Full text of Economic Policy Review (Federal Reserve Bank of New York) : Winter 1986, Vol. 11, No. 4

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Federal
Reserve Bank of
New Ybrk




Winter 1986-87 Volume 11 No. 4
1 Coping with Globally Integrated Financial Markets
6

Bankers on Pricing Consumer Deposits

14

The Pricing of Consumer Deposit Products—
The Non-rate Dimensions

19

Monetary Policy Influence on the Economy—
An Empirical Analysis

35

Inflation in the Service Sector

46

International “ Middle-Market” Borrowing

This Quarterly Review is published by the
Research and Statistics Group of the
Federal Reserve Bank of New York.
Remarks of E. GERALD CORRIGAN, President
of the Bank, on coping with globally
integrated financial markets begin on
page 1. Among the members of the staff
who contributed to this issue are
RICHARD G. DAVIS, LEON KOROBOW, and
JOHN WENNINGER (on bankers on pricing
consumer deposits, page 6); RICHARD G.
DAVIS and LEON KOROBOW (on the pricing
of consumer deposit products— the non­
rate dimensions, page 14); M.A. AKHTAR
and ETHAN S. HARRIS (on monetary policy
influence on the economy— an empirical
analysis, page 19); PETER RAPPOPORT (on
inflation in the service sector, page 35);
and JEREMY GLUCK (on international “ middlemarket” borrowing, page 46).




Coping With Globally Integrated
Financial Markets
Mr. President, My Lord Mayor, Mr. Governor of the Bank
of England, My Lords, Sheriffs, Ladies and Gentlemen,
it is a privilege and an honor to have this opportunity
to address the London Overseas Bankers Club. The City
of London has enjoyed a long history as one of the truly
dominant financial centers of the world. While that his­
tory has entailed more than a few difficult episodes of
economic and financial uncertainty, the current situation
is certainly formidable. Sluggish growth in the world
economy, massive and unsustainable imbalances in
international trade and finance, the rising tide of pro­
tectionism, and the continuing— and in some respects
Sluggish growth in the world economy, massive
and unsustainable imbalances in international
trade and finance, the rising tide of protectionism,
and the continuing—and in some respects more
vexing—problems associated with the LDC debt
situation, constitute major and interrelated points
of vulnerability.
more vexing— problems associated with the LDC debt
situation constitute major and interrelated points of
vulnerability. Simultaneously, financial markets around
the world are caught up in a near frenzy of activity.
Coming to grips with these problems in an orderly way
will not be easy and, under the best of circumstances, will
take time and patience— a lot of time and patience. But it
will also require that our financial markets and institutions
Remarks of E. Gerald Corrigan, President, Federal Reserve Bank of
New York, before the Overseas Bankers Club Annual Banquet,
London, England, on Monday, February 2, 1987.




are functioning in a smooth and disciplined way so that
they can play their historic and vital role of helping to
allocate the world’s scarce savings in a manner that best
helps to improve productivity and living standards.
In the current circumstances, I have a nagging sense
of unease about how well financial markets and insti­
tutions are serving that basic purpose, in part because
they are caught up in an unprecedented wave of change
and innovation which makes it very difficult to distin­
guish ends from means, causes from effects, and
actions from reactions. For example, while it is
unquestionably true that many new financial instruments
and practices gained popularity as devices to protect
against unforeseeable changes in credit conditions,
interest rates, or exchange rates, it is also true that
these same instruments can be the source of instability
and risk. In a similar vein, we now see some individual
Financial markets and institutions are caught up
in an uprecedented wave of change and
innovation which makes it very difficult to
distinguish ends from means, causes from effects,
and actions from reactions.
firms incurring the costs and, at times, the risk of
commencing new activities or moving into new markets
not because they are all that keen to do so but because
competitive pressures seem to leave little choice. All of
this, of course, takes place in a setting where rapid
advances in the application of telecommunications,
sophisticated mathematics, and computer technology to
banking and finance have introduced new elements of

FRBNY Quarterly Review/Winter 1987

1

speed and complexity into the marketplace and in the
process have amplified incentives to take advantage of
domestic and international differences in laws, regula­
tions, and tax and accounting practices. If it can’t be
done on the balance sheet, it is done off the balance
sheet; if it can’t be done onshore, it’s done offshore; and
if it can’t be done with a tried and tested instrument, it
is done with a new one.
Globally integrated markets and institutions with
round-the-clock trading and position-taking are a tribute
to man’s creative genius, but they also entail dangers
that shocks or disruptions can be more quickly trans­
mitted to markets, institutions, and geographic locations
far removed from the initial source of the shock.
Globally integrated markets and institutions are a
tribute to man’s creative genius, but they also
entail dangers that shocks or disruptions can be
more quickly transmitted to markets, institutions,
and geographic locations far removed from the
initial source of the shock.
In the light of the force of these events, the recent
agreement between the Bank of England and the
banking authorities in the United States regarding a
comprehensive and consistent approach to capital
adequacy standards for U.S. and U.K. multinational
banking organizations takes on particular importance.
For one thing, the initiative is a forceful illustration of
the fact that meaningful and successful international
cooperation in economic and financial policy matters is
possible even when the subject matter is laden with
highly technical issues. Hopefully we can build on that
success, for I am hard pressed to think of any major
aspect of economic and financial policy which will not
call for greater international understanding and coop­
eration in the future.
In the light of the force of these events, the
recent agreement between the Bank of England
and the banking authorities in the United States
regarding a comprehensive and consistent
approach to capital adequacy standards for U.S.
and U.K. multinational banking organizations
takes on particular importance.
In more specific terms, the U.S./U.K. initiative strikes
a balanced yet flexible approach to judging the ade­
quacy of a banking organization’s capital while taking
explicit account of balance sheet and off-balance sheet
activities. We also recognize that the proposal is
complex and will require care in its final implementation.

2 FRBNY Quarterly Review/Winter 1987




And it is also an approach which can be easily refined
and adapted to future developments as they occur. In
short, taking this rather large step of applying these
common standards to major U.S. and U.K. banks con­
stitutes a major breakthrough in the effort to better
rationalize and harmonize the competitive and prudential
framework within which our international banks conduct
their business. Having said that, I would also want to
stress that capital adequacy standards— no matter how
well structured— are only one element in an effective
overall supervisory process.
I would also want to stress that while this initiative is
of great importance, much remains to be done. For
example, I would hope that other industrial countries—
especially those that have major international financial
centers— will move quickly to bring capital adequacy
I would hope that other industrial countries—
especially those that have major international
financial centers—will move quickly to bring
capital adequacy standards into alignment with
emerging international norms.
standards into alignment with emerging international
norms. Indeed, broadly accepted capital adequacy
standards for all internationally active banking organi­
zations is a goal that must be pursued with vigor. For­
tunately, considerable groundwork has been laid toward
this end through the BIS and other international organ­
izations. Yet despite those efforts, it remains true that
in some countries progress will come more easily than in
others. But even where the obstacles to be overcome are
formidable, progress must be made. The competitive and
prudential implications of major international banking
organizations operating around the world with distinctly dif­
ferent capital requirements and resources is simply not in
the best long-run interests of strong, stable, and appropri­
ately competitive international banking markets.
While internationally harmonious bank capital stan­
dards are important, they are only part of the task that
lies ahead as we seek to better rationalize the structure,
operation, and official oversight of international money
and capital markets. Let me, therefore, briefly cite four
other areas that I believe will require attention in the
period ahead:
• First, many of these issues that arise in the context
of efforts to achieve a greater degree of harmony
and convergence internationally in banking markets
also arise in other areas. For example, a case can
be made that greater convergence in securities
market regulations among countries is a necessary
corollary to greater harmony on the banking side.

The case for greater convergence can also be
made in regard to specific markets such as foreign
exchange and swaps where banks and securities
companies compete directly.
While internationally harmonious bank capital
standards are important, they are only part of the
task that lies ahead as we seek to better
rationalize the structure, operation, and official
oversight of international money and capital
markets.
• Second, the international payments system re­
quires, in my judgment, continued attention with a
view toward ensuring that we have done all we
reasonably can to ensure its reliability and stability.
This may be especially true for the vast flows of
payments denominated in U.S. dollars, many of
which are interbank in nature and almost all of
which are associated with financial transactions.
These dollar-denominated payments— including
those which originate here in London and flash
through New York as electronic blips— can aggre­
gate to more than $1 trillion per day. As such, they
entail operational, liquidity, and credit interdepen­
dencies of very sizeable proportions among virtually
every major banking organization in the world.
There are numerous efforts underway within the
Federal Reserve and within and among private
banking organizations— foreign and domestic—
aimed at strengthening credit and operational
characteristics of these payments systems. How­
ever, these efforts take time and as time passes the
volume of transactions continues to grow very
rapidly. In these circumstances, I believe it impor­
tant that parent organizations of foreign branches
and affiliates with major operations in the United
States, as well as their central banks, are taking
steps to ensure that they understand the risks that
can be associated with international payments flows
including but by no means limited to dollar pay­
ments that are settled in New York.
• Third, fresh questions are arising concerning the
powers and privileges granted to financial institu­
tions operating on foreign soil. We in the United
States have for some years followed a policy of
national treatment whereby foreign banks and
securities firms operating in the United States have
the same privileges and responsibilities as our
domestic institutions. Others follow that same policy,
but in some countries reciprocity, or a blend of
reciprocity and national treatment, is the rule.
However, even where national treatment is the




policy, questions arise about whether practices are
always consistent with that policy.
The policy of national treatment is coming under
attack in the United States amid perceptions that
U.S. firms are not always treated even-handedly in
certain other countries. While this has not been a
particular problem here in London, we must rec­
ognize that protectionism in banking and finance is
susceptible to those same insidious forces that we
all fear on the trade side; in short, once unleashed,
it is very difficult to know where it will stop.
• Finally, and perhaps most importantly, there is a
host of questions regarding the implications of
efforts underway in a number of countries to
reshape the basic legislative and regulatory
framework within which banking and financial
institutions operate in the face of the changes that
The policy of national treatment is coming under
attack in the United States amid perceptions that
the U.S. firms are not always treated evenhandedly in certain other countries.
have been induced by market forces over the past
decade or more. In addition to difficult issues of
legal and regulatory philosophy, custom, and tra­
dition, these efforts must also come to grips with
differences in data reporting and consolidation
requirements, tax policies, disclosure rules, and
accounting standards.
Reflecting the importance of these related issues, the
Federal Reserve Bank of New York is in the final stages
of establishing an International Capital Markets Advisory
Committee. This advisory committee, which will be
comprised of leaders drawn from United States and
foreign banking and securities firms operating in the
United States, will meet with us from time to time for
an informal exchange of views on the kinds of issues
I spoke of a moment ago. While the Committee will be
consultative in nature, I am hopeful that at the very least
it can promote better understanding in both private and
official circles of these complex and difficult issues.
On the subject of financial market structure in the
United States, I believe it is widely recognized that
the current situation is an acutely troubling one.
On the subject of financial market structure in the
United States, I believe it is widely recognized that the
current situation is an acutely troubling one. The
process of loophole exploitation amid mixed, if not

FRBNY Quarterly Review/Winter 1987 3

conflicting, signals from the courts, the Congress, and
industry representatives has, to date, stifled efforts aimed
at legislative reform. This helter-skelter of events, left
unchecked, could in subtle but certain ways undermine
the strength and independence of the banking system.
All of the problems we face in this regard cannot be
overcome in the very near term. However, an essential
first step that should be within reach would center on
federal legislation that, among other things, would close
the so-called “ nonbank bank” loophole which, if not
done, could be the vehicle that effectively undermines
the historic separation of banking and commerce; pro­
vide authority for banks to engage in the underwriting
of certain classes of securities; facilitate the acquisition
of troubled banks or thrift institutions; and provide fresh
capital resources for the Federal Savings and Loan
Insurance Corporation. Such a legislative package would
go a very long way toward alleviating the points of
greatest immediate pressure and, at the same time,
provide a context in which longer term questions
regarding the evolution of the banking and financial
system in the United States can be discussed and
resolved in an orderly way.
In the expectation that the immediate legislative needs
will be addressed, and in anticipation of attention being
shifted to those longer term questions, I released last
Thursday in New York a rather lengthy essay entitled
Financial Market Structure: A Longer View. While the
essay and its proposals are far too lengthy to go into
on this occasion, I do want to stress that my purpose
in presenting it was much more to shape the debate—
with emphasis on its public policy elements— than to
press for a particular legislative or regulatory agenda.
This approach seeks to blend competitive and
market realities, together with public policy
considerations, in a manner that yields structural
arrangements that are market sensitive but also
consistent with a stronger and more viable
banking and financial system.
This approach seeks to blend competitive and market
realities, together with public policy considerations, in
a manner that yields structural arrangements that are
market sensitive but also consistent with a stronger and
more viable banking and financial system. The approach
is based on six guiding principles:
• First, the separation of “ banking” from commerce
should be preserved.
• Second, in the interest of competitive equity and
supervisory harmony, the regulatory costs associ­
ated with special “ banking” functions should, to the

4 FRASER
FRBNY Quarterly Review/Winter 1987
Digitized for


•

•
•

•

fullest extent possible, be neutralized or eliminated
across classes of institutions.
Third, the approach should provide scope for achieving
the benefits of greater competition in the marketplace
for financial services while preserving the important
public benefits growing out of an appropriate degree
of supervisory oversight of the system.
Fourth, supervision should take account of function,
not merely institutional form.
Fifth, the structure of the system should incorporate
principles of “ volunteerism,” whereby individual
firms can choose their position on the financial
landscape based on their own corporate strategies
and their own assessments of the costs and ben­
efits of one form of corporate organization over
others.
Sixth, and most importantly, the approach should
strengthen the stability and soundness of the
system in part by providing greater room for selfand market-discipline but also by enhancing the
strength and flexibility of the official supervisory
apparatus where necessary.

The initial and primary responsibility for ensuring
that our banking and financial institutions are
fulfilling their role in a safe and stable manner
lies not with the authorities but with the managers
of these institutions.
While the agenda for public policy initiatives relating
to the evolution of our banking and financial system in
the United States and around the world is long and
formidable, public policy alone cannot and should not
bear the full burden of adjustment. To the contrary, the
initial and primary responsibility for ensuring that our
banking and financial institutions are fulfilling their role
in a safe and stable manner lies not with the authorities
but with the managers of these institutions. In that
regard, I must confess, as I said earlier, that I have a
nagging sense of unease that competitive and other
pressures are producing patterns of behavior which may
not make a great deal of sense in the fullness of time.
From my perspective at 33 Liberty Street, let me cite
three quick examples of the kinds of things that give rise
to that sense of unease.
• Since 1984, the wave of takeovers, buyouts, and
buybacks has resulted in a cumulative net retire­
ment of $230 billion in nonfinancial corporate equity
in the United States. Over the same period, non­
financial corporate debt has risen by $480 billion.
• The volume of trading activity and the volatility in
financial markets have mushroomed in part because
computer-driven program-trading strategies now

unleash huge buy and sell orders that, as far as I
can see, have little or no relationship to economic
fundamentals.
• Attracted by the “action” and by lofty compensation
rates, the best and the brightest from our univer­
sities flock to Wall Street while questions about the
competitiveness of our manufacturing sector and
thus our ability to wind down our massive trade
deficit in an orderly way persist.

taken for granted. Indeed, as we continue to seek out
lasting remedies to these problems, it seems to me that
success will come sooner and surer in a context where
we also see a reaffirmation of what I have called “ prior
restraint”— saying “ no” to unduly risky activities and
transactions— rather than slipping into a situation in
which restraint and discipline are achieved only as a by­
product of instability or failure. I, for one, am confident
we are up to the task.

I could go on, but you know the symptoms as well as
I do. And I suspect most of you will agree with me when
I say that financial discipline and stability cannot be




FRBNY Quarterly Review/Winter 1987 5

Bankers on Pricing
Consumer Deposits

As part of a study of the evolving market for consumer
deposits in a deregulated environment, the Federal
Reserve Bank of New York undertook a series of inter­
views with senior commercial and savings bankers on
pricing these deposits. The interviews took place
between November 1986 and January 1987. The
bankers were asked to discuss their views of pricing
practices in the market generally as well as their own
approach to pricing the interest rate and non-rate
dimensions of these deposit products. In no sense
should these interviews be regarded as a “ scientific"
sample of nationwide banking practices. The interviews
were relatively few in number, were confined to New
York State institutions, and were mainly with larger
banks. From the general consistency of the responses,
however, it seems reasonable to believe that these
responses were at least representative of the views at
larger institutions in the New York market.
Our primary interest in these interviews was to gain
better insight into the ways in which pricing practices
for the various types of consumer deposits might be
influencing the way deposit rates respond to changes
in market rates. These deposit-rate responses, in turn,
clearly influence the volume of funds moving into and
out of the various types of deposits. Thus they influence
the behavior of the monetary measures targeted by the
Federal Reserve.
The statistical record of the past two and one-half
years, in which market interest rates have fallen some
500 basis points, suggests some interesting differences
in the response of interest rates on the various kinds
of accounts, and thus of deposit flows, to changes in

6 FRBNY Quarterly Review/Winter 1987




money market rates.1 Rates on consumer CDs have
tended to respond relatively rapidly and relatively com­
pletely to movements in market rates. Rates on MMDAs
have responded somewhat less rapidly and less com­
pletely, while the response of Super NOW rates has.
been even slower and less complete than the MMDA
response. Savings deposit rates, subject to a 51/2 per­
cent ceiling until April of last year, remained generally
at that ceiling until recently when there have been
declines in some markets.
The overall result of this divergent response to the
decline in market rates has been a substantial
compression of yields on the various kinds of accounts.
As the rate advantage of consumer CDs relative to the
other kinds of deposits has contracted, these CDs have
gone from rapid growth to outright declines. Similarly,
the narrowing rate advantage of MMDAs relative to
NOWs and savings deposits seems to have slowed their
growth too, though less dramatically. In the meanwhile,
inflows to relatively sticky-rate accounts, the savings and
NOW accounts, have accelerated as the rate advantage
of other kinds of instruments has narrowed. Indeed the
sharply declining opportunity cost of holding NOW ac­
counts (included in M1) appears to be a meyor factor in the
recently very rapid growth in that monetary aggregate.
Our interviews suggest that the falling opportunity
costs of holding NOWs, in turn, reflect the significant
differences in the market’s approach to pricing the var­
ious deposit products, differences that seem to stem
1See John Wenninger, “Responsiveness of Interest Rate Spreads and
Deposit Flows to Changes in Market Rates," this Quarterly Review
(Autumn 1986), pages 1-10.

rather naturally from the differences in the nature of the
products themselves. The interviews also touched on
the question of how the various deposit rates might
evolve if market rates were to continue at current levels
or decline, as well as on how deposit rates might
respond if market rates were once again to move sub­
stantially higher. Before reviewing the considerations
that enter into the pricing of the various individual
deposit products, we turn first to the major components
of the general pricing decision.
Major Components of the Pricing Decision
With some variations in emphasis and in ways of col­
lecting the relevant data, the institutions we talked to
tend to focus on similar factors in setting interest rates
on consumer deposit products. Rate decisions are
apparently reviewed frequently— several mentioned
weekly reviews— though of course actual rate changes
may be less frequent.
Most banks indicated that their rate decisions begin
with estimates of the relevant wholesale cost of funds
as a measure of the alternative cost of money. Rates
on large CDs were mentioned by several bankers as the
measure of wholesale funding costs. These wholesale
rates have to be measured in terms of the relevant term
to maturity. This is a relatively straightforward matter in
the case of consumer time deposits, but is much less
clear-cut in the case of MMDAs, NOWs, and savings
deposits since they are cashable on demand and
therefore have no definite “ maturity.” In comparing
wholesale and retail costs of funds;, adjustments also
have to be made for any differences in the relevant
reserve requirements and for the higher costs of ser­
vicing retail accounts.
Some institutions begin the pricing decision with a
desired spread under the wholesale cost of money they
would like to achieve in setting rates on consumer
accounts. However, all institutions mentioned a number
of factors that would influence the spread they would
actually set, and one or two said explicitly that they
often failed to meet their objective because of compet­
itive conditions or other factors.
All institutions indicated that they had to take explicit
account of what their competitors were doing in the
various markets. With varying degrees of explicitness,
they also try to take into account the interest rate
elasticity (responsiveness) of their customers’ demand
for the various kinds of instruments they offer— though
this is obviously hard to estimate in quantitative terms.
Most bankers also mentioned as decision inputs their
own deposit flow data for the various kinds of consumer
accounts (sometimes differentiated by maturity category
for consumer CDs) and the schedule of maturing de­
posits they faced over the coming period. Some banks




indicated that the rates they offered at different
branches or regions might differ depending upon local
competitive conditions. With one partial exception, the
banks indicated that they did not take variations in the
bank’s short-term funding needs into account in setting
consumer deposit rates, preferring to make such
adjustments in the wholesale market.
Most of the institutions we talked to obviously go to
considerable lengths to collect and organize the relevant
input data— the cost of money, deposit flows, rates
offered by competitors, etc.— needed to make rate
decisions. But this input seems much more directly rel­
evant in pricing some kinds of products, notably con­
sumer CDs, than it does for others such as savings and
NOW accounts where additional considerations, dis­
cussed further below, are also very important. Most
bankers emphasized, moreover, that no matter how
sophisticated the mechanism for collecting and orga­
nizing information may be, actual rate decisions cannot
be reduced to formula. Instead they must rely heavily
on experience and judgment.
Setting Rates on Consumer CDs
As noted earlier, the national data indicate that con­
sumer CD rates have responded most consistently and
fully to changes in money market rates. Several com­
ments by the bankers we interviewed suggested rea­
sons why this should be so. One banker argued that the
quick adjustment of CD rates to market rates, relative
to the slower adjustment of other consumer deposit
products, reflected differences in interest rate elasticity,
with CD demand highly responsive to rates and other
products less so. This seems highly plausible since
rates would seem to be by far the most important
determinant of consumer CD demand in contrast to
other deposit products where non-rate considerations
may also be important. And if customers are in fact
highly rate-sensitive with respect to CDs, banks would
stand to lose (or gain) market share relatively rapidly if
the rates they offer fail to adjust quickly to changing
market conditions.
Some bankers confirmed that they did try to respond
relatively quickly to changes in the wholesale cost of
money in pricing consumer CDs. One banker argued
that wholesale banks, especially, tend to price these
CDs in relation to wholesale funding costs. He also
argued, however, that thrifts and regional banks tend to price
more in relation to relatively slower changing asset yields
and therefore tend to adjust their CD rates more slowly.
The savings bankers we talked to did say that the CD
offering rates of thrifts tend to be somewhat higher than
those of their commercial bank competitors.2 While no
2The available data supports this contention. See "Responses to
Deregulation: Retail Deposit Pricing from 1983 Through 1985,"

FRBNY Quarterly Review/Winter 1987 7

full explanation was given for this phenomenon, one
savings banker commented that the thrifts “ may be a
little paranoid” about the risks of losing deposits. One
commercial banker, also noting a tendency for thrift CD
rates to exceed rates paid by commercial banks, said
he thought this spread had remained about constant as
the overall level of rates has come down, but that the
spread has become more important to consumers at the
lower absolute level of rates. Another commercial
banker argued that some thrifts were “ pricing well above
the market and can’t sustain this over time.”
Money Market Deposit Accounts
Bankers offered a number of explanations for the fact
that MMDA rates have tended to respond somewhat
more slowly and less fully than CD rates to changes in
money market interest rates. Several bankers suggested
that MMDA demand was less interest-sensitive than CD
demand, arguing that MMDA accounts were often used
simply as “ parking lots” for excess funds awaiting
decisions to reinvest the funds in other instruments. The
fact that spreads of money market rates over MMDA
rates were larger than the spreads of money rates over
consumer CD rates was also cited as a reason for
feeling "less urgency” to move MMDA rates when
market rates changed. One banker noted that when a
bank changes its offering rates on CDs, only new money
and rollovers are affected in the short run. When a
change in MMDA rates is made, however, it affects the
entire outstanding volume of deposits at once, making
banks more cautious about changing MMDA rates.
These various considerations would clearly help
explain why bankers might be relatively slow in adjusting
MMDA rates upward in response to rises in market
rates. However they are less clearly relevant in
explaining why MMDA rates might be slower than CD
rates to decline in the face of reductions in money
market rates. One banker offered the explanation that
as market rates have declined, banks have been
reluctant to breach successive single digit “floors” (such
as an even 6.00 percent) and have been particularly
slow to cut MMDA rates below the old ceiling rate on
regular savings deposits even though such cuts might
be justified on cost of money grounds. Such a line of
argument would suggest that the bankers believe that
at least at some critical points, the rate elasticity of
demand for MMDAs may be fairly high, so that they fear
losing market share by cutting rates at such points. In
any event, at the time of these interviews, MMDA rates
at the banks we talked to— mostly at 5 percent or
Footnote 2 continued
Patrick I. Mahoney, Alice P. White, Paul F. O ’Brien, and Mary M.
McLaughlin, Board of Governors of The Federal Reserve System,
Staff Study Number 151, January 1987.

8 FRBNY Quarterly Review/Winter 1987




somewhat higher— were at or below statement savings
account rates at the same institutions.
MMDAs were originally conceived largely as a
response to the rapid growth of the money market
mutual funds. Through late 1982, when the new MMDAs
first became available, these money market funds had
grown to some $185 billion. Certainly a significant part
of this money had come out of consumer deposits at
banks— though much of it may have been ultimately
recycled in the form of purchases by the money funds
of wholesale CDs and bank-related commercial paper.
In any case, only two bankers in our recent interview
program mentioned competition from the money funds
in connection with MMDA rate decisions. One banker
acknowledged that rates offered by the money funds
were initially “ very important” in pricing, but he argued
that they were much less important currently. Another
banker said that the MMDA could not compete fully with
money fund accounts, especially “ central asset
accounts,” because of the limitation imposed on the
number of third-party checks that can be written on
MMDAs. But he went on to say that for most smaller
savers, the presence of FDIC insurance on MMDAs
made it possible to market them competitively at 50 basis
points below rates being offered by the money funds.
Savings Deposits
Savings deposits come in two forms, the traditional
passbook account and the statement account. At the
time of the interviews, most banks we talked to offered
both kinds of accounts, but a minority no longer offered
passbook accounts. Moreover, one banker expressed a
desire ultimately to eliminate his bank’s passbook
account, which, he said, entailed significantly higher
maintenance costs than do statement accounts. Most of
the banks we talked to were continuing to offer state­
ment savings accounts at the old ceiling rate of 51A>
percent (deregulated at the end of March 1986) while
a minority offered somewhat lower rates. Of those banks
we talked to that continued to offer both kinds of sav­
ings accounts, a majority were offering passbook rates
below the rate offered on the statement savings account.
In one way or another, all the bankers we talked to
expressed the view that the time had come to cut sav­
ings account rates because of declines in the cost of
money. Nevertheless, they all expressed great caution
about taking such a step. Most noted that depositors
had continued to hold funds in these accounts during
periods when other rates were far above the old 51A>
percent ceiling. In various ways, the bankers conveyed
the feeling that this had imposed on them an implicit
obligation not to cut the savings rate when market rates
had fallen. Bankers used terms like “ moral commitment”
and “ implicit contract” to express their reluctance to cut

rates on depositors who had held savings accounts in
earlier years when other rates were far above the 51/2
percent ceiling. Thus some bankers expressed the fear
that these account holders would feel “ cheated” if the
rate were cut now. Moreover, they were reluctant to
“ sensitize” such account holders to rate considerations
since these depositors might then very well expect
savings deposit rates to move up if market rates were
to climb once again. In effect, the bankers seemed to
prefer the rate-sensitive savings customers to stay in the
MMDA accounts rather than in savings accounts—
although with MMDA rates below regular savings rates
at a majority of the institutions we talked to, some
thought there was evidence that the rate-sensitive
money was in fact moving into savings accounts from
the MMDAs.
Some of the bankers we talked to referred to savings
accounts as being, along with NOW accounts, “ core”
accounts— that is, accounts that tend to tie the holder’s
overall banking business with the bank at which the core
account is maintained. This consideration would mean
that the customer’s entire banking business, and not just
his savings account business, might be at stake if the
savings account rate were to be cut.
Despite all these considerations, many bankers
argued, as noted, that the savings deposit rates pre­
vailing at the time of the interviews were “ too high”
given the current money market rates, even while
expressing considerable reluctance to be the first to
move to a lower rate themselves. Some bankers men­
tioned that they had recently sent written notice to their
savings account customers that in the future they might
need to adjust their savings account rate if market
conditions warranted. However, they had not actually
lowered the rate as of the time of the interviews.
Moreover, several bankers suggested that any future
changes in savings accounts rates would be made only
infrequently and only in response to significant and
sustained changes in interest rates generally.
NOW Accounts
Until January 1986, Federal regulation distinguished
between two types of NOW accounts, “ regular” NOWs
subject to no balance requirements but subject to a
maximum interest rate of 51/4 percent, and “ Super
NOWs,” subject to a minimum balance requirement but
with no interest rate limitation. Currently, depository
institutions may offer interest rates without restriction on
any NOW account, regardless of balance. Even after the
rate restriction on “ regular” NOWs was removed, many
banks continued to offer two types of accounts, one
paying a rate fixed at or close to the old 51At percent
ceiling and another paying a higher rate adjusted from
time to time in light of changing market conditions.




By the time we conducted our interviews, however, the
decline in market rates had compressed NOW rates so
that most of the banks we talked to either no longer
offered a “ Super NOW” product or offered one with a
rate equal to or only slightly above the old regular NOW
ceiling rate of 51/4 percent. As one banker put it to us,
the Super NOW had become “ a product without much
meaning” in current market conditions. Thus in his view,
the pricing of Super NOWs as such had become a “non­
issue” in the market.
Nevertheless, it was clear from our conversations that
the pricing of NOW accounts, however distinguished,
presented some difficult issues. There are clearly
problems in measuring both the costs and the net rev­
enues arising from such accounts, making rational
pricing a complex problem. Some bankers, for example,
mentioned the difficulty of estimating accurately the
costs of account maintenance, both the “ brick and
mortar” fixed costs and the variable costs. Some also
cited the difficulty of getting a realistic handle on the
appropriate opportunity cost of funds for deposits that
have no fixed maturity. As one banker put it, it is very
hard to know what “notional” term to maturity to put on
these funds in measuring opportunity costs, “ not the
Federal funds rate, but not 10-year money either.”
Another intangible cited by one banker was the relative
stability of NOW account deposits, a feature that is
attractive to banks but for which it is hard to establish
a precise numerical value.
For all these reasons, it appears to be difficult for the
banks to measure the profitability of NOW accounts,
even on a “stand-alone” basis. Most who discussed the
subject did believe that at interest rates above 5 per­
cent, NOW accounts were not in fact currently profitable
on such a basis. But the most important complication
in pricing these accounts arises from the fact that most
bankers do not look at them on a stand-alone basis.
Instead, they view them as a “ core” product, the cen­
terpiece of a complete banking relationship where the
value of the NOW account as such cannot be mean­
ingfully separated from the total value of the customer’s
dealings with the bank.
Several of the institutions we talked to seek to rein­
force the “ relationship” aspect of NOW accounts by
permitting balances in other accounts to be used to
satisfy the minimum balances in NOW accounts required
to avoid fees and/or by offering reduced loan rates to
NOW account customers. One banker noted with some
irony that at the very time that the corporate banking
business is moving toward unbundled pricing, consumer
banking seems to be moving in the opposite direction.
As some bankers pointed out, the “relationship” aspect
of NOW accounts makes it doubly difficult to assess
their profitability. It is difficult not only because their

FRBNY Quarterly Review/Winter 1987 9

current profitability has to take into account the collateral
banking business they are currently attracting, but also
because accepting current losses on NOW accounts
may retain a customer whose total business over the
long run may make the account profitable when viewed
over that longer time horizon. Given all these problems,
one banker said quite frankly that you could make such
accounts look profitable or unprofitable depending upon
just what alternative plausible cost and revenue
assumptions were used in the calculation.
In expressing reluctance to lower NOW account rates
even at a time when they seemed “too high” in terms
of current money costs, some bankers voiced the same
kinds of reservations they had mentioned in connection
with possible cuts in savings deposit rates. Thus they
noted that regular NOW customers had maintained
balances at times when market rates were far above the
old 51/4 percent ceiling. Moreover, they feared that
“ sensitizing” such account holders to interest rate
movements could lead to significant reductions in NOW
balances in response to any subsequent increases in
other rates. One banker argued that customers’ deci­
sions in choosing NOW accounts were determined more
by convenience and service considerations and thus
were in fact rather /nsensitive to small or moderate
interest rate differences. But, he added, if the NOW
rate were to become so far off the market that the
customer were induced to move his account to another
institution, the original bank would lose not only the
deposit, but all the customer’s other banking business
as well.
The savings bankers we talked to suggested that
NOW accounts play a somewhat different, and lesser
role for thrifts than they do for commercial banks. One
savings banker said that NOW accounts at thrifts are
often secondary checking accounts and are viewed like
savings accounts by their holders. Another savings
banker noted that NOW accounts constitute only a small
fraction of his institution’s total deposits so that the
concept of “ relationship pricing” of such accounts as a
means of attracting other business is of little or no
consequence to them.

The Non-Rate Dimensions of Pricing
In addition to setting interest rates, banks must set
terms on a wide array of non-rate dimensions of the
total deposit package. These include minimum balances
to earn interest and/or avoid monthly fees, fee sched­
ules covering per-account fees, per-check fees and
other types of fees, as well as methods of computing
balances and of computing and crediting interest and
other matters. In the following article, we report the
results of a survey of commercial bank practices as of

10 FRBNY Quarterly Review/Winter 1987




late 1985 regarding these non-rate dimensions of con­
sumer deposit pricing.3 Our conversations with bankers
yielded a few additional insights on the issue of setting
non-rate terms on such deposit products.
Several bankers said that the balances in most of
their NOW accounts were above the minimum levels
needed to avoid monthly account fees. For this reason,
one banker said that these minimum balance levels
were “ a small issue” for him. He noted, however, as did
others, that they serve the purpose of making belowminimum-balance accounts at least cover account
maintenance costs through the fees charged. One
banker made the point that while fees enable low bal­
ance accounts to pay their way, and while high balance
accounts are also profitable even without such fees,
accounts with balances only a little above the minimum
needed to avoid fees may not be profitable. However,
he said that the alternative pricing approach of charging
fees on all accounts regardless of balance to ensure
that all accounts at least cover cost would “ irritate” the
higher balance customers, the value of whose deposits
are alone sufficient to cover costs.
Another banker said that establishing different min­
imum balance levels to avoid fees was a way of estab­
lishing “ product distinction,” with the different accounts
also differentiated with respect to fees, interest rates
paid, and collateral benefits offered. One banker sug­
gested that crediting balances in all the customer’s
accounts toward the minimum balance requirement for
his transactions account did cost the bank some fee
income. But he thought the approach was nevertheless
worthwhile as a means of building a total banking
“ relationship” with the customer. In general, decisions
about the non-rate terms offered on accounts appear to
be made relatively infrequently— several banks men­
tioned once a year— in contrast to rate decisions, which,
as noted earlier, appear to be reviewed at least weekly
at most institutions.
Future Prospects in Pricing Consumer Deposits
We asked the bankers whether they thought the pricesetting process in the industry had had time to settle
down following the completion of the deregulation
process or whether some further evolution was likely.
The answers we got varied considerably, in part
because the various bankers tended to focus on dif­
ferent aspects of the problem.
There seemed to be general agreement that the market
had not yet reached an “ equilibrium” with respect to the
relatively fixed rate accounts, the NOWs and savings
3See "The Pricing of Consumer Deposit Products— The Non-rate
Dimensions," this Quarterly Review, pages 14-18.

accounts. As noted earlier, most felt that these rates were
too high relative to money rates and would be under
downward pressure. Indeed, there were some rate
reductions on these products in the New York City market
after our round of interviews was completed. But with all
the potential, hard-to-quantify risks of cutting rates on
these accounts, few bankers were prepared to suggest
where the market would ultimately settle, even in the
absence of significant further changes in interest rates
generally. One banker, saying that the whole area of
consumer deposit pricing is “still evolving,” emphasized
that banks were still trying to get a good feel for the fixed
and variable costs of the various kinds of accounts—
implying that absent such a feel, they would remain
uncertain as to just what an appropriate “equilibrium”
price might be at any particular level of money rates.
Apart from the obvious continuing uncertainties sur­
rounding NOW and savings deposit rates, there was a
fairly general feeling that pricing practices had settled
down, at least to some extent. One banker noted, for
example, that the rates set by his competitors seemed
to be responding to changes in money market rates “in
a pretty predictable way,” suggesting to him that their
decision-making processes, at least on consumer CD
and MMDA rates, had stabilized. At the same time,
some bankers suggested that there would always be a
tendency for “ rate wars” to break out from time to time
as some banks sought to increase their market share
at the expense of competitors.
There was some disagreement as to whether deposit
rates would respond more slowly to a sustained rise in
money market rates than they had to the declines of the
past two and one-half years. One banker thought that
deposit rates would respond relatively more slowly to
the rise in market rates, with thrifts moving up even
more slowly than the commercial banks. Several
bankers, however, suggested that while banks might try
to lag more on the upside, competitive forces would
undermine any such effort. Thus if banks did lag, some
institution would see an opportunity to gain market share
by raising deposit rates and the others would then be
forced to follow.
A few bankers noted that the relative speed of
response of the various kinds of accounts on the upside
would be similar to the pattern observed when rates had
fallen. Thus consumer CD rates could be expected to
move relatively rapidly, with little or no increase in the
gap between money market rates and CD rates. On the
other hand, rates on the relatively fixed rate types of
accounts, NOWs and savings deposits, would respond
only slowly. Hence the rate gap on these accounts rel­
ative to market rates would widen once again as market
rates rose, much as this gap had narrowed when market
rates were falling.




Some Tentative Conclusions and
Unresolved Questions
Obviously no firm inferences can be drawn from a
small-scale survey of bankers in a geographically limited
portion of the consumer deposit market. But some ten­
tative conclusions about this market are at least sug­
gested by the survey results.
For one thing, the evidence suggests that consumer
CD rates are likely to continue to respond reasonably
promptly and fully to changes in money market interest
rates. To banks, consumer CDs are an alternative to
funding through wholesale deposits. And since con­
sumers’ demand for these CDs appears to be quite ratesensitive, the volume of funds a bank can raise from
this source will be responsive to changes in offering
rates. Thus whenever wholesale funding costs rise
above currently prevailing consumer CD rates (allowing
for differences in reserve requirements and other costs),
banks will have a strong motive to push up offering
rates to increase their takings from this source. Con­
versely, should wholesale rates decline, banks have a
strong motive to bring consumer CD rates down into line
with the wholesale rates. It was not completely clear
whether this adjustment process would move as rapidly
when market rates are rising as it does when they are
falling— our interviewees differed on this point. In any
case, the actual speed of adjustment in any given local
market will depend on the extent of competition in
that market.
With respect to money market deposit accounts, their
nature makes it likely that they will continue to respond
less rapidly than CD rates to changes in market rates.
On the downside, there is the apparent reluctance of
bankers to break visible psychological barriers posed by
even-numbered interest rate levels and by rates offered
on slow-adjusting accounts such as savings and NOW
accounts. On the upside, the likelihood that MMDA
money is less rate-sensitive than CD money, coupled
with the fact that a change in the MMDA rate applies
immediately to the entire outstanding stock of MMDA
deposits, suggests that bankers will tend to delay in
raising MMDA rates at least until they feel reasonably
sure the rise in market rates is likely to stick.
Given the variations that have occurred in the spread
between MMDA rates and money market rates generally
(including money fund rates), the question arises as to
what the long-run “ equilibrium” rate on MMDAs for given
levels of market rates may be. Econometric work sug­
gests that over periods of up to three months, the
MMDA rate makes only a partial adjustment (about 60
percent) to movements in money market rates.4 But over
a somewhat longer period, the response of MMDA rates
4See Wenninger, op. cit., page 7.

FRBNY Quarterly Review/Winter 1987

11

to market rates may well be fairly complete, and indeed
that is what one banker we talked to asserted. More­
over, since money fund rates, by their very nature, must
also respond fully to changes in market rates over a
period long enough for their portfolios to turn over, it
seems likely that over time MMDA rates and money fund
rates should tend to move more or less in tandem even
though bankers may not regard them as closely com­
petitive in the short run.
The savings deposit product is clearly designed to be
marketed to relatively rate-insensitive customers. The
banks’ approach to pricing this product suggests that
they seek to preserve this role for the savings deposit
account by responding only slowly and reluctantly to the
recent sharp declines in money market rates in setting
rates on saving deposits. As a result, the profitability of
these deposits to the banks has been much reduced in
the recent period. To the extent that the savings account
can be preserved as a repository for rate-insensitive
funds, however, it could once again become quite
valuable to the banks should market rates rise.
From the point of view of monetary policy, perhaps the
most interesting— and most perplexing— question raised
by our interviews is the likely course of NOW account
rates over time. Alone among the types of interest-bearing
accounts discussed in this article, NOWs represent a
component, and an important component, of M1. This
narrow money measure was, for a period, the monetary
aggregate most closely watched by the markets and the
policymakers. More recently, its importance has been
substantially downgraded because of its highly aberrant
behavior relative to earlier experience— a change in
behavior that is clearly related in part to the pricing
approach banks have adopted to consumer deposits.
When it first became apparent that deregulation would
make possible a transactions deposit whose rate could
fluctuate in line with market rates, many analysts sug­
gested that the responsiveness of M1 to market rates
would decline sharply. Their reasoning was that the
opportunity cost of holding these deposits need no
longer be affected by changes in market rates. Expe­
rience suggests, however, that deregulation has had just
the opposite effect on the responsiveness of M1 to
changes in market interest rates. On the one hand, the
creation of market-rate-sensitive alternatives to M1
accounts has made it much easier for the average
depositor to adjust his transactions balance levels in line
with changes in the opportunity costs of holding them.
All he needs to do is to shift money between different
deposit accounts— accounts that are more often than not
held in the same institution.
At the same time, it has turned out in practice that the
rates paid on NOW accounts respond only slowly and
incompletely (except perhaps in the very long run)

12 FRBNY Quarterly Review/Winter 1987




to changes in market rates. So the ability of depositors
to respond to changing rate spreads has increased. And
because NOW rates adjust slowly, these spreads have
continued to fluctuate substantially with fluctuations in the
general level of interest rates. Moreover, everything we
have learned in the course of our talks with bankers
suggests that the sluggish response of NOW rates is likely
to be a persisting feature of these accounts. So on bal­
ance, it appears that even though these transactions
deposit rates are now theoretically free to move in line
with market rates, the overall interest-rate sensitivity of
NOW accounts, and hence of M1, has probably been
significantly increased as a result of deregulation.
One perplexing and potentially important question is
where the long-run “ equilibrium” spread between money
market rates and NOW rates may turn out to settle. In
the last half of 1983 and most of 1984, when market
rates were much higher than they are now, market rates
(as measured by the six-month bill rate, for example)
tended to run from 2 to 3 percentage points above the
then-prevailing rates on Super NOWs. In recent months,
this spread has been much smaller, ranging between
roughly zero and one-half percent.
Clearly the bankers we talked to do not think the current
level of NOW rates represents a long-run “equilibrium.”
They obviously think there is downward pressure on the
NOW rate at current levels of money market rates. But
how far below current levels would NOW rates have to
fall to reach such an equilibrium? If the 1983-84 range
of spreads in fact did represent an equilibrium position,
NOW rates would ultimately have to fall to within a 2.5
to 3.5 percent range, far below their current levels. On
the other hand, the high spreads prevailing in the 198384 period may also have been abnormal— abnormally
high. Thus they may not be a reliable guide to where
market rate/NOW rate spreads may ultimately settle given
today’s lower level of market rates.
Most likely, the “ true” long-run equilibrium spread
between money rates and NOW rates lies somewhere
between the very high 1983-84 levels and the very low
to negligible levels prevailing recently. But just exactly
where it may lie within this range is far from clear—
especially in view of all the uncertainties, even for the
bankers themselves, about both the costs and the rev­
enues associated with NOW accounts.
In any case, if there is currently pressure for the NOW
account rate to fall, even absent further declines in
money market rates, this pressure poses a new problem
for the use of M1 as an indicator of monetary stimulus.
By itself, a downward drift in the NOW rate would
clearly reduce the demand for NOWs and thus for total
M1. If M1 growth were left unchanged under such cir­
cumstances, the downward drift in money demand would
tend to put downward pressure on market rates and

would thus provide additional stimulus to the economy.
If the additional stimulus were undesired from a policy
perspective, it would be necessary to reduce the target
rate of M1 growth by a sufficient amount to offset the
impact on market rates of the reduction in the demand
for M1.5 The problem is that it is very hard to say how
rapidly any downward movement in NOW rates might
occur, if it happens at all, and how far it might go.

Consequently, the needed allowance for this factor in
setting monetary targets is equally hard to determine.
Consideration of such questions makes it clear that the
behavior of the narrow money supply has become much
harder to analyze under deregulation than it was in the
old days when it consisted only of non-interest-bearing
demand deposits and currency.

5To the extent that the slower growth of NOW accounts reflects a shift
of funds from NOW accounts into consumer CDs, M 2’s growth would
not be affected since NOW accounts and consumer CDs are both
M2 components.

Richard G. Davis
Leon Korobow
John Wenninger




FRBNY Quarterly Review/Winter 1987

13

The Pricing of Consumer
Deposit Products—
The Non-rate Dimensions
The process of deregulating interest rate ceilings on
consumer deposits with transactions features began in
late 1982 and early 1983. By the end of March 1986,
all restrictions had been removed except the zero rate
limitation on demand deposits. Deregulation has ush­
ered in a new era of explicit pricing of the services
provided by consumer accounts offering transactions
features. Before deregulation, banks tended to compete
for these accounts by offering account services free or
below cost. Since the rate ceilings have been elimi­
nated, banks have been free to compete by offering
more attractive interest rates while charging explicitly for
account services when and as needed to make the
overall cost of funds from these accounts competitive
with alternative bank funding sources.
The way in which banks have adjusted interest rates
on the various types of consumer deposit accounts
under deregulation in response to changes in market
rates was explored in an earlier issue of this Review.'
In this article we present the results of a recent survey
of the non-interest-rate features of pricing by commercial
banks on four types of accounts: money market deposit
accounts, which provide limited transactions services,
consumer demand .deposits, “ regular” NOW, and Super
NOW accounts.2 Until January 1, 1986, regular NOW
'S ee John Wenninger, "Responsiveness of Interest Rate Spreads and
Deposit Flows To Changes In Market Rates," this Quarterly Review
(Autumn 1986), pages. 1-10. See also Michael C. Keely and Gary C.
Zimmerman, “Deposit Rate Deregulation and The Demand For
Transactions M edia,” Econom ic Review, Federal Reserve Bank of
San Francisco (Summer 1986).
2The survey data were obtained from the Trans Data Corporation, 530
Riverside Drive, Salisbury, Maryland, 21801. Trans Data developed
figures as of year-end 1985 covering a range of pricing

14 FRBNY Quarterly Review/Winter 1987




accounts were subject to a 51A» percent interest rate
ceiling while Super NOW accounts were free to pay a
market-related rate. This regulatory distinction, in effect at
the late 1985 date covered by our survey, no longer exists.
Nevertheless, many institutions continued to offer NOW
accounts whose rates change only infrequently alongside
other NOW accounts whose rates are, at least in principle,
more frequently adjusted in line with market conditions.
The problem faced by banks in determining appro­
priate pricing policies for consumer deposit accounts
with transactions features is extremely complex. These
accounts involve certain fixed costs associated with
setting up and maintaining the account as well as vari­
able costs related to the account's activity level. On the
revenue side, the account has value to the bank as a
source of funds that can be re-lent at a profit and, in
many cases, it is also a source of fee income. As noted
elsewhere in this issue,3 it may be very difficult for
banks to place an overall value on the funds gathered
in these accounts. Bankers tend to view transactions
accounts as an important focus of a complex “customer
relationship.” Thus the holder of a transactions deposit
account may tend to borrow and to purchase other
Footnote 2 continued
characteristics for traditional demand deposits owned by consumers
and for the various interest-bearing accounts having transactions
features that have become available over the last several years. The
data were obtained from a survey of 195 respondent banks across
the nation conducted early in 1986. Nearly all the survey
respondents had at least $500 million in total deposits and were
major participants in their respective markets. The total deposits of
the surveyed commercial banks amounted to approximately $600
billion in the aggregate, and they held close to 30 percent of the
nation’s total domestic deposits.
3See “Bankers on Pricing Consumer Deposits” this Quarterly Review ,
pages 6-13.

banking services at the same institution. Indeed, the
pricing of the various banking services, including
transactions accounts, may be designed to give cus­
tomers an incentive to do all their banking business with
the institution where they maintain a transactions
account. This relationship value of the transactions
account is difficult to measure and greatly complicates
the problem banks face in pricing such accounts
appropriately. And of course the competitive situation
any particular bank (or any branch of that bank) faces
is a further major complicating factor in determining
appropriate pricing policy.
The result, at least in the larger and more competitive
banking markets, is a rather bewildering array of avail­
able combinations of interest rates, fee structures, bal­
ance requirements, and interconnections with other
banking services. The survey results reported here
cannot begin to capture all this complexity. Neverthe­
less, a few generalizations about the products being
offered depositors can be gleaned from the survey that
have almost certainly retained their validity.

Table 2

Monthly Fees on Commercial Bank Accounts
with Balances Below the Minimum Required
to Earn Interest
December 31, 1985
Percent of respondents
Charge a Fee?

MMDA

NOW

Super
NOW

Yes
No

67.7%
32.3

96.0%
4.0

95.5% 100.0%
4.5
0.0

186

99

156

177

15.0
38.6
15.0
6.3
24.4

15 8
35.8
28.4
9.5
10.5

8.1
27.5
21.5
9.4
32.2

54.3
33.3
7.9

127

95

149

177

Number of respondents

Demand
Deposit*

Size of Fee Where Charged
Less than $4.00
$4.00 to $5.99
$6.00 to $7.99
$8.00 to $9.99
$10.00 and above
Number of respondents!

4.5

'Refers to minimum balance required to avoid a monthly fee.
tincludes a few banks that did not reply to all questions.
Source. Trans Data Corporation,

Survey results
First, most respondents require that interest-bearing
accounts with transactions features maintain some
minimum balance if any interest is to be earned. This
is the case for the overwhelming number of MMDA and
Super NOW accounts and is true for a majority of NOW
accounts (Table 1). Demand deposit accounts of course
pay no interest, but all the institutions surveyed required
that some minimum balance level be maintained, gen­
erally around $500, if a monthly account fee is to be

Table 1

Minimum Balances Required to Earn interest
at Commercial Banks
December 31, 1985
Percent of respondents
Balance Requirements
$0
1-999
1-500
501-999
1,000
1,001-2,499
2,500
2,500 and greater
Number of respondents

MMDA

NOW

4.6%
2.1

44.4%
43.2
18.5
24.7

51.3
1.0
40.5
0.5
195

Super
NOW
3.8%
1.6

2.2

31.3
4.4
46.7
12.1

178

182

10.1

Demand
Deposit*
100%

111

'Minimum to avoid a monthly fee at commercial banks that
waived the monthly fee if a minimum balance was maintained.
Source: Trans Data Corporation.




avoided. For the two types of accounts paying “ marketrelated” rates, MMDA and Super NOW accounts, the
minimum balances required to earn interest tend to
cluster either at $1000 or at $2500. Not surprisingly, the
minimum balance levels required to earn interest for
regular NOWs are almost always sm aller amounts,
usually under $1000.4
For most accounts, balance levels determine not only
whether interest will be paid (in the case of interestbearing accounts) but also whether a per-account
monthly fee will be charged. Virtually all NOW account
holders were charged a monthly fee if their balances fell
below levels required to earn interest, both for the
NOWs and Super NOWs, while two-thirds of MMDA
account holders were assessed a fee when balances fell
below the minimum required to earn interest (Table 2).
The size of these monthly fees, where charged, varied
over a wide range. Generally speaking, however, they
tended to be less than $8 per month, although a size­
able minority of MMDA and Super NOW fees were as
much as $10 or more. Demand deposit account holders
whose balances fell below levels needed to avoid fees
tended to be charged the lowest monthly fees, less than
$4 in a majority of cases.
A slim majority of institutions charge a monthly fee on
NOW accounts even where balances are above
4A majority of institutions defined the required minimum balance in
terms of the lowest balance on any given day during the accounting
period. Further, a majority of institutions compounded and credited
interest monthly.

FRBNY Quarterly Review/W inter 1987

15

minimum levels required to earn interest, as is also the
case for a sizeable minority of Super NOW accounts
(Table 3). A very small minority of MMDA accounts were
charged fees even where balances were above those
required to earn interest. For all types of accounts
where fees are charged at balance levels above the
minima required to earn interest, these fees are never­
theless waived in most cases if some still higher balance
requirement level is met (Table 4). In the case of Super
NOWs, to be sure, a sizeable minority of accounts had to
pay a monthly fee regardless of the level of balances.
In the case of demand deposit accounts, about two-thirds
of respondents waive the monthly fee if balances are above
some minimum (clustering, as noted earlier, around $500)
while roughly one-third of the holders of such accounts have
to pay fees regardless of balance levels.
The logic of setting minimum balance levels in order
to earn interest, and/or to avoid fees, seems fairly
straight-forward. The deposits gathered by the bank in
these accounts are a source of profit because they can
be reinvested at an interest rate spread. But if the
volume of deposits in a given account falls below a
certain level, the net interest revenues generated will
not even cover the fixed cost of maintaining the account.
Therefore, minimum balance requirements to earn
interest and/or avoid fees are needed to weed out
unprofitable accounts, or to make them profitable
through the collection of fee income. On the depositor’s
side, the burden, if any, of these minimum balance
requirem ents will depend on how the balances are
computed, on the depositor’s normal balance needs and
on the alternative investment options. It is important to
note that a sizeable minority of institutions allow customer
balances in other accounts to help fulfill the minimum bal­
ance levels needed to earn interest and/or avoid fees on
regular NOW and consumer demand deposit accounts
(Table 4). Such an approach is of course in line with the
“ relationship” pricing of consumer banking products and
greatly reduces or eliminates any burden of balance
requirements for depositors who hold other accounts in
banks where they maintain a transactions account.
While monthly per-account fees can compensate the
bank for the fixed costs of account maintenance, where
balances would not otherwise be large enough to make
the account profitable, banks also incur per-check costs
that may or may not be covered by the value of bal­
ances and per-account fees. Thus many banks impose
per-check charges under certain conditions. In the case
of regular and Super NOW accounts and demand
accounts, about a third of the institutions in the survey
assessed per-check charges regardless of the levels of
balances in the accounts (Table 5). In addition, about
20 percent of NOW and Super NOW accounts and
about half of demand accounts are assessed per-check

16

FRBNY Quarterly Review/W inter 1987




Table 3

Monthly Fees on Commercial Bank Accounts
with Balances Above the Minimum Required
to Earn Interest
D ecem ber 31, 1985
Percent of respondents
C harge a Fee?

MMDA

NOW

Super
NOW

D emand
D eposit

Yes
No

9.2%
90.8

51.7%
47.8

38.0%
62.0

37.5%
62.5*

195

178

163

177

22.2%
27.8
5.6

9.8%
46.7
27.2
9.8
6.5

12.9%
32.3
29.0
8.1
16.1

90.5%
8.0
0.10
0.4
0.0

92

62

66

N um ber of re sp o n d e n tsf
Size of Fee Where C harged
Less than $4.00
$4.00 to $5.99
$6.00 to $7.99
$8.00 to $9.99
$10.00 and above
Number of re sp o n d e n ts!

44.4
18

•Indicate s percentage of banks that w aived monthly fee if
minimum balance was m aintained,
fln c lu d e s a few banks that did not reply to all questions.
Source: Trans Data Corporation.

Table 4

Balances Required to Waive Monthly Fee
Where Balances Were Above the Minimum
Required to Earn Interest
D ecem ber 31, 1985
In pe rcent of respondents*
Is Fee W aived Above
A S pecified Amount?

MMDA

NOW

Super
NOW

Demand
D eposit*

Yes
No

83.3%
16.7

97.8%
2.2

61.3%
38.7

62.5%
37.5

18

92

62

177

N um ber of respondents

In dollars
Average B alance
Required
To Waive Fee
Are Fees W aived Based
on B alances In Other
A ccounts?
Yes

$3,299

$1,410

$5,487

$500t

In pe rcent of respondents
n.a.

Num ber of respondents

35.6%
90

n.a.

46.1%
177

‘ Refers to re spondents that cha rged fees on accounts with
balances above m inim um required to earn interest except
that in the case of dem and deposits, the figures shown are
for the entire sam ple.
tE stim ate d
Source: Trans Data C orporation.

charges whenever balances are below the minimum
levels required to earn interest and/or avoid per-account
fees. Roughly 50 percent of institutions, however, charge
no per-check fees on NOW and Super NOW accounts
regardless of balance levels, while about 20 percent
assess no per-check fees on demand deposit customers
regardless of balance. Average per-check charges vary
according to type of account (Table 6). Here too, these
charges are waived in many cases if balances are
maintained at or above specific levels (Table 7).
The status of per-check charges on MMDA accounts
is a little complicated. These accounts were designed
to have only a limited transactions account capability.
Federal Reserve Regulation D requires that all institu­
tions offering MMDAs have procedures in place to
monitor account activity, which cannot exceed a total of
six pre-authorized, automatic and telephonic transfers
per month, of which no more than three can be by
check to third parties. When excessive activity is
detected, the regulation requires the offering institution
to take follow-up action to prevent further violation of
Regulation D. Since MMDAs retain their exemption from
reserve requirements only when the regulatory limits are
observed, many banks have priced per-check charges
to discourage account holders from writing more than
three checks. Only a small minority of institutions assess
per-check charges for the first three checks written in
a given month on these accounts (Table 5). Fully 47.2
percent, however, assess per-check charges beyond the
first three, in amounts averaging about $4.75 per
check— compared to per-check charges averaging only
$0.24 or less on other kinds of accounts (Table 6).

As the results reported above indicate, fee schedules
at most institutions are designed to recover costs in
accounts where average balance levels are not high
enough, taken by themselves, to make the account
profitable. A significant minority of institutions actually
offer interest-rate incentives to increase the size of
account balances by presenting a “ tiered” interest rate
structure where higher rates are paid on successively
higher threshold levels of balances. Thus some 29
percent of the respondents offered tiered rate structures
on MMDAs, and 17 percent offered such rate structures
on Super NOW accounts. However, the rate incentives
offered in these tiering arrangements were modest. Thus
in no case would increasing balances over a given
threshold level raise the rate paid by more than 50 basis
points, and in most cases the differential between suc­
cessive tiers ranged between 20 and 35 basis points.

Table 6

Check Charges at Commercial Banks
December 31, 1985
Average charge
per check:

MMDA
$1.16* $4.73f

Number of
respondents
reporting the
charge

17

NOW

Super Demand
NOW Deposit

$0.24

$0.22

54

63

84

$0.18t

177

'First three checks.
fBeyond three checks.
^Partly estimated.
Source: Trans Data Corporation.

Table 5

Per-Check Charges Versus Balance
Requirements at Commercial Banks
December 31, 1985
Percent of respondents
Is There A Per-Check
Charge?
Yes, regardless
of balance
Yes, if balance
below minimumf
No, regardless of
balance
Do not offer checks
Number of respondents

Table 7

MMDA*

NOW

Super
NOW

Demand
Deposit

4.6%

31.5%

29.4%

30.5%

4.1

18.5

18.4

51.5

83.1
8.2

50.0

52.1

17.9

195

178

163

177

‘ In the case of MMDAs, the charge relates only to the first
three checks.
tMinimum required either to earn interest (MMDAs, NOWs and
Super NOWs) or avoid a monthly fee (demand deposits).
Source: Trans Data Corporation.




Minimum Balance Requirements for Waiver of
Per-Check Charges at Commercial Banks
December 31, 1985
Average Balance
To Waive Charges:*
(1) Total number of
respondents that
waived check charges
(2) Line 1 as a percent of
respondents that charged
a fee*

Super
NOW_____NOW
$1,356
$4,792

47

24

83.9%

50.0%

Demand
Deposit
$500f

911

51.5%

*For banks that imposed a charge when the balance was
above the minimum required to earn interest.
fEstimated
Source: Trans Data Corporation.

FRBNY Quarterly Review/W inter 1987

17

Conclusion
Clearly the process of setting non-interest-rate terms on
consumer transactions accounts cannot be reduced to
a simple formula. As mentioned earlier, we should
expect to see minimum balances to earn interest and/
or avoid fees set to permit earnings from low-balance
accounts to cover costs. At the same time, we might
expect competitive forces to discourage charging fees
on high balance accounts that would be profitable
without such fees. By and large, the survey results are
consistent with these expectations to the extent that
most accounts do require minimum balances to earn
interest, while fees do tend to be eliminated above this
or some other level of balances. Nevertheless, the
survey also shows that some institutions pay interest
regardless of balance levels and that a few charge no
fees. On the other side, some institutions charge fees
regardless of balance levels. Neither situation seems
consistent with any simple theory of account pricing.
Moreover, the wide variety of options offered by different
institutions and the significant differences among them
in setting specific balance levels and fee schedules sug­
gests that the market for these accounts has yet to settle
down to any uniform set of prices and approaches.
There are some obvious reasons for this. They include
the fact that the strength of competition and the com­
position of the depositor base may differ widely from
institution to institution, or even between branches of the
same institution. Moreover it is difficult to compute the
true costs and, especially, the true net revenues of
transactions accounts and therefore to compute what
balance levels and fee schedules might be appropriate
to them. For one thing, it is difficult for banks to know
what notional “ term-to-maturity” to assign to consumer
transactions balances in comparing them to the costs
of funding alternatives in a world where the yield curve
is rarely flat. Another major imponderable, already
noted, is how to value the net revenues earned by
banks from these accounts when they represent the

FRBNY Quarterly Review/Winter 1987
Digitized18
for FRASER


lynchpin of a full banking relationship. Given all the
imponderables, it is not surprising to find a wide diver­
sity of practices and some instances that seem to con­
tradict what a pure, and rather simplistic, theoretical
approach to pricing might imply.
Finally, it needs to be emphasized that the survey
from which the data in this article were taken represents
practices only as of a single date, late 1985. While it
appears that banks review the non-rate dimensions of
their consumer pricing policies only relatively infre­
quently, it is likely that there has been some further
evolution since this survey was taken. In particular,
there are signs of an increasing move toward relation­
ship pricing, a dimension of the problem not explicity
covered in the survey.
Changes in the non-rate dimensions of consumer
pricing could have some impact on the levels and
growth rates in the monetary aggregates as measured
and targeted by the Federal Reserve. For example, the
widespread use of minimum balances on transactions
accounts and changes in the levels of these minimums
are likely to affect the overall levels of these balances
because consumers may have an incentive to move
funds from other assets to meet the balance require­
ments. Thus the level of M1 could be affected. It could
also be affected by changes in the willingness of banks
to allow deposits in other accounts to count towards
balance requirements in transactions accounts. Indeed
the overall structure of non-rate terms on transactions
accounts could have long-run effects on the response
of these accounts to changes in consumer income and
wealth. But in the short- to medium-term, the move­
ments of interest rates paid on transactions accounts—
relative to rates paid on other consumer accounts and
relative to market rates generally— are clearly far more
important influences on their behavior.
Richard G. Davis
Leon Korobow

Monetary Policy Influence on
the Economy—An Empirical
Analysis
Some economists and policy makers are concerned that
the ability of monetary policy to influence economic
activity has been seriously weakened by developments
in the financial system during the 1970s and 1980s. The
main argument is that financial innovations and the
deregulation of interest rates have led to a breakdown
of non-price credit rationing barriers that were important
in transmitting monetary restraint to particular sectors,
such as housing and small business. Without those
credit availability effects, monetary policy must rely
largely on the response of private spending to interest
rates. This shift in the channels of monetary policy
influence implies that interest rates may have to rise to
much higher levels than in the past to attain a given
degree of restraint on private demand.1
There is not much doubt that the role of credit
rationing has been reduced greatly. Whether this implies
a significant decline in the effectiveness of monetary
policy, however, is not clear. The channels of monetary
policy transmission to the economy remain complex,
operating through interest rates, exchange rates, asset
values, and expectations about these and other vari­
ables. The same forces of innovation and deregulation
that reduced or eliminated credit availability effects may
have strengthened interest rate and wealth effects. For
example, in the deregulated financial market environ­
ment, economic agents may be more aware of, and
more sensitive to, changes in market interest rates, i.e.,
’ See, for example, Lyle E. Gramley, "Financial Innovation and
Monetary Policy,” Federal Reserve Bulletin (July 1982);
Richard G. Davis, "Recent Evolution in U.S. Financial Markets—
Implications for Monetary Policy,” Greek Econom ic Review
(Decem ber 1981); and William R. Keeton, "Deposit Deregulation,
Credit Availability and Monetary Policy,” Federal Reserve Bank of
Kansas City Econom ic Review (June 1986).




the interest and wealth elasticities of private demand
may have increased over time. Perhaps even more
importantly, the generalized floating exchange rate
environment and the growing link between the U.S.
economy and the rest of the world suggest a larger
potential effect of exchange rates on economic activity.
All these developments are relevant for assessing the
overall effectiveness of monetary policy, which depends
on the link between policy instruments and financial
variables as well as on the relationship between finan­
cial variables and real economic activity. These broad
linkages may be viewed as the two major steps in the
transmission of monetary policy influence to the
economy. In this article, we look at the second step in
the transmission by focusing on the key interest and
exchange rate-sensitive sectors of the economy: con­
sumer durable goods, producers’ durable equipment,
and residential construction. Together, these sectors
account for nearly a third of total private expenditures
and more than half of the recent business cycle fluc­
tuations in those expenditures. More broadly, these
sectors are of fundamental importance to the economy
in that their direct and indirect (or spillover) effects are
large and far reaching, extending to all sectors.
Based on a fairly standard framework we estimate
interest and exchange rate effects on demand and
explore the possibility of significant shifts in the esti­
mated effects. Our main findings are as follows:
• Interest and exchange rate effects on private
spending have been substantial and significant at
least since the mid-1970s, suggesting that the longrun monetary policy influence on the economy
remains powerful.

FRBNY Quarterly Review/Winter 1987

19

• The interest sensitivity of private expenditures
seems to have risen over time, and together with
the strong exchange rate effects, has served to
offset the reduced role of credit rationing. On bal­
ance, therefore, the long-run monetary policy
influence on the economy is likely to have been as
strong in recent years as in the earlier period.
• The short- to medium-term monetary policy influ­
ence seems to be quite uncertain and difficult to
estimate. It may have become less predictable over
time, presumably reflecting increased uncertainty
about the relationship between policy instruments,
and interest and exchange rates.
Given the complexity of issues involved and the diffi­
culties of estimating relationships in the face of on-going
financial and economic changes, these findings should
be viewed as tentative.
Changing Channels of Monetary Policy Influence
In the 1960s and early 1970s, monetary policy relied on
two principal channels to moderate private aggregate
demand: interest rates and credit rationing. Increases
in interest rates affected spending in interest ratesensitive sectors directly by raising the opportunity cost
of financing. At the same time, high interest rates trig­
gered credit rationing when they collided with institu­
tionally determined interest rate ceilings, restraining
spending especially in the housing and small business
sectors.
Credit rationing took two general forms. First, during
periods of high interest rates, banks and thrift institu­
tions experienced a decline in deposits and a loss of
liquid assets because of Regulation Q ceilings on
deposit rates. As a result, they were forced to reduce
their lending to households and small businesses.
Second, a variety of limits on lending rates— usury laws,
and interest rate ceilings on government-insured loans
and on local government borrowing— acted to block
credit to various sectors through reduced availability or
tightening of non-price terms. Together these restrictions
created substantial, though frequently short-lived, credit
shortages.2
2A necessary, but sometimes unstated, assumption in this argument
is that credit lost to one sector was not simply added to credit in
other sectors. This would be true if the alternatives were not perfect
substitutes. Implicit also is the notion that restrictions on the quantity
of credit are more effective in curbing spending than increases in
the price. For a more detailed discussion of the credit rationing
mechanism, see A.M. Wojnilower, “The Central Role of Credit
Crunches in Recent Financial History," Brookings Papers on
Economic Activity, 2 (1980); "Private Credit Demand, Supply, and
Crunches— How Different are the 1980's?” American Economic
Review (May 1985); Davis, op. c/f.; B.M. Friedman, Monetary Policy
in the United States: Design and Implementation, a study prepared
for the Trustees of the Banking Research Fund Association of

20

FRBNY Quarterly Review/Winter 1987




Since the early 1970s credit rationing mechanisms
have been weakening. In 1973, Regulation Q ceilings
on all large negotiable certificates of deposits were
removed, and during the next six years or so there was
a substantial easing of interest rate ceilings on various
types of deposit instruments. The Deregulation and
Monetary Control Act of 1980 phased out Regulation Q
ceilings at all depository institutions. Although the
phase-out lasted until April 1986, the bulk of deregu­
lation occurred in the early 1980s. In the late 1970s and
early 1980s, usury ceilings on various types of loans
were either eliminated or substantially eased.
These regulatory changes, together with financial
innovations and the growth of financial markets, have
led to greater interest-rate competition, more integrated
credit markets, and a freer flow of funds. The increased
role of market forces on the domestic scene has been
reinforced considerably by globalization of financial
markets, i.e., enhanced integration of domestic and
international financial markets. In these circumstances,
credit rationing no longer appears to be a significant
channel of monetary policy influence on the economy.
The breakdown of credit rationing mechanisms and
the greatly increased role of market forces and interest
rate competition in determining credit flows clearly imply
a significant shift in the manner of monetary policy
transmission to the economy. For example, interest rate
effects on spending are more gradual and less disrup­
tive than those of credit rationing. A more important
question, however, is whether the financial changes also
imply a significant weakening of the magnitude of policy
influence on non-financial sectors. A case for weakening
rests on at least two major assumptions: first, interest
elasticities of final demands have remained unchanged
at their earlier low levels, and second, developments in
the 1970s and 1980s have not opened new policy
channels or made existing channels more important.
Some features of the new financial environment sug­
gest that private spending may now be more sensitive
to interest rates.3 With an unprecedented rise in the
1970s, interest rates may have reached a threshold
where they start to have a stronger effect on spending.
It may be that financing costs are an important influence
on profits and investment decisions only at high rates.
Footnote 2 continued
Reserve City Bankers, June 1981, Chapter 2; and A.W. Throop,
"Financial Deregulation, Interest Rates and the Housing Cycle,”
Federal Reserve Bank of San Francisco Economic Review (Summer
1986).
3For a detailed discussion, see M.A. Akhtar, "Financial Innovations
and Their Implications for Monetary Policy: An International
Perspective,” BIS Economic Paper, No. 9 (Decem ber 1983); and
M.A. Akhtar and G.E.J. Dennis, “Financial Innovations and the
Interest Elasticity of Private Expenditures,” Federal Reserve Bank of
New York Research Paper No. 8422 (October 1984).

Once such cost considerations become a more impor­
tant part of investment decisions, they are likely to
remain so even after rates come down. This would be
particularly true if, as some economists have argued,
deregulation of rates and other changes in the financial
environment have pushed up the average level of
interest rates permanently.
Other forces more directly related to the process of
deregulation and innovation may also lead to greater
sensitivity of private demand to interest rates. The
increased market competition implies that any changes
in interest rates are more quickly transmitted to a larger
number of assets and economic agents than before.
Similarly, financial innovations may increase substitution
among various types of financial assets without any
significant alteration in the degree of substitution
between financial assets, as a group, and physical
assets. If so, changes in interest rates would tend to
have a greater impact on investment in physical assets
by immediately altering the rate of return on the whole
range of financial relative to physical assets. The
increased dependence on short-term and adjustable rate
loans may also increase interest sensitivity since
changes in interest rates will affect the cost of both
existing and new investments. On the other hand, the
adjustable rate environment may reduce the impact of
higher interest rates because borrowers have less
incentive to wait for lower rates.
The experience since the early 1970s suggests that
other monetary channels may have developed as well.
Floating exchange rates and the increased openness of
the U.S. economy have made the external sector an
important channel of monetary policy. Our international
transactions— both trade in goods and services, and
financial flows— have expanded greatly over the last
fifteen years or so. The total of exports and imports of
goods and services relative to gross national product
(GNP) is now about 60 percent above the 1970 level;
the ratio of imports to GNP is 90 percent above its 1970
level. The expansion of financial transactions is even
larger and is evident in virtually all measures of private
financial transactions. For example, U.S. bank claims on
foreigners in 1985 were more than 30 times greater than
they were in 1970.
With the increased scale of international transactions,
the exchange rate is an important influence on domestic
economic activity. The principal exchange rate effect
tends to reinforce, on balance, the more direct interest
rate effect. A tightening of monetary policy, for example,
not only drives up interest rates but also may lead to
an appreciation of the dollar exchange rate. This
reduces the competitiveness of domestically produced
goods, causing our demand for those goods to shift
abroad and exports to fall.




The workings of the exchange rate channel are quite
complex, however. The timing and extent of exchange
rate changes associated with monetary policy actions
are hard to predict, and together with uncertain lags in
the effect on relative prices of domestic versus foreign
goods, do not allow us to estimate reliably the exchange
rate influence on the economy, especially over a time
horizon of up to 2 or 3 years. To some extent, these
uncertainties reflect the more general problems of pre­
dicting exchange rates in an environment of high capital
mobility across national borders. Exchange rate move­
ments are subject to a large number of diverse influ­
ences— including expectations about the economy, future
exchange rates, and economic policy— and empirical
models have not been able to capture these influences
well enough to predict exchange rates systematically.
Another complicating factor in assessing the exchange
rate influence is that monetary policy actions lead to
changes in exchange rates partly through alterations in
interest rates. For this and other reasons, movements
in the two variables are closely associated over time.
Thus, it is very hard to separate the interest rate effect
on the economy from the exchange rate effect.
The complexity of the exchange rate channel arises
as well from the fact that not all the exchange rate
effects on economic activity work in the same direction.
While the primary effect of exchange rate appreciation
is to reduce the demand for domestic goods, it may also
have an offsetting influence on the economy. The latter
could happen, for example, if appreciation leads to
significant capital inflows, thereby putting downward
pressures on interest rates. Similarly, appreciation may
increase domestic demand through higher expected
wealth induced by the lower level of general prices.
These effects, which apply to domestic expenditures on
foreign as well as home produced goods, may be small
but they are difficult, if not impossible, to separate from
other interest rate and wealth effects.
Lack of Empirical Evidence
It is obvious from the preceding discussion that the
demise of the credit rationing mechanism does not
necessarily imply a weakening of monetary policy
influence on the economy. Whether developments in the
1970s and 1980s have made monetary policy more or
less effective, however, can only be resolved empirically.
Unfortunately, the literature has very little to offer on this
subject. The bulk of the evidence does not deal with the
experience of the last ten years or so; a few studies
analyze the recent experience in some sectors but
usually consider one sector at a time and differ greatly
in empirical methodology. To be sure, the evidence does
point to significant exchange rate effects on tradeable
goods, and a few studies, e.g., on inventories, also

FRBNY Quarterly Review/Winter 1987 21

suggest that interest rate effects may be stronger in
more recent periods. But none of these studies simul­
taneously considers internal and external sector chan­
nels of monetary policy influence on all the major sec­
tors of the economy, and none systematically examines
the possibility of a shift or drift in the impact of monetary
influences over time.
It is also not possible to discern a change by com­
paring estimates of the policy influences from earlier
studies to estimates from more recent studies. Over
time the objectives of research and statistical techniques
have changed so dramatically that the results from the
recent period are only remotely related to those from
the earlier period.
The present study focuses on the main interest and
exchange rate-sensitive sectors. Our presumption is that
the results for these sectors would give us some sense
of the broader trend in monetary policy influence on
domestic economic activity. Two caveats should be
mentioned at the outset. First, a comprehensive empir­
ical analysis covering all important non-financial sectors

C hart 1

C hart 2

Domestic Share of Expenditures and
Nominal and Real Exchange Rates*
P ercent

1960 62

Index 1 9 82= 10 0

64 66

68

70

72

74

76 78

80

82

84

86

♦D o m e stic share is total private expen ditures minus
imports, divided by total private expen ditures.
The exchange rate va ria b le s are in units of foreign
cu rren cy per dollar. P recise defin ition s a re given
in Appendix 2.
Sources: U.S. Departm ent of C om m erce, N atio n a l
Income and Product Accounts; F ederal R eserve Board,
F e d eral R e s e rv e Bulletin, Table A 68, various issues.

Private Expenditures and Real and
Nominal Interest Rates*
Billions of 1982 dollars
Percent
3 2 0 0 ------------------------------------------------------------------------------------------ 18

would be needed to reach a more complete judgment
on the effectiveness of monetary policy. Second, final
quantitative judgments on the issues involved may prove
elusive, not only because the financial and economic
environment is continuously changing but also because
some important aspects of the policy channels can not
be modeled empirically in a satisfactory manner.

Evidence on Monetary Influences

1200

' 1 1 1 1 1 1 1 1 1 1 1 11 11 1 11 11 1L 1

1960 62 64 66 68 70 72 74 76 78 80 82 84 86

* T h e nominal in te re s t rate is M oody’s AAA corporate
bond rate, and the real interest rate is constructed
by subtracting the eig ht-qu arter percent change in
the implicit GNP deflator.
S ources: U.S. Department of Commerce, National
Income and Product Accounts; Moody’s Investor
Service.

22

FRBNY Q uarterly Review/W inter 1987




A cursory look at the data reveals no systematic rela­
tionship between private spending and interest or
exchange rates. For example, movements of total pri­
vate spending appear to be only loosely related to
nominal and “ real” interest rates (Chart 1). The same
is true for private spending on domestic goods and the
dollar exchange rate (Chart 2). The influence of both
interest and exchange rates is somewhat more visible
when private spending is defined to include only the
three most policy-sensitive sectors— producers’ durable
equipment, housing, and consumer durables (Charts 3
and 4). Even so, neither of the two variables shows a
systematic and strong link to economic activity.
Further disaggregation at the sectoral level makes it
somewhat easier to see the effects of interest and
exchange rates. But their quantitative significance
remains in doubt. This is not particularly surprising since

many policy and non-policy influences operate simul­
taneously, making it difficult to identify the role of any
one of them at an impressionistic level. It is therefore
necessary to utilize a more elaborate framework to
examine monetary policy influence on the economy.
Our formal empirical analysis is based on a general
open economy macroeconomic framework, the main
features of which are described in Appendix 1. This
framework is consistent with a broad range of policy and
non-policy influences on the economy. Accordingly, our
estimated equations for each of the three sectors under
consideration include one or more policy-channel vari­
ables, such as interest rates, exchange rates, or credit
rationing, as well as measures of overall economic
activity. At a theoretical level, all these influences are
well understood, but there are no unique or even gen­
erally accepted empirical proxies for them. In fact, many
proxies are plausible for each variable, regardless of the
form of estimated equations. In Appendix 2, we discuss
various proxies used in the present study.

In what fo llo w s, we use two related em pirica l
approaches. First, we estimate total domestic expendi­
tures in the three sectors: residential construction,
consumer durable goods, and producers’ durable
equipment. These estimates allow us to focus on
interest rate effects, but they can not be used to
examine the demand shift between domestic and foreign
goods— the principal influence of exchange rates and
openness on dom estic econom ic a c tiv ity .4 Total
expenditures obscure the exchange rate effect because
they include domestic spending on both domestic and
Estim ates of total domestic expenditures as opposed to expenditures
on domestically produced goods are preferable for evaluating the
role of interest rates for at least two reasons. First, buyers’ (or
users’) financing cost considerations are independent of the supply
source. Second, since domestic output and import components of
total domestic demand for all goods are difficult to identify,
especially at the sectoral level, estimates of demand for domestic
goods are subject to greater measurement errors.

Chart 4

Domestic Share of Expenditures on
Durables, and Nominal and Real
Exchange Rates*

Chart 3

Expenditures on Consumer Durable Goods,
Producers’ Durable Equipment, and Housing
as a Share of GNP, and Nominal and Real
Interest Rates*
Percent
2 4 ---------

Index: 1982=100
125

Percent
--------- 16

y

Rea l in t e r e s t \
‘ S c a l e -------►

15U I
i9 6 0 62

Percent

V"V ~

V

LU-LUJ-L J.l.l.Ll.I.l LLL..L1 LL2
64

66

68

70

72

74

76

78

80

82

84

86

* The nominal interest rate is M oody’s AAA co rp o rate
bond rate, and the real in terest rate is constru cted by
subtracting the e ig h t-q u arter percent change in the
im plicit GNP deflator.
S ources: U.S. Department of C om m erce, National
Income and Product Accounts; M oody’s Investor
Service.




vnL-L.I [ I I I I M
1967 68

70

72

74

I II
76

78

I I II

I I I | 0

80

84

82

86

♦ The dom estic share is the percent of total expenditures
on dom estically produced consumer durable goods
and producers' durable equipm ent. The exchange
rate va ria b le s are in units of foreign c u rre n cy per
dollar. Precise d e finitio n s are given in Appendix 2.
Sources: U.S. Departm ent of Commerce, National
Income and Product Accounts; Federal Reserve Board,
Federal Reserve B ulle tin . Table A68, various issues.

FRBNY Quarterly Review/W inter 1987

23

fo re ig n goods and exclud e fore ig n spending on
domestically produced goods. We do attempt to test for
the offsetting effects of exchange rates which, as noted
above, apply to domestic demand for all goods and may
offset a part of the principal influence of exchange rates.
The second approach drops the non-trade housing
sector and explores the exchange rate influence on the
demand shift between domestic and foreign goods in the
other two sectors. For this purpose, we consider three
different definitions of the dependent variable: domestic
demand for home produced goods; domestic demand for
foreign goods (i.e., imports); and foreign demand for
domestically produced goods (i.e., exports).

Interest Rate Effects
Estimates of total expenditures in each of the three
sectors are based on quarterly data, and cover several
different specifications and a range of sample periods
over 1960-86. Details of these estimates as well as the
results for the full sample period and two subperiods are
reported in Box 1.
Expenditures in all three sectors show a significant
long-run response to interest rate movements over the
full sample period, 1960-86 (Table 1). This finding is
immune to moderate changes (up to three years) in the
investigation period, at the beginning or the end point
of the sample. More generally, the estimated equations
appear to be quite reliable in terms of both the standard
statistical criteria and theoretical considerations about

Box 1: Regression Estimates for the
Expenditure Equations
In the text we have concentrated on the long-run interest
elasticities and their policy implications. This box pre­
sents details of the empirical models. Specifically, we
compare the elasticities of the non-policy variables,
present tests for robustness to changes in the sample
period or explanatory variables, and report formal tests
of structural shift.
The elasticities reported in the text are based on
regression models developed with two general criteria in
mind. First, they are consistent with the theoretical
framework outlined in Appendix 1. In particular, they are
part of a Keynesian style “ IS” curve, which allows policy
variables such as interest and exchange rates to play a
direct role in determining real expenditures without an
explicit consideration of changes in the price level.
Second, considerable specification search was done to
ensure “ reasonable” estimates. By reasonable we mean:
(1) the coefficients are statistically significant and are
consistent with economic theory, (2) the equations
explain a large amount of the variation in the dependent
variable, and (3) the reported results are representative
of the broader body of work done.
The expenditure equations for consumer durables
(CON), residential structures (HOUSE), and producers’
durable equipment (PDE) are of the following form:
(1) CON = a0 + a, INCOME + a2 CHUN + a3 INTER
+ a4 DUM1 + a5 CON(-1),
(2) HOUSE = b0 + b, INCOME + b2 CHUN
+ b3 INTER + b4 DUM2 + b5 HOUSE(-1),
(3) PDE = c0 + d, INCOME + ei INTER + f* PRICE,

Table 1

Long-Run Interest Rate Sensitivity*
1960-86

1960-74

1975-86

9.59

-1 .364 :

- 0 .8 5

-1.664:

8.62

-2 .444 ;

- 1 .7 2

-2.374:

4.94

-8 .104 ;

- 9.284:

-8 .724 :

W e ig h tf
Consum er
D urable Goods
P rod ucers’
D urable
Equipm ent
Residential
C onstruction
Total§

23.16

- 3 .2 0
( - 2 6 .6 )

- 2 .9 7
( - 2 4 .7 )

- 3 .4 3
( -2 8 .5 )

'P ercen t cha nge in private spe nding in response to a 10
pe rcent change in interest rates (see A ppendix 2 and Box 1).
The minus sign refers to the dire ctio n of change in
expenditures.
tS h a re of total private expenditures in 1985.
4:The underlying elasticity estim ates are significant at the 95
percent or higher levels of con fid ence .
§Average of the three com ponent elasticities, w eighted by their
shares in 1985 total private expenditures. The num bers in
parentheses are changes in billions of 1982 dollars.

24

FRBNY Q uarterly Review/W inter 1987




where all variables except CHUN are in log form. The
variables are defined as follows: INCOME is a measure
of total activity relevant to each sector; CHUN is the
change in the unemployment rate; INTER measures the
interest or cost-of-capital effect; DUM1 and DUM2 are
dummy variables which account for, respectively, the
credit controls of 1980 and credit rationing in housing;
PRICE is the relative price of investment goods; and
HOUSE(-1) and CON(-1) are lagged dependent vari­
ables. The precise empirical proxies for each of these
variables are reported in Appendix 2. In line with pre­
vious research, the equations account for adjustment
lags in two ways: the housing and consumer durables
equations include lagged dependent variables, whereas
in the producers’ durable equipment equations each
explanatory variable enters as a distributed lag.
Table A reports the regression estimates for these
equations for the full sample, 1960-1 to 1986-11, as well
as two sub-samples, 1960-1 to 1974-IV and 1975-1 to
1986-11. All equations are corrected for serial correlation

Box 1: Regression Estimates for the Expenditure Equations (continued)
using the Cochrane-Orcutt procedure.* Since the vari­
ables enter in log form, the elasticities can be read
directly off the table. In the producers’ durables equa­
tions, the reported coefficients are the sum of the poly­
nomials, and therefore they should be interpreted as
long-run elasticities; in the consumer durables and
housing equations the long-run elasticities can be cal­
culated by dividing each coefficient by one minus the
coefficient on the lagged dependent variable.
On the whole, the full sample estimates are consistent
with previous results reported in the literature. Each
equation explains a large portion of the variation in the
dependent variable, with adjusted R-squares close to
one. This good fit reflects in part the use of lagged
dependent variables and long distributed lags. Appar­
ently, spending in these sectors responds slowly to
changes in the underlying determinants. Spending in
each sector is income-elastic: in the long-run a one
percent change in the income variables results in more
than a one percent change in spending for each of these
cyclically sensitive sectors.t Both credit rationing vari­
ables are highly significant. President Carter’s credit
controls reduced consumer durables purchases by an
estim ated average of 4 percent in the spring and
summer of 1980. Similarly, the immediate effect of credit
crunches in the mortgage market in this period was a
decline of 5 percent in housing expenditure. The most
important result for our purposes, however, is that each
equation shows significant and economically large
interest rate effects. Not surprisingly, the most interestsensitive sector in our sample is housing. The lowest
interest sensitivity is for consumer durables, but even that
sector plays an important role in the monetary transmission
mechanism because of its large share in GNP.
When we split the sample in the mid-1970s, the results
remain strong for the second half, but become weaker
for the first half. The overall fit continues to be good,
with high adjusted R-squares and low standard errors.
The long-run income effect is larger in the second half
for all three sectors. All else equal, this suggests that
the income m ultiplier has increased over time. The
interest rate is insignificant in the first half for both
consumer durables and producers’ durables. For the
second half, however, the interest elasticities are large
and highly significant for all three sectors.
‘ When the equation includes a lagged de pend ent variable,
more c o m plicated correction procedures are needed to
ensure consistent param eter estim ates. This is not a serious
problem for our estimates, however, because the serial
correlation is relatively small for all of our equations.
f i n housing the long-run incom e elasticity is less than one,
but the overall sensitivity to the business cycle is quite high,
as reflected in the coe fficien t on CHUN.




This impressionistic review of the results suggests that
there have been small but economically significant
changes in the regression coefficients over time. Formal
tests show that some of these changes are also statis­
tically significant. “ Chow” tests were used to detect shifts
in the overall structure of each model. Although these
results are only approximate because of overlapping lags
in the models, they provide marginal evidence of a
structural shift in the early to mid-1970s for both con­
sumer durables and housing.t
We also used “ dummy variables” to explore the pos­
sibility of a shift in the individual coefficients. These tests
show only a marginally significant increase in interest
sensitivity for consumer durable goods and producers’
durable equipment, and no clear pattern for housing.
They also show that shifts in interest sensitivity are not
the only source of structural change in these sectors. In
particular, income elasticity has increased in all three
sectors. Comparing samples before and after 1975, there
is a significant increase in income elasticity for both con­
sumer durable goods and producers’ durable equipment.
Are the results robust? Most important, how sensitive
are the interest elasticity estimates to changes in the
sample, the choice of interest rate proxy, and the inclu­
sion or exclusion of other variables? The general finding
is that the results are not sensitive to changes in the
start or end point of the samples, but in some cases they
are sensitive to what variables are used. For example,
the interest elasticity of producers’ durable equipment
appears to be quite sensitive to the particular proxy used
for the interest rate. Complicated cost-of-capital vari­
ables, such as the proxy used in the MPS model, did
not yield significant results, and measures of the real
interest rate were only significant if inflation expectations
were modeled as a long distributed lag. Similar consid­
erations apply for consumer durables.
One final note: in addition to testing for interest rate
effects we explored the role of exchange rates in our
expenditure equations. Exchange rates may affect total
expenditures through several indirect channels. Theo­
retical models suggest that most of these effects are
small and ambiguous. It is not surprising, therefore, that
our empirical tests of the exchange rate effect yielded in­
significant coefficients with changing signs. As Box 2 shows,
however, the exchange rate does have consistently strong
effects through its more traditional channel— substitution
in demand between domestic and foreign goods.
tA s an added check, we examined each model for structural shift
using the cusum squares methodology. This approach looks for
structural change by estimating the model recursively over the
sample to see if successive one-quarter ahead forecast errors
"pile up” over time. These tests show no evidence of structural
shift for housing and consumer durables, but some evidence of a
shift for producers' durables in the early 1980s.

FRBNY Quarterly Review/W inter 1987

Box 1: Regression Estimates for the Expenditure Equations (continued)
Table A

Regression Results for the Expenditure Equations*
Consumer Durables

Housing

Producers’ Durable Equipmentf

1960-86

1960-74

1975-86

1960-86

1960-74

1975-86

1960-86

1960-74

1975-86

-1 .4 9
(6.7)

-1 .2 8
(3.4)

-2 .3 2
(5.4)

0.33
(2.0)

0.17
(0.5)

-0 .5 6
(1.4)

-9 .1 4
(17.21)

-7 .8 8
(6.1)

-8 .3 0
(6.3)

Income

0.37
(6.7)

0.32
(3.3)

0.53
(6.2)

0.16
(6.5)

0.29
(4.2)

0.28
(4.3)

1.92
(23.6)

1.74
(90)

1.81
(10.2)

Interest

-0 .0 3
(4.0)

-0 .0 2
(1.1)

-0 .0 5
(5.2)

-0 .2 0
(4.5)

-0 .3 4
(2.8)

-0.21
(4.6)

-0 .2 4
(4.8)

-0 .1 7
(1.5)

-0 .2 4
(4.6)

Lagged Dependent

0.77
(21.0)

0.80
(11.6)

0.70
(15.9)

0.76
(22.6)

0.64
(7.9)

0.76
(26.4)

—

—

Chunemp

-0 .0 5
(8.1)

-0 .0 7
(6.5)

-0 .0 4
(5.8)

-0 .0 6
(4.1)

-0 .0 5
(2.3)

-0 .0 8
(5.3)

_

_

_

O ther!

-0 .0 3
(2.2)

—

-0 .0 4
(3.2)

-0 .0 5
(4.0)

-0 .0 6
(3.5)

-0 .0 4
(2.5)

0.41
(2.4)

0.88
(1.8)

0.32
(18)

Constant

Long-run Interest
Elasticity§

-0 .1 3 6

-0 .0 8 5

-0 .1 6 6

-0 .8 1 0

-0 .9 2 8

-0 .8 7 2

-0 .2 4 4

-0 .1 7 2

-0 .2 3 7

R2

.998

.995

.990

.962

.931

.978

987

.973

.980

SEE

.025

.025

.022

.040

.038

.036

.018

.017

.019

Rho

-.3 4 6

-.2 6 0

-.491

.078

.211

-.3 1 4

.585

.645

.209

*AII equations are estimated with Cochrane-Orcutt correction for first-order serial correlation. All variables except Chunemp, and ‘'Other"
enter in log form. See Appendix 2 for definitions of variables.
fThe reported results are the sum of the lagged coefficients.
f'O th e r” is a dummy for credit controls in 1980 for consumer durables, a dummy for credit rationing in housing, and the ratio of output
price to capital price in the producers’ durables equation.
§For consumer durables and housing this is calculated by dividing the short-run interest elasticity by one minus the coefficient on the
lagged dependent variable.

the role of the main explanatory variables. Interest rate

effects are particularly large in the housing sector, indicating
that a 10 percent decrease (increase) in the mortgage
rate— e.g., from 10 to 9 percent— would gradually lead to
about an 8 percent rise (decline) in expenditures on resi­
dential construction. The interest sensitivity of expenditures
in the other two sectors is also substantial but well below
that for the housing sector. Together, the results for the three
sectors imply that a 10 percent decline in the general level
of interest rates would augment expenditures in the long run
by 3.2 percent, or about $27 billion in 1982 prices, using
1985 as the base.5
For all three sectors, the short-run interest rate effects
are substantially smaller, but they are also less certain
and more difficu lt to quantify precisely. We have,
therefore, made no system atic attempt to explore
interest rate effects for the short run or for any period
less than the “ long run.”
5These and other estimates discussed here refer only to the direct
effect of interest rates; in fact, however, there are multiplier or
feedback effects as demand and income in each sector respond to
initial growth in the other sectors.

26

FRBNY Quarterly Review/W inter 1987




The estimates for the more recent sample period,
1975-86, are broadly similar to the full period estimates.
In particular, the long-run interest rate effects remain
significant in all three sectors. For the first part of the
sample period, however, interest rates are statistically
significant for the residential construction sector but not
for the other two sectors.
A comparison of the subperiod results suggests that
the interest sensitivity of expenditures on consumer
durables and producers’ durable equipment may have
risen over time. The estimates for various cut off points in
the 1970s confirm this impression. While the estimated
effects over the subperiods are somewhat sensitive to
moderate changes in the sample size, they do suggest
that the interest sensitivity of the two sectors has been
greater over the last 10-15 years than in the 1960s.
The housing sector results, by contrast, do not reveal
a trend in the interest sensitivity, which has remained
strong throughout the period. The subperiod estimates
for the housing sector are more sensitive to changes in
the sample size than those for the other two sectors:
the coefficients of the explanatory variables and their

significance vary considerably for small changes in the
sample period. This problem may reflect, in part, uneven
changes in the importance of various components of
capital costs and credit rationing, and their interaction
with one another as well as with the activity variables.
Formal statistical tests to examine the significance of
any shift in interest sensitivity are broadly in line with
our impressions based on results for various subperiods
(Box 1). They indicate a small but significant upward
shift during the 1973-76 period for the consumer dura­
bles and the producers’ durable equipment sectors but
not for the housing sector. Of course, even without a
shift in the interest elasticity, the whole structure
underlying our estimates may have shifted over time.
Statistical tests to explore this possibility are inconclu­
sive: they suggest a shift in the housing and consumer
durables sectors but not in the producers’ durable
equipment sector.
The expenditure equations also give some insight into
the changing role of credit rationing. We test for two
kinds of credit rationing. First, we find that the credit
controls imposed by President Carter in 1980 directly
reduced spending on consumer durables by about 3 or
4 percent. Second, and more important, as we argued
earlier, periods of tight monetary policy were often
associated with restrictions in the quantity of credit
available to the housing and small business sectors.6
Our estimates show that credit crunches in the housing
sector directly reduce spending by about 5 percent on
average for the sample period as a whole. The results
from dividing the sample confirm the view that credit
rationing plays a smaller role in recent years.
To sum up, there is significant evidence that the
interest sensitivity of spending on consumer durables
and producers’ durable equipment has risen since the
mid-1970s. The evidence for the housing sector is
ambiguous: it suggests a shift in the overall structure
but not in the interest sensitivity of expenditures. The
average interest elasticity for the three sectors appears
to have risen over time, as the impact of credit rationing
has declined. More generally, in all three sectors, the
long-run influence of interest rates on private spending
developments has been important, at least since the
mid-1970s.
Exchange Rate Effects
Estimates of total expenditures for the producers’
durable equipment and consumer durables sectors, as
•We limit our empirical tests to the housing sector because it is
difficult to separate small business investment from large business
investment. This limitation is not likely to have serious consequences
for our results for two reasons: (1) the results for housing should be
indicative of broader credit rationing effects, and (2) in equations
that exclude measures of credit rationing, its effect should be at
least partially captured by the interest rate variable.




noted earlier, do not allow us to examine the substitution
between foreign and domestic goods resulting from
changes in exchange rates. In this section, we explore
this “ substitution effect” in two ways: first, we test how
exchange rates affect the division of expenditures
between imports and domestically produced goods; and
second, we estimate the effect of exchange rates on
exports. Measures of relative prices and trade-weighted
exchange rates were tried as proxies for the exchange
rate variable. In our primary estimates, the exchange
rate influence appears through relative prices— the ratio
of import prices to prices of competing domestic goods
and the ratio of export prices to prices of competing
foreign goods, all expressed in dollars.
Because of data limitations and our desire to focus
on a period with significant exchange rate movements,
the estimates in this section cover only the period from
around 1970 to the present. We are therefore unable to
examine possible shifts in the external sector influence
on the economy during the early or mid-1970s.
The equations for domestic demand for home pro­
duced goods— constructed by subtracting imports from
total domestic expenditures for each sector— are similar
to the expenditure equations, with the addition of
exchange rate variables. Details of the estimates along
with four representative equations are reported in Box 2.
The results are broadly consistent with our earlier find­
ings for total expenditures: spending in both sectors is
sensitive to economic activity and interest rate variables.
In addition, demand in both sectors also appears to be
quite sensitive to changes in exchange rates. However,
these results are considerably less robust than our
estimates of total expenditures. The interest and
exchange rate variables are not consistently significant,
and in most cases are sensitive to small changes in the
sample period. As noted above, the interest and
exchange rate effects are difficult to separate empirically
presumably because the two variables tend to move
together over time. More fundamentally, the relative
weakness of these estimates may be due to the diffi­
culties of measuring and identifying domestic demand
for home production and its explanatory variables.
Given the mixed results for expenditures on domestic
output, it is useful to estimate import demand directly,
and thereby infer spending on domestically produced
goods. In addition, to round out our results, we estimate
the exchange rate effect on the demand for exports.
Import and export demand equations for consumer
durables and producers’ durable equipment were esti­
mated for a number of overlapping sample periods from
1970 to 1986. Details of the equations as well as esti­
mates for two sample periods, 1971-86 and 1975-86,
are reported in Box 2. Judged in terms of the standard
statistical criteria, these estimates appear to be reliable,

FRBNY Quarterly Review/Winter 1987 27

Box 2: Regression Estimates for the Tradeable Goods Sectors
In this box we present the details of our empirical esti­
mates for the external sector, as well as additional evi­
dence on the robustness of our results. Exchange rate
effects are estimated for two sectors— consumer durable
goods and producers’ durable equipment— using three
different dependent variables— domestic goods demand,
imports, and exports. To give an idea of how sensitive
the results are to changes in sample period, estimates
for both the 1971-86 and 1975-86 periods are reported.
The domestic goods demand equations are shown in
Table B. The results are somewhat weaker than the
expenditure equations, but they provide us some insight
into the role of exchange rates. The overall fit is not as
good but there is less serial correlation. The interest rate
effect remains strong and significant in the consumer
durables equation, but becomes smaller and insignificant
in the p ro d u c e rs ’ d u ra b le s e q u a tio n . Finally, the
exchange rate effects are economically large in both
equations, but only marginally significant in the consumer
durables equation.
These mixed results are probably due to two problems
with the data. First, domestic demand is measured with

Table B

Regression Estimates for Demand
for Domestic Goods*
Consumer Durables
1971-86
Constant

-0.5 8
(1.4)
Income
0.33
(45)
Interest
-0.0 5
(43)
Rel price
-0 .1 0
(2.3)
Chunemp
-0.0 4
(4.5)
Lagged Dependent
0.65
(11.1)

Credit

-0.0 5
(2.5)

Producers’
Durable Equipment!

1975-86

1971-86

1975-86

-0.6 9
(1.7)

-9.82
(98)
1.68
(15.8)
-0.12
(1.7)
-0.4 6
(58)

-9.76
(3.6)
1.66
(66)
-0.0 9
(0.9)
-0.4 6
(2.4)

0.38
(46)
-0.0 6
(3.7)
-0 .1 5
(1.7)
-0.0 4
(3.6)
0.61
(9.2)
-0.0 6
(3.0)

—

—

—

—

_

—

Summary Statistics
R2

.976

.957

.969

942

SEE

.032

.030

.023

.026

Rho

-.42 8

-.47 8

.083

.058

*AII equations are estimated with Cochrane-Orcutt correction for
first-order serial correlation. All variables except Chunemp enter in
log form. See Appendix 2 for definitions of variables.
fThe reported results are the sum of the lagged coefficients.

FRBNY Quarterly Review/W inter 1987




error because the trade and expenditure data classify
final demand in different ways. Furthermore, our measure
of domestic final products includes an unknown quantity
of imported materials and supplies. These measurement
errors bias our exchange rate elasticities toward zero.
The second problem is that interest and exchange rates
are closely related both behaviorally and statistically. This
multicolinearity may explain the low t values for some
of our interest and exchange rate elasticity estimates.
By directly estimating import equations we can avoid
the problem of measurement error. The import and export
equations are of the following form:
(1) TRADE = a + b, INCOME + c, RELPRICE
+ d OTHER,
where all variables except the change in unemployment
are in log form and both INCOME and RELPRICE enter
as long polynomial lags. TRADE is the constant dollar
value of imports and exports for both consumer durable
goods and producers’ durable equipment. INCOME is a
measure of overall economic activity: in the import
equations it measures domestic activity, and in the export
equations it is a weighted average of foreign income.
RELPRICE is a sector-specific measure of the relative
price of foreign versus domestic goods. OTHER is the
change in unemployment in the consumer durable
imports equation and a dock strike dummy in the pro­
ducers’ durables import equation. More precise defini­
tions of the empirical proxies are given in Appendix 2.
Table C reports the estimates for both imports and
exports.* The reported coefficients are the sums of the
lagged coefficients and should be interpreted as longrun elasticities. All the equations have good overall fit
and reasonable autocorrelation estimates. The income
and exchange rate elasticities are in line with previous
work. Note in particular the high income elasticity for
both import equations.
We also tested the robustness of our results to
changes in sample period and to different proxies for the
exchange rate effect. Varying the sample starting point
from 1971 to 1975 and the end point from 1983 to 1986
confirms that the reported elasticities are representative,
but it also shows that the parameters are unstable. Using
the real exchange rate— the exchange rate adjusted for
inflation differentials— yields similar results. As expected,
the real exchange rate elasticities are generally lower
than the relative price elasticities. The real exchange rate
elasticities are also more variable, reflecting the insta­
bility of the relationship between real exchange rates and
relative prices.
'Consumer durables exports excludes auto exports to Canada.
Auto trade with Canada is determined more by trade
agreements and marketing considerations than by macro­
variables such as income and exchange rates. When we
included Canadian autos in our export data, the overall fit
deteriorated and the income variable became insignificant.

Box 2: Regression Estimates for the Tradeable Goods Sectors (continued)
Table C

Regression Estimates for imports and Exports*
Exports

Imports
Consumer Durables

Producers’
Durable Equipment

Consumer Durables

Producers’
Durable Equipment

1971-86

1975-86

1971-86

1975-86

1971-86

1975-86

1971-86

1975-86

-31.66
(14.4)

-27.27
(199)

-28.74
(7.4)

-30.18
(8.9)

8.43
(11.1)

-4.68
(36)

-1.29
(1.4)

-3.6 8
(2.9)

Income

4.64
(16.3)

4.06
(22.7)

4.83
(12.8)

5.03
(16.1)

1.94
(13.3)

1.21
(49)

1.85
(12.6)

2.37
(9.2)

Relprice

-1.55
(8.0)

-1.00
(4.7)

-1.22
(4.6)

-1.27
(5.6)

— 1.61
(17.3)

-1.4 2
(13.2)

-0.94
(7.1)

-1.00
(65)

Otherf

-0.07
(4.2)

-0.06
(2.8)

— 1.17
(5.1)

-0.70
(0.9)

—

—

—

—

Constant

Summary Statistics
R2

.894

.971

.930

.987

.871

.898

.813

SEE

.039

.038

.045

.038

.074

.059

.034

.027

Rho

.679

.282

.766

.433

.173

-.074

.699

.750

.702

'All equations are estimated with Cochrane-Orcutt correction for first-order serial correlation. The reported coefficients are the sum of the lagged
coefficients. Each variable, except “Other," enters in log form. See Appendix 2 for definition of variables.
f'O ther" is the change in unemployment in the consumer durables equation and a dock strike dummy in the producers' durables equation.

although the explanatory power of some variables is
moderately sensitive to changes in the sample period.
The relative price variables are highly significant in all
import and export equations (Table 2). The price elas­
ticity estimates for imports are roughly similar in the two
sectors. They imply that a 10 percent increase in the
relative price of imports will gradually reduce imports of
consumer and producers’ durables by about $22 billion
in 1982 prices, using 1985 as the base. On the export
side, the price elasticity is considerably larger for con­
sumer durables than for producers’ durable equipment,
but both estimates are substantial. These results imply
that a 10 percent increase in relative export prices will
eventually lower the combined exports of the two sec­
tors by about $10 billion in 1982 prices, using the 1985
base level. As with the interest rate effects, the short-run
influence of changes in relative prices and exchange rates
is much smaller, quite uncertain, and difficult to quantify.
The relative price variables take into account not only
price changes due to nominal exchange rate changes
but also price changes unrelated to exchange rate
movements. To estimate the influence of exchange rates
on imports and exports, it is necessary to determine the
extent to which exchange rate changes affect import and
export prices as well as prices of competing domestic
and foreign goods.
No significant evidence about exchange rate effects
on prices exists at a level comparable to disaggregate




categories in this article. Recent studies at a much
higher level of aggregation suggest, however, that in the
long run exchange rate changes lead to large but usu­
ally less than equal percentage changes in import and
export prices. Moreover, studies also indicate a con­
siderable influence of exchange rate changes on
domestic prices here and abroad. Using certain plau­
sible assumptions based on these studies, Table 2
provides the likely effects of exchange rate changes on
imports and exports of the two sectors under consid­
eration. Since the same assumptions are used for both
sectors, the estimated exchange rate effects preserve
the underlying relative pattern of the price elasticities
reported in the table.7
The estimated exchange rate effects on imports and
exports, though smaller than the relative price effects,
are substantial. On the import side, combining the two
sectors, a 10 percent decline in the trade-weighted
7For a review of the evidence on exchange rate effects on prices,
see M. Goldstein and M.S. Khan, "Income and Price Effects in
Foreign Trade" in Handbook of International Economics, edited by
PB. Kenen and R.W. Jones (Amsterdam: North-Holland, 1983).
Incidentally, note that only in the extremely unlikely case where
exchange rate changes have equal percentage effects on import
prices but no significant effect on export prices and on prices of
competing goods would the exchange rate elasticity be the same as
the price elasticity. Also note that the sign for the exchange rate
effect is positive for imports, the opposite of that for the relative
import price effect, since changes in import prices are inversely
related to changes in the dollar exchange rate.

FRBNY Quarterly Review/Winter 1987

29

nominal exchange value of the dollar is estimated to
reduce the volume of imports by 7-8 percent in the long
run. Using the 1985 base level, this implies a reduction
of about $13 billion in 1982 prices. On the export side,
the long-run exchange rate effect is considerably smaller
than for imports but it is statistically and economically
significant.
Due to considerable uncertainty about exchange rate
effects on prices of imports, exports, and domestic
goods, these results should be viewed not as precise
estimates, but as evidence of strong exchange rate
influence on U.S. international trade in consumer and
capital goods. Some caution in interpreting exchange
rate results is also suggested by the fact that the mag­
nitude of the underlying price elasticities is somewhat

Table 2

Long-Run Relative Price and
Exchange Rate Effects*
Imports
Percent

$ 1982
(billions)

Exports
Percent

$ 1982
(billions)

-1 5 .1 5

$ -1 .8 3

-6 .0 6

-0 .7 3

-9 .4 9

-9 .7 0

-8 .0 2

+ 5.69

-3 .8 8

-3 .1 9

— 12.61

-2 2 .1 2

-1 0 .4 0

-9 .8 0

+ 7.57

+ 13.26

-4 .1 6

-3 .9 2

Consumer Durable Goods
-1 2 .7 5 $ -1 2 .6 3
Price Effectt
Exchange Rate
+ 7.57
+ 7.64
Effectt
Producers’ Durable Equipment
Price E ffect!
-1 2 .4 5
Exchange Rate
+ 7.47
Effectt

sensitive to moderate changes in the sample, although
those elasticities remain substantial and important
regardless of the estimation period.

Further Analysis and Conclusions
Our empirical work indicates substantial long-run interest
rate effects on spending in all three sectors. These
effects are particularly large for the housing sector. We
also find evidence of strong long-run exchange rate
effects on consumer durables and producers’ durable
equipment.
To get an impression of the quantitative importance
of interest and exchange rates, consider the effect of
simultaneous changes in the two variables on domestic
output. A 10 percent increase in both interest rates and
the trade-weighted exchange value of the dollar would
eventually lead to nearly a 6 percent drop in the com­
bined output of the three sectors (Table 3). This is
equivalent to nearly 11/a percent of GNP and 12/a per­
cent of total private expenditures. As noted elsewhere
in this article, this is only the direct effect; the actual
long-run GNP outcome would also include multiplier or
indirect effects.
Our work also provides some evidence of a rise in the
interest sensitivity of spending in the early or mid-1970s.

Table 3

Long-Run Interest and Exchange Rate Effects
on Domestic Output*
Totalf

Total§
Price Effect
Exchange Rate
Effectt

'Change in imports or exports in response to a 10 percent
change in the relative price variable or in the trade-weighted
nominal exchange rate. The real or 1982 dollar figures use
the 1985 average for each series as the base. The signs
refer to the direction of changes in imports and exports.
|The price elasticities are the average of two estimates
reported in Box 2. All estimates are statistically significant at
the 99 percent level.
tFor a 10 percent decline in the trade-weighted nominal dollar
exchange rate, we assume the following effects on various
prices (all expressed in dollars): 7.5 percent for import
prices: 4.0 percent for export prices: and 1.5 percent for
domestic prices. In addition, prices abroad are assumed to
decline by 2.0 percent in foreign currency terms. These
assumptions imply that relative import prices will change by
6.0 percent and relative export prices by - 4 0 percent. Of
course, all signs would be reversed for appreciation of the
dollar.
§The elasticity estimates represent the average of the two
component elasticities, weighted by their share in 1985 total
private expenditures The dollar figures are the sum of
changes for the two components.

30

FRBNY Q uarterly Review/W inter 1987




Contribution o ft
Interest Exchange
Rate
Rate

Percent

$ 1982
(billions)

Consumer Durable
Goods

- 4 .8

-1 2 .4

32.8

67.2
(91.2)

Producers'
Durable Equipment

- 4 .6

-1 4 .4

38 3

61.7
(58.4)

Residential
Construction

- 8 .7

-1 5 .4

100.0

0

Total

- 5 .6

-4 2 .2

59.3

34.8
(87.1)

‘ Based on the interest rate elasticities for the sample period
1975-86 in Table 1 and the exchange rate elasticities in
Table 2.
fChange in domestic output (i.e., expenditures minus imports
plus exports) in response to a simultaneous 10 percent
change in interest and exchange rates, using 1985 as the
base year. The sign refers to the direction of change in
domestic output. Note that the table assumes no net change
in inventories over the sample period.
^Percent of total contribution. The numbers in parentheses
refer to the portion of the exchange rate effect due to
imports.

The upward shift appears to be significant in the con­
sumer durable and producers’ durable equipment sec­
tors. On the exchange rate side, data limitations prevent
us from exploring the possibility of a shift in the
exchange rate sensitivity. But the relevant price and
exchange rate elasticities are likely to have been greater
since the mid-1970s than in the earlier period, as sug­
gested by empirical analyses at the aggregate level.
Even without any change in the underlying elasticities,
the exchange rate effects on domestic economic activity
may have risen over time, because of larger exchange
rate movements and the increased scale of international
financial and non-financial transactions of the U.S.
economy.
These findings suggest that monetary policy continues
to have powerful long-run effects on the economy. The
declining impact of credit rationing seems to have been
offset by the increasing sensitivity to interest rates and
the greater role of exchange rates. On balance, the
long-run link between monetary policy variables and
output appears to be stronger today than in the past.
But such a conclusion would tend to overreach our
results for at least three reasons: first, our empirical
analysis does not cover all sectors of the economy;
second, our analysis of credit rationing effects, with
focus only on the most important of those effects, is not
comprehensive and may understate the role of credit
rationing in the 1960s and the 1970s; and third, given
that the financial and economic environment has con­
tinued to undergo significant changes in recent years,
uncertainty about our results may be greater than would
normally be the case in such estimates.8
The strong long-run link between financial variables
and economic activity by itself suggests but does not
necessarily imply efficacious monetary policy. For policy
actions to be effective, the relationship between policy
'Standard econometric techniques are not satisfactory for estimating
relationships in the face of on-going structural changes or for
detecting uneven effects of those changes.




instruments and financial variables must also be reliable
and sufficiently predictable. This aspect of the trans­
mission mechanism, as noted in the introduction, is
beyond the scope of our investigation. It should be
emphasized, however, that policy implications of our
findings are best appreciated by keeping in mind that
recent changes in the financial system are widely
believed to have made the link between policy instru­
ments and financial variables less reliable than before.
Many economists have argued, for example, that the
increased role of market forces and international finan­
cial integration have weakened the ability of monetary
policy to exert a significant and predictable influence on
interest and exchange rates.
The implications of the results in this study are con­
siderably less favorable for monetary policy over the
short- to medium-term. The channels of policy influence
are complex and operate with long and variable lags.
The increased importance of exchange rates and the
external sector has added further complexity and
uncertainty to the workings of the policy channels. Our
results suggest that the extent and timing of the lagged
interest and exchange rate effects are uncertain, making
it difficult to assess the short- to medium-term influence
of monetary policy on economic activity.
These unfavorable implications aside, our main find­
ings are encouraging for the role of monetary policy. In
particular, the breakdown of credit rationing mechanisms
seems not to have weakened the long-run monetary
policy influence on the economy. To be sure, because
of uncertain lags, interest rate effects on economic
activity do not appear as quickly as credit rationing
effects. Over a longer period, however, the average
increase in interest rates needed to restrain demand is
unlikely to be higher than in the past.

M.A. Akhtar
Ethan S. Harris

FRBNY Quarterly Review/Winter 1987 31

Appendix 1: The Theoretical Framework
The analysis in the text is based on the open economy
framework developed by Mundell and Fleming. Before
presenting the model, however, it is useful to review
some of the basic accounting of open economy macro.
GNP is equal to expenditure (aggregate spending by
domestic residents), minus the portion of expenditure
devoted to imports, plus exports (purchases of home
goods by foreign residents):

The Balance of Payments curve (BOP) traces points
at which there is no net flow of foreign exchange out of
the United States. The Mundell-Fleming model assumes
perfect capital mobility; here we generalize the frame­
work by assuming that capital is partially mobile between
countries. This means that increases in U.S. interest
rates will cause some increase in capital flows into the
United States. Algebraically,

(1) Y = E - M + X.

(6) 0 = K(r) + X(yf,e) - M(y,e),

In addition it is useful to consider spending on domestic
goods by domestic residents:

where K is net capital inflows. The BOP curve slopes
upward because with a given exchange rate higher
incomes stimulate imports, worsening the balance of
payments, while higher interest rates cause capital
inflows, improving our balance of payments. The BOP
curve shifts down and to the right if the exchange value
of the dollar declines or if foreign incomes rise.
With this model it is simple to show the macroeconomic effects of monetary policy (see graph). An in­
crease in the money supply shifts the LM curve down

(2) DD = E - M.
Combining (1) and (2) we see that GNP is the sum of
demand for home goods by residents and by foreigners:
(3) Y = DD + X.
The Mundell-Fleming model divides the economy into
three markets, represented graphically by an IS, LM, and
BOP curve.1 These are shown in the graph below. The
IS curve plots points at which the goods market is in
equilibrium. In algebraic terms, it sets output equal to the
sum of private expenditure, government spending, and
net exports:
(4) y = E(y,r,6) + G + X(yf,e) - M(y,e),

Monetary Policy in an Open Economy
Under Flexible Exchange Rates

where r is the nominal interest rate, C is a measure of
credit availability, G is government spending, yf is foreign
income, and e is the exchange rate (in dollars per unit
of foreign currency, so that an increase in the exchange
rate means a depreciation of the dollar). The signs of
the partial derivatives are shown above each right-hand
variable. The IS curve slopes downward because low er
interest rates encourage higher spending in the interest
sensitive sectors of the goods market and this tends to
increase income. The IS curve shifts up and to the right
when gove rn m en t spending increases, when the
exchange value of the dollar falls, and when credit con­
straints are relaxed.
The LM curve plots points of equilibrium in the money
market:
(5) M/P = L(y,r),
where M is the nominal money stock and P is the price
level. The LM curve slopes up and to the right: higher
income increases money demand and higher interest
rates reduce money demand, so income and interest
rates must move together to maintain money demand
equal to a fixed money supply. Increases in the money
stock shift the LM curve down and to the right.
’ Several heroic assumptions are made to keep the exposition
simple. For example, we assume static expectations and
fixed prices and we do not fully take into account stock and
flow distinctions.

32

FRBNY Q uarterly Review/W inter 1987




Note: Initial equilibrium is A (r0 ,y0 ,e0 ). The increase in
the money supply shifts LM0(M 0 ) to L M ^ M ^ causing
in te re st rates to fall towards B. Lower in te re st rates
stim ulate spending, pushing income tow a rd C. This
causes the exchange rate to increase, shifting IS0 (e 0 )
to ISi(e-j) and BOP0(e 0) to BOP^e-j). Final equilibrium
is at D (r1,y1,e1).

Appendix 1: The Theoretical Framework (continued)
and to the right. This stimulates expenditure in the
interest-sensitive sectors of the economy, causing income
to rise. In addition, the increase in the money supply
may help relax credit restraints, shifting the IS curve up
and to the right. With lower interest rates and higher
income, however, there is upward pressure on the
exchange rate, causing both the IS curve and the BOP
curve to shift to the right. At the final equilibrium, income
is higher for several reasons: (1) lower interest rates have
encouraged spending in interest-sensitive sectors, (2) the
weaker dollar has caused demand to shift away from foreign
goods in favor of home goods, and (3) with greater liquidity
in the economy there may be less rationing of credit to the
housing and small business sectors.
Relaxing some of the strict assumptions of the model
complicates the exposition and may alter some of the
conclusions. For example, if the domestic price level is
allowed to change in response to an increase in the
money supply, this will reduce the real money supply,
offsetting some of the short-run increase in GNP. Indeed,
if the economy is near full employment, prices may rise
one-for-one with the money supply, completely offsetting
the stimulative effect of the monetary expansion. As a
further example, if traders anticipate a loosening of
monetary policy the exchange rate may overshoot, initially
jumping above its new long-run level. These short-run
adjustments can have long-run implications because they
have long-lasting effects on the stock of foreign assets.

Using this framework we can also explore the impacts
of financial innovation and the increased openness of the
economy on policy effectiveness. Financial innovation
may have reduced the role of credit rationing in trans­
mitting monetary policy to the economy. This means a
smaller sympathetic shift in the IS curve in response to
stimulative monetary policy. If spending is also relatively
insensitive to interest rates, so that there is a steep IS
curve, then monetary policy has lost its effectiveness.
On the other hand, our results suggest that financial in­
novation and other structural changes in the economy have
increased the interest sensitivity of aggregate demand, flat­
tening the IS curve and enhancing policy effectiveness.
The opening up of the economy may have increased
the power of monetary policy. As we pointed out earlier,
under flexible exchange rates the balance of payments
curve shifts to the right when monetary policy eases.
This shift will be larger if imports and exports are more
sensitive to exchange rates. Greater capital mobility may
also increase the effect of a change in the money supply
by flattening the BOP curve. It is worth reiterating,
however, that the increased openness of the U.S.
economy has probably increased the unpredictability, as
well as the magnitude, of policy effects. That is, although
the slopes of the various curves may now be more
favorable to policy makers, the curves may also have
become more unstable.

Appendix 2: Empirical Proxies
This appendix provides detailed descriptions of the
variables used in this study. The explanatory variables
can be divided into four general categories: aggregate
activity, interest rates, exchange rates and trade prices,
and dummy variables. Most of the data comes from
either the National Income and Product Accounts (NIPA)
or the Federal Reserve Board’s MPS model of the United
States Economy (MPS).1

Dependent variables
With one important exception, the dependent variables
are taken directly from the NIPA (Tables 1.2 and 4.4).
The exception is exports of consumer durable goods,
which includes autos. Because of the special nature of
auto trade with Canada, however, we decided to net-out
Canadian autos. This, in turn, required constructing
quarterly Canadian auto data from annual data for the
’ The National Income and Product Accounts are published by
the U.S. Department of Commerce in the Survey of Current
Business', the MPS model is described in an unpublished
manuscript, Flint Brayton and Eileen Mauskopf, The MPS
Model of the United States Economy (February, 1985).




period before 1977. Most of the other series are avail­
able back to the late 1940s, but the disaggregated trade
data does not start until 1967.
A c tiv ity v a ria b le s

Each expenditure equation includes measures of general
activity that are in some way specific to the individual
sectors. The producers’ durable equipment expenditure
equations capture “ accelerator” or activity effects using
real gross private domestic business product (NIPA).
Both consumer durables and housing include a measure
of permanent income: real disposable income, averaged
over eight quarters (NIPA). They also include the effect
of temporary liquidity constraints on spending, measured
by the change in the unemployment rate. (See Bureau
of Labor Statistics, The Employment Situation— House­
hold Survey, various issues.)
In the tradeable goods equations, somewhat more
elaborate income variables are used. The import and
domestic goods demand equations use the same activity
variables as the expenditure equations, except consumer
durable imports uses current real disposable income

FRBNY Quarterly Review/W inter 1987

33

Appendix 2: Empirical Proxies (continued)
rather than permanent disposable income. Both export
equations use the Federal Reserve Board’s weighted
average of foreign GNP (MPS).

amalgam of other tax effects. This measure is adopted
from the MPS model.

Exchange rates and trade prices
Interest rates
In theoretical models, interest rate effects often appear
through complicated cost-of-capital variables. These
variables serve as proxies for the price of a unit of ser­
vices from a durable good, taking into account physical
depreciation, taxes and relative prices, as well as the
financial (or interest) cost of investment. For each sector,
we experimented with several cost-of-capital variables,
but in many cases the best fit resulted from the simplest
measure— a nominal interest rate.
The consumer durable goods and producers’ durable
equipm ent equations use the six-month commercial
paper rate and M oody’s AAA corporate bond rate,
respectively. The commercial paper rate is a proxy for
the short-term borrowing cost of households, and the
bond rate captures the long-run financing cost of busi­
ness investment. Cost-of-capital effects are also captured
in the producers’ durables equation by including the ratio
of the price of output to the price of new capital (FMP).
The commercial paper rate is from Board of Governors
of the Federal Reserve System, Federal Reserve Bul­
le tin ; the corporate bond rate is from Moody’s Investor
Service.
In contrast to these simple measures, the housing
equations use a com plicated measure which is a
weighted average of the cost-of-capital for owner-occu­
pied and rental housing. These cost-of-capital variables
take the general form:
(1) Cost = (Ph/P) • [d + i • (1-t) - Ph] • TAX,
where Ph/P is the price of housing relative to a general
consumer price index, d is the rate of physical depre­
ciation, i is the effective interest rate on fixed rate
mortgages, Ph is distributed lag on past housing inflation,
t is the m arginal incom e tax rate, and TAX is an

34

FRBNY Quarterly Review/W inter 1987




Exchange rates affect output primarily by altering the
relative price of domestic versus foreign goods. In the
regressions reported in the text, these relative price
variables are constructed from implicit deflators (NIPA).
For the import and domestic goods demand equations,
(1) Relpricel =

M/M82
(E-M)/(E82-M82) ’

where M is imports, E is expenditure, and the suffix “ 82”
designates a constant dollar figure. The relative price
variable is similar in the export equation, except that a
general price index is used to represent the price of the
foreign country’s home goods:
(2) Relprice2

(X/X82) • e
FCPI

where X is nominal exports, X82 is real exports, and e
and FCPI are the Federal Reserve Board’s measure of
the effective exchange rate and foreign consumer prices
(where each variable is weighted by the volume of mul­
tilateral trade for our principal trading partners).

Dummy variables
We used three different dummy variables. In the con­
sumer durables equations, the dummy variable accounts
for President Carter’s restrictions on credit cards. It has
a value of one in the second and third quarters of 1980,
and zero otherwise. The housing dummy takes a value
of one in periods when deposits declined at savings and
loan institutions (MPS). These credit rationing episodes
occurred in the following periods: 1966-111 to 1966-IV,
1969-111 to 1970-111, 1973-1V to 1975-1, 1979-1V to 1980III, and 1981-1 to 1982-11. The third dummy captures the
effect of dock strikes on imports (MPS). It takes non-zero
values in 1962-65, 1968-69, and 1977-78.

Inflation in the Service Sector

Inflation rates for services have exceeded those for
goods in every year since 1949, except during periods
of large oil price increases. From 1949 to 1981, the
GNP deflator for expenditures on services rose at an
average annual rate of 4.8 percent compared with 3.7
percent for goods. Since 1982, the gap between the two
indexes has widened to 3.5 percent, with services rising
at an average of 5.5 percent and goods at 2.0 percent.
These figures suggest that the recent decline in
inflation rates is not necessarily the result of inflation
having been "wrung out” of the system by the pro­
tracted recession of the 1980s. Instead, the burden of
the decline has been borne disproportionately by the
manufacturing sector, where the recession, the increase
in foreign competition resulting from the dollar’s appre­
ciation, and the conditions of oversupply in raw mate­
rials markets have been responsible for unprecedented
slackness in prices in recent years. In contrast, the
recent behavior of service inflation suggests that, absent
the unusual circumstances in manufacturing, the
economy would again be prone to high inflation rates.
Thus, the future course of inflation depends critically on
the behavior of inflation in services.
Several explanations have been advanced for high
inflation rates in services. One is that service price
indexes are constructed in ways that systematically
overstate price increases by accounting inadequately for
improvements in the quality of the services delivered.
Accounting for changes in the quality of services is held
to be fraught with practical difficulties. Unlike durable



and nondurable goods, little tangible is left to examine
for quality changes once a service has been rendered.
In general, quality improvements cause increases not
only in the costs of products, but also in benefit to
consumers. Correctly constructed output and price
measures would treat these increased benefits as
equivalent to increases in the quantity of the product,
not in its price.
A second type of explanation regards the existing data
as accurate and seeks to explain them on economic
grounds. One such approach notes that, unlike manu­
facturing, the personal element in the provision of many
services limits the scope for improvements in labor
productivity. In manufacturing, the faster growth of labor
productivity affords more room to grant wage increases
without passing them on to prices. In order to maintain
its labor force, the service sector must match the wage
increases in manufacturing. However, there is no off­
setting productivity improvement for services, whose
prices must then rise in order to maintain profit margins.
Thus, labor productivity growth differentials can cause
prices in the two sectors to diverge.1
Another approach focuses instead on the fast growth
of the nondistributive services sector2 in recent years.
1See William J. Baumol, “The Macroeconomics of Unbalanced
Growth: The Anatomy of Urban Crisis," American Econom ic Review,
57 (1967), pages 415-426.
*This sector is defined here as comprising Finance, Insurance, and
Real Estate, and the Services sector proper. In the sequel, it will be
referred to as “services" for brevity’s sake, unless ambiguity arises.

FRBNY Quarterly Review/Winter 1987 35

market relative to the male market, has been behind the
high rate of service sector inflation.

After remaining roughly constant during the 1950s and
1960s, the share of nondistributive services in real
output grew to 35 percent by the 1980s (Table 1). This
rapid expansion has maintained upward pressure on
both wages and prices in the sector, a situation exac­
erbated by its disproportionate and increasing reliance
on female labor.
These three perspectives on the inflation gap between
services and goods have very different implications for
future service price inflation. If service price increases
are systematically overstated, the problem of service
price inflation is more apparent than real, but if inherent
productivity growth differences are the cause, it is here
to stay. Finally, if service price inflation results from the
growth of demand for services, then it may be mitigated
if service sector growth slows down in the future.
The purpose of this article is to contribute to a deeper
understanding of the inflation differential between ser­
vices and manufacturing, by examining the success of
these explanations in accounting for the post-war data.
The analysis shows that there is no proof positive of the
mismeasurement view. Nor do the data suggest that the
inflation differential is explained exclusively by sectoral
differences in productivity growth rates. There is, how­
ever, some evidence suggesting that continued growth
of the service sector relative to the manufacturing
sector, reflected by the tightening of the female labor

Overview of service price inflation
This section describes more fully the course of inflation
in different industries in the economy and forms the
basis for the choice of industries that are the focus of
the rest of the analysis.3 The broadest grouping of ser­
vice industries, often called the “ service-producing
3The available measures of service price inflation are distingu ish ed
by method of classifica tio n (by consum ers’ exp enditure cate gory or
by industry of origin) and by breadth of coverage. The data on GNP
deflators by industry are discussed here because they are
consistent with the w age and productivity data to be used in the
subsequent analysis. Other sources of data on service price inflation
are the deflators for com ponents of GNP and personal consum ption
expenditures (PCE), and the consum er price index (CPI). The GNP
deflator for services involves purchases by the governm ent,
foreigners, and consumers, the third category being the largest.
Since GNP accounts register final rather than interm ediate
transactions, purchases of services by business are excluded.
PCE deflators are calculate d by a method that ag greg ate s
inform ation on real and current do llar outlays on sub categ ories of
consum ption expenditures. The real figures for most of these
subcategories are calculated by deflating current do llar expenditures
by the CPI for com parable com m odities and services. Hence, the
underlying price inform ation in the PCE is largely the same as that
in the CPI. The two indexes exhibit very sim ilar movem ents at a
disag greg ated level and only differ in the aggreg ate as a result of
different w eighting schemes. The d isag greg ated PCE data may also
be roughly com pared with the industry data for categories of
expenditures that bear sim ilar titles. The two sets of inflation rates
tell roughly the same story.

Table 1

inflation and Productivity by Industry
S ervice-P roducing Industries
N ondistributive Services
M anufacturing

Total

Transportation
& Public Util.

Inflation rates*
1949-85
1949-69
1970-81
1982-85

3.3
2.1
5.9
1.9

4.3
2.6
6.9
5.4

4.4
2.6
6.9
6.2

3.6
1,9
6.7
3.2

4.9
3.3
7.1
6.4

5.4
4.3
7.4
5.4

4.0
2.1
6.5
6.4

5.4
4.0
7.5
6.8

P roductivity grow th*
1949-85
1949-69
1970-81
1982-85

2.7
2.8
2.0
4.7

1.3
2.0
0.4
0 2

2.8
3.2
2.2
1.9

1.3
1.8
0.2
1.4

0.8
1.5
0
-0 .6

0.1
0.2
0
0.1

2.1
4.3
-0 .5
-1 .6

0.6
1.0
0.2
-0 .2

Share of o u tp u tf
1950-59
1960-69
1982-85

27
26
25

54
57
65

10
9
11

18
18
19

27
29
35

4
4
5

9
11
13

13
14
18

Share of e m p lo y m e n t
1950-59
1960-69
1982-85

38
36
26

53
56
67

10
8
7

22
23
26

21
25
34

4
5
6

1
1
1

16
19
27

’ Percent per annum.
tP e rce n t of nonfarm business sector.

36for FRASER
FRBNY Quarterly Review/W inter 1987
Digitized


Wholesale
& Retail

Total

Finance &
Insurance

Real Estate

Services

sector,” comprises transportation and public utilities,
wholesale and retail trade, finance, insurance and real
estate (FIRE), and the catch-all group “ services.”
Inflation performance is not uniform across serviceproducing industries (Table 1). The behavior of prices
in wholesale and retail trade differs moderately from that
in manufacturing, and transportation and public utilities
prices started to increase rapidly only in response to
energy price shocks. It is the “ nondistributive” ser­
vices— FIRE and the narrow service industries— that
have been the source of persistently high inflation rates,
exceeding those in manufacturing by 1.6 percentage
points per year since 1949, and 4.5 percentage points
from 1982 to 1985.4
The table shows several other features of nondistri­
butive services that set them apart from the rest of the
economy. First, the growth of labor productivity in this
group of industries has been considerably lower in each
period than in manufacturing. As noted above, this may
be a consequence of the inherently limited scope for
labor-saving improvements in service activities. Alter­
natively, it may reflect inaccurate measurement, causing
inflation figures to be biased upward and growth of
output (and hence, output per worker) to be biased
downward. Second, the share of these industries in total
4The wage, price, output, and employment series in this article are
taken from annual data by industry in the National Income and
Product Accounts. At the time of writing, data for 1986 were not
available. Comparable data for 1986, taken from the National
Income and Product Accounts and Bureau of Labor Statistics
sources suggest that the trends described here have moderated
only slightly, if at all.

output has grown from 29 to 35 percent since the
1960s, after remaining relatively stable for two decades.
Manufacturing and distributive services show essentially
no change. Third, employment in nondistributive ser­
vices accounted for 21 percent of nonfarm business
workers in the 1950s, rising to 34 percent by the 1980s;
the share of manufacturing employment declined from
38 percent to 26 percent over the same period. The
faster rate of growth in services’ employment share than
its output share is a reflection of the disparate rates of
labor productivity growth in the two sectors.
Two industries, business services and medical care,
have grown in size relative to the rest of the nondis­
tributive services sector, while personal and domestic
services have shrunk, the latter quite dram atically
(Table 2). However, while nondistributive services com­
prises a diverse group of activities, inflation in services
is not restricted to a few specific areas (such as health
care); it is a feature of practically all such services.
Hence, a first analysis of service price inflation should
focus on features common to all service activities. Two
such approaches are examined below.

Mismeasurement of service price inflation
One explanation for high service price inflation is that
it is systematically overstated because published data
fail to take into account improvements in the quality of
the services delivered. To see what is at issue here,
consider the concrete case of a durable good such as
a refrigerator. As frost-free refrigerators come to dom­
inate the market, the price of the average refrigerator

Table 2

Output and Employment Shares and Inflation in Nondistributive Services Industries
Rate of Inflation*
1949-85

1949-69

Finance & insurance

5.4

Real estate

4.0

Hotels & lodging

Share of Outputf
1949-69

1982-85

Share of Employmentt
1949-69
1982-85

1970-81

1982-85

4.3

7.4

5.4

15

14

21

20

2.1

6.5

6.4

37

37

5

5

5.6

3.3

8.3

9.7

3

2

5

5

Personal services

4.9

3.3

7.4

5.4

9

6

13

8

Business services

5.6

4.9

6.3

7.6

10

16

11

21

Entertainment

4.9

3.8

5.9

4.8

3

2

5

4

Medical care

5.4

3.9

7.5

6.7

11

16

15

25

Legal services

7.3

5.0

9.4

12.9

4

3

2

3

Education

63

6.3

6.4

6.2

2

2

6

6

Domestic services

5.0

3.7

8.4

1.6

4

1

17

3

‘ Percent per annum.
fPercent of nondistributive service sector.




FRBNY Quarterly Review/W inter 1987

37

rises because the frost-free variety costs more. Price
indexes that merely record the price of the average
refrigerator will thus register increases, and all other
things being equal, refrigerators will exhibit more infla­
tion than commodities that have not undergone quality
improvements. Correct measures of prices and output
(that are comparable with earlier figures) should, how­
ever, reflect the fact that the average refrigerator con­
stitutes “ more” refrigerator than it did before the intro­
duction of fro s t-fre e technology. Hence, quality
improvements should be represented as increases in
output and may not necessarily cause increases in the
prices of the (quality-adjusted) goods. The argument
asserts further that the problems of capturing quality
improvements are greater in the case of services than
in the case of goods. The quality of many services, for
example legal counsel, can only be observed at the time
the service is rendered, whereas for goods something
tangible remains to be examined after purchase.
These problems will cause measures of the growth in
labor productivity (output per worker) to be biased
downward, because not enough of the increase in
expenditures is attributed to growth in real output. Other
aspects of the methods of measurement of industry
prices and output can cause output and labor produc­
tivity measures to be understated and inflation estimates
to be biased upward. In some industries, no direct
measurements of prices are available, and real output
has to be extrapolated from some measure of inputs to
the production process, often an indicator of employ­
ment. Setting the growth of real output equal to the
growth of employment obviously allows for no growth in
labor productivity. In summary, the problems posed by
quality changes and the intangible nature of service
output make it difficult to divide successive observations
on expenditures into information on prices and quantities
that are comparable over time.
In the absence of direct information on quality and
productivity changes with which the measured price and
output data can be compared, it is difficult to come to
any definite conclusions about the extent of the quality
bias in services. However, several indirect and circum­
stantial pieces of evidence seem to suggest that
measurement biases may not be the major cause of the
inflation differential between services and goods.
The CPI takes systematic account of quality changes
only in the case of automobiles, where the effects of
annual model changes are analyzed using cost data
supplied by manufacturers. For other goods and ser­
vices, information on quality changes enters the
measurement of prices in an ad hoc manner: if a field
representative (the person who samples prices in stores,
hospitals, and so on) believes a quality change has
occurred, he or she notifies a “quality specialist” at the

38 forFRBNY
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FRASERQuarterly Review/Winter 1987


Bureau of Labor Statistics, who determines whether an
adjustment needs to be made. Changes in the speci­
fications of appliances are as likely to be picked up by
this method as improvements in medical diagnostic
procedures through the use of more sophisticated
equipment. Similarly, changes in the longevity of durable
goods are as likely to be missed as changes in the
degree to which providers of services “ cut corners.” 5
While there are changes in service quality that are not
taken into account by the CPI, it is not clear that
changes in the quality of goods are captured substan­
tially better.6
The significance of quality measurement problems is
also called into doubt by consideration of specific
components of the CPI. For categories such as medical
care and entertainment, indexes are calculated for both
the relevant services (visits to doctors’ offices and
entrance to sporting events) and the corresponding
goods (drugs and sporting goods). If, for example, there
is fast growth of demand for medical care, we would
expect the. prices of both the goods and services related
to medical care to rise quickly. In contrast, if the diffi­
culties of capturing service quality changes were the
main cause of higher price inflation in services than in
goods, we would expect to see the goods in these cat­
egories experience low inflation rates relative to the
corresponding services. The gap between inflation rates
for goods and services in these expenditure categories
is, with few exceptions, substantially less than the gap
between overall goods and services inflation rates
(Table 3). With the same exceptions, the detailed goods
inflation rates are typically no less than the corre­
sponding overall goods inflation rates. Thus, these data
suggest that whatever causes the prices of medical
care, personal care, entertainment, education, and
housekeeping services to rise rapidly also infects the
prices of the corresponding commodities. For example,
the data are consistent with growing demand for these
categories of expenditure. It is not what would be
expected were the differential treatment of quality
improvements in goods and services responsible for the
observed high service inflation rates. Only for home
maintenance after 1982 and apparel is the discrepancy
between the commodities and services indexes similar
to that between overall goods and services inflation.
This divergence of prices could be explained by
•In "Determining the Effects of Quality Changes on the CPI," (Monthly
Labor Review, May 1971), Jack Triplett surveyed a number of
studies of quality bias in medical care prices and found no
conclusive evidence of an upward bias in this component of the
CPI. He also suggested that it was not possible to rule out a
deterioration of quality in services, in which case the price indexes
would be biased downward.
•The author would like to thank (without implication) Patrick Jackman
for useful discussions on which this argument is based.

Table 3

Average Annual Inflation Rates of Related Goods and Services in the CPI
1977-86
Category
Home maintenance
Housekeeping
Apparel
Medical care
Personal care
Entertainment
Education

Goods
4.9
5.9
3.7
8.1
6.2
5.2
9.1

Goods in CPI*
Services in C PIf

1977-81

Services
7.3
5.9
7.8
9.1
6.2
6.1
96
5.2
7.0

1982-86

Goods

Services

Goods

Services

8.0
8.4
4.8
8.2
7.5
7.0
8.4

10.0
8.4
10.3
10.1
7.8
6.4
9.0

1.8
3.5
2.1
8.0
4.9
3.4
98

4.6
3.4
5.2
8.1
4.5
5.8
10.1

7.1
8.5

3.2
6.0

‘ Excludes food, energy, and used cars.
fExcludes energy.

increasing competition from imports, especially during
the period of the dollar’s appreciation.
An alternative perspective on the accuracy of service
price inflation rates is provided by examining in detail
the construction of price series for different industries.
Ideally, inflation in the value added price deflator for an
industry is the difference between the rates of growth
of current dollar value added (receipts net of materials
purchases) and real value added. In practice, the
method used to arrive at price indexes varies from
industry to industry, depending on the availability and
reliability of data. For some industries, data on pur­
chases of intermediate goods are not available, and real
value added is approximated by “ extrapolation” of an
index of some measure of real activity, such as real
personal consumption expenditures or employment. This
has the effect of measuring the real value of total rather
than net output.7 (Inflation is then the difference in the
rates of growth of the current dollar and real output
measures). In other cases, a deflator is calculated
directly by combining personal consumption deflators
and detailed earnings data for products and industries
contained in the particular industry aggregate.8
7For some industries, notably banking and credit agencies, and
holding and other investment companies, no direct measure of
current dollar output is available since many services are performed
without explicit charges. The practice employed is to impute a value
for these services. In the case of banking, this imputation is based
on the excess of interest income over interest disbursed. For a full
discussion, see John A. Gorman, “Alternative Measures of the Real
Output of Commercial Banks,” in Production and Productivity in the
Service Industries, ed. Victor Fuchs (New York: National Bureau of
Economic Research, 1969).
•For example the deflator for amusement and recreation services is
derived by combining price data on admissions to various sporting
and artistic events. Details of the construction of these indexes are
to be found in Martin L. Marimont, “ Measuring Output for Industries
Providing Services: OBE Concepts and Methods,” in Fuchs, op. cit.




Evidently, some of these methods of measurement
ignore productivity improvements to a greater or lesser
degree. If real output is measured by employment, then
productivity growth is, by definition, zero. Similarly, if
prices are measured by earnings, then to the extent that
earnings rise because of productivity increases, real
output growth will be understated and inflation over­
stated. In contrast, extrapolation of real output from
measures such as the number of admissions to sporting
events permits productivity growth to be nonzero and
does not necessarily attribute productivity improvements
to inflation. Thus, the extent to which productivity growth is
missed and incorporated in inflation should be related to the
methods used to measure prices and output, if incorrect
accounting for productivity growth is a serious problem.
Grouping industries according to the way their prices
are measured should show whether the industries in any
particular group experience inflation rates that differ
significantly from those in other groups. For example,
if measurement of output by employment biases esti­
mates of inflation upward relative to other methods of
measurement, we would expect higher average inflation
in this measurement group. To assess the long-term
importance of measurement problems, we calculated the
average inflation rates for the industries in each meas­
urement group for each decade. The ordering of
measurement groups by inflation rates changes in each
decade (Table 4). In particular, industries using an
employment indicator to measure output (group E) show
no tendency toward system atically higher average
inflation rates than other groups.
Differences in measurement methods thus do not
appear to explain the differences in inflation among
service industries. Of course, the finding that measure­
ment methods do not explain the variations in inflation

FRBNY Quarterly Review/W inter 1987

39

rates among service industries does not allow us to
conclude that they do not contribute to the gap between
goods inflation and the inflation of the service sector as
a whole. It may be that some feature of service sector
real output growth is missed system atically by all
measurement methods, and wrongly attributed to price
inflation. This type of mismeasurement would not be
detected as the particular consequence of one meas­
urement method as opposed to another. Nevertheless, if
the measurement method used for an industry were
responsible for the level of its inflation rate, then variations
in measurement methods should be related to variations
in inflation rates among service industries.
This section has examined the extent to which high
rates of service sector inflation can be explained by failure
to take account of quality and productivity improvements.
We have not turned up positive evidence of mismeasure­
ment. This result does not allow us to conclude that data
on the service sector is accurate, for which a case-by-case
analysis of measurement procedures would be required.
However, it does suggest that it may be more fruitful to
attempt to explain the manufacturing/services inflation dif­
ferential on economic grounds.

Economic explanations of sectoral inflation rates
In this section we investigate the economic determinants
of the manufacturing/services inflation differential.9 We
find support for the view that the differential stems from
9The definition of services used in this section of the paper is
nondistributive services excluding real estate. Real estate is
excluded because the output figure is chiefly an imputation for the
services provided by owner-occupied housing. However, no
imputation is made for the corresponding labor of homeowners.

the higher growth rate of demand for services than for
manufactured goods. An alternative view, stressing
sectoral differences in productivity growth, is somewhat
at odds with the evidence. These conclusions are based
both on an informal examination of relevant data and
on the estimation of a three-equation econometric model
explaining the manufacturing/services inflation differ­
ential, manufacturing wage inflation, and service wage
inflation.
After experimenting with a variety of forms of the
inflation differential equation, we conclude that unit labor
cost changes are important determinants, that there is
no clear indication of effects from aggregate demand
variables, and that variables capturing changes in
international competitiveness do not register a large
effect. Thus, wage movements are central to the
behavior of the price inflation differential.
It is possible to distinguish the “ productivity growth
differential” and “ services demand growth” views of the
inflation process mentioned earlier by the behavior they
prescribe for sectoral wage inflation. Only if wages are
tightly linked, because workers can find jobs with equal
ease in the two sectors, will productivity growth differ­
entials be the principal cause of the inflation differential.
Otherwise, wages can be set to match productivity
changes in each industry without fear of losing workers
to another sector. This behavior leaves unit labor costs
Footnote 9 continued
The employment figures for real estate in Table 2 only include real
estate agents and janitorial staff. Thus, "output per head” has an
interpretation for this industry very different from its meaning in other
industries, and the industry is thus omitted to preserve the
homogeneity of the data.

Table 4

Average Inflation Rates of Nondistributive Service Industries*
Grouped According to the Method of Measurement of Prices
Group

Measurement
Method:
1950s
1960s
1970s
1980s:):

A

ct

01-

Et

Prices Based
On Earnings Index

B
Prices Taken
Directly from CPI
or Personal
Consumption Deflators

Total Real Output
Extrapolated

Net Real Output
Extrapolated

Employment
Extrapolated

4.5
4.2
5.8
9.6

2.9
2.4
6.2
7.6

2.5
3.6
7.9
9.8

3.3
2.9
9.3
- 0 .6

5.6
3.5
6.9
7.8

‘ Industry inflation rates are weighted by the industry's share of group nominal output.
tU nder these methods, an index of real output is first calculated The industry inflation rate is then the difference between the rates of
growth of industry gross product originating (in current dollars) and of the real output measure.
£1980-85.
Note: Group A: Motion pictures, Medical services, Educational services, Nonprofit membership organizations, Miscellaneous professional
services, and Private households; Group B: Banking, Credit agencies, holding, and other investment companies, Real estate,
Personal services, Automobile repair and services, and garages, Amusement and recreation services, except motion pictures, and
Legal services; Group C: Hotels and other lodging places; Group D: Insurance carriers; Group E: Insurance agents, brokers, and
service, Security and commodity brokers, Miscellaneous business services, and Miscellaneous repair services.

40 forFRBNY
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unchanged and hence puts no upward pressure on the
prices in one industry as opposed to another. Alterna­
tively, differences in sectoral wage behavior can show
that the inflation differential is driven by the faster
growth of demand for services if the two sectors draw
on different labor force groups (services being pre­
dominantly female and manufacturing disproportionately
male), and if wage inflation is systematically related to
the tightness of these labor markets.
To capture these effects, we ran modified Phillipscurve wage equations for each sector. These included
the wage grow th of the o th e r s e cto r among the
explanatory variables, as well as the male and female
unemployment rates. We found that there is little inter­
dependence between the wages in the two sectors,
contradicting the productivity differential view. However,
the female unemployment rate turns out to be an
important determinant of service wage inflation, while
the male unemployment rate is not. This result conforms
with the demand-induced view of the inflation differential.
We now proceed to discuss the findings in detail,
starting with the inflation differential equation. Output
and employment in the service sector are less volatile
and cyclically sensitive than they are in manufacturing.
Similarly, the service sector is typically more sheltered
from foreign competition and developments in foreign
economies than the manufacturing sector. The extent to
which these differences are reflected in the price
behavior of the two industries is an empirical matter.
Manufacturing prices should be more sensitive to
movements in the costs of materials, particularly oil. In
contrast, service sector prices should be more responsive
to changes in labor costs, as these are a higher proportion
of total costs in services than in manufacturing.
The estimated inflation differential equation suggests
that relative price inflation is most strongly related to
changes in energy prices and unit labor costs (Box 1).
Energy prices exerted a highly significant effect, raising
manufacturing inflation relative to services inflation when
they rose.10 By far the bulk of relative price movements
is explained by changes in unit labor costs.11 After these
variables are taken into account, there is little left that
can be explained statistically by indicators of interna­
tional competitiveness, such as the exchange rate or the
relative prices of imports and exports, or by indicators
of the stage of the business cycle, such as real GNP
or the prime age male unemployment rate. This does

Box 1. Inflation Differential Equations
Our econometric analysis of the manufacturing/services
inflation differential attempted to relate it to determinants
of the individual sectoral inflation rates of which it is
composed. Two representative equations are shown
below. They demonstrate the relative lack of importance
of aggregate demand factors (the prime age male
unemployment rate) and prices of competing foreign
goods (the exchange rate) in explaining the differential.
The conclusions are not sensitive to the particular
specification of the variables employed. For example, the
percentage changes in the real exchange rate (exchange
rate times the ratio of foreign to domestic producer price
indexes), the price of nonpetroleum imports, and the
price of nonpetroleum imports relative to manufacturing
prices all yielded small and insignificant coefficients
when they were entered in place of the growth in the
exchange rate. The level and rate of growth of real GNP,
and rates of change of the prime age male and female
unemployment rates also had negligible effects. The re­
gressions were run on annual data for the period 1954-85.
P -P =
* m * s

.85 + .02e - .13upm., + .13pe., + .44ulcm - .83ulcs
(.95) (.25) (-.72)
(5.5)
(4.1)
(-5.2)
R2 = 0.7

S.E. = 1.2

DW = 2.23

Pm-Ps = -46 + .ISpe., + ,50ulcm - .88ulcs,
(0.7) (5.5)
(5.8)
-(5 .9 )
R2 - 0.7

S.E. = 1.2

DW = 2.18

(t-statistics are in parentheses beneath the coefficients)
where
p = inflation rate of sectoral price deflator,
upm = prime age male unemployment rate,
pe = rate of change of producer price index for
energy, and
ulc = rate of growth of unit labor costs.
The subscript m refers to the manufacturing sector, while
s denotes nondistributive services. The subscript -1
indicates that the variable in question is lagged one year.

10The large effect of energy prices on inflation remains even when
the manufacturing sector is redefined to exclude petroleum
production.
11If prices are marked up on costs, we would expect the coefficients
of unit labor costs to be similar to labor's share in total revenue,
which is approximately 60 percent in manufacturing and 75 percent
in services.




FRBNY Quarterly Review/W inter 1987

41

not mean that these factors are ultimately irrelevant. For
instance, unit labor costs in manufacturing fell relative
to those in services in the 1980s, and this is held to
be due, at least in part, to the influence of import com­
petition on wage concessions. In summary, our analysis
of the inflation differential equation suggests that to
explain the excess of service price inflation over man­
ufacturing price inflation we should look to the deter­
minants of unit labor costs in each industry. This
approach is also supported by the statistical results
presented in Box 1. These results suggest that if no
changes occur in the economic determinants of the
differential, the differential will be negligible.
The change in unit labor costs is the difference
between wage inflation and productivity growth. As
mentioned above, we are interested in establishing
whether the cause of the inflation differential is the dif­
ferent rates of productivity growth between the two
sectors, or whether it is the different rates of growth of
consumer demand. These two causes have different
implications for the functioning of the labor market, and
ultimately for the behavior of wages in the two sectors.
The productivity-differential explanation requires that
labor is mobile between sectors, in which case wages
of comparably skilled workers in both sectors will move
in the same way. If not, then workers would tend to
move away from the sector paying the lower wages,
which would then have to bid up wages to stem the
attrition in its labor force. The theory assumes that
improvements in productivity accrue to workers in the
form of increased wages. By definition, wages can rise
as fast as productivity without causing unit labor costs
to rise. Consider what would occur in a typical year,
when productivity rose faster in manufacturing than in
services. Initially, manufacturing wages rise to the extent
of the manufacturing productivity increase. In order not
to lose its labor force, services must keep wages
increasing at the same rate as manufacturing wages.
But this means that unit labor costs will rise faster in
services than in manufacturing because the service
wage increase (which is dictated by manufacturing
productivity growth) is not fully offset by service pro­
ductivity growth. As both sectors adjust prices to main­
tain their profit margins, prices will tend to rise faster
in services, a situation that is exacerbated by the
greater share of labor in service sector costs and by the
need of the service sector to expand its labor force to
meet increasing demand.
Alternatively, consider what will occur if labor is
immobile between the two sectors. Higher productivity
growth in manufacturing than in services now exerts no
upward pressure on service sector wages, since
workers are unable to move to manufacturing jobs.
Thus, there is no "push” on service sector wages, and

42 FRBNY Quarterly Review/Winter 1987




hence on prices, that has its source in the superior
productivity performance of the manufacturing sector.
However, if demand for services is growing sufficiently
fast, service wages will tend to rise to attract more
labor. The faster services demand grows, relative to the
pool of available labor, the faster the industry will have
to raise wages. Of course, the fact that productivity
growth is low in services will mean that service prices
will rise more quickly than they would have were pro­
ductivity better. But slow productivity growth in services
is not a necessary ingredient of high wage inflation
according to this view, whereas it is central when labor
is mobile between the two sectors. When labor does not
move freely between manufacturing and services, the
‘‘pull” of excess demand for service sector labor is the
driving force.12
The basic facts of low service sector productivity
growth with high inflation, and high manufacturing pro­
ductivity growth with relatively low inflation, are in broad
conformity with the mobile labor view. A deeper analysis,
however, supports the view that inflation has resulted
from increased demand for services in the face of
immobility of labor from manufacturing to services.
There is indeed a large difference in the demographic
composition of the manufacturing and nondistributive
services labor forces (Table 5). Three-fifths of workers
in nondistributive services are female, whereas women
make up only one-third of the manufacturing labor force.
The proportion of women in nondistributive services was
only 50 percent in the 1950s. To achieve such growth,
nondistributive services have accounted for 45 percent
of new female jobs created since 1963, although the
sector represented only 38 percent of female employ­
ment in recent years, and about 35 percent in 1963.
During this period, the female participation rate has
risen by about one-third. Meanwhile, wages have risen
faster in nondistributive services than in manufacturing,
especially in recent years. While the female labor force has
grown rapidly, the upward pressure on wages suggests
that nondistributive services demand has grown faster.
Further data suggest that the service industries whose
employment is growing fast will not be able to alleviate
the upward pressure on wages by attempting to attract
male workers in large numbers. The tra ditio na l
employers of the prime age male labor force— manu­
facturing industries— continue to pay substantially higher
wages than service industries, although the gap is
narrowing. The average hourly wage in manufacturing
was $9.03 over the period 1982-86; in services, it was
16 percent lower, at $7.58. While some workers
12lt should be noted that both of these scenarios describe a twosector economy. Since our empirical analysis does not deal with all
the sectors in the economy, this theoretical discusssion should be
regarded as only a suggestive guide to the interpretation of the
empirical results.

Table 5

Labor Market Statistics by Sector

Sector

Manufacturing
Distributive services
Nondistributive services

Growth in Wages and Salaries per
Full-Time Equivalent Employee
1949-85

1949-69

1970-81

1982-85

5.8
5.1
6.0

4.7
4.2
4.9

7.8
7.2
7.8

5.6
3.8
6.4

Female Share
of
Industry
Employment*!

Industry
Share of
Total
Em ployment'f

Industry
Share of
Total Female
Employment*!

Share of
Increase in
Total Female
Employment
since 1963

34
42
60

20
29
28

15
27
38

8
28
45

‘ Average over 1983-85
tNonfarm economy.

displaced from declining manufacturing industries have
moved to jobs in the service sector, the loss of pay and
status involved tends to make this transition a slow
one.13 Making service jobs more acceptable in the near
future to this group of workers could presumably be
accomplished only by increasing wages rapidly. Thus,
it is plausible that the pressure on wages in the service
sector is aggravated by the “ immobility” of workers in
other sectors paying higher wages. In the long run, this
immobility may lessen, as service wages continue to
rise relative to manufacturing wages.
Other labor market statistics, consistent with this view
of continued strength in the female labor market, sug­
gest an explanation of the recent divergence of price
and wage inflation rates in manufacturing and services.
The unemployment rate for females aged 20 and above
averaged 6.7 percent from 1982 to 1985, while for prime
age males, it averaged 6.8 percent. These figures
reverse the pattern of the preceding two decades when
the male rate was always below the female rate by an
average of 1.2 percentage points. While the pressures
on the female labor market, originating largely in the
nondistributive services sector, have continued unabated
into the 1980s, those on the male labor market have
declined substantially. The result has been that service
sector wages and prices have grown faster than man­
ufacturing wages in the 1980s.
To weigh the merits of the two views, it is useful to
employ a more formal approach that involves statistical
estimation of the determinants of wage inflation in the
two industries (Box 2). The estimates for each industry
attempt to account for aggregate demand pressure,
captured by the prime age male unemployment rate,
and for inflationary expectations. Unlike typical aggre­
gate wage equations, they include the wage growth of
the other industry, the female unemployment rate, and
13See Kenneth B. Noble, “ Millions Who Lose Plant Jobs Pay in Shift to
Services," New York Times, February 7, 1986, page 1.




sectoral productivity growth terms to capture sectorspecific effects. The other industry’s wage growth cap­
tures the extent of the transmission of labor market
pressures between sectors. If labor is mobile between
manufacturing and services, we would expect long-run
wage movements to be similar in the two sectors; that
is, we would expect wage movements in one industry
to match closely wage changes of the other. By the
same reasoning, the smaller the influence of wage
growth in the other industry, the less important are
spillovers of wage pressure from one sector in deter­
mining wage movements in the other.
In contrast, the female unemployment rate is included
to capture the notion that labor is immobile between
sectors. This theory suggests that pressures on service
sector wages emanate from scarcity of the labor
employed by the sector, which is predominantly female.
If it is valid, we would expect the female unemployment
rate to be the principal labor market variable in the
services wage equation and to be relatively unimportant
in the manufacturing equation.
The results show that manufacturing wage inflation is
not directly influenced by service wage growth and is
most strongly correlated with movements in the CPI. It
also responds to the prime age male unemployment
rate, albeit insignificantly,14 and is insensitive to the
female unemployment rate.
Service wage growth displays a weak response to
manufacturing wage changes: only 29 percent of these
changes are passed through into service sector wage
inflation. In a perfectly mobile labor market, much more
should be passed through in the long run. Service
wages differ most dramatically from manufacturing in
their response to unemployment. While manufacturing
14Michael Bruno and Jeffrey Sachs find a similar result for the United
States and cite several other studies that are in agreement with
theirs. See The Economics of Worldwide Stagflation (Cambridge,
1985), Chapters 9 and 10.

FRBNY Quarterly Review/W inter 1987

43

Box 2. Wage Inflation Equations
We estimate wage equations that are amended versions
of augmented Phillips curves for the two sectors. The
equation for the service sector is
ws =

a0 +

+ a 6uf +

a ^

+

a 2w mi +

a 3iTs + a 4 TrSl + a 5upm

a 7 pc., + error,

where ws and wm are the annual growth of wages and
salaries per employee in services and manufacturing
respectively, tts is annual labor productivity growth, upm
and uf are the prime age male and female unemploy­
ment rate, and pc., is the lagged value of the rate of
growth of the consumer price index, included as a
measure of inflationary expectations. The equation for
manufacturing wage growth is the same, except that
service wage growth replaces wm and wm^ on the right
hand side, and m anufacturing p roductivity growth
replaces irs and irs :*
w m = b0 + b ,w s + b2w s t + b3i7m + b4irm t + b5upm
+ b6uf + b7pc., + error.

The econom etric estim ation of the sectoral wage
equations pays particular attention to the problems of
“ simultaneity” that are present in the two equations. The
service wage equation says that a one percent increase
in manufacturing wage growth causes service wage
growth to increase immediately by a, percent, while the
manufacturing wage equation implies that a one percent
increase in service wage growth leads to a contempo­
raneous increase in manufacturing wage growth of bD
percent. Using regression techniques, we can only esti­
mate the correlation between manufacturing wage growth
and service wage growth. This means that if we run the
manufacturing wage regressions, for example, we do not
know whether the estimated coefficient of service wage
growth reflects the value of bOI aD, or some combination
of both (wm and ws can be positively correlated, but
because wm affects ws, and not vice versa). It is possible,
however, to test for the presence of simultaneous
relationships by examining the correlations of wm with
variables that we believe affect ws without affecting wm.f
'Further lags of each right hand side variable were not
significant in either equation.
fThe testing procedure used is described in detail in the
working paper, of which this article is a summary, available
on request from the author.

44for FRASER
FRBNY Quarterly Review/W inter 1987
Digitized


Such tests reveal that any correlation between contem­
poraneous manufacturing and service wage growth is not
the result of the direct effect of services wage growth
on manufacturing wage growth. The lagged value of
service wage growth is also insignificant in the manu­
facturing equation. The equations used annual data from
1954 to 1985. The final versions of the equations esti­
mated are:
ws = 6.2 + .22wm + .07wmi + .34 tts 4.2
(1.5)
(0 .6 )'
(1.8)

,23tts 1
(-1.2)

+ .15upm - .87uf + .61 pc.,
(0.6)
(-2.3)
(3.8)
R2 = 0.83

SE = 0.84

DW = 1.71

wm = .46 + .07irm + .01 irm - .51upm
(2.9) (0.9)
(0 .1 )'
(-1.5)
+ .01 uf + .74pc.,
(.01)
(5.7)
R2 - .73

SE -

1.158

DW = 1.73.

Several tests of the significance of the effect of man­
ufacturing wages on service wages were carried out. If
a,, + a, = 1, then increases in manufacturing wages are
passed through fully to the service sector, indicating
substantial interdependence of the two sectors. The tstatistic for this hypothesis is 3.68, whereas the .005
significance level is 2.8. Thus, the hypothesis is soundly
rejected. The coefficients aD and a, are, in fact, insig­
nificantly different from zero. The hypothesis that they
are both zero yields an F-statistic of 1.36, whereas the
5 percent significance level is 3.4. Thus, the predictions
of the mobile labor model are not supported by the data.
In contrast, the female unemployment rate has significant
negative coefficients in the services equation, but is
practically irrelevant for the determination of manufac­
turing wages. The importance of the effects of the prime
age male unemployment rate is the reverse. These
results suggest that conditions peculiar to the female
labor market may be important in the determination of
service sector wage growth, and hence inflation.

wage growth is somewhat moderated by increases in
the prime age male unemployment rate, and not at all
by the female unemployment rate, service wage inflation
responds in a roughly opposite manner. Decreases in
female unemployment have a substantial inflationary
effect on service sector wages, while changes in male
unemployment have neither a large nor significant
impact. These results suggest that there has been
substantial immobility between the services and manu­
facturing sectors. Service sector wages respond to move­
ments in the female unemployment rate, since women
constitute a major source of workers for this sector.
Thus the influence of one sector’s wage growth on the
other is at best weak. This result, in turn, suggests that
productivity growth differences between manufacturing
and services do not explain the difference between their
inflation rates. In contrast, the analysis produces some
evidence that the two labor markets are separated: each
sector’s wage inflation is most responsive to the
unemployment rate of the demographic group that
constitutes the bulk of its labor force.
Given that the data support the view that labor does
not move freely between the two sectors, what is to be
inferred about the source of the higher inflation rates
in services? A story consistent with the evidence is that
service price inflation has been driven by growing
demand for services relative to manufacturing. This, in
turn, has caused an increase in the demand for labor
in services, which has drawn disproportionately on the
female labor force. The effects of the growth in demand
have been to tighten the female labor market relative
to the male labor market, resulting in greater upward
pressure on wages and prices in services than in
manufacturing.




Conclusion
This article has considered several explanations for the
high rate of price inflation in service industries relative
to manufacturing. In spite of the difficulties of capturing
quality changes in services, no positive evidence was
turned up to substantiate the view that the inflation dif­
ferential stems from data collection or measurement
problems. While a more complete analysis is required
before this view can be dismissed, it seemed promising
to attempt to explain the data on economic grounds.
The principal source of wage and price differentials
between services and manufacturing seems to be the
growth of demand for services against a background of
low labor mobility between manufacturing and services.
The implications of this model appeared to be more in line
with the behavior of wages than an alternative model that
traced the inflation differential to underlying differences in
productivity growth between the two sectors.15
The aggregate historical record is consistent with the
view that growth in demand for services has outstripped
growth in the available labor supply, causing wages to
rise rapidly and putting upward pressure on prices.
Recent developments do not suggest any significant
change in this trend. For example, average earnings in
finance, insurance, and service industries have grown
at about 4 percent per annum since 1984, while price
increases have slowed by about one-half of a per­
centage point, but remain above 4 percent. During the
same period, annual employment growth has consis­
tently exceeded 5 percent. Thus, demand pressures on
nondistributive services do not appear to be easing.
18Of course, a more detailed study focusing on individual industries
and on their wage and price inflation rather than on the aggregate
differential might suggest a more significant role for the behavior of
labor productivity.

Peter Rappoport

FRBNY Quarterly Review/Winter 1987 45

International “Middle-Market”
Borrowing
Two of the most important developments in the inter­
national capital markets since 1980 have been the onset
of the less developed country (LDC) debt problem and
the surge in international securities issuance. Both of
these suggest a diminished role for commercial bank
lending. The debt problem has reduced the perceived
creditworthiness of LDCs, making loans to some of
these countries unattractive at any interest rate. On the
other hand, the growing credit needs of industrialized
countries have principally been met not by banks but
by the international securities markets, to which the most
creditworthy borrowers have consistently had good access.
This article assesses supply and demand shifts in lending
to a third group of countries, the medium-risk borrowers, for
whom the impacts of the debt problem and securities market
growth are less clear. These borrowers constitute a “middle
market” for international lending.
Our analysis suggests that the international middle
market passed through two distinct stages in recent
years. First, after the debt problem arose in late 1982,
banks reduced the supply of loans to the middle market.
Hence the quantity of bank credit fell and spreads
increased. While the least risky middle-market borrowers
used fixed- and floating-rate bond issues to replace
syndicated credits, this did not fully offset declining bank
lending to the middle market as a whole.
By 1984, improved opportunities for all middle-market
borrowers to raise funds in the securities markets
reduced their need for bank loans, with an accompa­
nying fall in spreads. The increase in the supply of
funds through bond issuance came primarily from non­
bank investors and was not unique to the middle
market; medium-risk borrowers benefitted from the same
forces that allowed top-tier borrowers to make rapid
increases in bond market borrowing. Even if we assume

46 FRBNY Quarterly Review/Winter 1987




that all floating-rate notes issued by middle-market
borrowers were purchased by banks, the total demand
for bank funding of middle-market countries fell after
1983. This occurred despite an increase in overall (bank
and nonbank) financing of middle-market countries.
The following section defines the international middle
market and examines the composition of borrowing by
industrialized countries, middle-market countries, and
LDCs. We then evaluate changes in middle-market loan
and floating-rate note terms, as well as the issuance of
fixed-rate bonds. The loan and bond data, considered
together, lead to conclusions about supply and demand
shifts in the middle market.
Changing patterns of international borrowing
International borrowers can be divided into three groups
according to country of residence: industrialized nations,
middle-market countries, and non-middle-market LDCs.
The middle market consists of countries that have had
less access to international securities markets than
industrial country borrowers, but offer substantially less
credit risk than the poorer LDCs or those countries that
have rescheduled debt.1
To make these distinctions operational, we begin by
applying a common definition of the top tier of inter­
national borrowers and then rely on country risk ratings
to distinguish between middle-market and LDC bor­
rowers. Of course, some degree of arbitrariness cannot
’ A pure country risk criterion is not the only possible way to
distinguish borrower groups. A more extensive credit risk measure
would also be plausible. In that case, medium-risk firms in the most
creditworthy countries could also be viewed as part of the middle
market. However, the available data do not readily distinguish
between corporate and noncorporate borrowers, so that standard
would be difficult to apply empirically.

be avoided. Specifically, the industrial country borrowers
in the top tier are the G-10 members, including Swit­
zerland. Their long histories of participation in the
international credit markets, high per capita incomes,
extensive financial resources, and well-developed
framework for cooperation in economic matters suggest
a low degree of country risk. The middle market
includes those countries not in the top tier that meet two
principal criteria: a) no reschedulings of debt payments
in the decade before 1983, and b) 1983 Institutional
Investor country risk ratings at least as high as any
country that rescheduled or postponed payments.2 The
year 1983 serves as a reference point because we want
to see how medium-risk borrowers fared after the debt
problem arose. Those countries that rescheduled or
postponed payments in 1982 and early 1983 were no
longer medium-risk borrowers. Also, the analysis of
market lending terms to follow does not apply to invol­
untary loans made under rescheduling agreements.
Using this definition, the middle market consists of 24
countries: Algeria, Australia, Austria, the Bahamas,
Bahrain, Colombia, Denmark, Finland, Greece, Hong
Kong, Indonesia, Ireland, Kuwait, Malaysia, Norway,
Portugal, Saudi Arabia, Singapore, South Africa, South
Korea, Spain, Taiwan, Thailand, and the United Arab
Emirates. Some of these nations have had difficulty
meeting debt payments since 1983, demonstrating that
there are real risks in lending to the middle market.
We can use OECD data on the composition of new
international financing arranged by country borrowers to
examine the funding behavior of the three groups of
countries. New financing can take the form of bonds,
loans, or other facilities (including note issuance,
bankers’ acceptance, and standby loan facilities).3
2The Institutional Investor index is a rough ordering of the likelihood
that a sovereign borrower will default on a loan. The index ranges
from zero to 100 with higher values implying a lower probability of
default. The values are published in March and September;
September 1983 ratings were used to define the middle market.
Although we should not make too much of the precise numerical
ratings, the index is based on a survey of international loan officers
and reflects their perceptions of relative creditworthiness.
One further criterion is used to ensure that middle-market
members are important borrowers: liabilities to U.S. banks must
exceed $1 billion in 1983. Liabilities to U.S. banks are used
because the Country Exposure Lending Survey (CELS), in which
these data are reported, is in some respects superior to alternative
debt measures. Unlike other international lending data, the CELS
reports claims adjusted for lending to foreign branches of the
borrowing country’s banks and third-party guarantees, and is
therefore a more accurate measure of debt.
3The figures reported in the OECD's Financial Statistics Monthly
represent new financing arranged in the international markets.
Arranged credits need not be drawn down. For example, only about
20 percent of the funds arranged under note issuance facilities
(NIFs), included in “ Other Facilities," have actually been used by
borrowers. NIFs are medium-term facilities through which a borrower
issues short-term notes; a group of banks agrees to buy any unsold
notes at a prearranged spread over a reference interest rate.




Consider first the LDC segment of the international
capital market. These borrowers account for a small and
declining share of new financing, especially after 1982
(Chart 1). The post-1982 figures also overstate the level
of voluntary new financing arranged by non-OPEC LDCs
because the figures include new funds supplied under
debt rescheduling agreements. Bank loans have dom­
inated new financing for these borrowers (Chart 2).
In contrast to LDCs, middle-market borrowers have
gained progressively better access to the international
securities markets. New funding arranged by middlemarket countries has grown substantially over the 198186 period. This growth is attributable mainly to bond
issuance and, to a lesser extent, the arrangement of
other facilities. In fact, middle-market borrowers relied
on bonds for 52 percent of new funds in the first half
of 1986, compared with only 19 percent in 1981 (Chart 3).
New bank lending to the middle market has declined
both absolutely and relative to other types of credit.
The top tier of borrowers— the G-10 countries and
Switzerland— accounts for the bulk of new financing
Footnote 3 continued
Also, only publicly announced medium- and long-term loans are
included here. Short-term trade credits and loans arranged privately
are omitted. Hence the OECD figures differ from those derived from
bank balance sheets, such as the Bank for International Settlements
loan data.

Chart 1

New International Financing Arranged
Billions of dollars

200

I
150

I LDC

□

Middle m arket

□

G-10 and Switzerland

100

50

r
1981

1982

1983

1984

r
1985

1986*

* First and second quarter 1986 data at an annual rate.
Source:

OECD Financial S tatistics Monthly.

FRBNY Quarterly Review/W inter 1987

47

arranged since 1981, particularly in the 1984-86 period.
These low-risk borrowers have consistently relied more
on bonds than on loans for new funds (Chart 4). Other
facilities are also important funding sources for the top
tier of borrowers, although these have generally not
been drawn down.

Changes in syndicated loan terms
and market conditions

Chart 2

Proportion in each category
Percent

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

Proportion in each category

Loans

□

Other facilities

20

HI
1981

1982

D

i

1983

1984

1985

1986*

* 1 9 8 6 data through June.
Source:

OECD Financial Statistics Monthly.

4 Financing Shares: G-10 and Switzerland
Percent
1 0 0 -------------------------------------------------------------------------------------------------------------

Bonds

□

Bonds

□

Proportion in each category

Percent
140 — —----------------------------------------------------------------------------------------

|

□

Chart 4

Financing Shares: Non-Middle-Market LDCs

100

Financing Shares: Middle Market

80

Is the decline in bank lending to the middle market due
to a shift in loan market supply or demand? To answer
this question, we examine the interest rates charged on
middle-market loans. These rates consist of a reference
rate, usually the London Interbank Offer Rate (LIBOR),
plus a spread representing a risk premium.
To evaluate spreads, we used a sample of 305
LIBOR-based loans made from 1981-1 to 1986-11. To limit
credit risk variations within middle-market countries, we
considered only loans to governments, government
agencies, or (borrower) government-guaranteed loans.
We used semiannual averages because of the limited
number of observations in some quarters.
Changes in loan spreads over time appear to define
three periods (Table 1). Spreads declined from the
beginning of 1981 until the end of 1982. Following the
emergence of the debt problem, spreads increased,

□

Chart 3

□

Loans

8 0 __ I M

Other facilities

Bonds

Loans

□

-

80

____________________

__

Other facilities

6 0 --------------------------------------

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

-----------

—

20*

I

- f l -

—

60

40

20

,id
1981

IT
1982

1983

1984

id

1985

*1 9 8 6 data through June.
Source:

48

OECD Financial Statistics Monthly

FRBNY Quarterly Review/W inter 1987




a

1986*

9

1981

-

. ------

1982

------

1983

-

1984

-

1985

* 1 9 8 6 data through June.
Source:

OECD Financial Statistics Monthly.

1986*

peaking in the second half of 1983. From 1984 until
1986, spreads once again fell.
The changes in spreads are good m easures of
changes in returns since they have not been offset by
variations in other terms and conditions on loans or in
the degree of risk. To show this, we analyze two sets
of factors. The first is the non-spread loan terms—
maturity and grace period.4 The second includes two
determinants of returns that are not explicitly part of the
loan contract— the general level of interest rates and the
degree of country risk.
Of the two non-spread loan terms, maturity variations
tend to confirm the impression of tighter loan terms in
1983, while grace period variations show no real trend.
In general, borrowers seek longer grace periods and
maturities while lenders have opposite preferences.
4During the grace period, the borrower pays only interest on the loan
without making amortization payments. Though management,
participation, and agency fees also contribute to the profits of major
syndicate members, these profits are small compared to the spread
component of returns. We have only limited information about fees.

Table 1

Middle-Market Syndicated Loan Terms
Weighted Average Semiannual Data*

Quarters

Spread

Maturity

Grace
Period

LIBOR
(sixmonth)

Country
Risk
Index

1981
l-ll
lil-IV

54bp
50

8.5 years
8.9

3.8 years 16.7%
14.9
3.1

63.4
64.0

1982
l-ll
lll-IV

50
42

8.8
8.7

4.1
3.7

15.1
11.8

65.5
62.2

1983
l-ll
lll-IV

60
67

7.9
7.4

3.6
4.1

9.6
10.3

58.8
58.2

1984
l-ll
lll-IV

62
61

7.0
7.8

3.7
4.0

11.0
11.7

60.3
54.3

1985
l-ll
lll-IV

54
46

8.0
7.3

4.8
2.3

9.1
8.2

55.4
54.9

1986
l-ll

45

7.5

3.8

7.4

53.7

‘ All averages are weighted by the dollar value of each loan.
Since the value of LIBOR reported here is the weighted
average of the level prevailing at the loan’s signing date, it
may differ from LIBOR averages reported in subsequent
tables in this article. There are 89 observations for 1981, 74
for 1982, 52 for 1983, 42 for 1984, 36 for 1985, and 13 for
1986(1-11). Fee income is excluded because of missing
observations.
Sources: Euromoney Capital Markets Guide-, Institutional
Investor.




Hence, extending the grace period or the maturity
implies easier credit.5 Maturities became somewhat
shorter in 1983, with little change afterwards (Table 1). On
the other hand, grace periods moved erratically. Thus
among the contractual terms, the spreads summarize most
of the information about changes in market tightness.
Among the determinants of loan profitability other than
the explicit loan terms, an interest-rate increase reduces
the return on a loan with a given spread. The expla­
nation is that if the lender’s cost of funds moves closely
with the reference rate used in the syndicated loan, the
present value of payments associated with the spread
declines as interest rates rise. Thus if rates rise,
spreads must rise to offer the same expected loan
return.6 An increase in country risk also requires that
lenders be compensated by higher spreads to maintain
the same expected return.
From the end of the period in which the debt problem
emerged (1981-82) until the end of the first post-debt
problem phase (1983), average LIBOR fell by about 150
basis points while the average country risk rating
declined by four points. The drop in LIBOR implies
greater loan returns, reinforcing the conclusion that
terms became tighter in this period. Even though the
decline in the country risk index suggests that higher
spreads may have been appropriate, a fall of four points
in the risk index is not substantial and cannot explain
the 25-basis-point rise in spreads between the end of
1982 and the end of 1983; countries four points apart
in the index have similar country risk and would not
normally pay spreads 25 basis points apart.
In the following period (1984-86), LIBOR fell sharply
while the risk index continued to drop. The deterioration
of the country risk index tends to confirm the impression
given by loan spreads of easier credit terms. But in this

5Theory alone cannot tell us whether longer grace periods and
maturities are consistent with higher or lower expected returns. If
there is no possibility of default, extending the grace period or the
maturity increases the rate of return on a syndicated loan. A longer
grace period implies that interest is paid on the full principal of the
loan for a longer period. A longer maturity extends the period over
which interest payments (including the spread) are made. However,
if there is a possibility of default, the expected return on a loan may
decline when either the grace period or the maturity is lengthened.
The cumulative probability of default rises over time, so the lender
may prefer rapid amortization.
Ultimately, liquidity and general interest-rate risk may be more
important than credit risk; for example, the yield curve for default
risk-free Treasury bonds usually slopes upwards, providing a
premium for longer term investments.
6This is difficult to show for a syndicated loan but can be illustrated
by a $1 perpetual bond that pays a spread s over LIBOR. If banks
discount future payments at LIBOR and have flat interest rate
expectations, then the present value of the bond is (LIBOR+ s)/
LIBOR. To keep this value constant as LIBOR rises, the spread must
increase at a rate of s/LIBOR. In general, we observe that the
various types of interest rate spreads increase as interest rates rise.

FRBNY Quarterly Review/W inter 1987

49

case, the drop in LIBOR suggests the possibility that
loan returns increased despite falling spreads.
We can show that the decline in LIBOR was not suf­
ficient to offset the fall in spreads by calculating the
change in spreads that would be required to offer the
same contractual return in the first half of 1986 as in
late 1983. This contractual return is the percentage by
which the present value of loan payments exceeds the
amount loaned.7 Using the average values of the grace
period and maturity over the late 1983 to early 1986
period, and noting that LIBOR fell from 10.3 percent to
7.4 percent, we can calculate that the average spread
would have to fall by about 5 basis points to offer the
same contractual return. Hence despite the decline in
LIBOR in the second period after the debt problem
emerged, the 22-basis-point fall in spreads cannot be
explained by declining interest rates. Credit terms did
indeed ease after 1983.®

7ln calculating the contractual return, we assume that there is no
possibility of default. The greater the probability of default, the less
sensitive the expected return to interest rate variations. This follows
because as the probability of default rises, the likelihood of
receiving payments in the more distant future declines. It is these
more distant payments that are most affected by a change in the
rate of discount. Therefore if default is possible, an even smaller fall
in spreads is needed to offset the drop in LIBOR.
•This view is supported by the financial press; see for example,
“ Back to the Borrowers’ Market,” Euromoney, May 1984.

Table 2

Nonbank and Bank-Supplied
Middle-Market Funds
Billions of Dollars*

1981
1982
1983
1984
1985
1986f

(1)
Fixed-rate
Bonds
4.5
7.1
8.5
11.3
16.3
24.6

Loans

(3)
Floating-rate
Notes

(2 + 3)
Total Bank
Funding

27.9
28.5
24.3
21.1
15.3
17.5

1.6
2.7
4.4
7.8
9.5
5.3

29.5
31.2
28.7
28.9
24.8
22.7

(2)

'Assumes all floating-rate notes are purchased by commercial
banks and fixed-rate bonds are purchased by other investors.
The proportion of fixed-rate Eurobond issues in the Securities
Data Corporation international bond data base is applied to
the OECD total of international bond market issues. Although
traditional foreign bond market issues prior to 1984 are
excluded from the Securities Data Corporation base, very few
foreign issues for middle-market borrowers have been FRNs.
tYear through June at an annual rate.
Sources: OECD Financial Statistics Monthly, Securities Data
Corporation.

50

FRBNY Q uarterly Review/W inter 1987




The easing of lending terms after 1983 has allowed
many middle-market borrowers to refinance loans at
lower spreads. For example, the Danish Export Finance
Corporation renegotiated a $200 million loan in October
1984 at a spread of 37.5 basis points over LIBOR for
eight years. The initial loan, made in July 1983, carried
a spread of 50 basis points for three years, rising to
62.5 basis points for the next four years. Ireland rene­
gotiated a $120 million loan in December 1985 at a
spread of 25 basis points for 10 years. The spreads on
the original loan, completed in January 1984, were 37.5
and 50 basis points for the first three and next seven
years respectively.

Middle-market floating-rate note issuance
The decline in bank lending to the middle market coin­
cided with an increase in floating-rate note (FRN) issu­
ance by middle-market borrowers.9 Since FRNs are
known to appeal mainly to bank investors, the question
arises whether middle-market borrowers merely shifted
from one form of bank funding to another. This, however,
was not the case.
An FRN is a medium-term security (typically five to
ten years) that pays a coupon which is tied to a base
interest rate. For example, the note might offer a coupon
equal to LIBOR plus a spread of 25 basis points. An
FRN, therefore, resembles a syndicated loan with a
grace period equal to maturity, but is more liquid, pro­
vided the borrower remains creditworthy.
A borrower that issues an FRN is probably still relying
on bank funding while an issuer of a fixed-rate note is
not; banks hold roughly 75 percent of the total volume
of FRNs issued and may prefer FRN investments to
loans because of their greater liquidity.10 Banks are far
less likely to invest in fixed-rate issues because the
coupons on fixed-rate bonds do not rise and fall with
bank funding costs; i.e., fixed-rate bonds present greater
interest rate risk to banks than FRNs.
Middle-market borrowers have, for the most part,
issued fixed-rate bonds (Table 2). Even if we assume
that all FRN investors are commercial banks, while all
fixed-rate bond investors are not, then total bank-sup­
plied funds to middle-market borrowers have declined
more or less steadily since 1982. This is certainly true
relative to total middle-market borrowing, and with the

9Note issuance facilities are not considered in this section. As
described earlier, these facilities have been substantially less
important as a source of new funds for middle-market borrowers
than the bond market.
10See G. Ugeux, Floating Rate Notes (London: Euromoney
Publications, 1985), page 59. Although banks do hold fixed-rate
securities, they generally hold very low risk bonds like U.S.
Treasuries or tax exempt issues.

exception of a slight 1984 increase in bank funding, it
is true in absolute terms as well. While a shift from bank
lending to FRN issuance apparently began in 1983, the
volume of FRN issuance did not fully offset the decline
in loans.
To determ ine w hether FRN investors, like bank
lenders to the middle-market, received less compen­
sation for given country risk levels after 1983, we
assembled a sample of 89 FRN issues by middle-market
sovereign borrowers. Using average annual figures
calculated from this sample, we can assess changes in
FRN spreads over the 1981-86 period (Table 3).
It is apparent that the spreads on FRNs are much
lower than on syndicated loans. These lower FRN
spreads are at least partially offset by the greater
liquidity of the notes. Like syndicated loans, FRN
spreads declined sharply after 1983.
As in the case of syndicated loans, we must consider
FRN maturities, the level of LIBOR, and country risk to
be certain that changing spreads are indicative of
changes in market tightness. Looking first at maturities,
it is clear that maturities lengthened after 1983 (Table 3).
This may be somewhat misleading because many of the
FRNs are subject to call or put options that change their
effective maturities. In any case, the maturity figures do
not suggest a tightening of terms.
To measure the effect of declining interest rates, we
can again calculate the change in spreads that would
maintain a constant contractual return, given the drop
in LIBOR. Since weighted average LIBOR fell from 10.3
percent in 1983 to 7.8 percent in 1986, and the average
maturity over the post-1983 period was 16.5 years, an
8-basis-point drop in spreads would offer the same

Table 3

Middle-Market Floating-Rate Note Terms
;

W SM

Weighted Average Annual Data*

Spread
1981
1982
1983
1984
1985
1986+

Maturity

17bp
22
23
14
11
12

7.2 years
8.9
9.5
16.6
17.2
13.4

LIBOR
(sixmonth)
17.0%
13.3
10.3
11.2
9.0
7.8

Country
Risk
Index
72.9
69.4
65.1
65.8
62.0
68.0

*AII averages are weighted by the dollar value of each issue.
There are 8 observations for 1981, 14 for 1982, 15 for 1983,
19 for 1984, 24 for 1985, and 6 for 1986. No effort is made
here to evaluate the effect of call and put options on
spreads. A careful analysis of these would require the use of
options pricing theory.
fVear through June.
Sources: Securities Data Corporation; Institutional Investor.




contractual return as in 1983.11 Hence the 13-basis-point de­
cline can only be partially explained by falling interest rates.
The average risk rating of FRN issuers has consis­
tently been better than the corresponding loan market
figure; less risky borrowers have better note market access.
But as middle-market borrowers that traditionally relied on
syndicated loans for funds have instead issued FRNs, the
average country risk rating of these FRN issuers has gen­
erally deteriorated.12 Thus in the FRN market as well as in
the syndicated loan market, the risk-compensated returns
to middle-market funding seem to have fallen.

Middle-market fixed-rate bond issuance
The declining quantity of bank-supplied funds to the
middle market and the falling spreads on loans and
FRNs imply a contracting middle-market demand for
bank financing after 1983. At the same time, rising
issuance of fixed-rate bonds by these borrowers sug­
gests an increase in either the supply of or demand for
nonbank funds.
While we do not have enough data on fixed-rate
yields to distinguish supply from demand shifts,13 indirect
evidence suggests that the growth of fixed-rate middlemarket borrowing parallels the experience of the top tier
of country borrowers. For example, the increase in fixedrate issuance by both middle-market and G-10 bor­
rowers primarily occurred in the Eurobond market, rather
than in traditional foreign bond markets (Table 4). Also,
the middle-market members with country risk ratings
most like those of G-10 borrowers have benefitted most
from the expansion of Eurobond market issues. The
average country risk rating of middle-market fixed-rate
issuers has been better than the the index levels for
middle-market FRN issuers and borrowers in the syn­
dicated loan market.
Improved access to the fixed-rate bond markets was
not a matter of medium-risk issuers entering the market
for the first time. Instead, countries that already had
access to the market were able to issue bonds in much
greater volume. This group includes the more highly
11The fall in the average spread needed to maintain a constant
contractual return is greater in the FRN case than the syndicated
loan case. Because FRNs are generally amortized only at maturity,
the present value of an FRN is more sensitive to interest rate
variations than a syndicated loan. That is, the “ duration" of an FRN
exceeds that of a syndicated loan with an equal maturity.
12The increase in the risk index in the first half of 1986 is based on
only six observations. The financial press clearly believes that riskcompensated FRN spreads have declined over time. For example,
see "Risk Without Reward," Standard & Poor's International Credit
Week, December 1985; "The Deteriorating Risk-Reward Ratio,”
International Financing Review, July 26, 1986.
13A sample restricted to fixed-rate bonds, without special features
such as call or put options, issued by government or governmentguaranteed borrowers contains few observations prior to 1983.

FRBNY Quarterly Review/W inter 1987

51

rated European middle-market countries, Australia, and
some East Asian borrowers such as South Korea and
Malaysia. Even prior to 1984, these and other middlemarket members were able to tap the foreign bond
markets, particularly in Tokyo.14
Since the growth of middle-market fixed-rate bond
issuance in the Eurobond market coincides with the
growth of fixed-rate issuance by top-tier borrowers, and
because the least risky middle-market members were
the most active issuers, we conclude that the same
basic factors account for the expansion of both middlemarket and G-10 fixed-rate borrowing. A full discussion
of these factors is too broad a topic for this article, but
several important developments can be cited: the growth
of the current account surplus in Japan, coupled with
the preference of Japanese investors for securities over
nonmarketable assets, the general decline in long-term
real interest rates after 1982, financial market innova­
tions, particularly swaps, and the increased competition
among financial institutions to provide credit enhance­
ments for securities issues.
14See OECD F inancial M arket Trends, O cto ber 1984, pages 70-72.

Table 4

G-10 and Middle-Market
Fixed-Rate Bond Issuance
Billions of Dollars*

1981
1982
1983
1984
1985
1986t

G-10 and Switzerland

Middle Market

Total
Fixed-rate Of which:
Issuance Eurobonds

Total
Average
Risk
Fixed-rate Of which:
Issuance Eurobonds Rating

31.0
46.2
43.6
58.5
82.1
139.2

20.0
33.4
28.9
44.1
66.2
119.1

4.5
7.1
8.5
11.3
16.3
24.6

1.6
3.2
4.1
7.1
12.1
18.0

83.1
80.8
75.5
77.0
77.1
78.4

'Assumes all traditional foreign bond market issues are fixedrate. Eurobond fixed-rate issues are estimated by applying
the proportion of fixed-rate Eurobond issues in the Securities
Data Corporation international bond data base to OECD
international bond issuance totals. The OECD figures are
more comprehensive prior to 1985 but do not provide a
breakdown of fixed- vs. floating-rate issues. A sample based
on the 1985-86 Securities Data figures supports the
assumption that nearly all middle-market traditional foreign
bond market issues were fixed-rate.
fVear through June at an annual rate.
Sources: Securities Data Corporation, OECD Financial
Statistics Monthly, Institutional Investor.

FRBNY Quarterly Review/W inter 1987
Digitized52
for FRASER


All of these imply that at a given cost, middle-market
borrowers enjoy an increase in the supply of fixed-rate
funds. The surge in Japanese investment represents a
clear increase in supply, particularly since East Asian
middle-market borrowers had found favor with Japanese
investors before 1984. The general decline in real
interest rates from historically high levels made fixedrate borrowing more attractive compared to the floatingrate alternative, benefiting all fixed-rate borrowers.
Financial market innovations, such as swaps, have
complex effects on international borrowing, but to the
extent that they improve the efficiency of securities
markets, these innovations tend to reduce borrowing
costs. These innovations took hold first in the unregu­
lated Eurobond market where fixed-rate issuance grew
most rapidly. Competition among suppliers of credit
enhancements can provide new participants access to
the bond markets.

Conclusion
The data on the quantity of new middle-market financing
and spreads suggest that two distinct phases followed
the emergence of the LDC debt problem. The first post­
debt problem phase extended from early 1983, after the
debt problem arose, until roughly the end of 1983. This
period was characterized by a declining supply of new
bank funds (loans and FRNs) to middle-market borrowers.
A plausible explanation for the declining supply of
bank funding to the middle-market is that the LDC debt
problem widely tainted international lending. Even
though middle-market countries did not reschedule debt
payments by 1983, the debt problem made rescheduling
by sovereign borrowers appear more likely.
The second post-debt problem phase began in 1984
and continued through the first half of 1986, the latest
period for which we have comprehensive data. The level
of new bank funds continued to decline, but spreads
declined as well. Hence this period is characterized by
a fall in the demand for bank funds.
The second post-debt problem period coincides with
the worldwide boom in securities issuance. Middlemarket borrowers benefitted from the declining cost of
issuing fixed-rate bonds, reducing their reliance on
bank-supplied funds. Since the most creditworthy
members of the middle market have gained the most
rapid access to nonbank financing, the average riskiness
of borrowers that still rely on bank funding has increased.

Jeremy Gluck

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