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FEDERAL RESERVE BANK OF RICHMOND

MONTHLY
REVIEW
E conom etric M od els:
The M onetarist and N on -M on etarist
V iew s Compared
F orecasts 1973
Financial F oreca sts: 1973




T he M o n t h l y R e v i e w is produced by the Research
D epartm ent of the F ederal R eserv e Bank of Richm ond.
Subscriptions are available to the public w ithout charge.
A d d ress inquiries to Bank and Public R elations, F ed ­
eral R eserv e B ank of R ichm ond, P . O. B o x 2 7 622,
Richm ond, Virginia 23261. A rticles may be reproduced
if sou rce is given. P lease provide the B ank’s Research
D epartm ent with a copy of any publication in which an
article is used.

2



MONTHLY REVIEW, FEBRUARY 1973

ECONOMETRIC MODELS:
THE MONETARIST AND NON-MONETARIST
VIEWS COMPARED
In recent years a grow in g number o f Government
agencies and private business firm s have turned to

the events of the 1930's redirected econom ic thinking
tow ard problem s o f the econom y-in-the-large, i.e.,

large com puter-solved econom etric models as aids in

toward

forecasting future business conditions or in analyzing
the effects o f alternative econom ic policies. E co n o ­
metric models are statistical representations of the

fram ew ork established by John M aynard K eynes in

structure, or w orkings, of the econom y.

in use today.

T hey usu­

ally take the form of systems of equations, represent­
ing their
structure.

m odel-builder’s view o f the econ om y’s
Since economists differ in their view s 011

m acroeconom ics.

F ollow in g

the

general

the 1930’s, m acroeconom ics developed rapidly, fo rm ­
ing the basis for the large-scale econom etric models
In statistics, the early w ork o f K arl Pearson p ro ­
vided a method o f estimating statistical relationships
and laid the foundation fo r the science of econ o­

the nature of the econom y, different types of econ o­

metrics.

metric m odels are to be expected. One m ajor way in
which econom etric models differ is in the role they
assign to financial variables in passing the influence

lands and Ragnar Frisch o f N orw ay began exp eri­

of policy changes to the real sectors of the econom y.
T w o m ajor schools of thought may be identified.

In the 1930’s, Jan T inbergen of the N ether­

menting with models o f their national econom ies.
F or this w ork they received the 1969 N obel Prize in
E conom ics.
In the 1940’s, T . H aavelm o and A .

First, the M onetarist position generally argues that

W a ld restructured econom etrics as a problem in
statistical inference. T his w ork was extended and

policy influences on econom ic activity are routed

consolidated by the Cowles Com m ission in the 1940’ s

primarily through changes in the m oney supply; the
importance of fiscal policy is generally downgraded.

and 1950’s. By the early 1950’s, econom etrics was
generally recognized as a separate and distinct sci­

Second, the non-M onetarist, or neo-Keynesian, p osi­

ence.1

tion argues that monetary policy influences econom ic
activity primarily through changes in interest ra te s;
the need for an appropriate m ix of monetary and

Law rence R. Klein in the early 1940’s.

fiscal policy is emphasized.
T his article com pares the Monetarist and n eo-K ey nesian views by exam ining tw o representative e con o­
metric models. First, the general development and
the nature of econom etrics are summarized.
A
simple model illustrates the problem s of constructing
and specifying econom etric models. Then, typical
neo-Keynesian and M onetarist models are surveyed.
Both the underlying theoretical position and the
logical structure of these models are studied.

T he first model of the U . S. econom y was built by
T his was

follow ed by the very successful K lein-G oldberger
model in 1950 and by the W h arton forecasting model
in 1960. T od ay the W h arton model has a substan­
tial forecasting record and a clientele of over a
hundred large corporations using its forecasts. A
number o f other models are similarly being used,
including those of Chase E conom etric Associates and
Data Resources, Inc. L arge structural models have
also been produced by the B rookings Institution, the
Department of Com m erce, and the Board of G ov ­
ernors of the Federal R eserve System. T he F e d ­
eral R eserve model is one of the tools used for policy

I.

ECONOMETRICS

analysis and forecasting by a number of District

Econom etrics is a unified collection of statistical
techniques used to express econom ic relationships as
single equations or as systems of simultaneous equa­
tions.

This definition implies that the subject matter

of econom etrics is drawn from the two closely related
fields of econom ics and statistics.

Recently, the Federal R eserve Bank

of St. Louis has developed a small model conform ing
to the M onetarist view of the econom y.

A number

of other models, for exam ple the R C A forecasting

Developments in

both of these fields have converged to make possible
the m odern science of econom etrics.



Banks of the Federal Reserve System as well as by
the Board itself.

In econom ics.

1 For a summary of these developments and appropriate references,
see Lawrence R. Klein, “ Wither Econometrics,” Journal of the
American Statistical Association, 66 (June 1971), 415-21; and
“ ’Figuring the Future,” Wall Street Journal, August 23, 1972, pp. 1, 6.

FEDERAL RESERVE BA N K OF RIC H M O N D

3

m odel, also follow the M onetarist approach.

T he

rent time period, Y t is national income, Ct—i is last

Federal R eserve Board model and the St. Louis
model will serve as the representative models ana­
lyzed in this article.2

period’s consum ption, representing habitual consum p­
tion patterns, and f i ( ) means “ is a function o f.”

Econometric Model-Building
Several types o f variables appear in econom etric
models. T hose variables that are explained within
the context o f the m odel are termed endogenous
variables; those taken as given (determ ined outside
the m od el) are said to be exogen ous.

W hether a

variable is treated as exogenous or endogenous is
determined by the m odel-builder himself in light of
the analytical purpose o f the model. F or example,
population w ould likely be treated as exogenous in a
short-term m odel but endogenous in a long-term
model o f econom ic grow th, since population trends
interact with long swings in econom ic activity. A lso,
variables whose influence is felt in the current period,
but observed in past periods, are known as lagged, or
predetermined, variables.

Finally, instrum ent vari­

ables, which derive their value from policy decisions,
are usually treated as exogenous in econom etric
models.

A Simple Model

Investment may be explained, at first a p p rox i­
mation, as a function of expected profits and the
existing level of capital stock. Since measuring e x ­
pectations is difficult, it can be further hypothesized
that current period profits are a p r o x y fo r expected
profits. Sym bolically, I t= f 2 ( P t ,K t _ i ) , where It is
investment expenditures, Pt is profits (o r nonw age
in com e), and K t_ i is the nation’s capital stock at the
end o f the previous period.
National incom e is distributed between wage and
nonwage income. W a g e income, W t, may be e x ­
plained as a function of the level of econom ic activity,
measured by Y t, and a measure o f time, t, taken as a
p rox y for increasing productivity, price changes, and
other changes that generally proceed at a fairly uni­
form rate over time.
Sym bolically, W t = f a ( Y t,t).
N on wage incom e is then determined by subtracting
wage payments from national income.
In addition to the three behavioral equations dis­
cussed above, the model is made com plete by three
identities. First, national incom e is simply the sum
o f consum ption, investment, and Governm ent e x ­
penditures.

That is, Y t = C t + I t + G t .

Second, non­

T his m odel is d e­

wage incom e is national incom e less wage p a ym en ts:
P t = Y t — W t. Finally, the capital stock at the end

signed to determine measures of the broad com p on ­

of the current period is identical to capital stock at

ents of national in co m e :

the beginning of the period plus net investment e x ­
penditures during the current period. Sym bolically,

T hese concepts may be illustrated by exam ining a
simple model of the econom y.3

consum ption, investment,

and Governm ent expenditures. It also determines
the distribution of incom e between wage payments
and nonwage, i.e., profit, payments. T he first step
in m odel-building is to hypothesize the relationships
am ong the variables. T here are generally tw o types
of relationships to be defined. First, a number of
behavioral equations set forth the m odel-builder’s
hypotheses concerning the determinants of the be­
havior o f certain endogenous variables. Second, a
number of variables are linked together by identities,
which are simply econom ic or accounting definitions.
T he

follow in g

hypothesized.

behavioral

relationships

may

be

Consum ption is dependent upon, i.e.,

is a function of, income.

A lso, people have a ten­

dency to maintain past consum ption patterns.
bolically, we could state:

S ym ­

C t = f i ( Y t,Ct—1 ) , where

Ct represents consum ption expenditures in the cu r­

K t = K t _ i + I t - T he model therefore consists o f six
equations, each of which explains a corresponding
endogenous variable. O f the tw o remaining vari­
ables, time is exogenous, and Governm ent expen di­
tures are policy determined.
T he second step in m odel-building consists of
specifying the behavioral hypotheses in precise
mathematical form . A n y one o f several alternative
form s may be appropriate. F or example, consum p­
tion may be linearly
changes

related to income, that is,

in consum ption

changes in income.

may be

proportional

to

Alternatively, consum ption may

be related to the change in income, the logarithm of
income, etc.

F or simplicity, all equations o f this

illustrative model are assumed to be linear.

The

complete model is presented in E xhibit 1.

Estimation Problems
2 Frank de Leeuw and Edward M. Gramlich, “ The Channels of
Monetary Policy: A Further Report on the Federal Reserve-MIT
Model,” Journal of Finance, 24 (May 1969), 265-90; and Leonall C.
Andersen and Keith M. Carlson, “ A Monetarist Model for Economic
Stabilization,” Review, Federal Reserve Bank of St. Louis, 52 (April
1970), 7-25.
3 This model is similar to the small illustrative model presented in
M. Liebenberg, A. Hirsch, and J. Popkin, “ A Quarterly Econo­
metric Model of the United States: A Progress Report,” Survey of
Current Business, 46 (May 1966), 13-16.

4



An

important step

in building an econom etric

model is to specify numerically the coefficients of
relationship am ong the variables in the behavioral
equations.

A s presented in E xhibit 1, the equations

of the m odel contain nine coefficients, the a’ s, b ’s, and

MONTHLY REVIEW, FEBRUARY 1973

c ’s, that must be given numerical values if the m odel
is to be mathematically operational. These coefficients
are determined statistically by exam ining past data.
T here can conceivably be a large number o f esti­
mating equations relating, fo r example, consum ption
to incom e and past consum ption. A statistical tech­

Exhibit 1

AN ILLUSTRATIVE MODEL
(1)

C t = a 0 - f - a iY t - f a 2 C f_,

nique known as regression analysis selects the set of
coefficients that minimizes the variation o f observed
consum ption values from the corresponding values

(2)

l t = b Q + b , P t + b 2 K t_,

estimated by the equation.

(3)

W t = c0 + C lYt + c 2 t

(4)

Yt = C t + I t + G t

(5)

Pt = Y t - W t

(6)

K t = K t_, + l t

T his “ best fitting” equa­

tion is adopted for use in the model.

O nce these

coefficients are specified, the model is complete in
the sense that it can be solved mathematically.
Clearly, how ever, perfect estimates or predictions
are not to be expected. First, these statistical equa­
tion systems produce solutions that are essentially
a verages; no such system can reproduce reality in
full detail.

Second, the model may be misspecified

because errors in the data may provide incorrect
estimates o f the coefficien ts; or because the hypothe­
where C =

sized structure may include incorrect variables, or

Y == income

exclude significant variables, or specify an incorrect
mathematical form for an equation.

W =

F or example,

A lso, it may be that

net investment

K =

capital stock at end of period

G =

Finally, several sources o f error relate

to the statistical method o f regression.

nonw age income

I =

credit conditions and other financial considerations,
which are not included in the m odel, help to explain
consum ption.

w age income

P =

consum ption may be m ore properly related to after­
tax incom e than to total income.

consumption

government expenditures on
goods and services

t =

time

F o r example,

if several explanatory variables m ove through time in
similar patterns, it is difficult to measure their sepa­
rate influence on the dependent variable being e x ­
plained. A lso, the coefficients may be biased when
the equations are part of a simultaneous system.4

Source:

Adapted from a similar model presented in M.
Liebenberg, A. Hirsch, and J. Popkin, " A Q u a r­
terly Econometric M odel of the United States: A
Progress Report," Survey of Current Business, 46
(M ay 1966), 13-16.

M uch recent theoretical w ork in econom etrics has
been directed tow ard finding methods to minimize
such errors.
A lthough these sources o f error exist, econom etric
models have a number of clear advantages over alter­
native methods of analysis and prediction.
Such
models provide a logically consistent fram ew ork
within which the interrelations o f all variables in
the model may be studied. Forecasts are provided
that meet all accounting identities, as well as the
requirements o f

the

behavioral

equations.

A lso,

econom etric models may be used to simulate the
econom y under alternative time paths for policy
variables or different time paths fo r exogenous vari­

estimates for the exogenous variables in the period
being forecast. H ow ever, the prim ary advantage of
econom etric forecasting over judgm ental methods is
the potential for perfecting forecasting as econom etric
models im prove in perform ance.5

The Logical Flow Chart
Large-scale econom etric models may be extrem ely
com plex in structure.

A clear understanding o f their

logical structure may be difficult to acquire from
studying their equation systems.

Perhaps a better

approach is to study each m odel’s flow chart.

To

M oreover, while the assumptions underlying

illustrate this, E xhibit 2 charts the flow o f econom ic

traditional judgmental forecasts are often unstated,

interaction am ong the variables o f the model pre­

the assumptions built into an econom etric forecast are
necessarily explicit, taking the form of numerical

m axim um advantage by tracing the effects o f a given

ables.

l Ibid., p. 16.




sented in E xhibit 1.

T his flow chart may be used to

5 “ Bad Year for Econometrics,” Business Week, December 10, 1969,
p. 40.

FEDERAL RESERVE B A N K OF R IC H M O N D

5

change step-by-step through the chart. In this simple
case the equation system is given and can be co m ­
pared directly with the flow chart. A rise in G ov ­

Depression.
T he development of an alternative
theory o f m oney, interest, and output was initiated
by the British econom ist John M aynard Keynes.

ernment expenditures, for example, causes national
incom e

to

rise.

T his

is

shown

in

equation

creased profits (equation 5 ) , and increased wages
(equation 3 ) .

Consum ption then feeds back into

national incom e (equation 4 ) and, after a one period
lag, induces further increased consum ption.

R ising

profits induce increased investment expenditures
(equation 2 ) , resulting in a further rise in national
incom e (equation 4 ) .

Increased investment is also

reflected, at the end o f the period, in a higher level
of capital stock (equation 6 ) .
Changes in wages
and profits are generally offsetting, as national in ­
com e is distributed between these tw o com ponents
(equation 5 ).

T his procedure of tracing through the

logical flow chart of a model provides a method for
presenting and

studying even the m ost com plex

econom etric models in a manner that can be under­
stood by nonmathematicians.

This procedure will

be follow ed below in studying the M onetarist and
neo-Keynesian

approaches

to

econom etric

model

building.

II.

Neo-Keynesian Theory

4,

where G is a com ponent of Y . R ising national in­
com e induces higher consum ption (equation 1 ), in­

THE NON-MONETARIST VIEW

T w o fundamentally different views of the role of
m oney in econom ic activity underlie current econ o­
metric models. T he M onetarist view is form ulated
as an econom etric model by the Federal R eserve
Bank of St. Louis. T h e non-M onetarist view , based
largely on a disaggregated Keynesian approach to
monetary analysis, has given rise to several largescale econom etric models containing up to several
hundred equations. T he approach is illustrated in
this article by the so-called F R B -M I T m odel.6

T h e approach to m acroeconom ics developed by
Keynes and those w ho refined his w ork is know n as
the incom e-expenditure approach.

Its basic char­

acteristics may be summarized briefly.
First, the
econom y is viewed as consisting of a num ber of
sectors, e.g., the consum ption, investment, and g o v ­
ernment sectors. Dem and in each sector is deter­
mined by factors peculiar to the sector.

Then, all

sectoral demands are added together to determine
aggregate demand, measured by gross national p ro d ­
uct, G N P . T his process is illustrated in E xhibit 1,
where equations 1 and 2 determine consum ption and
investment d em a n d ; governm ent demand is e x o ­
genous.

A ggregate demand is added together in

equation 4.

W ith

larger, m ore com plex m odels,

each of these m ajor com ponents of aggregate demand
is disaggregated. Consum ption may be divided into
expenditures for durables, nondurables, and serv ices;
in some cases, automobile demand is explained sepa­
rately. Investment may be broken dow n into e x ­
penditures for producers’ equipment, p rodu cers’
structures, residential construction, and inventory
changes. Governm ent spending may be classified as
Federal or state and local, with Federal expenditures
further subdivided as defense or nondefense.

T his

disaggregation procedure can be carried to any p rac­
tical degree of detail, limited, o f course, by the avail­
ability o f appropriate data.
A second characteristic of neo-K eynesian models
is a built-in policy transmission mechanism that deemphasizes the role of money. F o r the m ost part,
this mechanism involves the indirect linkage of
m oney with aggregate demand via interest rates.
In its simplest form , it may be stated sym bolically as :

The Historical Setting
P rior to the D epression o f the 1930’s, conventional
econom ic theory considered the econom y basically

O M O ----- - R ----- - M ----- - i ----- - I ----- - G N P .

stable over the long run and tending tow ard full

A n open market purchase o f Governm ent securities

employment.

T he main theme of theoretical analysis

by the Federal Reserve, O M O , increases com m ercial

was tow ard long-run equilibrium relationships, with

bank reserves, R , and raises the banks’ reserves-

little attention

earning assets ratio.

devoted

to

the

short-run

process

Banks operate to restore their

through which long-run equilibrium was attained.

desired ratios by extending new loans or by expan d­

In this context, the quantity of money, together with

ing bank credit in other ways.

the level o f output, was view ed as determining the

new demand deposits, thereby increasing the m oney

level of prices, but having little to do with long-run

supply, M .

real productive grow th.

a rising money supply causes the general level o f

T his quantity theory was

was brought into serious question as a result o f the

N ew loans create

Given the public’s liquidity preferences,

interest rates, i, to decline.

Given businessmen’ s

“ expected profits,” expressed by Keynes as the m ar­
e See de Leeuw and Gramlich, loc. cit., and Andersen and Carlson,
loc. cit.

6



ginal efficiency of investm ent, falling interest rates,

MONTHLY REVIEW, FEBRUARY 1973

are important as points o f com parison with M on e­
tarist models. First, the m oney supply, in the p roc­
ess described above, is an endogenous variable,
whereas M onetarists consider it exogenous. Second,
the basic Keynesian model treats the price level as
independent o f monetary forces.
Large-scale neoKeynesian econom etric models, which generally en­
compass non-m onetary theories of price level deter­
mination, are consistent with this treatment. These
tw o points will be clarified at appropriate points in
the discussion below.

The FRB-MIT Model
T he generalized neo-Keynesian approach to m odelbuilding may be illustrated by the F R B -M I T model,
which is a large-scale model of the U . S. econom y
constructed by the B oard of G overnors of the Federal
Reserve System and the E conom ics Department o f
the Massachusetts Institute of T echnology.
Its
stated purpose is to quantify the monetary policy
process and its impact on the econom y.9 T he model
consists of 10 sectors, the most important o f which
i.e., reduced capital costs, induce expanded invest­
ment expenditures, I.

Finally, increased investment

are the financial, investment, and con su m ption /in ventory sectors. T he financial sector is displayed in
E xhibit 3 and the real sector in E xhibit 4.

spending causes successive rounds of new final d e­
mand spending, causing G N P to rise by a multiple of

The Financial Sector

the initial change in investment.7
A number of refinements to this process have been

cial sector is to establish the linkage between the
instruments of monetary policy and the financial

made by later economists.

variables that are important in the real sector of the

F or example, this trans­

T h e p u rp o s e o f the fin a n ­

mission process involves K eyn es’s liquidity prefer­
ence trade-off of m oney and financial assets.
In

econom y.

more sophisticated versions, this trade-off is general­
ized to better approxim ate a real w orld o f “ numerous
financial assets, hence num erous interest rates on . . .

are nonborrow ed reserves and the Federal R eserve

different securities.

Different types o f investment

spending are most sensitive to particular interest
rates, e.g., plant and equipment investment to the
corporate bond rate, residential construction to the
m ortgage rate, and inventory investment to the bankloan rate.” 8 Policy-induced changes in bank reserves
cause portfolio adjustm ents over a wide range of
financial and real assets, eventually influencing the
com ponents of final demand spending.
In further refinement o f the Keynesian theory, a

sector.

Several types o f variables appear in this
First, the instruments of monetary policy

discount rate.
N on borrow ed reserves serve as a
p rox y for open market operations. Second, demands
for short-term financial assets are explained. These
assets include free reserves, demand deposits, cu r­
rency, com m ercial loans, and time deposits held by
banks, savings and loan associations, and mutual
savings banks. Supply, i.e., rate setting, equations
explain interest rates on T reasury bills, com m ercial
loans, com m ercial paper, m ortgages, industrial bonds,
and state and local bonds. Other rate setting equa­
tions determine the stock market yield and rates on
time deposits held by banks, savings and loan asso­

number of writers now argue that changes in the

ciations, and mutual savings banks.

m oney supply have direct wealth effects on co n ­

ture equation relates the corporate bond rate to the

A term struc­

sumption spending, in addition to the indirect wealth

com m ercial paper rate.

effects operating via interest rate changes, described

T h e workings o f the financial sector may be illu­

above.
T w o other characteristics of neo-Keynesian models

strated by tracing the effects o f a Federal Reserve
purchase of Governm ent securities, represented in the
model as an increase in n onborrow ed reserves, R U .

7 William L. Silber, “ Monetary Channels and the Relative Importance
of Money Supply and Bank Portfolios,” Journal of Finance, 24
(March 1969), 81-2.

A s shown in E xhibit 3, this purchase causes a rise

8 Ibid., pp. 84-5.

9 See de Leeuw and Gramlich, op. cit., p. 2G6.




FEDERAL RESERVE BA N K OF RIC H M O N D

7

in free reserves, R F , and a rise in the price o f T reas­
ury bills, represented by a fall in the bill rate, R T B .
Com m ercial banks are assumed to have, under given
market conditions, a desired proportion o f earning
to non-earning assets (reserv es).
A n increase in
nonborrow ed reserves low ers the proportion o f earn­
ing assets in the banks’ portfolios below the desired
level.
In attempting to restore this ratio, banks
attempt to purchase similar fixed cou pon short-term
financial assets, increase their loan offerings, and
increase their demands for com m ercial paper. T he
declining T reasury bill rate represents not only a
decline in the yield on short-term Governm ent se­
curities but also a decline in short rates generally, for
which R T B is a p rox y . Other short rates, the co m ­
mercial paper rate, R C P , and the rate on com m ercial
loans, R C L , follow R T B downw ard. T here follow s
a com plex adjustm ent process serving to restore
portfolio balance to the com m ercial banking market.
T his process is expressed prim arily in the equations
that determine the time deposit rate and the com ­
mercial loan rate.10
Part of the adjustm ent involves acquisition of
longer-term financial assets, represented by a term structure relationship linking the com m ercial paper
rate and the corporate bond rate, R C . T he corporate
bond rate influences other long-term rates, the m ort­
gage rate, R M , and the stock market yield, R D .
T hese rates pass the m onetary stimulus to the real
sector by way of the industrial bond rate, R C B I ; the
state and local governm ent bond rate, R S L ; and the
deposit rates of nonbank savings institutions, R S L A
and R M S B .
The Financial-Real Sector Linkage

M o n e ta ry

effects spread through the econom y by way o f three
separate ch ann els: the cost o f capital, the net w orth
of households, and the availability of credit to the
household sector. Continuing the above illustration,
the impact of low er interest rates may be traced in
E xhibit 4.

T he cost-of-capital channel captures the

effect of three long-term

interest rates— the c o r­

porate bond rate, the m ortgage rate, and the stock

expenditures for single and multiple fam ily housing,
and state and local governm ent construction spend­
ing.11

market yield —on investment expenditures for plant

The net worth channel passes the effect o f chang­

and equipment, expenditures for consum er durables.

ing rates o f return on bonds to the stock yield, to
equity values in the net worth of households, and to

1 This process is simplified in two ways for presentation in Ex­
0
hibit 3. First, the portfolio balance terms are commercial loan-todeposit ratios, which serve as measures of portfolio composition in
determining each financial institution’s desired deposit or loan rate.
The actual market rate is a function of the discrepancy between the
lagged actual rate and the desired rate. For simplicity, in Exhibit 3
each separate component of these ratios is shown rather than the
CL
full ratio. For example, rather than showing the ratio: --------------,
D D+DT
each component— commercial loans, CL; demand deposits, DD; and
time deposits, DT— is shown separately. Second, in order to simplify
the chart and to emphasize financial market interaction, no real
sector feed-back variables appear. These variables, such as GNP or
net worth, enter the several asset demand equations as transactions
or scaling variables. For further discussion of these points, see
de Leeuw and Gramlich, op. cit., pp. 267-80.

8



consumption expenditures.
Finally, credit rationing, the third channel, is found
to be important in the housing sector.

Savings in ­

stitutions experience large fluctuations in their de­
posit flows, because of the sluggishness of their
lending and deposit rates.

In addition, their p ort­

1 For a more detailed description of the cost-of-capital channel, see
1
de Leeuw and Gramlich, loc. cit.

MONTHLY REVIEW, FEBRUARY 1973

Exhibit 4

FIRST-ROUND EFFECTS OF MONETARY POLICY IN THE FRB-MIT MODEL
B A S IC
IN T ER E ST
RAT E

Source:

IN V E S T M E N T
R A T E S O F RE T U R N

C O S T O F C A P IT A L
O N T A N G IB L E
C A P IT A L

VALUE OF
NET W ORTH

R A T IO N IN G
V A R IA B L E

E X P E N D IT U R E
D E C IS IO N V A R IA B L E S

F IN A L
E X P E N D IT U R E S

de Leeuw and Gramlich, "The Channels of Monetary Policy/' Journal of Finance, May 1969, p. 281.

folios usually include a high proportion o f long-term ,

size o f this markup include a productivity

low turnover m ortgages. In times of rising interest
rates, these institutions are forced to restrict m ort­
gage lending.
T h is non-price rationing o f credit

variable, which allows producers to maintain profit
shares even though wages rise faster than prices.
Dem and shifts and non-labor cost-push forces are

influences the residential construction com ponent o f
final demand.

other factors involved in this essentially non-m onetary theory o f the price level.

trend

T he F R B -M I T m odel thus illustrates tw o basic
characteristics of neo-Keynesian m od els:
(1 ) a
highly detailed sector-by-sector buildup of aggregate
demand and ( 2 ) a detailed specification o f the p ort­
folio adjustm ent process that attaches a central role
to interest rates as an indirect link between m onetary
policy and final demand.
A s a point of com parison with M onetarist models,
one further characteristic o f the F R B -M I T model
should be mentioned.

Prices are determined in this

model by real sector forces, that is, by a variable
markup over wage costs.12 Factors influencing the

III.

THE MONETARIST VIEW

A lthough the quantity theory was in eclipse during
the period of neo-K eynesian preeminence, a group
of economists, led by P rofessor M ilton Friedm an at
the U niversity of Chicago, continued to develop the
M onetarist approach, restructuring the theory and
gathering supporting statistical evidence.

W ith the

problem s of increasing inflation in the late 1960’s
and the questionable effectiveness o f the 1968 tax
surcharge in dampening inflationary pressures, the
policy prescriptions and forecasts o f neo-K eynesian

12 See de Leeuw and Gramlich, op. cit., Appendix, pp. A15-16.




economists became increasingly subject to question.13

FEDERAL RESERVE BA N K OF R IC H M O N D

9

T h e M onetarist view gained increased respect am ong
academic econom ists and policymakers.

Monetarist Theory
M odern Monetarists consider the econom y basic­
ally stable, with m ost elements of instability the
product o f faulty monetary arrangements or im proper
policy. T he reasoning behind this may be briefly
summarized. First, there is a stable, but not precise,
relationship between the grow th rates o f m oney and
nominal, i.e., current dollar, national incom e or G N P .
If m oney balances g ro w m ore rapidly in relation to
incom e than people wish, they will attempt to spend
the excess, causing prices to rise.

O n the other hand,

if m oney grow s too slow ly in relation to income,
people w ill try to build up their cash balances by
reducing spending, which w ould result in a slow ing of
incom e grow th and rising unem ployment.14 Changes
in m oney and incom e do not occur simultaneously.
O n the average, a change in monetary grow th will
result in a change in real output grow th six to nine
months later, follow ed by changes in prices in another
six to nine months, according to Friedm an’s esti­
mates.15
Carrying this logic further, the M onetarists co n ­
sider fiscal policy, when not accom panied by changes
in the m oney supply, to be an unlikely source ot
econom ic change. F o r example, increased G overn ­
ment spending, if not accompanied by m onetary e x ­
pansion, will tend to “ crow d out” som e private
spending and have minimal impact on aggregate
dem and.16 Fiscal policy distributes incom e between
the private and public sectors but has little impact
on price level changes.17 Thus, short-run variations
in prices, output, and employm ent are thought to be
dominated by movements in a policy-determ ined
m oney supply.18
L on g-ru n real econom ic grow th, on the other hand,
is thought to be independent of monetary change,
being determined by basic grow th factors such as
expanding productive capacity, population grow th,
advancing technology, and natural resources.

In the

long run, m onetary change affects only the price
1 There is some debate concerning the effectiveness of the 1968 tax
3
surcharge. See, for example, Robert Eisner, “ Fiscal and Monetary
Policy Reconsidered,” American Economic Review, 59 (December
1969), 897-905; and the subsequent comments and reply in American
Economic Review, 61 (June 1971), 444-61. See also, Milton Fried­
man, “ The Counter-Revolution in Monetary Theory,” Occasional
Paper No. 33 (London: The Institute of Economic Affairs, 1970 f,
pp. 19-20 and Arthur M. Okun, “ The Personal Tax Surcharge and
Consumer Demand, 1968-70,” Brookings Papers on Economic A c­
tivity (January 1971), pp. 167-213.
1 William N. Cox, III, “ The Money Supply Controversy,” Monthly
4
Review, Federal Reserve Bank of Atlanta, 54 (June 1969), 73.
15 Friedman, op. cit., p. 22.
1 Andersen and Carlson, op. cit., p. 8.
6
17 Friedman, op. cit., p. 24.
1 Ronald L. Teigen, “ A Critical Look at Monetarist Economics,”
8
Review, Federal Reserve Bank of St. Louis, 54 (January 1972), 13.

10



level. A ccordin gly,
policy is to “ prevent
source o f econom ic
stabilization policy

the basic objective o f m onetary
m oney itself from being a m ajor
disturbance.” 19 It follow s that
should seek a grow th rate o f

money that closely approxim ates the long-term rate
of grow th of real productive capacity.
T he M onetarist view o f the role o f interest rates
in the policy transmission process may be summarized
in the follow in g w a y :
. . . Monetary impulses are . . . transmitted by
the play of interest rates over a vast array of
assets. Variations in interest rates change rela­
tive prices of existing assets, relative to both
yields and the supply prices of new production.
Acceleration or deceleration of monetary im­
pulses are thus converted by the variation of
relative prices, or interest rates, into increased
or reduced production, and subsequent revisions
in supply prices of current output.20

Further, while interest rates serve to facilitate real
and financial asset adjustm ents, “ the impact o f
changes in m oney on any specific interest rate is
both too brief and too weak to be either captured
statistically or identified as a strategic variable in the
transmission process.” 21 Therefore, the M onetarists
view the m on ey supply as the strategic variable,
affecting incom e directly. T his view may be repre­
sented schematically a s :
O M O ----- - M ----- - S P E N D I N G — - G N P .
A com parison o f this description with the general­
ized neo-Keynesian portfolio adjustm ent process, as
illustrated by the F R B -M I T m odel, focuses on tw o
crucial points at issu e : the range o f assets involved
in the adjustm ent process and the response patterns
o f interest rates and prices. Concerning the form er,
Friedm an argues that the spectrum o f assets and
rates o f return influenced by m onetary action is e x ­
tremely broad, including many im plicit rates, which
are not recorded.22
Friedm an further argues that recorded rates do
not reflect the real cost o f capital but rather include
anticipated rates of inflation.

M oreover, m onetary

policy may be routed through as yet undiscovered
channels.

In short, the transmission process is too

complicated to be captured by statistical models.

T he

standard practice of using recorded interest rates both
1 Milton Friedman, “ The Role of Monetary
9
Economic Review, 58 (March 1968), 12.

Policy,”

American

2 Karl Brunner, "The Role of Money and Monetary Policy,” Review,
0
Federal Reserve Bank of St. Louis, 50 (July 1969), 18.
2 W . E. Gibson and G. C- Kaufman, “ The Relative Impact of Money
1
and Income on Interest Rates: An Empirical Investigation,” Staff
Economic Studies (Washington, D. C. : Board of Governors of the
Federal Reserve System, 1966), p. 3.
22 Friedman, Occasional Paper No. 33, p. 25.

M ONTHLY REVIEW, FEBRUARY 1973

Exhibit 5

FLOW DIAG RAM OF THE ST. LOUIS MODEL

Source:

Andersen and Carlson, " A Monetarist M odel for Economic Stabilization," Review, Federal Reserve Bank of
St. Louis, April 1970, p. 10.

underestimates the full impact of monetary actions

effect.24 Thus, changes in interest rates may be only

and narrows the scope of the transmission process to

a result o f the adjustm ent process, rather than a

only a relatively few channels.

crucial lin k; and may be directly, rather than in­

Therefore, Friedm an

concludes, even the most com plex econom etric model

versely, related to changes in money.

cannot adequately represent the monetary process.23

Prices, in this process, are a function o f “ demand

Monetarists also question the response patterns o f
interest rates and prices in neo-Kevnesian models.
T h ey regard the fall in interest rates in response to

pressure” — determined by h ow close to full em ploy­
ment the econom y is operating.
In addition, an
accumulation o f price changes over time tends to

monetary expansion as a tem porary effect.
In a
lon ger view , monetary expansion, whether via inter­
incom e and expenditures. T he M onetarists are care­
ful to distinguish nominal from real changes. W hen

generate “ price expectations,” which serve as a sepa­
rate influence in future price movements. Thus, the
long-run insensitivity o f real variables to changes in
the m oney supply and the predom inant short-run in ­
fluence of m oney on real output and em ploym ent are

the econom y is operating below the full-em ploym ent

consistent.

est rate effects or direct spending effects, causes rising

level, changes in nominal m oney may significantly

The St. Louis Model

affect real econom ic variables— output and em ploy­
ment— rather than raising prices. A s the econom y

T h e process described above has recently been in­

approaches full employm ent, however, quantities be­

corporated into an econom etric model by the Federal

com e less responsive, and prices begin to rise.

Reserve Bank of St. L ouis.25

T he

real value of money balances grow s more slow ly, or

T h e m odel makes no

declines, causing a reversal of the initial interest rate

2 For similar, but more detailed, expositions see Friedman, “ The
4
Role of Monetary Policy,” American Economic Review, 58 (March
1968), 6; and David I. Fand, “A Monetarist Model of the Monetary
Process,” Journal of Finance, 25 (May 1970), 279-83.

2 Yung C. Park, “ Some Current Issues on the Transmission Process
3
of Monetary Policy,” IM F Staff Papers, 19 (March 1972), 24-6.

2 For a more detailed development, see Andersen and
5
op. cit., pp. 8-11.




FEDERAL RESERVE BA N K OF R IC H M O N D

Carlson,

11

attempt to specify the structure of the eco n o m y ;
rather, it explains such broad measures as total
spending, prices, and unem ployment in terms of
changes in money, Governm ent expenditures, poten­

In sum, the St. L ouis model is a direct form ulation
of the M onetarist view that m onetary changes p re­
dominate short-run changes in the real econom y,
while in the long run m oney affects only nominal

tial output, and price expectations.

quantities.

T h e process by which monetary action predom i­

This model also reflects the contention

that the full transmission mechanism cannot be cap ­

nates short-run changes in total spending can be

tured by econom etric models.

seen by tracing through the flow chart, E xhibit 5.

found between m oney and total spending becom es the

T he responses in the actual model accumulate over a

basis fo r a small, simple model that explains changes
in broad econom ic aggregates in terms o f changes in
the m oney supply.

number of periods, but no lags except price changes
appear in the chart.
GNP,

responds

T otal spending, measured by

m ore

strongly

to

m oney

T he stable relationship

supply

IV.

SUMMARY

changes than to changes in the full-em ploym ent bud­
get. T h e latter actually has a negative impact after
three quarters, reflecting the M onetarist’s “ crow ding

econom etrics and has exam ined the econom etric im ­

out” hypothesis.

plications o f tw o alternative theories o f the monetary

Potential output is determined by underlying fa c­
tors such as grow th o f natural resources, technology,
labor force, and productive capacity. T otal spending

process. Both the neo-Keynesians and the Mone-i
tarists see a general portfolio balance mechanism at
w ork in the econom y, but agreement seems to stop
there. T heir divergent views concerning the im p or­

and potential output together determine the amount

T his article has presented a summary view o f

o f “ demand pressure” existing in the econom y in the

tance o f interest rates, the direction of effect o f m oney

short-run.

Dem and pressure, a measure of short-run

on interest rates, the nature o f price determination,

market conditions, com bines with long-run price e x ­
pectations to determine the current change in the
price level. P rice expectations, measured by a five

and the feasibility of representing the adjustm ent

quarter weighted average of past price level changes,
enter price determination as a separate influence.
T he model thus determines changes in total spend­
ing and prices separately.
Short-run changes in
real output are then calculated as a residual by

process econom etrically have been discussed above.
A lthough the tw o m odels presented here are repre­
sentative o f current thinking, som e preliminary m ov e­
ment tow ard synthesis is evident. R ecent analytical
w ork has introduced prices into Keynesian m odels
as endogenous variables.26

Later unpublished v e r­

sions of the F R B -M I T model are structured so that

subtracting the price factor from changes in total

either the m oney supply or reserves may be used as a

spending.

policy variable.27 Recent unpublished M onetarist
w ork specifies structural detail m ore than in the

Changes in output are subtracted from changes in
potential output to determine the G N P gap, a meas­
ure of productive slack in the econom y. T h e unem­
ploym ent rate is directly related to current and past
levels of the G N P gap.

Changes in output com bine

with changes in the m oney supply, current and past
changes in price levels, and price expectations to
determine the level of interest rates. Market interest
rates are a result of market interaction, not a crucial
link in the transmission process as in the Keynesian
view.

12




past.28 T he problem o f im plicit interest rates re­
mains unresolved. T he resolution o f this problem
and the thrust o f current research point in the d irec­
tion of larger, m ore detailed econom etric m odels.
Joseph M . C rew s
“ Arthur Benavie, “ Prices and Wages in the Complete Keynesian
Model,” Southern Economic Journal, 38 (April 1972), 468-77;
Teigen, op. cit., p. 15 and footnote 27.
2 “ FRB-M IT-PEN N Econometric Model,” unpublished staff paper,
7
Federal Reserve Board of Governors, July 13, 1971.
2 Leonall C. Andersen, “ Influence of Monetary and Financial
8
Actions in a Financially Constrained Economy,” unpublished paper.
May 1971, p. 40.

MONTHLY REVIEW, FEBRUARY 1973

ew J>urpnses in j>tore . . .

FORECASTS 1973
T h e forecasters this year expect the econom y to
m ove ahead at about the same rate as in

1972

in consum ption expenditures. Indications, now , seem
to be that the inventory accumulation will proceed

but with gradually decelerating quarter-by-quarter

m ore rapidly in 1973.

growth.

T he rate o f un­

M ost o f the forecasters included in the consensus,
none o f w hom anticipated the President’s Phase I II

employment, however, is expected to fall somewhat

program , thought that wage and price controls would

m ore than in 1972.

continue at least until A pril.

T hey also expect the rate of inflation to

remain about the same as in 1972.

In general, this year’s crop of

T hey expected Federal

forecasters foresee few m ajor surprises in store for

G overnm ent expenditures to increase only modestly,

us.

but state and local expenditures to rise m ore than

Last year’s consensus forecast fell short of the
G N P gain realized in 1972 and also underestimated
the im provem ent in the inflation rate.

But it over­

stated the amount of decline in the unemployment
rate. T his year’s forecasts might have been influ­
enced by these 1972 misses. In any case they, in
general, call for g ood econom ic grow th, moderate

last year’s 10.1 percent because of revenue sharing.
T h e 1973 forecasts summarized here represent the
best efforts of business and academic economists
during the autumn and early winter of 1972 to pre­
dict the perform ance o f the U . S. econom y in 1973.
This article attempts to convey the general tone and
pattern of some 50 forecasts reviewed by the Research

price increases, and a modest decline in the unem ­

Department of this Bank.

ployment rate.

com prehensive forecasts, and some incorporate esti­

M any forecasters expect to see substantial in­

N ot all o f them are

mates o f the future behavior o f only a few key e co ­

creases in consum er expenditures, particularly for

nom ic indicators.

durable goods. T he durable g ood s expenditures will
be buoyed by large, in many cases unexpected, F ed ­

than individual efforts.

eral tax refunds brought about by over-w ithholding
during 1972. Significantly increased social security
benefits are also expected to boost consumer outlays.
T he surge in consum ption is expected to be especially

Several represent group rather

T he vietvs and opinions set forth

in this

article arc those of various forecasters.

No

agreem ent or endorsem ent by this Bank is im ­
plied.

heavy during the first and second quarters o f the
year. M any forecasters predict that automobile sales,
in particular, will turn in an excellent perform ance in
1973.

1972 FORECASTS IN PERSPECTIVE
T he consensus forecast fo r 1972 G N P published

O n the other hand, some believe that because

in last F ebruary’s M on th ly R ev iew was $1,141.0

o f an expected slow ing in residential construction,

billion, a projected increase of 9 percent over 1971.

sales o f household durables will increase at a slower

T he collection of forecasts ranged from a low of
$1,135.0 billion to a high of $1,155.0 billion. A fter
allowing for expected price rises, the grow th of real

rate than in 1972.
Business investment is expected to increase at
about the same rate as in 1972, but most of the 1973

G N P was predicted to account for slightly over tw o-

increase is expected in inventory accumulation and

thirds o f the 9 percent rise.

in expenditures for business plant.

The predicted in­

Department of C om m erce indicate a 1972 G N P total

creases in plant expenditures are attributed to an

of $1,152.1 billion, which is over $11 billion higher

Latest estimates by the

expected availability of long-term funds at only m od ­

than the consensus forecast of the business and aca­

estly higher interest rates, com bined with a stronger

demic economists.

demand for increased plant capacity.

seers overestimated the G N P by only $3 billion, the

Com pared to

1971, when the

Business inventories are expected to be a leading

1972 forecasting perform ance seems to leave som e­

source of grow th in 1973 as businesses respond to
increases in sales. M any forecasters were surprised

thing to be desired, at least so far as current dollar
G N P is concerned.

that inventory investment increased by such a small

In late 1971 and early 1972, forecasters were an­

amount in 1972 in the face o f an 8.5 percent increase

ticipating an increase in the implicit price deflator




FEDERAL RESERVE BA N K OF R IC H M O N D

13

RESULTS FOR 1972 A N D T YPICA L FO RECAST FOR 1973

Unit or
Base

Preliminary
1972

Gross national product ________________ ___________ $ billions

Forecast
1973*

Percentage
Change
1972/
1971/
1972
1973

1,152.1

1,261.5

9.7

9.5

Personal consum ption expenditures .___________
Durables _________________________ ___________
N ondurables _____________________ ___________
Services __________________________ ___________

$
$
$
$

billions
billions
billions
billions

721.1
116.3
299.5
305.4

784.6
127.5
323.8
332.6

8.5
12.4
7.7
7.8

8.8
9.6
8.1
8.9

___________
G ross private domestic investment
Business fixed ____________________ ___________
Residential structures _____________ ___________
Change in business inventories ______________

$
$
$
$

billions
billions
billions
billions

180.2
120.4
53.9
5.9

201.5
135.5
54.0
10.5

18.6
13.8
26.5

11.8
12.5
0.1

—

—

Governm ent expenditures __________ ___________ $ billions
N et exports _________________________ ___________ $ billions

254.9
-4 .1

276.8
-0 .6

9.5
—

8.6

Gross national product (1958 dollars) _
.___________ $ billions
Plant and equipment expenditures ______________ $ billions
Corporate profits before taxes _______ ___________ $ billions

789.7
88.49
93.9

837.1
99.46
105.9

6.5
9.0
12.7

6.0
12.4
12.8

Private housing starts ________________ ___________
A utom obile sales _______________________ ___________

millions
millions

2.38
10.76

2.10
11.01

16.1 6.2

11.7
2.3

Rate of unemployment ________________ ___________

percent

5.6

5.0

—

—

Industrial production i n d e x _______________________
W holesale price index ____________________________
Consumer price in d e x _________________ ___________
Im plicit price d e fla to r _____________________________

1967=100
1967=100
1967=100
1958=100

114.1
118.7
125.1
145.9

122.1
122.5
129.4
150.7

6.8
4.2
3.1
3.0

7.0
3.2
3.4
3.3

* Figures are constructed from the typical percentage change forecast for 1973.

for G N P of around 3.2 percent.

Compared to their

billion in the second, $25.8 billion in the third, and

perform ance during the past tw o years, the forecast­
ers came remarkably close to predicting the rate of

$25.6 billion in the fourth. T he realized increases
com e to $31.0 billion, $30.3 billion, $24.6 billion, and

increase in this price index, which actually rose 3.0
percent during the year. Thus, the consensus was
for a rate of grow th of real G N P of slightly under 6
percent for 1972. Real G N P in 1972 increased 6.5
percent, com pared with the 1972 consensus forecast
of slightly under 6 percent.

The predictions for real

G N P were closer to the mark than the predictions
for current dollar G N P

because of the offsetting

$31.8 billion for the four quarters, respectively.

The

quarterly predictions of the implicit G N P deflator
were 3.4 percent, 3.0 percent, 3.3 percent, and 3.3
percent. F or the four 1972 quarters, the implicit
deflator rose at annual rates of 5.1 percent, 1.8 p er­
cent, 2.4 percent, and 2.7 percent during the year.
The consensus
consum ption

1972 forecast projected personal

expenditures fo r the year at $717.8

errors in the predictions o f current dollar G N P and

billion.

Current estimates place the figure at $721.1

prices.

billion.

Gross private dom estic investment was also

A pparently, the wage and price control p ro ­

gram w orked even better than our forecasters e x ­

underestimated and by a substantial $12.7 billion

pected.

margin.

A lthough

the forecasters

came

close

to

That account was predicted to reach $167.5

predicting the actual amount of increase in the im ­

billion, but it actually totaled $180.2 billion.

plicit deflator, it is of interest that their error was on

underestimate was characteristic of all three com p on ­

the high side.

In past years, forecasters exhibited

ents of gross private dom estic investment

T he

(in v en ­

a definite tendency to underestimate the rate o f price

tories, business investment, and residential con stru c­

increase.
The consensus of quarter-by-quarter forecasts for

tio n ), but much of it was attributable to the greater-

1972 was for current dollar G N P to rise by ap p rox i­

struction.

mately $26.5 billion during the first quarter, $25.4

had private housing starts totaling 2.07 m illion in

14



than-expected continuing upsurge in residential co n ­

MONTHLY REVIEW, FEBRUARY 1973

A year ago, the consensus of forecasters

1972. T h e realized figure was 2.36 million, a new
record.
W ith respect to the public sector of the econom y,
governm ent purchases of g ood s and services were
predicted relatively accurately.
The consensus of
forecasters projected outlays of $252.7 billion on a
National Incom e A ccoun ts basis.
T he figure
amounted to $254.9 billion.
Sum m ing the errors in predicting consum ption e x ­
penditures, gross private dom estic investment, and
governm ent

purchases

of

g ood s

and

services,

it

Personal consum ption expenditures are expected to
total $785.2 billion in 1973, up 8.8 percent from 1972.
Forecasters estimate that expenditures for durable
good s will increase at a faster rate than those for
either nondurables or services.
Governm ent purchases o f g ood s and services are
projected to total $276.6 billion. T his estimate repre­
sents an 8.6 percent increase, somewhat less than the
9.4 percent gain o f 1972. T he largest share o f this
year’s increase will occur am ong state and local
governm ents, w hose finances will benefit substan­

seems that the forecasters were $18.2 billion too low .

tially from

If the one remaining com ponent o f G N P , net exports

sharing program s.

of good s and services, had not been considerably
overestimated, they would have been much further
from the mark than the $11 billion mentioned earlier.

rise about 11.8 percent to $201.1 billion. This esti­
mated increase is considerably smaller than the sub­

Net exports, predicted to show a surplus o f $3.0
billion, actually were $4.7 billion in deficit.

business fixed investment is projected to show ap­

A lthough

the

forecasters

underestimated

the

grow th of real G N P , which is presumably a deter­
minant of the unemployment rate, they expected the
unemployment rate to fall somewhat m ore than it

funds obtained through new revenue-

Gross private domestic investment is expected to

stantial 18.4 percent gain registered for 1972.

WTiile

proxim ately the same rate o f increase in 1973 as it
did in 1972, expenditures fo r residential structures
are expected to show only a slight gain this year.

A s a matter o f fact, virtually every

T h e forecasters were far from unanimous about esti­
mates for the residential construction sector— p ro je c ­

observer o f the econom ic scene expected a greater
recovery in unemployment than materialized. T he

tions ranged from an increase of 8.8 percent to a d e­
cline o f 7.6 percent— but m ore than half projected

unemployment rate, forecast to average 5.4 percent
fo r 1972, actually averaged 5.6 percent.

forecasters, however, did indicate declines from the

In other areas, the 1972 forecasters underestimated,

record-high grow th characterizing the construction

actually did.

by a slight margin, the recovery o f industrial p rod u c­
tion. T he industrial production index rose 6.8 per­
cent for the year, against a forecast of a 6.5 percent
gain.

T he recovery in profits, however, was over­

estimated. Corporate profits before taxes were p re­
dicted to increase 15 percent but in fact rose only 12.7
percent.
T he Price C om m ission’s profit margin
ruling may have figured in the miss. T he forecasters
were on target with their prediction for a 3.12 p er­

F o re ca sts fo r 1973 c u r ­

rent dollar G N P center around $1,261.7 billion. This
typical forecast represents an approxim ate 9.5 per­
cent yearly gain, which is slightly less than the 9.7
Price increases

are expected to amount to 3.3 percent and thus to
account for about a third of the rise in G N P this
year.

Estimates for G N P

T he consensus prediction, in fact,

Inventory investment is expected to increase around
$4.9 billion for 1973.
Industrial Production

T h e m edian fo re ca st for

the Federal R eserve index o f industrial production
(1 9 6 7 = 1 0 0 ) is 122.1, which indicates an increase of
Anticipated gains are greatest in steel, automobile,
and consum er household durables production.

1973 FORECASTS IN BRIEF

percent increase registered in 1972.

industry in 1972.

indicates an actual decline in real (constant dollar)
residential construction spending from its 1972 level.

7.0 percent, only slightly greater than that of 1972.

cent increase in consumer prices.

Gross National Product

within a range of — 2.0 percent to — 2.0 percent. A ll
1
—

range from a low

$1,250.0 billion to a high o f $1,269.7 billion.

of

The

typical quarterly estimates indicate that G N P should
increase almost $30.0 billion in the first quarter 1973.
Increases are expected to decline steadily thereafter

Housing T h e c o n str u c tio n in d u stry is e x p e cte d
to experience some slow ing from its record 1972
pace.

T he consensus forecast calls fo r a total of 2.10

million private housing starts, around 280,000 less
than the 1972 total.

Forecasters are impressed with

the grow in g vacancy rates for apartments and seem
to believe that pent-up housing demand has been
largely accom m odated by houses built in the 1970-72
housing boom . Residential construction expenditures
are expected to total $54.0 billion for 1973, ap p rox i­
mately the same as in 1972.

and to dip to approxim ately $24.0 billion by the

Corporate Profits

fourth quarter.

cates that this year should be slightly m ore profitable




FEDERAL RESERVE BA N K OF RIC H M O N D

T h e co n se n su s fo r e c a s t in d i­

15

Quarter-by-Quarter Forecasts T w e n t y fo r e c a s t­
ers made quarter-by-quarter predictions fo r 1972.
A s indicated by the accom panying table, these fo re ­

T Y P IC A L* Q U ARTERLY FO RECAST FOR 1973
Q uarter-by-Q uarter C hanges in Billions of Dollars
Unless Otherwise Noted

casters generally foresee an increase in G N P fo r the
first quarter of around $30.0 billion, with gradually
declining quarterly gains over the rest o f the year.

I

Personal Consumption
Expenditures
Gross Private Domestic
Investment
Net Exports

III

IV

29.9

26.2

24.5

23.9

16.2

16.5

15.4

14.9

5.7

4.9

5.1

4.0

quarter forecast called for an increase o f $99.1 billion
over the fourth quarter 1972 total.
T h e highest
predicted an increase o f $121.8 billion. Prices, as

-1 .7 -1 .3 -0 .5

Gross National Product

II

0.0

measured by the im plicit price deflator, are expected

T o illustrate the diversity in their estimates o f the
expansion path fo r G N P , how ever, the low est fourth

7.0

4.8

5.8

6.2

to increase to 4.1 percent in the first quarter, then

Implicit Price Deflatorf

4.1

3.2

3.5

3.7

Rate of Unemployment(%)

5.2

5.0

5.0

4.9

slow to a rate o f 3.2 percent in the second, then grad ­
ually rise again in the third and fourth. N et exports

Government Purchases

are anticipated to continue to im prove until im ports
and exports balance in the fourth quarter. T h e un­

* Median.

employm ent rate, on the other hand, is expected by

f Percentage changes at annual rates.

m ost to decline by 0.4 of a percentage point to 4.9
percent by the fourth quarter o f 1973.

T h e fourth

for business than 1972, with pretax corporate profits

quarter unemployment estimates ranged from 4.7
percent to 5.2 percent, so none o f the seers is looking
for a sharply declining unemployment rate during the

expected to rise 12.8 percent to $105.9 billion.

year.

P re­

dictions for grow th in profits ranged from around
11.0 percent to 16.0 percent.
Unemployment

M o s t fo re ca ste rs are p re d ictin g

Summary F o re ca ste rs g e n e ra lly u n d erestim a ted
the prim e econom ic indicators fo r 1972. P relim in­
ary estimates for

1972

indicate that the typical

a decline in the rate of unemployment in 1973. M any

forecast for G N P was som e $11 billion low er than

predict the rate will dip below the 5.0 percent mark
by the end o f the year. T he median forecast for the

the actual amount. O veroptim ism , on the other hand,
was reflected in the areas of inventory accumulation,

year is around 5.0 percent, well below the 5.6 percent

unemployment, profits, and especially in the U . S.

average for 1972. Since the unemployment rate aver­
aged 5.2 percent in N ovem ber and Decem ber, h ow ­
ever, the expected fall in the unemployment rate is

trade position. T he typical forecast for net exports
was $3.0 billion ; in actuality, net exports declined
$4.1 billion. P rojections fo r expenditures fo r n on ­
durable good s and the percentage increase in the

rather small.

consum er price index, however, were right on target.
Forecasters seem to be in substantial agreement

Prices T h is y ea r the co n se n su s fo re ca st in d ica tes
some increase in the rate of advance o f prices. T he
implicit G N P deflator, which rose 3.0 percent in

concerning the 1973 outlook and, as the consensus

1972, is expected to increase 3.3 percent.

favorable econom ic activity. A cco rd in g to m ost p ro ­

T he co n ­

sumer price index is also expected to increase m ore
rapidly, 3.4 percent com pared to 3.1 percent in 1972.
T he wholesale price index, on the other hand, is e x ­
pected to rise at a slower rate than it did in 1972.
N et Exports

forecast indicates, are anticipating another year o f
jections, the 1973 econom y will be characterized by a
declining unem ployment rate, an im proving trade
position, and a healthy expansion that will gradually
slow to m ore “ norm al” grow th.

T h e n a tio n ’s trade p o s itio n , w h ich

Som e forecasters expressed concern over the possi­

showed a deficit o f over $4 billion in 1972 was of

bility of excessive grow th exem plified by overspend­

prim ary interest to forecasters this year. T he seers
were unanimous in p rojectin g an im provem ent in

however, believe that the challenge o f prom oting a

net exports with estimates ranging from a deficit of
$3.4 billion to a surplus of $2.0 billion.

M ost fore­

casters projected net exports around — $0.6 billion
for 1973, a considerable im provem ent over this year’s
hefty deficit.
16



ing that could lead to a new burst o f inflation.

M ost,

continued expansion w ithout a rekindling o f infla­
tionary fires will be met and that the result w ill be a
healthy and stable econom y fo r the new year.
W illiam E . Cullison and Carla R . G regory

M ONTHLY REVIEW, FEBRUARY 1973

FINANCIAL FORECASTS: 1973
F or 1973, most econom ists are predicting another

T he view s and opinions set forth in this article

year of rapid econom ic grow th and financial stability

are those o f the various forecasters.

similar in m ost respects to 1972.

ment or endorsem ent by this Bank or by the

Gross national

product is again expected to increase by about 10

N o a gree­

author is implied.

percent, with personal consum ption expenditures and
other G N P com ponents g row in g accordingly. Unlike
the latter 1960’s when rapid econom ic grow th was
accompanied by sharp increases in prices and interest
rates, 1972 was characterized by ready availability of
credit and, by com parison with other recent years,
relatively stable prices and interest rates.

A lthough

short-term interest rates advanced noticeably during
the fourth quarter of 1972, they remained well below
the levels recorded during the tight money periods of
the latter 1960’s.

Thus, 1973 com m ences with inter­

est rates at relatively moderate levels com pared to
recent years.

Furtherm ore, most observers see little

evidence to suggest that the U . S. econom y will be
incapable of generating sufficient funds to finance the
growth projected for 1973.
Certain developments in 1972 are responsible for
this sanguine view of the econom ic and financial
scenes. A s the pace of econom ic activity im proved
sharply during 1972, it became evident that the econ ­
om y was experiencing an expansion o f considerable
breadth, orderliness, and sustainability. N early all
sectors of the econom y were sharing in the growth,
and no serious bottlenecks seemed to be developing.
A lso, toward the end of the year, investor (and co n ­
sum er) confidence was largely restored after many
months o f anxiety and indecision. T he decisiveness
of the presidential election, the apparent breakthrough
in the Vietnam peace talks in October, and contin­
ually im proving econom ic statistics contributed to
investor confidence.
F or some time, investors in
long-term markets have been particularly sensitive to
the rate of inflation, which has an important impact
on securities prices. Increases in the general price

Short-Term Financial Markets A s the e c o n o m y
continues to expand, the demand for short-term
funds is expected to grow rapidly. In the absence o f a
comparable grow th in the supply o f short-term funds,
upward pressure on short-term interest rates similar
to that experienced in the fourth quarter of 1972 will
continue.
T he supply o f short-term funds hinges heavily on
the reserve positions o f com m ercial banks and the
cash positions o f nonbank businesses and state and
local governm ents. D uring 1972, banks and non­
bank corporations registered substantial improvement
in their liquidity. A t the same time the financial
positions o f state and local governm ents took a dra­
matic turn for the better.

A ll this helped to keep

interest rates relatively low during the first three
quarters of the year.
In 1973 there will be three important short-term
borrow ers w hose demands for funds are likely to
increase over 1972— businesses, consum ers, and the
U. S. Treasury. T he demand for funds by businesses
is expected to show the sharpest increase. F or most
o f 1972 several forces were at w ork to hold dow n the
amount o f short-term borrow in g undertaken by the
business com m unity. In general, m ost firm s were
able to accom m odate the increased demand for output
without greatly enlarging their inventories o f raw
materials and finished goods.
Inventory-to-sales
ratios were much low er than most analysts expected.
F or several reasons many corporations, especially the
large ones, en joyed highly favorable liquidity posi­
tions and internal cash flows. Corporate treasurers
had undertaken a massive program to rebuild liquid­

level have been quickly translated into interest rate

ity during 1971 by replacing maturing short-term

increases in recent years, causing large price declines

debt with freshly-issued long-term debt.

and capital losses on long-term security issues. Thus,

was unusually g o o d during 1972 as aggregate c o r ­

a reduction in inflation and inflationary expectations,

porate profits increased by 15 percent and the effects

Cash flow

which occurred in 1972, makes for an im proved cli­

of the investment tax credit and accelerated depreci­

mate of expectations, especially in bond markets.

ation allowances were felt.

T he financial forecasts for 1973 presented in this
article represent the efforts o f several well known
economists.

T heir forecasts have been aggregated

into a consensus view as shown in Tables I and II.



A lso, the limitation on

dividend payouts established under the wage and
price controls helped corporations conserve cash.
M any o f the factors lim iting the need fo r b o r­
rowed funds in 1972 are likely to be altered during

FEDERAL RESERVE BA N K OF RIC H M O N D

17

1973.

Continued grow th in the demand for output

will almost certainly force greater spending on in­
ventories and other form s of short-term assets.
Typically, such assets are financed with short-term
debt.

Profits are not expected to g row as rapidly

in 1973, and some uncertainty has developed re­

lion unit level rather than at the 9-10 million level. In
1973 consumers are expected to purchase larger cars
with m ore optional equipment, which should result in
m ore installment borrow ing. A lso, the record num ­
bers o f new houses being built need to be furnished
with assorted consum er durables. F or these reasons

garding the continuance of the investment tax
credit and other tax benefits.
Som e analysts are
even predicting a corporate tax increase sometime in

consumers are expected to continue purchasing and

1973.

have an important impact on money market b o rro w ­
ings o f finance companies and on efforts o f com m er­
cial banks to raise funds through sales of C D ’s.

A ll of this adds up to a grow in g need for

short-term funds by businesses, as shown in Table I.
T his demand will most likely be manifested in in­
creased use of bank loans, sales of com m ercial paper,
and business finance com pany borrow ing. A s banks
experience greater loan demand, they will bid more
aggressively for certificates of deposit and may sell
off some tem porary investments such as Treasury
securities and short-term municipal securities. M any
corporations will also be selling short-term securities
acquired earlier when their liquidity positions were
m ore favorable. Each o f these actions tends to put
upward pressure on short-term interest rates. M ost
analysts, how ever, as is evident from their predictions
of short-term rates for 1973 shown in Table II, do
not expect increased borrow in g by businesses to re­
sult in an unusually sharp upward shift in short-term
rates.
Consumers are also expected to increase their b o r­
row ings in 1973.

A s personal income continues to

expand, consum ers will en joy a larger cash flow ,
which can be used to pay off increased installment
borrow ing. F or some time in the recent business
slow dow n, consum ers saved at historically high rates,
presumably as a reaction to fears o f unemployment
and to continued inflation. N ow that consum er co n ­
fidence has im proved, the saving rate has retreated
somewhat, and consumers are spending m ore freely.
F or example, it appears that beginning with 1972 a
good year for automobile sales will be at the 11 mil-

borrow ing at a very substantial rate in 1973.

T heir

demands, while not exactly of a short-term nature,

Treasury Borrowing

M o s t o b s e rv e rs feel that

the T re a s u r y w ill h ave to b o r r o w a la rg er q u a n ­
tity o f fu n d s in 1973 than it did in 1972.

Som e of

the most important factors affecting Treasury b o r­
rowing, however, remain clouded with uncertainty.
In 1972 the T reasu ry’s cash position was larger than
expected on several occasions because o f purchases of
securities by foreign central banks, overw ithholding
of income taxes by individuals, and delays in expendi­
tures.
Traditionally, the T reasury has conducted most of
its financing activities in the second half o f the year,
with the first half characterized by debt repayment.
T his year, however, it is reasonably certain that the
Treasury

will

be

borrow ing,

perhaps

substantial

amounts, in the first half. A n y large amount of
contraseasonal borrow in g by the Treasury this spring
would tend to push up interest rates.
A lthough the A dm inistration has vow ed to limit
Federal expenditures in the com ing year, the high
level of expenditures built into the Federal budget
will produce a sizable deficit. Thus, new borrow in g
from the public will probably increase, as shown in
T able I. N ow that long-term interest rates are low er
than they were in 1968-1970, the Treasury has been
trying to lengthen the maturity of its outstanding debt
by selling m ore long-term securities. Notwithstand­
ing this effort, most o f the financing is still carried
out in the short-term markets because of the greater

Table I

breadth and depth o f these markets.

CONSENSUS FUNDS FORECASTS*

A lthough it

is difficult to be at all precise in forecasting the

($ Billions)

T reasury’ s need for funds in 1973, most factors point
197 2 f
Business Credit
Consum er Credit
U. S. Treasury Securities
Corporate Bonds
State and Local Debt
Residential M ortgages
Corporate Stock

1973

19
15
15
18
16
53
12

22
17
20
17
15
53
11

to an increase that will tend to put some upward
pressure on short-term interest rates.
L ong-Term Financial Markets

M o s t o b se rv e rs

see the balance between supply and demand in lon g ­
term markets as m ore favorable than in short-term
markets.

A s a result they expect very little upward

pressure on long-term interest rates.

Several ana­

* These numbers represent an estimation of the consensus forecasts
of many well known economists.

lysts, in fact, dare to hazard a prediction that long

f Estimated.

rates may decline slightly.

18



MONTHLY REVIEW, FEBRUARY 1973

These forecasters base

Table II

did in 1972.

C O N S E N S U S INTEREST RATE FO R EC A ST S*
Year end
1972
Certificates of D epositf
Treasury Billsf
Commercial Pa pe rf
Prime Rate
A a a Corporate Bonds
Bond Buyer Municipal Index
Long-Term Treasuries

5.50%
5.10%
5.50%
6 .00%
7.10%
5.10%
5.70%

M idyear
1973
6 .00%
5.60%
6 .00%
6.25%
7.25%
5.20%
6 .00%

Year end
1973
6.60%
6 .20%
6.60%
6.50%
7.35%
5.30%
6.25%

O n balance, how ever, no serious up­

ward pressures on interest rates are expected to
emerge in the tax-exem pt market.
T he demand fo r residential m ortgage funds will
probably be about the same in 1973 as in 1972.
H ou sin g starts are expected to decline somewhat in
1973, but because o f the lag between the time build­
ing begins and permanent financing is obtained,
m ortgage demand is not expected to show a com ­
mensurate decline.

T he m ajor sources of m ortgage

funds are the thrift institutions, which experienced
* These numbers represent an estimation of the consensus fore­
casts of m any well known economists.
f Three-month maturity.

record deposit inflow s in 1972.

T his process may

taper o ff somewhat in 1973, but the available supply
o f m ortgage credit is generally view ed as adequate
to satisfy demand without much upward pressure on

their predictions not only on the flow s of funds that
develop in the econom y, but also on the willingness of
investors to com m it funds to the long-term markets.
N ow that investor confidence has im proved, lon g ­
term investors w ho earlier were driven by inflation
fears into short-term markets are expected to m ove
in greater numbers back into longer commitments.
The m ajor purchasers of long-term debt, led by life
insurance companies and pension funds, are expected

interest rates.
S to c k M a r k e t

M o s t a n a lysts a p p ear to b e c a u ­

tiously bullish on the prospects fo r the stock market
in 1973.

T he rapid rate o f expansion in the econom y

should produce another year of im provem ent in c o r ­
porate earnings, with much of the increase being
attributable to increased productivity and output
rather than to inflation.

In terms of earnings p ro­

spects, many stocks are conservatively valued.

F or

to have substantial cash flow s in 1973. L ife insur­
ance companies, in particular, have im proved their

example, the price-earnings ratio for Standard and

liquidity positions since 1969-1970.

recent bull market periods.

P o o r ’s 500 Stocks is n ow much low er than in other
T he stocks of those in­

A lso contributing to the behavior o f long-term

dustries whose perform ance is closely tied to cyclical

markets will be the smaller demands of m ost lon g­
A lthough the short-term

movements in the econom y should also begin to rise
in value as econom ic expansion continues.

borrow in g needs o f business are expected to in­
crease in 1973, their need for long-term funds may

M arket analysts expect institutional investors to
continue to participate on a broad scale. Som e ana­

register a slight decline, as shown in Table I.
In historical terms, however, corporations will be

lysts also see evidence that the small investor, w ho

issuing new long-term debt at rather high rates.
O nly in the very early 1970’s during the period of
massive liquidity rebuilding, did corporations sell
m ore debt securities than they probably will in 1973.
Thus, corporations will be expanding plant and
equipment during 1973 at a healthy rate, but they
will not be financing an unusually large proportion

years, is returning to the marketplace in greater force.

of these expenditures externally.

vestors w ho entered the market in 1972 are expected

term borrow ers in 1973.

State and local governm ent financing needs are

has been relatively inactive in the market in recent
M ost analysts believe that substantial im provem ent in
econom ic conditions and the strong market perform ­
ance in recent months should allay the fear o f the
stock market acquired by many individuals during the
bear markets o f 1969-1970.

A lso, many foreign in­

to continue to invest in stocks in 1973.

T he volum e

also expected to decline slightly in 1973 from 1972

of new equity issues, shown in Table I, is expected

rates.

to be relatively large in 1973.

Funds acquired from the Federal G overn­

In the 1970’s new

ment under revenue sharing will augment the spend­

issue volum e has grow n sharply com pared to the

ing capacity of most municipalities and presumably

1960’s.

reduce borrow ing requirements. Nevertheless, like

Stock prices reflect expectations o f future earn­

corporations, state and local governm ents will record

ings perform ance, and indexes o f their movement are

one o f their highest rates o f borrow in g ever in 1973.

widely

T he supply of funds in the tax-exem pt market may be

H ence, as analysts suggest, the perform ance of the

cut back somewhat in 1973 as comm ercial banks

stock market in 1973 depends in part on expectations

channel more of their resources into loans than they

regarding the econ om y’s perform ance in 1974.




regarded

FEDERAL RESERVE BA N K OF R IC H M O N D

as

leading

econom ic

indicators.

19

T h e co u rse o f m o n e ta ry p o lic y

expansion is not excessive, that sufficient funds will

always plays an important role in shaping conditions

be generated in the process of econom ic grow th to

in financial markets.

finance the current expansion, and that the Federal

M o n e t a r y P o lic y

M ost investors now appear to

believe that the chief problem facing the Federal

R eserve will be careful to avoid the extrem es o f

Reserve System is that o f preventing an overheating
o f the econom y. Thus, many analysts are predicting

overheating or tight money.

that the Federal R eserve will attempt to moderate
the recent relatively rapid rate of grow th o f the
m oney supply in the months ahead. A t one time,
such thinking prom pted talk of a credit crunch in
1973.

O n balance, the co n ­

sensus o f forecasters is that the econom y will co n ­
tinue to expand in 1973 and that there will be suffi­
cient credit available to avoid any sharp upward
movement o f interest rates.

M ost analysts, however, feel that the current

Philip H . Davidson

F E D E R A L R E S E R V E B O A R D P U B L IC A T IO N
IN D U ST R IA L P R O D U C T IO N :

1971 E D IT IO N

The publication, I n d u s t r i a l P r o d u c t i o n : 1971 E d i t i o n , is available fo r distribution by the Board
of G overnors of the Federal R eserv e S ystem . This book provides detailed descriptive material and
statistical tables on the revision of the industrial production index, the results of which w ere sum ­
marised in the July 1971 issue of the F e d e r a l R e s e r v e B u l l e t i n . C opies are available at a charge
of $4.00 fo r single copies and $3.50 each for copies of ten or m ore sent in a single shipment. P lease
address all requests to Publications S ervices, D ivision of A dm inistrative S ervices, B oard of G overn ­
ors of the F ederal R eserv e S ystem , W ashington, D . C. 20551.

F E D E R A L R E S E R V E B A N K O F R IC H M O N D P U B L IC A T IO N
B U SIN E SS FO RECASTS FOR 1973
The F ederal R eserv e Bank of R ichm ond is pleased to announce the publication of B u s i n e s s F o r e ­
1973. B u s i n e s s F o r e c a s t s , which is a compilation of representative business forecasts
■
—with names and details of estimates— for the com ing year, is available free o f charge from this
Bank. P lease address requests to Bank and Public R elations D epartm ent, F ederal R eserv e Bank
of R ich m on d , P . O. B o x 27622, R ichm ond, Virginia 23261.
c a sts fo r

20



MONTHLY REVIEW, FEBRUARY 1973