are 14 utilities whose total investment in
nuclear construction projects exceeds their stockholders’
equity (Table 2, column 3).
No one knows exactly what would happen in the event that
a privately-owned utility sought court protection from its cred
itors. Surely the legal proceedings would be lengthy, complex,
and costly. It is highly unlikely, however, that delivery of electrical
power to consumers in the bankrupt utility’s service area would
be disrupted, at least in the short run.

The uncertainty lies in the short- and long-term financial
impacts of a utility’s recourse to the courts for protection,
and especially its eventual effect on electricity rates. If the
utility loses access to short-term capital markets, and if cash
flows are insufficient to meet current expenses, the company
could make operating decisions that would lead to a dete
rioration in the quality of service. In the longer run, investors
might eventually be willing to lend money to the utility or
its reorganized successor, but only at a very high rate of
return. It is unclear how large the capital markets’ penalty
would be, but any higher cost of capital to the utility would

Table 2

Investor Owned Utilities with Nuclear Construction Work in Progress*

(continued)

First Year
Required
Revenue
Increase
(percent)

Revenue
Increase,
Net
Operating
Savings
(percent)

Current
Revenues
per Kwh
(cents)

First Year
Net
First Year
Net
Revenue
Increase:
Revenue
Increase % Personal
per Capita
Income
(dollars)}: (percent)}:

Plant
Completion
Cost
(millions)

Expen
ditures
Remaining
(percent)

New York State Electric & Gas Corp
Niagara Mohawk Power Corp (NY)
Ohio Edison Co
Pacific Gas and Electric Co. (CA)
Pacific Power & Light Co (OR. CA. ID.
WY M I WA)

918
2.091
2.823
2.220

25
25
27
4

34
43
85
55

26
23
52
15

22
20
37
9

64
5.9
6.4
6.5

40
101
227
33

04
10
2.3
0.3

388

100

0.3

Pennsylvania Power & Light Co
Pennsylvania Power Co
Philadelphia Electric Co
Portland General Electric Co (OR)
Public Service Co. of New Hampshire

1.943
266
6.423
388
1.968

1
31
43
100
41

62
67
96
23
119

40
35
73
16
107

31
27
48
15
61

54
56
76
4 1
73

125
36
416
66
539

11
0.3
3.6
0.6
55

Public Service Electric & Gas Co (NJ)
Public Service Co of Indiana. Inc
Public Service Co of New Mexico
Puget Sound Power & Light Co (WA)
Rochester Gas & Electric Corp

3.591
4.209
479
194
714

15
53
4
100
25

69
0
53
30
56

33
121
36
9
35

21
98
23
8
28

84
49
64
35
69

134
615
225
20
159

11
68
25
0.2
14

Southern California Edison Co..........
Texas Utilities Co
The Toledo Edison Co
Union Electric Co (MO)
United Illuminating Co (CT)

743
3.417
1.630
2.850
1.049

4
19
28
2
39

51
80
103
114
119

5
26
81
60
59

2
18
56
50
20

7.5
5.6
6.9
46
9 7

18
97
557
361
168

0.1
0.8
5.4
3.2
1.2

194
439

100
17

24
96

21
41

22
26

24
77

75
132

08
14

93.709

6.0

143

1.3

Washington Water Power Co
Western Massachusetts Electric Co
Totals o'r Averages ....................................

Nuclear
Exposure
(percent)t

'Information as of December 31. 1983
tExposure is measured as value of construction work in progress on nuclear protects as a percentage of the proprietors capital in each utility.
^Population and income figures are the totals for the counties served, in part or in whole, by each utility These figures understate the actual
per-capita cost and cost as a percentage of personal income because in many cases utilities serve only part of a single county. The
understatement is probably greatest for the utilities in the New England states.
§The Carroll County Facility is on order, but construction has not yet begun
Source: Federal Energy Regulatory Commission. Census Bureau. Atomic Industrial Forum and individual utilities

FRBNY Quarterly Review/Summer 1984

be translated into higher electricity rates.
The consequences of several electrical utilities experi
encing difficulties at the same time would be felt in the
financial system as a whole; the aggregate investment at
risk is substantial. If we take those utilities with more than
100 percent of their proprietors’ capital invested in a nuclear
project to be most severely at risk, then the nuclear
investment most threatened is about $21.5 billion.
Capital markets have already taken note of this situation.
Over the past six months the common stocks of utilities with
nuclear projects underway did significantly worse than the
average for the industry. In fact, regression analysis of utility
stock price changes between November 1,1983 and June 1,
1984 for a sample of utilities with and without nuclear con
struction projects shows an additional decrease in the
aggregate market value of a company’s common stock of
between 10 and 15 cents for every dollar the firm has spent
on nuclear construction work in progress.11 In other words,
the stock market may have essentially “written off” this
proportion of the value of nuclear construction work in
progress between November 1983 and June 1984, either
in anticipation of rate hike denials or in response to the
added uncertainty of the return to their investment. It
remains to be seen whether capital markets are correct in
their current assessment that, on average, state public
service commissions will disallow 10 to 15 percent of the
rate increases necessary to recover from ratepayers the
utilities’ investment with a competitive return.
Conclusions
At present, it looks as if the construction of many nuclear
power plants in the United States could turn out to be a
poor investment. The capacity and power produced by these
plants is, for the most part, not needed immediately. More
over, current fossil fuel prices and the huge capital costs
incurred in building these plants make most of them very
expensive sources of electricity. But given the market
structure and regulatory environment unique to the electric
utility industry some or all of the costs of these plants can
be passed onto electricity users.
A competitive return on utilities’ entire investment in
nuclear plants could only be guaranteed in some parts of
the country by requiring consumers to pay more for elec
tricity than the cost of production at available alternative
sources. There are places served by utilities with nuclear
construction work in progress which could, in the short run,
acquire both electrical energy and firm peak load capacity
at much less than the capital plus operating costs of a

11The finding that each dollar invested in nuclear projects reduces the total
market value of a company's common shares by between 10 and 15
cents is sustained even when the four utilities with the most widely
publicized difficulties, Lilco, Public Service of New Hampshire, Public
Service of Indiana, and Consumers Power, are omitted from the sample.

56 FRBNY Quarterly Review/Summer 1984

newly completed nuclear plant. In other places moderate
additions to transmission capacity would facilitate sufficient
imports from neighboring regions of the United States or
from Canada.
This does not mean, however, that construction of any
given nuclear plant should be abandoned. Once built,
nuclear plants have relatively low marginal operating costs,
so abandonment of most projects that are close to com
pletion is probably not cost beneficial. Furthermore, com
pletion of nuclear plants now provides some insurance
against increases in fossil fuel prices and against possible
“brownouts” caused by unexpectedly rapid increases in the
demand for electricity.
Ordinarily, an acceptable reconciliation of the interests of
investors and ratepayers could probably be reached through
routine regulatory processes or through litigation. However,
the regulatory system for electrical utilities we have in place
was not designed to contain or manage controversies with
stakes running into billions of dollars. Consequently, the
controversy inevitably takes on a political dimension. The
relative losers in the regulatory process, whoever they are,
will almost certainly make an arguable claim that the out
come is unfair or inefficient. There will be calls for special
legislation or regulatory reform aimed at reducing or real
locating the burden imposed by new nuclear plants.
There have already been some proposals for passing part
of the burden onto state or federal taxpayers. For example,
it has been suggested that state authorities purchase some
plants. However, substantial new borrowing by state power
authorities could increase the cost of capital for
other state operations.
Under some proposals the federal government might
purchase the plants and retain them as a “strategic energy
reserve” against the possibility of an interruption in oil
supplies. The federal government would face lower capital
costs than the investor-owned utilities, because it pays a
much lower risk premium than a private firm. But the debt
service payments associated with the purchase of the plants
would make it harder to reduce the federal budget deficit.
Regulatory reform of various types might reduce the cost
marginally or make it easier to bear. Under current regu
latory practice the immediate effect of plant completion is
to increase electricity rates markedly. Over time, however,
the cost of individual plants to consumers in terms of rates
per kilowatt hour will probably decline for two reasons. First,
as consumption of energy increases with general economic
growth, the fixed cost of the plant is spread over more kilo
watt hours generated. Second, as the book value of the
plant depreciates, the amounts customers must pay to
stockholders as a return on the owners’ equity in the facility
declines.
Therefore, a part of the rate shock associated with plant
completion is an artifact of the effective “front loading” of
the cost of plants in the first few years of operation. But

C h a rt 2

E x pe c t e d Requi r ed N e t R e v e nu e I ncrease:

P e r c e n t of S t a t e P ersonal I n c o m e

Less than 0.1%
0.1 -. 9 9 %
1-1.99%
2% or g re a te r

S o u rc e s :

F e deral E nergy R e g u la to ry C om m ission , In d iv id u a l U tilitie s , and F e d e ra l R eserve Bank o f New Y o rk c a lc u la tio n s .

“front loading” is not the only way of compensating utilities’
investors for the funds they have provided. It might make
more sense to spread out the costs and savings over the
life of the plant. Alternative regulatory schemes might “phase
in” the lifetime cost of the plant over a long period, possibly
commencing before commercial operation, while maintaining
the same net present value as the current system.
There are other regulatory reforms, which while not
directly related to nuclear facilities financing, have an impact
on this problem. A number of proposals have been offered
in recent years aimed at enhancing the competitiveness of
the electrical utility industry. For example, one proposal aims
to promote competition among wholesale producers of
electricity by separating production and distribution. Other
proposals would make utilities’ rate structures more complex
by encouraging wider use of differentials by time of day and

for different service qualities. It is expected that rate struc
tures more closely based on costs would create an incentive
for more efficient use of energy and capacity and reduce
the overall cost of electricity.
Unfortunately, in the current environment of uncertainty
regarding the return on investments in nuclear plants it
would be very difficult to implement any reform. Capital
markets are likely to interpret any changes in the rules of
the game as an attempt to pass the cost of nuclear plants
back to stock and bondholders. Further disenchantment with
electric utilities on the part of capital markets would make
electricity even more expensive, and defeat the intent of
reform over the long run. Therefore, the challenge is to
minimize the burden to be borne, to find and implement a
just allocation of the burden, and to do both in a way that
maintains investor confidence.

Aaron S. Gurwitz and Daniel E. Chall

FRBNY Quarterly Review/Summer 1984

In Brief
Economic Capsules
Collateralized Mortgage
Obligations: Do They Reduce
Cash Row Uncertainty?
The collateralized mortgage obligation (CMO) has become
a very popular instrument in the secondary mortgage
market: over $9.5 billion of these securities have been
issued since the first offering in June 1983. Like standard
mortgage pay-through securities, the cash flow generated
by the CMO mortgage collateral pool is used to provide for
interest and principal repayment. However, the conventional
wisdom is that the CMO structure creates two advantages
over the standard pay-through bond.
First, CMOs offer a wider variety of expected maturity
dates and thus may appeal to a broader spectrum of
investors. Second, they “offer a more predictable principal
repayment schedule.” 1 If both propositions were true (and
there were no alternative means in the market to accomplish
the same ends), one would expect the CMO to lower
mortgage rates by making mortgages more marketable in
the secondary market.
But the second proposition is not necessarily true.
Although the CMO structure does lead to a more diverse
selection of expected maturity dates, our research indicates
that the timing of the cash flows cannot be more predictable
for all CMO investors.2 In fact, we show that under a variety
of conceivable circumstances the timing of the payment
stream for many CMO investors will be considerably less
The authors would like to express their appreciation to Amy Barber for
her assistance in the calculation of the figures in this article.
1Real Estate Finance Today, "Lack of Consensus May Delay CMO
Guidelines" (May 1984), page 9.
2For a proof of this assertion, see Arturo Estrella and Andrew Silver, "The
Collateralized Mortgage Obligation: A Statistical Analysis of Its Cash
Flows” Federal Reserve Bank of New York Working Paper, forthcoming.

58 FRBNY Quarterly Review/Summer 1984

certain than with a standard pay-through bond. Furthermore,
under some scenarios, all CMO investors may receive less
predictable cash flows.
Uncertainty about the timing of payments on any mort
gage or pay-through security (including CMOs) arises from
the borrower’s option to prepay the mortgage at any time
(usually with little or no penalty).3 With a pay-through bond,
these prepayments would be passed onto the holder of the
security, effectively reducing the instrument’s duration— a
measure of its average life. Investors generally view this
duration uncertainty as a disadvantage, since it could leave
them vulnerable to some unexpected interest rate risk.4
While all investors in a standard pay-through security
receive a pro rata share of each of the payments, CMO
investors get a pro rata share of only a specific segment
of the total mortgage payments. By design, the CMO
mortgage pool is divided into two or more maturity classes.
Initial principal payments (both prepayments and regular
repayments) from the total pool are paid to investors in the
shortest maturity class only, until their entire principal has
been repaid. Principal repayments to investors in any sub
sequent class are made only when all of the shorter maturity
classes are fully paid off.
Therefore, while all investors in standard pay-through
securities share the same randomly timed payment stream,
CMO investors can choose among classes with different
expected cash flow patterns, ranging from very short to very
long periods. However, the variability around those expected
*We are abstracting here from any other payment uncertainty, such as
default risk.
♦Interest rate risk is the risk that net worth may decline due to a change
in interest rates. To avoid this, investors may in principle adjust their
portfolios so that the ratio of the duration of liabilities to the duration of
assets equals the ratio of assets to liabilities. However, when the duration
of an asset is uncertain, as in the case of a mortgage with a
prepayment option, it is not possible to adjust so precisely. For a further
explanation of duration and interest rate risk, see Richard W. McEnally,
"Duration as a Practical Tool for Bond Management" Journal of Portfolio
Management (Summer 1977), pages 53-57.

IN BRIEF—ECONOMIC CAPSULES

Duration Statistics for a Simulated Collateralized Mortgage Obligation
Prepayment rates*
FHA
Security

M eant

Variance^

Flat
M eant

Variance^

Increasing
M eant

Variance^

Decreasing
M eant

Variance^

Mortgage pool ....................... ..................5.73

038

5.51

.043

6.50

.020

4.71

.051

CMO class
1
2
3
4
5

.084
.137
.102
.020
.001

2.02
4.37
6.11
7.24
7.84

092
.172
.098
027
.002

3.83
6.16
7.08
7.57
7.88

.150
.057
.017
.004
.000

1.44
3.08
4.82
6.50
7.73

.037
.129
.156
.102
.009

..................2 47
..................4 64
..................6.28
..................7.40
..................7.87

*One of our prepayment assumptions represents the actual FHA experience from 1970 to 1983. See Thomas N. Herzog and Dominick C. Stasulli,
"Survivorship and Decrement Tables for HUD/FHA Home Mortgage Insurance Programs as of December 31, 1983” U.S. Department of Housing
and Urban Development (March 1984). A second schedule assumes a flat expected prepayment rate of 6 percent (of the remaining outstanding
mortgages) per year over the 30 year period— the average of all the annual FHA rates. Finally, two sets of more strongly tilted rates are used. One
increases linearly from 1.1 percent in the first year to 10.9 percent in the twenty-ninth, and the second decreases linearly from 10.9 percent to 1.1
percent. Once again, the average rate is 6 percent in both cases,
tin years,
tin years squared.

patterns depends on the variability of the repayments in
which the investors share. The investor in a CMO class
shares the cash flow from just a portion of the mortgage
pool, a portion segmented by the timing of payments. One
would thus expect that the repayment period for a CMO
class probably would be less spread out than for a standard
pay-through security. This would tend to reduce the vari
ability of the payments and is probably behind the conven
tional conclusion that CMOs provide a more predictable
repayment schedule.
Another factor, however, tends to increase the variability.
Prepayments which come in at unexpected times have a
much larger impact on the duration of a CMO class than
of a standard pool. This is because in a standard pool,
deviations from expectations are averaged over the entire
pool, while CMO deviations are averaged over only a seg
ment of the pool.
So it is not clear, a priori, whether the duration of the
repayment schedule would tend to be more predictable with
a CMO class than with a conventional pay-through security.
The answer depends on the relative magnitudes of the two
opposing factors described above, which in turn depend on
5To shift the uncertainty, issuers could direct all or part of the initial
prepayments to classes other than that with shortest stated maturity.
Alterations of the conventional CMOs along these lines have not yet
become commonplace in the market, although at least one variant was
offered in early 1984, in a private placement. (See Bondweek, "Lepercq
Structures CMOs to Protect Short-term Investors” [March 19, 1984], page
1.) As with conventional CMOs, however, any alteration would leave at
least one class of investors with greater uncertainty than with a standard
pay-through security. For a proof of this assertion and an example of an
alternative structure, see Arturo Estrella and Andrew Silver, op. cit.

the probability distribution of the timing of the prepayments.
What is clear, however, is that not all of the CMO classes
can have more predictable cash flows. At best, the uncer
tainty can be shuffled from class to class.5 At worst, the
uncertainty for all classes is greater than that for the pool.
To illustrate these points, we examined the effects of
uncertain prepayments on the duration for a variety of
possible distributions. Prepayment experience will vary with
interest rates; generally, higher interest rates lead to slower
prepayment rates. Thus, the exact distribution may vary if
the CMO is offered at different points in the interest rate
cycle.
We measure the uncertainty regarding cash flow timing

by the variance of the duration, which quantifies the dis
persion around the expected duration.6 The method of
Monte Carlo simulations was used to estimate the means
and variances of the duration for a standard pay-through
security and CMO classes based on the same underlying
mortgages. In each simulation, the basic pool consisted of
100 independent 14 percent 30-year mortgages, and the
CMO was assumed to have five classes (each with the
same initial principal).
The mean and variance of the duration for each distri
bution are presented in the table for the mortgage pool and
for each of the five CMO classes. The results indicate that:
instea d of looking at the deviations from the mean duration, one can look
at the dispersion around any “ desired” duration. This amounts to
attributing a specific form to investors’ preferences regarding duration. In
our basic simulation (five CMO classes, FHA prepayment rates), the pool
was preferable to all CMO classes for some of the desired durations.
See Arturo Estrella and Andrew Silver, op. cit.

FRBNY Quarterly Review/Summer 1984

• the claim that the CMO provides a wider selection of
expected durations is correct, but
• the claim that duration is more predictable for the CMO
classes is incorrect in most cases.7
CMO classes, then, offer a variety of combinations of
expected durations and variances. For some investors, certain
classes may provide both a more appealing expected duration
and more payment timing certainty than a standard pay-through
bond. Other investors, however, may find that a CMO class
offers more desirable expected cash flow timing only at the
expense of higher variability. Thus the total cost of issuing a
CMO instead of a standard pay-through security can be lower
only if the premium relinquished by the group which benefits
from the CMO exceeds the premium required by the group
which is made worse off.
^There are conceivable situations in which all of the classes would have a
higher variance than the pool. For example, with two CMO classes, an
interest rate of eight percent and annual prepayment rates decreasing
linearly from 7.4 percent to 4 6 percent, the class variances are 130 and
.107, while the pool variance is .098.

Arturo Estrella and Andrew Silver

Table 1

Countervailing Duty and Antidumping Cases,
1980-84
In number of cases
Total
cases

Year initiated
1980
1981

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

1982
1983
1 9 8 4 * ...................

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

Total

Nonsteel

Steel

55
27

23
19

32
8

113
66

45
42

68
24

149

151

300

'Through April 30, 1984
Source: United States Office of the Trade Representative,
Trade Action Monitoring System (June 1984).

Table 2

Value of Nonsteel, Nonpetroleum Imports
Covered by Countervailing Duty and
Antidumping Suits, 1980-84
In thousands of 1979 dollars, customs value

Newly Initiated Investigations

Trade Impact of Recent
Actions on Unfair Trade Suits
In recent years U.S. industries have filed record numbers
of petitions for import relief under the antidumping (AD) and
countervailing duty (CVD) laws— and the pace is picking up
(Table 1). Some observers regard this as a worrisome
development. And it is true that suits charging unfair trade
practices are often merely the opening move by companies
and industries in a broader campaign for relief from imports.
The steel industry, for example, accounts for half of the AD
and CVD suits filed since 1980, and those actions were
clearly just one element of a multifaceted effort to gain
protection.
Nevertheless, a close inspection of the data indicates that
apart from steel, the recent escalation in trade suits has so
far had only a limited impact on U.S. imports. From January
1980 to April 1984 the value of all nonsteel imports covered
under successful suits amounted to only $1.3 billion, less
than 1 percent of total nonsteel, nonoil imports in 1979, the
base year (Table 2). Suits involving some $3.4 billion of
imports were denied, including a negative determination on
a case involving $2.6 billion of lumber imports from Canada.
Therefore, the degree of protection actually emanating from

FRBNY Quarterly Review/Summer 1984

Year initiated
1980
1981
1982
1983
1984’

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

Total

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

Affirmative

Negative

Pending

Total

550,303
164,284
470,339
83.320
0

75,243
159,959
3,090,260
23.810
29,683

0
0
2,917
39,233
375,797

625,546
324,243
3,563,516
146,363
405.480

1,268,246

3.378,955

417,947

5,065,148

'Through April 30. 1984, figures not annualized.
Source: Trade Policy Staff Committee, TRADENET database and
United States Office of the Trade Representative, Trade Action
Monitoring System (June 1984).

AD and CVD suits is not very large even when the suits
that were unsuccessful are factored in. That conclusion is
true both in the aggregate and for individual trading partners.
The problem of protectionism is still of concern'. But the
true source of that concern has to do with nontartff barriers
to trade including various orderly marketing arrangements
and voluntary quota arrangements which do inhibit trade to
an important degree. Recent petitions for import relief under
AD and CVD laws have not been a major source of pro
tectionist pressure.
Paul Glotzer and Leonard Sahling

IN BRIEF—ECONOMIC CAPSULES

Fiscal Stimulus
in the Current Recovery

C h a n g e in the Ratio of the
H i g h - e m p l o y m e n t D e fi c i t to
Pot ent i al GNP in E x pa n s i on
P e rc e n ta g e p o in t c h a n g e in y e a rly a v e ra g e

In view of the recent budget measures passed by the U.S.
Congress, will the reduced, but nevertheless still large,
federal budget deficits continue to have a stimulative effect
on the economy? Our analysis suggests that unusually
strong fiscal thrust should persist through 1984 and 1985,
even with the recent “downpayment” package included in
the Deficit Reduction Act of 1984.1
In its latest forecast, the Congressional Budget Office
estimated that prior to the Deficit Reduction Act, the federal
deficit would have been around $195 billion in 1985. This
would represent about 5.0 percent of GNR down from a
peak of 6.1 percent in 1983. With the $13 billion down
payment package, though, the deficit should fall to roughly
4.6 percent of GNP in 1985. And, if Congress cuts defense
spending, the ratio could be even lower.
On the surface, this may seem to indicate that the stim
ulatory effect of fiscal policy will decline from 1983 to 1985.
In measuring fiscal stimulus, however, it is important to
separate business cycle effects from discretionary policy. For
example, the federal deficit usually falls during an economic
upturn whether or not new policies are enacted, as higher
1The Deficit Reduction Act of 1984 includes nearly $11 billion in higher
revenues and about $2 billion in lower nondefense outlays in fiscal 1985.
It does not include reductions in defense outlays.

P e rce n ta g e p o in ts
2 . 5 ------------------------------------------------------------------------------------A v e ra g e o ve r last five e xp a n sio n s
2 0 —

llllll C u rre n t

e xp a n sio n , w ith o u t d o w n p a y m e n t

~] C u rre n t exp a n sio n , w ith do w n p a ym e n t
1 5 -------------------------------------------------------------------------------------

A positive number indicates an increase in the ratio of the highemployment deficit to potential GNP; a negative number indicates a
decrease.
The high-employment deficit and potential GNP estimates for 1984
and 1985 were calculated by the authors in two steps. First,
adjustments were made to the Bureau of Economic Analysis’ (BEA)
estimates for different assumptions regarding interest rates,

The Effect of Federal Policy Changes Since 1981
on Budget Deficits*
In billions of dollars, by fiscal year
Legislative changes

1982

1983

1984

1985

Tax reductions! ..........................
Defense spending increases . .
Nondefense spending cuts . .
Effect of legislative actions on
interest c o s ts .................................

-4 0
-1
39

-7 3
-1 7
46

-9 3
-2 5
48

-1 0 6
-3 6
61

-2

-9

-1 8

Total changes

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

Budget, embodied in the BEA’s estimates, were omitted in the
"without downpayment” scenario and were replaced with the
revenue and outlay provisions in the Deficit Reduction Act of 1984 in
the “ with downpayment” scenario.
Sources: The high-employment deficit and potential GNP estimates
through 1983 are calculated by the BEA. For recent estimates,'see
Joseph C. Wakefield and Richard C. Ziemer, “ Federal Fiscal

t
-2

-4 7

-7 9

-9 9

*The figures for 1982-84 are Congressional Budget Office (CBO)
estimates. The 1985 figures are CBO estimates adjusted by the
authors to include the revenue and outlay provisions contained in
the Deficit Reduction Act of 1984. A negative figure indicates that
the legislative change contributed to the federal budget deficit.
The aggregate changes are in net terms and are the difference
from the CBO baseline in each year.
fThe effects of changes in social security tax rates and maximum
taxable income legislated prior to the 1983 Social Security
Amendments are not included.
tLess than $500 million.
Source: Baseline Budget Projections for Fiscal Years 1985-1989,
Congressional Budget Office (February 1984).

potential GNP, and profit and income shares. Second, the proposed
spending and tax changes in the Administration’s Fiscal Year 1985

Programs” , Survey of Current Business (February 1984), pages
9-19.

growth brings about an increase in federal tax receipts and
a drop in unemployment benefits. For this reason, we focus
on the ratio of the high-employment deficit to potential GNR2

^The high-employment deficit is calculated under the assumption that the
economy is at full employment, which, in recent years, is defined as 6
percent unemployment. This measure is derived by adjusting many
components of outlays and receipts; e.g., unemployment insurance
benefits and individual and corporate income taxes, to reflect the
impacts of differences between actual and potential levels of economic
activity.

FRBNY Quarterly Review/Summer 1984

The high-employment deficit as a share of potential GNP
rose from 0.6 percent in 1981-1 to 3.3 percent in 1984-1.
Even with the downpayment, it will average 4.4 percent in
1985. Legislative changes since 1981 are mostly responsible
for the increasing high-employment deficit. In particular, the
1981 tax cut package, the growth of defense outlays, and
the indexing of the individual income tax in 1985 contribute
substantially to the increase (table).
As a result, fiscal thrust in this expansion is quite large
compared with that in past economic upturns. To be sure,
the nearly one percentage point rise in the high-employment
deficit to potential GNP ratio in 1983 is similar to what
generally occurred in the first year of earlier recoveries
(chart). But the consecutive increases in 1984 and 1985
contrast markedly with the typical declining or neutral pattern
over the second and third years of expansion. The current
stance of fiscal policy, then, may be an important factor
behind the unusually strong growth in real GNP so far in
1984. Our results also indicate that next year’s economic
activity should still be buoyed by the impetus of fiscal policy.

A. Steven Englander, Carl J. Palash, and
Peter D. Skaperdas

Outlook for State and Local
Government Holdings of U.S.
Treasury Securities
In 1982 and 1983, state and local governments financed
a significant portion of the Federal deficit, as they
increased their holdings of Treasury securities by $17.2
and $39.6 billion, respectively.1 Most of the investments
in these two years appear to have come from the
unused proceeds of municipal security issues. Those
issues were extremely high, particularly in 1983, as a
result of the strength in the bond market and the rush
to beat the deadlines for issuing bearer bonds and
single-family mortgage revenue bonds. Most experts in
the municipal markets expect levels of issuance to be
substantially lower in the coming months. By contrast,
only a part of the 1983 acquisitions of U.S. Treasury
'This analysis deals only with state and local governm ents p e r se,
and not their pension funds, w hich independently buy Treasury
obligations, along with other securities.

obligations can be explained by the budget surplus at
the state and local government levels.
The ability of state and local governments to invest
the proceeds of tax-exempt securities, whether in
Treasury instruments or in anything else, is restricted by
guidelines established by the U.S. Treasury. In general,
the Treasury has ruled that if the proceeds of a munic
ipal bond are invested at a materially higher yield than
the interest paid on the bond, the interest on the
municipal bond w ill not be exempted from Federal
income taxes. Therefore, to retain the bond’s tax-exempt
status, the yield earned on the unused proceeds of the
bond may be at most slightly higher than the cost of
funds.
In practice, however, several exceptions to the rule
drastically lessen the constraints on how state and local
governments may invest the proceeds of bond issues
for temporary periods of time. The trouble is that once
the temporary time period lapses the investments must
be liquidated. The guidelines are strict enough to make
it likely that state and local governments will be required
to disinvest the unused proceeds of past bond issues
in the near future. In fact, net purchases of Treasury
securities have already fallen to $2 billion in the first
quarter of 1984, compared with an average quarterly
rate of $10 billion in 1983.
These are the key elements of the guidelines:
(1) When the securities are issued to raise “ new
money,” the unused proceeds on most general obligation
and revenue bonds can be invested without yield
restriction for a “temporary period” of up to three years
if at least 85 percent of the proceeds are spent within
three years.
(2) When the securities are issued to refund outstanding
issues, the restriction-free “ temporary period” is gen
erally two years, provided that the principal and debt
service of the original bond are repaid at the end of this
“temporary period.”
Because the time limit based on the heavy issuance
of municipal securities in the 1982-83 period is coming
up and because the special factors which operated to
create that period of heavy issuance have vanished, the
likelihood is that state and local holdings of Treasury
securities will be run off, with new acquisitions sharply
limited.2 Therefore, this substantial source of Treasury
financing will be much less important in the near future.
2The authorization to issue tax-exem pt single-fam ily m o rtga ge revenue
bonds, which expired at the end of 1983, was reinstated by the
recently passed D eficit Reduction A ct of 1984. This may increase
somewhat the issuance of new tax-exem pt securities, and hence
m unicipalities' purchases of Treasury securities, relative to the first
quarter of 1984.

Eric M. P. Tang

62 FRBNY Quarterly Review/Summer 1984

IN BRIEF—ECONOMIC CAPSULES

Impact of IRAs on Saving:
An Update
In an earlier Quarterly Review article, we argued that the
expansion of the Individual Retirement Arrangement (IRA)
program by the Economic Recovery Tax Act of 1981 (ERTA)
would probably not produce much new saving by house
holds— the main intent of the law.1 Instead, it seemed likely
to result in large-scale reshuffling of existing assets to take
advantage of the tax break. Although the amount of new
saving generated by IRAs cannot be measured directly, we
cited indirect evidence suggesting that most of the individ
uals newly eligible to open IRAs probably were in middleto-high-income brackets and therefore had many assets that
could be used to fund such investments.
Prelim inary data on 1982 tax returns have recently
become available, so it is now possible to see which indi
viduals did in fact make most of the new IRA contributions.
Because publicity surrounding the passage of ERTA may

’ See Robin C. DeMagistris and Carl J. Palash, “ Impact of IRAs on
Saving” this Quarterly Review (Winter 1982-83), pages 24-32.

have helped boost contributions in 1981, we compare IRA
contributions in 1982 with those in 1980 to get a sense of
the legislation’s full impact.
Most of the new IRA contributors belong to the uppermiddle and high-income groups. The number of tax returns
with income in excess of $20,000 (the top 40 percent of
all returns) showing IRA contributions climbed by about eight
million between 1980 and 1982 (table). For those with lower
income, the gain was less than two million returns.
The distribution of IRA contributions bears out the larger
role of higher-income individuals in the expanded program.
Individuals in the top 20 percent of the income distribution
were responsible for about two-thirds of the $25 billion
increase between 1980 and 1982. About 90 percent of this
overall gain came from the highest two income groups. It
is not known whether these people boosted their saving to
fund IRAs. But, as we showed in our earlier article, these
individuals already had many assets, and therefore probably
switched from these other assets into IRAs. Chances are
slim that they saved significantly more specifically in
response to the availability of IRAs.
Most of the IRA contributions, then, may not constitute
new private saving, but they have reduced tax revenue. We
estimate that the tax loss from IRA contributions in 1982
may have been about $9 billion.

Distribution of IRA Tax Returns and Contributions by Income Group
In recent years*

Income g ro u p t
(annual income in dollars)

1980

Tax returns with
IRA contributions
(thousands of returns)
1981
1982

1980

IRA
contributions
(millions of dollars)
1981
1982

less than 6,000 .............................................
above 6,000 and less than 11,000 ...........
above 11,000 and less than 20,000 ........
above 20,000 and less than 30,000 ........
30,000 and more .........................................

16.4
99.2
310.9
643.8
1,494.1

42.9
180.2
419.7
857.7
1,914.8

147.5
503.6
1,348.7
2,978.7
7,119.5

13.3
78.0
321.7
799.0
2,218.9

37.2
150.3
489.0
1,122.9
2,950.8

296.3
786.7
2,388.5
6,068.5
18,876.1

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

2,564.4

3,415.1

12,098.0

3,430.9

4,750.2

28,416.0

'Columns may not add to totals because of rounding.
fE ach income group represents 20 percent of all tax returns filed. The annual income cutoffs of the income groups are approximate.
Source: Internal Revenue Service, Statistics of Income: Individual Tax Returns (1980-1982) The data for 1982 are preliminary.

Robin C. DeMagistris and Carl J. Palash

FRBNY Quarterly Review/Summer 1984

February-April 1984 Interim Report
(This report was released to the Congress
and to the press on June 8, 1984.)

Treasury and Federal Reserve
Foreign Exchange Operations
The dollar declined modestly on balance over the three
months ended in April. It dropped through the first five
weeks of the period but later rose against the major foreign
currencies to offset much of its earlier move.
The dollar’s fall early in the period occurred amid indi
cations that the incentives for capital flows might be shifting
away from dollar-denominated assets. News of strength
ening foreign industrial activity and orders, especially in
Germany, generated expectations of rising earnings abroad
where inflation remained low. Thus the climate for growth
and investment abroad was improving. At the same time,
the U.S. economy showed unexpected buoyancy well into
1984 and market participants came to focus on the risks
for the dollar of a potential overheating of the domestic
economy. Following the President’s State of the Union
address and budget message, participants in the financial
markets increasingly questioned the implications of growing
U.S. fiscal deficits. Market participants also questioned the
financing of the U.S. current account deficit, especially after
public officials expressed concern about extended depen
dence on foreign capital inflows and the vulnerability of the
dollar to a potential shift in investor sentiment.
Against this background, reports circulated in February
that some internationally oriented investors were already
reducing the share of dollar-denominated assets in their
portfolios in favor of the German mark and other foreign

A report presented by Sam Y Cross, Executive Vice President in charge
of the Foreign Group at the Federal Reserve Bank of New York and
Manager of Foreign Operations for the System Open Market Account.
F’atricia H. Kuwayama, Manager, was primarily responsible for the
preparation of the report.

64 FRBNY Quarterly Review/Summer 1984

currencies. Earlier in the year, when U.S. stock prices fal
tered while stock markets in Germany and Japan were
experiencing net inflows and rising to set new records, talk
spread that investors had made substantial net sales of U.S.
equities. Doubts were voiced whether the dollar’s exchange
rate could be sustained without a sharp rise in U.S. interest
yields. Although U.S. interest rates rose modestly in Feb
ruary in response to strong credit demand, market partici
pants were uncertain how the Federal Reserve would
respond if the demand for credit continued to mount. Under
these circumstances, the increases in interest rates already
underway were viewed in the market more as a sign of
pressure against the dollar than as a source of support.
In this context, the belief spread that the dollar had begun
a long-awaited and potentially sustained decline, encour
aging a pronounced shift of both professional positions and
commercial leads and lags in favor of foreign currencies.
These shifts added to the momentum of the dollar’s decline
throughout February and early March, which by the first
week in March brought the dollar down 13 percent com
pared with its high in early January against the German
mark, and about 7 percent lower in terms of a tradeweighted average.
After early March, the dollar’s fall came to an abrupt halt,
and dollar exchange rates rose more or less steadily until
the end of the period under review. Reports of progress in
efforts by Congress and the Administration to agree on a
“down payment” package of budget cuts lent some support
to the dollar. Also, as U.S. market interest rates climbed
during March and April, observers concluded that the
increases were unlikely to be resisted by the monetary
authorities inasmuch as they reflected a continuing buildup

of credit demands generated by the strong domestic
expansion. By the time the Federal Reserve announced a
one-half percentage point rise in its discount rate to 9 per
cent, effective April 9, market participants had become
convinced that the U.S. authorities were prepared to accept
yet higher rates.
Meanwhile, yields in foreign centers remained steady. With
little or no acceleration in U.S. price indexes, real interest
differentials were perceived to be widening in favor of the
United States and these perceptions were a factor under
pinning the dollar in the exchanges. Concerns over the
financing of U.S. current account deficits receded and the
announcement of two more record monthly deficits in U.S.
international trade received little notice in the exchange
markets.
In addition, the dollar was supported by labor conflicts in
several countries in Europe which received increasing
attention during April and brought into question the imme
diate outlook for continued economic recovery there. In
particular the prospect of strikes in Germany, resulting from
a major union’s call for shorter hours and higher pay, raised
new worries about the investment climate there and con
tributed to a weakening of German stock prices. Talk of
shifting out of U.S. assets subsided and inflows to U.S.
equities resumed.

As the dollar rose in April, its m ovem ent gained
momentum from professional positioning based on technical
models and a reversal of commercial leads and lags. It
closed the period under review only 3 to 31/2 percent lower
against EMS currencies and the Japanese yen. In terms of
the Swiss franc, the dollar’s value was little changed com
pared to end-January; against the pound sterling and
Canadian dollar it closed somewhat higher on balance. The
dollar’s average decline in trade-weighted terms came to
about 2 percent for the three months as a whole.
The U.S. authorities did not intervene in the exchange
markets during the period under review and extended no
new credits through foreign exchange swap arrangements.
The Bank of Jamaica repaid on March 2 the $10 million it
had drawn against the U.S. Treasury temporary swap facility
on December 29, 1983, and this facility then expired.
On March 30 the U.S. Treasury announced that it would
participate in an arrangement to support the efforts of the
Government of Argentina to put into place an economic
adjustment program backed by the International Monetary
Fund (IMF). The Treasury’s participation consisted of-agreeing to extend temporary swap credits of up to $300
million to Argentina when agreement on an economic
adjustment program is reached between Argentina and the
IMF Argentina would repay any such drawings on the

Table 1

Federal Reserve Reciprocal Currency Arrangements
In millions of dollars

Institution

April 30, 1983

Amount of facility
April 30, 1984

Amount of facility

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

250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000

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

700
325
500
250
300
4.000

700
*
500
250
300
4,000

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

600
1,250

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

30,425

30,100

Austrian National Bank .........................................................................................................................
National Bank of Belgium......................................................................................................................
Bank of C anada......................................................................................................................................
National Bank of Denmark.....................................................................................................................
Bank of England......................................................................................................................................
Bank of France........................................................................................................................................
German Federal Bank.............................................................................................................................
Bank of Ita ly ............................................................................................................................................
Bank of Jap an.........................................................................................................................................
Bank of Mexico:
Regular facility..................................................................................................................................
Special fa cility..................................................................................................................................
Netherlands B ank....................................................................................................................................
Bank of Norway.......................................................................................................................................
Bank of Sw eden......................................................................................................................................
Swiss National Bank................................................................................................................................
Bank for International Settlements:
Swiss francs-dollars........................................................................................................................
Other authorized European currencies-dollars............................................................................

'Facility, which became effective August 30, 1982, expired on August 23, 1983.

FRBNY Quarterly Review/Summer 1984

Treasury using proceeds of IMF drawings. This undertaking
was part of a $500 million financing package that was used
to pay certain interest arrears. The $500 million package
consisted of: $300 million credits extended to Argentina by
the governments of Mexico, Venezuela, Brazil and Colombia,
to be repaid upon Argentina’s drawing from the U.S.
Treasury; $100 million additional credits extended by certain
of Argentina’s commercial bank creditors and $100 million
provided from Argentina’s resources.
In the period from February through April, the Federal
Reserve and the Exchange Stabilization Fund (ESF) of the
Treasury realized no profits or losses from exchange
transactions. As of April 30, cumulative bookkeeping, or
valuation, losses on outstanding foreign currency balances
were $860.6 million for the Federal Reserve and $586.1
million for the ESF (Valuation gains and losses represent
the increase or decrease in the dollar value of outstanding
currency assets and liabilities, using end-of-period exchange
rates as compared with rates of acquisition.) These valuation
losses reflect the fact that the dollar has appreciated since
the foreign currencies were acquired.
The Federal Reserve and the Treasury invest foreign
currency balances acquired in the market as a result of their
foreign exchange operations in a variety of instruments that
yield market-related rates of return and that have a high
degree of quality and liquidity. Under the authority provided
by the Monetary Control Act of 1980, the Federal Reserve
had invested $1,528.0 million of its foreign currency
resources in securities issued by foreign governments as
of April 30. In addition, the Treasury held the equivalent of
$1,852.4 million in such securities as of end-April.

C h a rt 1

T he Dol l a r a g a i n s t S e l e c t e d
F o r e i g n C ur r e n c i e s
P e rc e n t

P e rc e n ta g e c h a n g e of w e e kly a ve ra g e bid ra te s
fo r d o lla rs from the a ve ra g e ra te fo r the w eek of
M arch 26-31, 1983. F ig u re s c a lc u la te d from
New Y ork noon q u o ta tio n s .

C h a rt 2

S e l e c t e d I n t e r es t Rates
T h re e -m o n th m a tu ritie s *
P e rc e n t
11

Table 2

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

United States Treasury
Federal
Reserve

Exchange
Stabilization
Fund

General
Account

February 1 through
April 30, 1984 ....................

-0 -

-O -

-0 -

Valuation profits and
losses on outstanding
assets and liabilities
as of April 30, 1984..........

-8 6 0 .6

-586.1

-0 -

Period

Data are on a value-date basis.

FRBNY Quarterly Review/Summer 1984

A S
1983

* W e e k ly a v e ra g e s o f d a ily ra te s .

M
1984

NEW PUBLICATION
A table— Depository Institutions and Their Regulators—
is now available from the Federal Reserve Bank of New
York. The grid-like form shows the responsibilities that
national and state regulators have in ten areas— from
branching to consum er p ro te c tio n — fo r a va rie ty of
depository institutions. The table contains footnotes
summarizing laws and rulings affecting the activities of
regulators and depository institutions. It is intended to
provide easy reference for bankers and advanced stu
dents of banking.
Single copies of the H V 2 " x 2 2 V2" foldout table can
be obtained free. Quantities for classroom use are also
available free when ordered from a university address.
Write to the Public Information Department, 33 Liberty
C itroot

Mouu VorU

K1 V 1 nO /lR

FRBNY Quarterly Review/Summer 1984

Subscriptions to the Quarterly Review are free. Multiple copies in reasonable
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FRBNY Quarterly Review/Summer 1984

Full text of Economic Policy Review (Federal Reserve Bank of New York) : Summer 1984, Vol. 9, No. 2

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