View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

THE MONETARY APPROACH TO
ITS HISTORICAL EVOLUTION AND
Thomas M. Humphrey

One of the oldest debates in economics is that between the monetary and balance of payments approaches to the determination of exchange rates in a
flexible exchange rate regime.
The monetary approach attributes exchange rate movements largely
to actual and anticipated changes in relative money
stocks.
It stresses a channel of causation running
from money to domestic prices to the exchange rate.
By contrast, the balance of payments approach holds
autonomous nonmonetary
factors affecting individual items in the balance of payments to blame. It
stresses a causal channel running from real factors
through the balance of payments to the exchange
rate and thence to domestic prices and sometimes
further to the money supply.
Both views underlie
current discussions of the weakness of the dollarthe monetary
approach
holding excessive U. S.
money growth to blame while the balance of payments view sees excessive oil imports and the sluggish foreign demand for U. S. exports as the culprits.
Although the difference between these two rival approaches is fairly well understood, what is not so
fully appreciated is that the current debate between
them is largely a repetition of earlier disputes going
back more than 200 years.
The purpose of this article is to trace the emergence and development of the monetary approach in
three of these early controversies,
namely (1) the
Swedish bullionist controversy of the 1750’s, (2) the
English bullionist controversy of the early 19th century, and (3) the German inflation controversy
during and immediately following World War I.1
These debates are crucial to the evolution of the
monetary approach in two respects.
First, they
established the analytical foundations of the monetary approach. These foundations consist of a quan* This article draws from the author’s paper of the same
title in the forthcoming
volume A Monetary
Approach
to
International
Adjustment,
ed. by Bluford H. Putnam and
D. Sykes Wilford
(New York: Praeger
Publishers,
1978).
1 For another treatment
of the role of the monetary
and
the balance of payments
approaches
in these debates see
Johan
Myhrman,
“Experiences
of Flexible
Exchange
Rates in Earlier Periods:
Theories,
Evidence,
and a New
View,” Scandanavian
Journal
of Economics,
78, no. 2,
(1976), 169-196.

2

tity theory relationship linking money to prices, a
purchasing power parity relationship linking prices
to the exchange rate, and an expectations theory
specifying how anticipations of future money stocks
are formed and how they influence the exchange rate.
Second, the’ earlier debates are the origin of current
monetarist policy prescriptions for strengthening the
dollar. These prescriptions call for the gradual deceleration of the growth rate of the money supply so
as to eliminate the excess supply of dollars alleged to
be the basic cause of the fall of the internal and external value of the dollar.
The Swedish

Bullion &

Controversy

(1755-1765:)

One of the earliest debates in which the monetary
approach played a leading role was the Swedish bul
lionist controversy of the mid-1700’s.2
The events
precipitating the debate were as follows.
In 1745
Sweden shifted from a metallic monetary system with
fixed exchange rates to an inconvertible paper system
with flexible exchange rates.
The suspension of
convertibility was followed by a steady rise in the
prices of commodities and foreign exchange.
A
debate then arose between the two main political
parties of the time-the
so-called Hats and the Caps,
respectively-over
the cause of these price increases.
The Hat Political Party
The Hats advanced the
balance of payments theory, blaming both the external and the internal depreciation of the Swedish mark
on Sweden’s adverse trade balance. Specifically, they
held that the adverse trade balance had produced a.
depreciating
exchange, that exchange depreciation
had rendered imported goods more expensive, and
that the rise in import prices had spread to the rest
of the economy thereby raising the general level of
prices. Here is an early example of the tendency of
balance of payments theorists (1) to attribute both
domestic inflation and exchange depreciation to external nonmonetary shocks and (2) to assert a chain
of causation running from the exchange rate to
prices rather than vice versa as in the monetary ap*On what follows,
see Robert
V. Eagly, The Swedish
Bullionist
Controversy
(Philadelphia:
American
Philosophical Society, 1971).

ECONOMIC REVIEW, JULY/AUGUST 1978

proach.
Consistent with their balance of payments
view, the Hats prescribed export promotion and import restriction schemes as remedies for inflation and
eschange rate depreciation.
Nothing was said about
money.

As for policy recommendations,
Christiernin was
opposed to the Caps’ plan to restore the exchange
rate to its original pre-inflation level via contraction
of the note issue. His opposition stemmed from his
belief that prices adjusted sluggishly in response to
deflationary pressure so that the monetary contraction required to restore the exchanges to parity would
bring painful declines in output and employment
rather than the desired price decreases.
For this
reason he recommended stabilizing the exchange rate
at the level established during the inflation rather
than restoring it to the pre-inflation level3
Unfortunately, his advice was ignored and the Caps
enacted a deflationary policy that resulted in the very
drop in output and employment that he had predicted.

The Cap Party
The opposition
Cap party emphatically rejected the Hats’ balance of payments
theory and instead pointed to the importance of the
monetary factor. They blamed both domestic inflation and the external depreciation of the Swedish
mark largely on the Riksbank’s overissue of banknotes following the suspension of convertibility. They
favored a policy of monetary contraction to roll back
prices and the exchange rate to pre-inflation levels.
Their position can be summarized by the relationship

(1)

The English

E = E(M)

expressing the exchange rate E (defined as the domestic currency price of a unit of foreign currency)
as a function of the domestic money stock M.
The preceding was not tine only explanation offered
by the Caps. They also adhered to an evil-speculator
theory of exchange rate movements. This conspiracy
theory is no part of the monetary approach.
For
that reason the Caps cannot be considered as fullfledged consistent advocates of -the monetary approach.
Pehr

Niclas

Christiernin

Price

of Foreign

One participant
who
did articulate the monetary view was Pehr Niclas
Christiernin, an academic economist at the University
of Uppsala, who advanced a quantity theory explanation of the transmission mechanism linking money
with the exchange rate. In his Lectures on the High
Exchange

in

Sweden

(1761),

Christiernin maintained that the chief cause of currency depreciation was an overissue of banknotes by
the Riksbank and that causation flowed from money
to spending to all prices, including the prices of commodities and foreign exchange.
He saw monetary
expansion as stimulating demand.
Part of the demand pressure falls on domestic commodity markets
raising prices there.
The rest spills over into the
current account of the balance of payments in the
form of increased demand for imports. The resulting
import deficit then puts upward pressure on the
exchange rate which consequently rises to restore
equilibrium in the current account. Clearly, moneyinduced changes in total spending constitute the
driving force in Christiernin’s version of the transmission mechanism running from money to the exchange rate. This component has been a hallmark of
the monetary approach ever since.

Bullionist

Controversy

(1797-1819)

The monetary and balance of payments theories
clashed again in the famous controversy
over the
cause of the fall of the British pound following the
Bank of England’s suspension of the convertibility of
banknotes into gold during the Napoleonic wars.4
As in the earlier Swedish controversy,
one side
blamed currency depreciation on the central bank’s
overissue of notes while the other side blamed it on
an adverse balance of payments. This time, however,
the proponents of the monetary and balance of payments views were known as the bullionists and the
antibullionists, respectively.
The bullionists did more than any group before or
since to develop and clarify the monetary view. The
so-called strict bullionists crystallized the theory in
rigorous form and the moderate bullionists refined
and extended it.
The strict bullionists included
William Boyd. David Ricardo, and John Wheatley
while the moderate bullionists included William
Blake, Francis Horner,
William Huskisson,
and
above all, Henry Thornton.
The

Strict

Bullionists:

Ricardo

and

Wheatley

The strict bullionists made several major contributions to the monetary approach. They were the first
to specify both the quantity theory and purchasing
power parity links in the transmission mechanism
connecting money and the exchange rate. In addition, they stated the monetary approach in its most
rigid and uncompromising form, asserting that, under
conditions of inconvertibility
where money cannot
3

Ibid,

pp. 27-29, 34.

4 On the
O’Brien,
University
Studies in
Augustus

English
bullionist
controversy
see Denis
P.
The Classical
Economists
(London:
Oxford
Press,
1975), pp. 147-153 and Jacob Viner,
the Theory of International
Trade (New York:
Kelley, 1965),
pp. 119-170.

FEDERAL RESERVE BANK OF RICHMOND

3

drain out into foreign trade, the exchange rate varies
in exact proportion
with changes in the money
supply.
They arrived at this latter conclusion via
the following route.
First, they assumed that under inconvertibility domestic prices P vary in strict proportion with the
quantity of money in circulation M. This of course
is the rigid version of the quantity theory which may
be expressed as
(2)

P = kM

where k is a constant equal to the ratio of the circulation velocity of money to real output, both treated
as constants by the strict bullionists.
Second, they maintained that under inconvertibility
the exchange rate E moves in proportion to the ratio
of domestic to foreign prices P/P*.
First enunciated
by Wheatley in 1803, this proposition is the famous
purchasing power parity doctrine, so christened by
Gustav Cassel who rediscovered it more than 100
years later in 1918. The Wheatley-Ricardo-Cassel
purchasing power parity condition may be written as
(3)

E = P/P*

implying that external currency valuations derive
from their real internal values and that the general
price level and its counterpart, the purchasing power
of money, are everywhere the same when converted
into a common unit at the equilibrium rate of exchange.
Third, they assumed that the foreign price component P* of the purchasing power parity ratio was a
constant equal to the given world bullion price of
commodities so that exchange rate movements reflected corresponding movements in domestic paper
money prices only. Given this assumption the exchange rate is a good proxy for domestic prices and
may be expressed as
(4)

E = P

assuming the constant foreign price level is “normalized” and set equal to unity.5
Finally they substituted the exchange rate proxy
for the price variable in the quantity theory relationship, thereby obtaining the result
(5)

which states that the exchange rate varies in exact
proportion with the money supply.
On this basis
they were able to conclude that a rise in the exchange
rate above its gold parity constituted both proof and
measure of overissue of inconvertible currency.
In
other words, if the exchange rate stood 5 percent
above its gold parity, then this was prima facie evidence that the note issue was 5 percent above what
it would have been under convertibility.
This was
most clearly stated by Ricardo who wrote
If a country used paper money not exchangeable
for specie, and, therefore,
not regulated by any
fixed standard, the exchanges in that country might
deviate from par in the same proportion
as its
money might be multiplied beyond that quantity
which would have been allotted to it by general
commerce, if . . . the precious metals had been
used.6

Wheatley extended the analysis to the case
both countries are on an inconvertible paper
dard.
He simply substituted quantity theory
tionships for both the domestic and foreign
variables in Equation 3. This gave him the
that the exchange rate varies in proportion
relative money supplies, i.e.,
(6)

E = kM/k*M*

where
stanrelaprice
result
with

= K(M/M*)

where K is the ratio of the constants k and k*.
Wheatley stated this result when he declared that
“the course of exchange is the exclusive criterion [of]
how far the currency of one [country] is increased
beyond the currency of another."7
Another contribution of the strict bullionists was
their assertion that exchange rate movements are
purely a monetary phenomenon.
They rejected the
antibullionist argument that real disturbances to the
balance of payments-e.g.,
harvest failures, wartime
disruption of trade, military expenditures abroad,were responsible for the fall of the paper pound
Regarding supply
during the Napoleonic wars.
shocks and foreign remittances, they denied that such
factors could influence exchange rates even in the
short run. Their position was that the slightest real
pressure on the exchange rate would, by making
British goods cheaper to foreigners,
result in an
instantaneous
expansion
of exports sufficient to
eliminate the pressure.
In their view, an adverse

E=kM
Ricardo,
The Principles of Political Economy
and Taxation (London:
J. M. Dent and Sons, 1917), p.
151, quoted in James W. Angell, The Theory of International Prices (New York: Augustus
Kelley, 1965), p.
69 n. 3. Emphasis
added.

6 David
5Due to the unavailability
of reliable general
price indexes, the Classical economists
also used the paper money
price of bullion as an empirical proxy for the commodity
price level.
Accordingly,
they interpreted
a rise in the
market price of gold above its mint price as both a sign
and measure
of general
price inflation
and therefore
of
the need for monetary
contraction.

4

7 John
(London:
p. 52.

Wheatley,
Burton,

ECONOMIC REVIEW, JULY/AUGUST 1978

Remarks on Currency and Commerce
1803), p. 207, quoted in Angell op. cit.,

exchange was solely and completely the result of an
excess issue of currency.
Ricardo even went so far
as to argue that even if foreign transfers and domestic
crop failures did affect the exchanges by reducing
real income and hence the demand for money, the
cause of exchange depreciation is still an excess
stock of money, albeit one arising from a reduction
of money demand rather than an expansion of money
supply. Ricardo’s point was simply that real factors
could only affect the exchange rate through shifts
in money demand not offset by corresponding shifts
in money supply.
In such cases the latter was to
blame for exchange rate movements. The notion that
all factors affecting the exchange rate must do so
through monetary channels, i.e., through the demand
for or supply of money, is of course central to the
modern monetary approach.
Finally, the strict bullionists prescribed monetary
restraint as the only cure for a depreciating currency.
They held that a rise in the price of foreign exchange
constituted an infallible sign that the currency was
in excess and must be contracted.
Ricardo even
defined an excess issue in terms of exchange depreciation, thus implying a single unique correct money
stock, namely one associated with the exchange being
at its former gold standard parity.8
The

Moderate

Bullionists:

Blake

and Thornton

The moderate bullionists modified the strict bullionists’ analysis in three respects.
First, they pointed
out that it applies to long-run equilibrium situations
but not necessarily to the short run. Second, while
acknowledging that long-run (persistent)
exchange
depreciation
stemmed solely from note overissue,
they were willing to admit that real shocks could
affect the exchanges in the short run. Their position
is best exemplified by William Blake’s distinction
between the Real and the Nominal exchange.” According to Blake, the real exchange or real barter
terms of trade R is determined by nonmonetary
factors-crop
failures, unilateral transfers, structural
changes in trade and the like-that
affect the balance
of payments.
The nominal exchange, N, however,
reflects the relative purchasing powers of different
currencies as determined by their relative supplies
M/M*.
Blake’s analysis can be summarized by the
equation
(7)

E = RN

that expresses the actual exchange rate as the product of its real and nominal components, both of
8Regarding
the policy
implications
of the Ricardian
definition
of excess, see O’Brien, op. cit., p. 138.
9 On Blake,

see O’Brien,

op. cit., pp. 150-151.

which contribute to exchange rate movements in the
short run. Blake maintained, however, that in the
long run the real exchange R is self-correcting (i.e.,
returns to its original level) and that only the
nominal exchange N can remain permanently depressed. Therefore, persistent exchange depreciation
is a sure sign of an excess issue of currency.
The third modification was made by Henry Thornton, whose analysis of the money-price-exchange
rate nexus was much more subtle and sophisticated
than that of the strict bullionists.
In particular, he
argued that interest rates and the velocity of money
enter the nexus, that velocity is extremely variable
in the short run owing to shifts in business confidence, and that this variability invalidates the rigid
money-price-exchange
rate linkage postulated by the
extreme bullionists.10 In terms of Equations 2 and 5
he argued that the velocity-output ratio k is a variable
determined by the interest rate i and the state of
business confidence c, i.e.,
(8)

k = k(i, c).

Since k varies in the short run, the exchange rate
and money do not exhibit exactly equiproportional
movements.
A given change in the money stock
affects k as well as the exchange rate. In the long
run, however, k is a constant and the equiproportionality proposition holds.
The Antibullionists
Except for an expectations
mechanism, the bullionists had assembled and integrated all the elements of the monetary theory of
exchange rate determination.
Compared to this accomplishment the contributions of the antibullionists
appear pretty meager indeed.
They attributed exchange depreciation and domestic inflation solely to
real factors-crop
failures, overseas military expenditures and the like-operating
through the balance of
payments. They correctly asserted that the exchange
rate is determined by the supply and demand for
foreign exchange arising from external transactions.
But they failed to see that an important factor influencing supply and demand might be relative price
levels determined by relative money stocks. In fact,
they rejected all monetary explanations, claiming that
banknote expansion could not affect the exchanges in
the slightest. They thought the price of foreign exchange could rise indefinitely without indicating the
existence of an excess note issue.
As for policy
recommendations,
they urged curtailment of imports
and overseas expenditures to improve the balance of
10 Thornton’s
contribution
cit., pp. 119-150.

FEDERAL RESERVE BANK OF RICHMOND

is discussed

in O’Brien,

op.

5

payments and to strengthen the pound. They doubted
that any conceivable reduction in the banknote issue
could restore the exchanges to parity.
Their main analytical tool was the real bills doctrine, which they employed in an unsuccessful attempt
to refute the charge that the Bank of England had
overissued the currency. The real bills doctrine states
that money can never be issued in excess as long as
it is tied to bills of exchange arising from real transactions in goods and services.
Henry Thornton,
however, exposed the fallacy of this doctrine when
he pointed out that rising prices would require an
ever-growing
volume of bills to finance the same
level of real transactions.
In this manner inflation
would justify the monetary expansion necessary to
sustain it and the real bills criterion would not effectively limit the quantity of money in existence.
Thornton’s
demonstration
of the invalidity of the
real bills doctrine constituted a victory for the bullionists and for the monetary approach to the exchange rate. The victory, however, was not definitive. For when the debate erupted again in World
War I, the balance of payments approach was the
dominant view.
The German Inflation
Controversy
(1918-1923)
The debate reopened in 1918 when Gustav Cassel
used his purchasing power parity doctrine together
with the quantity theory to attack the official balance of payments explanation of the wartime fall of
the German mark. Whereas the policymakers blamed
the currency depreciation on real disturbances to the
balance of payments-e.g.,
obstructions to German
shipping, wartime disruption of trade and the likeCassel blamed it on excessive monetary expansion in
Germany relative to that of her trading partners.
Cassel’s
Critique
of the Balance
of Payments
Approach
Cassel’s criticism of the balance of

payments theory was virtually the same as that of his
strict bullionist counterparts, Wheatley and Ricardo.
Like them, he argued that the exchange rate is automatically self-correcting
in response to real shocks
to the balance of payments.
Therefore the theory is
incapable of accounting for persistent exchange rate
depreciation such as that experienced by the German
mark during World War I.
Regarding the operation of the self-correcting exchange rate mechanism, he noted that when balance
of payments disturbances push the external value of a
currency below its internal value, the currency becomes undervalued on the foreign exchanges, i.e., its
domestic purchasing power is greater than indicated
by the exchange rate. Such undervaluation, he held,
6

will immediately invoke forces returning the exchange rate to equilibrium.
For as soon as a country’s currency becomes undervalued relative to its
purchasing power parity, foreigners will find it profitable to purchase the currency for use in procuring
goods from that country.
The resulting increased
demand for the currency will bid its price back to
the level of purchasing power parity. In short, deviations of the exchange rate from purchasing power
parity generate corrective alterations in the trade
balance that eliminate the deviations.
Both the balance of payments and the exchange rate return
swiftly to equilibrium. Thus, contrary to the balance
of payments view, external nonmonetary shocks have
no lasting impact on the exchange rate.ll It follows
that any persistent depreciation must be due to excessive monetary growth that raises domestic prices
and thereby alters the purchasing power parity or
equilibrium exchange rate itself. In this connection
he repeated Ricardo’s dictum that an excess supply
of money, whether stemming from a rise in money
supply or a fall in money demand, is always and
everywhere the cause of exchange rate movements.‘”
Cassel also criticized the proposition that exchange
depreciation causes domestic inflation rather than
vice-versa. He acknowledged that currency depreciations relative to purchasing power parity produce
import price increases.
But he denied that these
import price increases could be transmitted to general prices provided the money stock and hence total
spending were held in check. He maintained that,
given monetary stability, the rise in the particular
prices of imported commodities would be offset by
compensating reductions in other prices leaving the
general price level unchanged.
In short, he denied
that causation ran from the exchange rate to domestic
prices as contended by the balance of payments approach.13
Hyperinflation

ment

Despite

attack,

the debate

and the Reverse

Cassel’s

Causality

and

did not go into high gear

post-war hyperinflation
11 Gustav

forceful

Argu-

vigorous
until

the

episode of the early 1920’s.14:

Cassel, Money and Foreign Exchange After
MacMillan, 1922), pp. 149, 164-165.

1914 (New York:

12 Cassel held that drops in output and the demand for
money could not affect the exchange rate if offset by
corresponding
equiproportional
reductions in the money
supply. Therefore an inappropriate money supply was to
blame for exchange rate movements.
Ibid., pp. 61-62,
168-169.
13 Ibid., pp. 145, 167-168.
14 What follows relies heavily on Ellis’s classic survey of
the German inflation controversy.
See Howard
S. Ellis,
German Monetary Theory, 1905-1933 (Cambridge:
Harvard University
Press, 1934), Chapters
12-16.

ECONOMIC REVIEW, JULY/AUGUST 1978

During this episode the price of foreign exchange
rose to fantastic multiples of its prewar level and
everybody wanted to know why. Advocates of the
monetary approach, including Cassel and his followers, pointed to the explosive growth of the money
supply as the obvious answer. But proponents of the
balance of payments approach dismissed the monetary factor and instead attributed exchange depreciation to the adverse balance of payments caused by
the burden of reparations payments combined with
Germany’s alleged “fixed need for imports” and
“absolute inability to export.” In their view, money
had nothing to do with the fall of the mark. On the
contrary, they claimed that causation ran from the
exchange rate to money rather than vice-versa. They
specified the following causal order of events : depreciating exchanges, rising import prices, rising domestic prices, consequent budget deficits and increased demand for money requiring an accommodative increase in the money supply.15
Regarding the increase in the money supply, they
contended that the exchange-induced
rise in prices
created a need for money on the part of business and
government, that it was the Reichsbank’s duty to
meet this need, and that it could do so without
affecting prices.
Far from seeing currency expansion as the source of inflation, they argued that it
was the solution to the acute shortage of money
caused by skyrocketing prices. Here is the familiar
argument that the central bank must accommodate
supply-shock inflation in order to prevent a disastrous contraction of the real (price-deflated)
money
stock. German proponents of the balance of payments view, however, pushed this argument to ridiculous extremes.
In 1923 when the Reichsbank was
already issuing currency in denominations as high as
100 trillion marks, Havenstein, the President of the
Reichsbank, expressed hope that the installation of
new high speed currency printing presses would
help overcome the money shortage.
Citing the real
bills doctrine, he refused to believe that the Reichs15 Balance of payments theorists placed the blame for
government
deficits financed
by new money issues
squarely on inflation rather than- on the actions of the
policy authorities.
Inflation, they said, caused government expenditures-which
were largely
fixed in real
terms and thus rose in step with prices-to
rise faster
than revenues-which
were fixed in nominal terms in
the short run and thus adjusted sluggishly to inflation.
The result was an inflation-induced
deficit that had to
be financed
by money growth.
The authorities
had
nothing to do with the deficit.
The monetary
school
rejected this argument on the grounds that the government possessed-the power to reduce its real expenditures
and, moreover, that the authorities had deliberately engaged in deficit spending for several years prior to the
hyperinflation
thus establishing the monetary preconditions essential to that episode.

bank had overissued the currency.
He also flatly
denied that the Reichsbank’s discount rate of 90
percent was too low although the market rate on
short term loans was an astronomical 7,300 percent
per annum.16
Characteristics
of the
School
It is instructive

Balance

of

Payments

at this point to identify
the chief characteristics
of the German balance of
payments school if only because some of these characteristics survive in vestigial form in popular discussion of the fall of the dollar. First, members of
the school tended to adhere to superficial supply and
demand explanations of the exchange rate.
Some
merely asserted that the exchange rate is determined
by supply and demand without saying what influences supply and demand.
Others specified certain
autonomous real factors affecting the balance of payments as the underlying determinants
of foreign
exchange supply and demand.
None recognized
that relative price levels and/or relative money stocks
might also play a role. These variables were effectively excluded from the balance of payments school’s
list of exchange rate determinants.
The school’s second characteristic was its tendency
to identify exchange depreciation with one or two
items in the balance of payments.
In particular,
members singled out raw material imports as the
culprit just as some analysts currently blame petroleum imports. Third, they tended to treat the items
in the balance of payments as predetermined
and
independent when in fact they are interdependent
variables determined by prices and the exchange rate.
For example,. they asserted that Germany’s import
requirements were irreducible regardless of price and
that her exports were likewise fixed.
They then
extended this reasoning to the other accounts of the
balance of payments.
Fourth, they denied the operation of a balance of payments adjustment mechanism. This denial followed from their assumption
that both the balance of payments and the exchange
rate are exogenously determined by factors that are
independent of money, prices, and the exchange rate
itself. This assumption permitted no equilibrating
feedback effects from the exchange rate to the balance of payments.
M. J. Bonn, a prominent balance
of payments theorist, expressed the point as follows.17
Suppose, he said, that import contraction is impos16 Leland
Yeager,
International
Monetary
Relations:
Theory, History, and Policy, 2nd edition,
(New York:
Harper
and Row, 1976), p. 314.
17 Bonn’s views are discussed
in Paul Einzig, The History of Foreign Exchange
(London:
MacMillan,
1962),
pp. 271-272, and Ellis, op. cit., pp. 248-252.

FEDERAL RESERVE BANK OF RICHMOND

7

sible given Germany’s dependence on imported raw
materials and foodstuffs. Likewise export expansion
is impossible because of tariff barriers and economic
Now assume a disturbance that
depression abroad.
produces a deficit in Germany’s trade balance thereby
causing an exchange rate depreciation of the mark
relative to its purchasing power parity equilibrium.
According to Cassel and his school, the depreciation
should, by lowering the foreign price of German
exports and raising the domestic price of her imports,
spur the former and check the latter thereby restoring equilibrium in the trade balance. But these priceinduced readjustments
in trade are impossible when
imports and exports are independent of exchange
rate changes. In such a case, an adverse trade balance may persist in the face of an undervalued currency, contrary to the conclusion of the monetary
school. Finally, the fifth characteristic of the German
balance of payments school was its categorical rejection of the proposition
that money influences
prices and the exchange rate. As previously mentioned, this antimonetarist
view was implicit in the
school’s reverse causation, money shortage, and real
bills doctrines.
The

Monetary

School’s

Critique

Members of the
monetary school had little trouble exposing the fallacies in these views. They noted that supply and demand constitute only the proximate determinants of
the exchange rate, that the ultimate determinants
are the factors underlying supply and demand themselves, and that these factors include relative price
levels determined by relative money stocks.
They
pointed out that the components of the balance of
payments are variables not constants, that they are
determined simultaneously
by prices and the exchange rate, and that exchange rate movements primarily reflect monetary pressure on the entire balance of payments rather than nonmonetary disturbances to particular accounts. Regarding the reparations account, they noted that the depreciation of the
mark was not caused by these payments per se but
rather by the inflationary way they were financed,
i.e., by fresh issues of paper money.
As for Germany’s alleged need for a fixed physical quantity of
imports regardless of price, they argued that needs
are not incompressible
and that even the import
demand for absolute necessities possesses some price
elasticity.
Moreover, they pointed out that exports
too are responsive to changes in relative prices and
that the exchange rate mechanism would therefore
tend to equilibrate exports and imports were it not
continually frustrated by inflation. They maintained
that had domestic prices stopped rising, a further
8

depreciation of the mark would, by making German
goods cheaper to foreigners
and foreign goods
dearer to Germans, have stimulated exports and restrained imports until a new equilibrium was reached.
In their view, it was only the rise in domestic prices
consequent upon the increase in the money supply
that prevented the expansion of exports and the contraction of imports. Otherwise current account equilibrium would have been restored by the exchangeinduced shift in the relative prices of exports and
imports.
Most important, advocates of the monetary approach argued convincingly that exchange depreciation originated in excessive money growth and that
the monetary authorities could have stopped the depreciation had they been willing to exercise control
over the money stock. In short, they showed that
the price of foreign exchange could not have risen
indefinitely unless sustained by inflationary money
growth.
Had the latter ceased, the exchange rate
would have stabilized.
The Expectations
Element
The German inflation
controversy contributed the last of the three major
The English
elements to the monetary approach.
bullionist writers had already established the quan
tity theory and purchasing power parity elements.
All that remained was the statement and development of the expectations theory linking anticipations
of future money supplies with the current exchange
rate. This step was taken during the hyperinflation
debate when the monetary school sought to explain
why the dollar/mark
exchange rate actually rose
faster than the German money supply. According to
the strict quantity theory and purchasing
power
parity hypotheses, the two variables should rise at
roughly the same rate. Their failure to do so was
taken by the balance of payments school as constituting evidence of the invalidity of the monetary
approach.
Advocates of the monetary approach,
however, rescued it from this criticism by explaining
the exchange rate-money growth disparity in terms
of market expectations.
In a nutshell, they contended that in disequilibrium the exchange rate is
influenced by the expected future exchange rate (i.e.,
the anticipated purchasing power parity) which depends on prospective price levels governed by expected money stocks. Howard Ellis, in his German
Monetary Theory 1905-1933 (1934), cites several
economists, notably Gustav Cassel, Walter Eucken,
Fritz Machlup, Ludwig von Mises, Melchior Palyi,
A. C. Pigou, and Dennis Robertson, who claimed
that exchange rate movements reflected anticipated
increases in the money stock and who argued that

ECONOMIC REVIEW, JULY/AUGUST 1978

the external value of the mark varied in proportion
to the expected future quantity of money rather than
to the actual current quantity.
In sum, observers
watching the money supply accelerate month after
month naturally came to expect future money growth
to exceed present money growth and these expectations caused the exchange rate to outpace the money
supply.
Similar explanations were advanced to account for
disparities between the rate of domestic price inflation and the rate of currency depreciation in Germany.
Eucken, Machlup, and von Mises argued
that the exchange rate embodies inflationary expectations and that exchange rate movements parallel
movements in expected future prices, not actual current prices.
For this reason, they claimed, the
exchange rate may deviate from the purchasing
power parity computed from current price levels.
Cassel perhaps put the matter most clearly when he
wrote that
A depreciation
of currency
is often merely an
expression for discounting
an expected fall in the
currency’s internal purchasing
power.
The world
sees that the process of inflation
is continually
going on, and that the condition of State finances,
for instance,
is rendering
a continuance
of the
depreciation
of money probable.
The international
valuation
of the currency
will, then, generally
show a tendency to anticipate
events, so to speak,
and becomes more an expression
of the internal
value the currency is expected to possess in a few
months, or perhaps in a year’s time.18
As this passage suggests, members of the monetary school not only explained how expectations
affect the exchange rate, but also how expectations
themselves are determined. In essence, they said that
people base their exchange rate expectations on observations of the behavior of the policy authorities,
especially the latter’s monetary and fiscal response to
large budgetary commitments like reparations payments. These observations yield information about
the authorities’ policy strategy which people use in
predicting future policy actions affecting the exchange
rate.
As Dennis Robertson put it in his famous

l8 Cassel, op. cit., pp. 149-150.

textbook Money (1922), “. . . the actual rate of
exchange is largely governed by the expected behavior of the country’s monetary authority . . ."19
In the case of Germany, the authorities were already
demonstrating
a pronounced
tendency to finance
reparations payments with budget deficits and excessive monetary growth.
People expected this policy
to continue in the future and these expectations were
embodied in the exchange rate.20
Conclusion
This article has surveyed
the development of the monetary approach to the exchange
rate in three historical controversies with the rival
balance of payments approach.
The article offers
some support for Sir J. R. Hicks’s argument that
monetary theory, unlike other branches of economic
theory, tends to be influenced by historical events
and episodes, notably severe monetary disturbances
and institutional changes that alter the character of
the monetary system.21 In the case of the monetary
theory of the exchange rate, at least, Hick’s argument seems validated.
For, as discussed above, the
main elements of the monetary approach emerged
from controversies triggered by currency, price, and
exchange rate upheavals following the suspension of
metallic parities. Specifically, the article argues that
the monetary approach originated in the Swedish
bullionist controversy of the 1750’s, that its quantity
theory and purchasing power parity components were
thoroughly established during the English bullionist
controversy of the early 1800’s, and that the expectations component was added during the German
inflation debate of the early 1920’s. Thus all the
elements of the modern monetary approach were
firmly in place by the mid-1920’s.

19 Dennis Robertson,
Money
versity Press, 1922), p. 133.

(London

: Cambridge

Uni-

20 Expectations
were not the only factor
cited by the
monetary
school as causing
the exchange
rate to lead
prices and money.
Another
was currency
substitution,
i.e., the substitution
of stable dollars for unstable
marks
in German
ances.

residents’

transactions

and asset money

bal-

21 Sir John Hicks, Critical Essays in Monetary
Theory
(London: Oxford University
Press, 1967), pp. 156-158.

FEDERAL RESERVE BANK OF RICHMOND

9

SEASONAL IN
MOVEMENTS YIELD
SHORT-TERM
SPREADS
Thomas A. Lawler

One of the more interesting aspects of the behavior
of short-term interest rates over the past 15 years
has been the volatilty of the spread between the
yield on Treasury bills and the yield on private
money market instruments.
One such spread, the
difference between the three-month
Treasury bill
yield and the yield on three-month large negotiable
certificates of deposit (CD’s) traded in the New
York secondary market, ranged from 3 basis points
to over 400 basis points during the 1963 to 1977
period.
(All yields referred to in this paper are
bond-equivalent yields.) The volatility of this spread,
which is shown in Chart 1, appears, at least on an
intuitive basis, to be much greater than can be attributed to changes in the relative riskiness of bills
and negotiable CD’s

10

Analysis of the three-month Treasury bill-negotiable CD yield spread indicates that it is subject to
seasonal variation.
Chart 1, which also plots a
centered 12-month moving average of the spread,
reveals a definite seasonal pattern in the yield spread
series. For example, the Treasury bill-negotiable CD
yield spread in February lies above its corresponding
12-month moving average in every year save one,
and for 11 of 14 years the June yield spread is below
its moving average. Moreover, in all but two of the
fifteen years from 1963 to 1977 the June Treasury
bill-negotiable CD yield spread was below the February yield spread. Analysis of the three-month billprime bankers acceptance and three-month
billprime commercial paper yield spreads reveals that
they exhibit seasonal movements similar to that of

ECONOMIC REVIEW, JULY/AUGUST 1978

the three-month bill-negotiable CD yield spread. The
presence of seasonality in the spreads between threemonth Treasury bill yields and three-month private
money market yields also suggests that risk factors
alone cannot explain movements in these spreads,
since it is unlikely that investors’ perceived risk of
default on these private debt instruments varies in a
seasonal fashion.
At first glance it seems perplexing that the spread
between Treasury bills and private money market
yields exhibits such seasonality. When, for example,
the three-month
bill-negotiable
CD yield spread
widens beyond that point which reflects the relative
riskiness of the two instruments, one would think
that investors would demand fewer bills and more
negotiable CD’s, bidding up the relative yield on
bills until the risk-adjusted yields of the two instruThe apparent absence of this
ments are equal.
equalization, at least in the short run, suggests that a
significant number of billholders view private money

market instruments
as imperfect
substitutes
for
Treasury
bills, and that these billholders have at
times dominated the market for bills in such a way
that they have kept the risk-adjusted yields on bills
and private money market instruments from equalizing.
When investors who view private money market
instruments
as imperfect substitutes for Treasury
bills dominate the market for bills, then a change in
the supply of bills may affect the yield spread between bills and other money market instruments.
Thus the seasonal behavior of the bill-private money
market yield spread may be the result of seasonal
movements in the supply of bills, which in turn arise
from seasonality in the Treasury’s short-term debtfinancing needs. The hypothesis that the seasonal
pattern of the supply of bills has been the dominating
factor affecting the seasonal pattern in the spread
between bill yields and other money market yields is
held by a number of participants
in the money

FEDERAL RESERVE BANK OF RICHMOND

11

The hypothesis states that a seasonal increase in the supply of Treasury bills causes bill
yields to be bid up relative to private money market
yields, and a seasonal decrease in the supply of bills
results in bill yields being bid down relative to private money market yields.
Consequently, evidence
indicating that seasonal movements in the supply of
bills are positively related to seasonal movements in
the spread between bill yields and private money
market yields would tend to support the hypothesis
that investors who consider private money market
instruments as imperfect substitutes for Treasury
bills have been dominating the market for bills, at
least in the short run.
This paper examines the relationship between seasonal movements in the three-month Treasury billnegotiable CD yield spread and seasonal movements
market.10

in the amount of Treasury bills outstanding.
In the
first section the seasonal components of the two
The second section deals with
series are analyzed.
some of the reasons why certain investors may consider instruments such as negotiable CD’s and prime:
commercial paper as imperfect substitutes for Treasury bills. Finally, the last section discusses some
of the implications of the analysis.
Seasonal Movements in Treasury Bills Outstanding and in the Bill-Negotiable
CD Yield Spread
Treasury Bills Outstanding
The multiplicative
version of the Bureau of the Census’ X-11 seasonal
adjustment
program
was used to estimate the
monthly seasonal component of the amount of TreaThe series used measures
sury bills outstanding.2
2 For a description

1 For

example,
see Salomon
Credit, March 31, 1978.

12

Brothers,

Comments

on

of the X-11 program
see [9].
For a
less technical
description,
as well as a discussion
of some
of the shortcomings
of the X-11, see Lawler
[5].

ECONOMIC REVIEW, JULY/AUGUST 1978

the par value of Treasury bills maturing within one
year that are held by private investors at the end of
each month.3 The solid line in Chart 2 represents
the monthly X-11 seasonal factors obtained for this
series from 1963 to 1977. The chart shows that the
amount of Treasury bills held by private investors
has exhibited a recurring intrayear pattern, with the
amount of bills outstanding falling on average from
February to June as Federal tax revenues rose relative to expenditures, and increasing on average from
September to February as tax revenues fell relative
to expenditures.
Three-Month
Treasury Bill-Negotiable CD Yield
Spread
The monthly seasonal component of the
spread between the three-month Treasury bill yield
and the three-month negotiable CD yield was esti3 That is, Treasury
bills held by Federal
government
agencies
and the Federal
Reserve
are excluded.

mated by using the additive version of the X-11
Since the additive
seasonal adjustment program.
version assumes that the seasonal component equals
the difference between the original series and the
seasonally-adjusted
series, the seasonal factors for
the bill-negotiable CD yield spread series are measured in basis points. The dashed line in Chart 2
plots the monthly X-11 seasonal factors obtained for
the three-month Treasury bill-negotiable CD yield
spread series from 1963 to 1977. The chart indicates
that on average the spread has tended to rise from
September to February and decline from January
to June.
Comparison
Chart 2 also illustrates the remarkable similarity between the seasonal pattern of the
three-month Treasury bill-negotiable CD yield spread
and the seasonal pattern of the amount of bills outstanding.
The chart shows that, on average, both
series have tended to peak in February, fall from

FEDERAL RESERVE RANK OF RICHMOND

13

February to June, and rise from September to February. It should be noted that seasonal movements in
the two series do not coincide exactly.
This is not
surprising, since the bills outstanding series is an
end-of-month series, while the yield spread series is a
monthly average series.
On the whole, however,
Chart 2 suggests that there is indeed a positive relationship between seasonal changes in the amount of
bills outstanding and seasonal movements in the billnegotiable CD yield spread.

cording to the chart, the major change in the shape
of the seasonal pattern of bills outstanding over the
ten year period was that the amount of bills outstanding declined on average from July to September during the 1973 to 1977 period, while in the
earlier period the amount of bills outstanding inThe
creased seasonally from July to September.
chart also shows a similar change in the seasonal
pattern of the three-month Treasury bill-negotiable
CD yield spread.

Closer examination of Chart 2 also reveals that
changes in the shapes of the two seasonal patterns
over time are related. Chart 3 compares the average
estimated seasonal factors of the two series for the
1963 to 1967 period with the average seasonal factors
of the two series for the 1973 to 1977 period. Ac-

The seasonal pattern in yield spreads, moreover,
is not limited to the spread between Treasury bill
yields and negotiable CD yields. Chart 4 plots the
average X-11 seasonal factors for the three-month
Treasury bill-prime commercial paper yield spread
for the 1963-1967 and 1973-1977 periods as well as

14

ECONOMIC REVIEW, JULY/AUGUST 1978

the average seasonal factors for the amount of bills
outstanding for these two five-year periods.4
The
chart illustrates that the seasonal pattern of the Treasury bill-commercial paper yield spread is quite similar to that of bills outstanding and that of the billnegotiable CD yield spread.
4 The three-month
prime
commercial
paper rate used
here is that for high-grade
prime
commercial
paper
The commercial
quoted
by Salomon
Brothers
[7].
paper yield for each month is the average of the yield
for the first day of the month
and the yield for the
first day of the following
month.
Since the Treasury
bill yield
series
employed
is a monthly
average
of
daily yields,
the different
averaging
procedures
may
cause this bill-commercial
paper yield spread series to be
more volatile.
There is no reason, however,
why the
different
averaging
procedures
themselves
should cause
the yield spread
series
to exhibit
either
seasonal
or
cyclical movements.

The similarity of the seasonal patterns of Treasury
bills outstanding and the spread between bill yields
and private money market yields suggests that shortrun changes in the supply of bills have affected the
yield on bills relative to the yield on other money
market instruments.
This implies that investors who
are insensitive to the differential yields of Treasury
bills and other money market instruments have indeed at times dominated the market for bills, at least
in the short run. The next section examines possible
reasons for such investor behavior, as well as who
these investors might be.
Determinants
of the Substitutability
of Treasury
Bills and Private
Money Market
Instruments
Investors manage their portfolios in such a way that
the risk-adjusted
return on the marginal dollar of

FEDERAL RESERVE BANK OF RICHMOND

15

each asset held is equal to that on the marginal dollar
of all other assets held. Optimal portfolio behavior
does not, however, necessarily imply that the pecuniary risk-adjusted market yields on all assets held
will be equal. For example, investors hold demand
deposits even though the pecuniary yield on such
deposits is zero. The reason demand deposits are
held, of course, is that they provide nonpecuniary
returns to the investor in the form of safety, convenience, liquidity, and the like.
The relative risk-adjusted pecuniary yields on any
two debt instruments of the same maturity may not
reflect their implicit relative returns to a given investor for a number of reasons.5
For one thing,
one debt instrument may provide services not adequately measured by its explicit market yield and
not provided by other instruments.
Additionally,
the markets for different debt instruments may be
such that the minimum denomination of one instrument is much larger than that of another instrument,
and wealth constraints may limit an investor’s choice
of investments to those debt instruments below the
minimum denomination of one but not another instrument.
Finally, legal constraints may prohibit
certain investors from holding one instrument but
not another instrument.
Commercial banks constitute an investor group for
which Treasury bills provide services not provided
by private money market instruments.
Banks in
most states are required to pledge certain assets equal
to a set percentage (typically 100 percent) of their
state and local deposits, and Treasury bills are acceptable pledging assets in all states while private
debt instruments are almost never acceptable.6 Further, thirty states allow banks outside of the Federal
Reserve System to hold some fraction of their reserve requirements in Treasury bills, while only a
few states allow any private debt instruments
to
fulfill part of a bank’s reserve requirements.’ Finally,
bank regulators often judge a bank’s capital adequacy
by its ratio of equity to risky assets, where the latter
are defined as total assets less cash and U. S.
Government securities.
Therefore a bank may hold
Treasury bills simply to maintain this capital adequacy ratio and thus appease its regulators.8
For
these and other reasons, a bank’s demand for Treasury bills may be sizable even when the explicit yield
5 This discussion
assumes that there are no technical
factors such as differential tax treatment affecting shortterm

yield

spreads.

6See Gilbert and Lovate
7 See Haywood

A group for whom wealth constraints
have
limited the substitutability of Treasury bills and private money market instruments consists of small
investors. The minimum denomination of negotiable
CD’s is $100,000, and commercial paper, while sometimes issued in units as small as $25,000, is usually
traded in the money market in lots of $100,000 face
value. Treasury bills, on the other hand, are issued
in denominations as small as $10,000. Consequently,
a number of small investors have been able to purchase Treasury bills but have been unable, due to
wealth constraints, to purchase negotiable CD’s and
commercial paper.
Finally, state and local governments’ holdings of
Treasury bills have been fairly insensitive to billprivate money market yield spreads because a number
of state statutes allow these governments
to hold
Treasury bills but not commercial paper or out-ofstate CD’S.9 A number of foreign official institutions
face similar constraints in that their holdings of U. S.
securities are limited by regulation to Treasury securities such as bills.
These examples do not comprise an all-inclusive
list of those investors whose demand for bills is
inelastic with respect to the bill-private money market yield differential.
They do illustrate, however,
that there exist a large number of billholders whose
demand for bills is relatively insensitive to these
yield spreads.
On the other hand, there are a
number of investors whose demand for bills is quite
sensitive to yield differentials.
Consequently,
the
question of whether a change in the supply of bills
results in a change in the relative yield on bills and.
other instruments is an empirical one. The evidence
presented in this paper supports the hypothesis that:
changes in the supply of bills have affected the
spread between bill yields and private money market
yields, at least in the short run. It should be realized,
however, that past dominance of the bill market by
investors who view private money market instruments as imperfect substitutes for Treasury bills does
not imply that they will dominate the bill market in
the future. Indeed, the emergence of money market
funds, which pool individual investors’ funds to purchase money market instruments, suggests that small
investors’ holdings of Treasury bills will be more
sensitive to the spread between bill yields and private
money market yields than they have been in the past.

[4].

8 See Summers [8].
16

[3].

differential between bills and private money market
instruments exceeds that corresponding to their relative riskiness.

9See [1].
ECONOMIC REVIEW, JULY/AUGUST 1978

Further, the recent change in Regulation Q allowing
banks and savings and loan associations to issue
small ($10,000) floating-rate six-month certificates
of deposit whose yield is tied to the six-month Treasury bill rate now provides small investors with a
close substitute for bills.
Thus, it is difficult to
determine what effect, if any, short-run changes in
the supply of Treasury bills will have on the yield
spread of bills and private money market instruments in upcoming years.
Implications
The Treasury
bill rate is often used
as an overall indicator of credit market conditions.
If, as seems to be the case, bill yields rise or fall
relative to private money market yields as the supply
of bills changes, then it is questionable whether the
monthly bill rate actually reflects the general price
of credit. The problems with using the bill rate as a
short-run credit market indicator may not be trivial,

as the average estimated seasonal change in the threemonth Treasury
bill-negotiable
CD yield spread
during the 1970’s from seasonal peak to seasonal
trough is almost 50 basis points.
Further, if supply factors can affect bill-private
money market yield spreads, then changes in the
demand for Treasury bills of investors who view
private money market instruments as imperfect substitutes for bills should also have affected these yield
spreads.
For example, the huge amount of bills
purchased by small investors during the 1973-74
period of disintermediation, as well as the large purchases of bills by foreign central banks over the last
year to help support the dollar, may have affected
the spread between bill yields and private money
market yields during these periods. Thus, caution is
advised in using the Treasury bill rate as a historical measure of the short-run general price of credit.

References
1. Advisory
Commission
tions.
Understanding
agement.
Washington,
Office (May 1977).
2.

on Intergovernmental
RelaState and Local Cash ManD. C., Government
Printing

“Limited
Habitats,
Required
Cook, Timothy
Q.
Habitats,
and Preferred
Habitats
: the Determinants
of Short-Term
Yield Spreads.”
Unpublished
manuscript,
Federal
Reserve
Bank of Richmond,
1978.

3.

Gilbert, R. Alton, and Lovate, Jean M. “Bank Reserve
Requirements
and Their
Enforcement:
A
Comparison
Across
States.”
Review, Federal
Reserve Bank of St. Louis
(March
1978), pp. 22-32.

4.

Haywood,
C. F.
The Pledging of Bank Assets: A
Study of the Problem of Security
for Public Deposits. Association
of Reserve
City Banks, Chicago

5.

Lawler,
Thomas
A.
“Seasonal
Adjustment
of the
Money Stock : Problems
and Policy
Implications.”
Economic Review, Federal
Reserve
Bank of Richmond (November/December
1977), pp. 19-27.

6.

Salomon
issues.

7.

Brothers.

Yield Spreads.

Comments

on

An Analytical Record
New York (1977).

Credit,

various

of Yields

and

8.

Summers,
Bruce.
“Bank
Capital
Adequacy:
Perspectives
and Prospects.”
Economic Review, Federal
Reserve
Bank of Richmond
(July/August
1977),
pp. 3-8.

9.

U. S. Department
of Commerce,
Bureau
of the
Census.
The X-11 Variant of the Census Method II
Seasonal Adjustment Program, by J. Shiskin, A. H.
Young, and J. C. Musgrave.
Technical
Paper
No.
15, Washington,
D. C.: 1967.

FEDERAL RESERVE BANK OF RICHMOND

17

LIFO INVENTORY ACCOUNTING: EFFE
INVENTORY-SALES RATIOS, AND
Walter A. Varvel
Changes in the rate of inventory investment have
played an important role in the pattern of economic
growth in the current recovery that began in early
1975. Though inventory investment accounts for
only a small portion of gross national product,
changes in the rate of activity in this sector have
often dominated the influence exerted by all other
components
(final sales) of GNP on quarterly
economic growth rates.
Table I compares growth
rates of inflation-adjusted
GNP, real final sales, and
changes in the rate of inventory investment over the
last ten quarters.
The dominant role of inventory
investment is especially evident in each of the first
and fourth quarters shown in the table. Reductions
in the rate of change in business inventories in the
fourth quarters of 1975, 1976, and 1977, respectively,
have overshadowed strong gains in final sales and
significantly moderated economic growth in those
quarters. Conversely, increases in inventory building
in the first quarters of 1976, 1977, and 1978 offset
concurrent slowdowns in sales and led to higher
GNP growth rates than would be indicated from total
sales figures alone.
Inventory behavior, therefore,

Table I

INVENTORY INVESTMENT, REAL FINAL SALES,
AND REAL GNP
Inventory

Change In
Inventory

Investment1 Investment1

Sales2

Real GNP2

1975 IV

-

4.6

-

+5.6

+3.0

1976 I

+

9.7

+14.3

+ 3.9

+

2.4

+

1.7

+4.3
+3.3

+8.8
+5.1
+3.9

II
III
IV
1977 I
II
Ill
IV
1978 I

+12.1
+13.8

7.5

Real Final

-

1.8

-15.6

+6.3

+1.2

+

9.7

+11.5

+7.5
+6.2

+13.2
+ 15.7

+ 3.5
+ 2.5

+3.8
+5.1
+4.4

+

-

7.0

+6.1

+

6.0

-1.7

8.7

+14.7

+5.1
+3.8
0.0

has been watched carefully as an indicator of prospective changes in aggregate economic output.
According to the generally accepted view, the most
important factor affecting business demand for inventory stocks is the expected rate of business sa1es.l
When sales are expected to increase, firms generally
increase their accumulation of inventories.
A slowdown in expected sales, on the other hand, usually
leads to a slowdown in inventory investment.
The
ratio of inventories to sales (I/S),
consequently, is
frequently used by managers and economic analysts
as a rough measure of the adequacy of business inventories relative to the level of sales. Chart 1 shows
the historical relationship between book value inventories to sales ratios since 1960 for the manufacturing
sector separately and for all manufacturing and trade
combined. Each series suggests that fairly lean inventory stocks were maintained in 1977 relative to
sales levels (i.e., I/S ratios appeared
to be below
historical averages).
This knowledge would seem
to support expectations that inventories may increase
relative to sales in the near term.
This article describes a recent significant shift in
accounting methods used to value business inventories that has been encouraged by the severe inflation of the 1970’s. In an effort to remove inflationrelated inventory profits from corporate profit statements, businesses have increasingly taken advantage
of an industry accounting option granted 40 years
ago. The switch from FIFO (first in-first out) and
other related inventory accounting methods to LIFO
(last in-first out) eliminates unrealized inventory
profits and appears to be a rational response by
business to an inflationary environment.
The switch to LIFO accounting, however, has also
resulted in a change in the manner in which a portion
of ending inventories are reported on corporate balance sheets. Inflation
causes LIFO inventories to
be biased downward and this problem is exacerbated
as LIFO usage increases. Present aggregate inventories may be understated, therefore, upsetting the

1 Billions of 1972 dollars, annual rate.
2Quarter-to-quarter
dollars.
Source:

18

compounded annual

rates of change, 1972

Department of Commerce, Bureau of Economic Analysis.

1 For a discussion of the determinants
of inventory investment and its influence on gross national product,
with special reference to the present business cycle, see
[18] and references cited in that paper.

ECONOMIC REVIEW, JULY/AUGUST 1978

historical comparability of I/S ratios.
The article
then examines whether explicit recognition of inventory accounting techniques used by business enriches
understanding of recent quarter-to-quarter
inventory
swings. Before these effects of the LIFO method of
inventory accounting are discussed, however, the
impacts LIFO and FIFO have on corporate profit
statements and balance sheets, respectively, are first
described and the economic incentives for a switch
to LIFO are explored.
FIFO

and LIFO

Defined

FIFO and LIFO have
substantially different ways of allocating inventories
purchased over time at different prices to corporate
balance sheets and income statements. FIFO accounting charges the cost of the first, or earliest,
inventory acquired against current revenue for purposes of measuring corporate profits.
Because of
this, it is referred to as a historical cost accounting
During inflationary times the cost of
technique.
goods sold, therefore, often reflects the lower inventory prices experienced in earlier periods. The cost
of the unsold (most recently acquired) inventory is
carried forward to the next accounting period. FIFO

inventories on balance sheets, therefore, are valued at
price levels prevailing relatively near the time when
accounts are closed.
The LIFO inventory valuation method exactly
reverses the FIFO treatment of inventories.
The
last, or most recent, inventory costs incurred are
charged against current revenue in profit reports of
firms using LIFO.
These costs approximate
the
replacement cost of inventory sold during the period.
Cost of goods sold with LIFO, therefore, is based on
the advanced prices of inventory most recently purEnding inventories on balance sheets are
chased.
carried at the (lower) acquisition costs of earlier
Some LIFO inventories could conceivably
periods.
remain on balance sheets perpetually.
From the above, it is clear that the inventory valuation method a business chooses can affect both its
reported profit and stock of inventory during periods
when prices are changing. During a severe inflation,
as experienced in this decade, FIFO reports lower
cost of goods sold and, therefore, higher profits than
the LIFO accounting method. The entire difference,
however, is attributable
solely to inventory price
changes and is generally referred to as inventory

FEDERAL RESERVE BANK OF RICHMOND

19

profits.
In an effort to eliminate inventory profits,
many businessmen have shifted inventories to the
LIFO method. The next section will briefly discuss
inflation’s impact on corporate profits and will look
at the potential adjustment provided by a mass shift
to LIFO.
Inflation’s
Effect
on Profits
A great deal of
attention has been given the subject of inflation accounting in recent years by accountants, financial
analysts, and economists.
General agreement exists
on the desirability of adjusting financial reports and
the National Income Accounts for inflation’s impact
on the valuation of business inventories and fixed
capital assets (plant and equipment, etc.) depleted
in the production process.2 The Inventory Valuation
Adjustment (IVA) was adopted by the Department
of Commerce for the National Income Accounts in
1947 to adjust aggregate corporate profits for differences between the valuation of inventories reported
on a historical cost basis and the cost at which inventories are replaced.
In addition, the Internal Revenue Service has allowed individual firms to achieve
essentially the same effect for tax purposes since

2 This is consistent
with
Pigou’s
capital-maintenance
“From the joint work of the whole
definition
of income.
mass of reproductive
factors
there comes an in-flowing
stream of output.
This is gross real income.
When what
is required
to maintain
capital intact is subtracted
from
this there is left net real income”
[12].
Fellner
adds
that “using up physical
capital plus replacing
it involves
no realization,
and hence any gains or losses developing
from this practice should not enter into the tax base” [5].
20

1939 by reporting inventories valued by the optional
LIFO method.
The Capital Consumption Adjust,ment (CCA), first applied to the National Income
Accounts in 1977, attempts to remove from aggregate
corporate profits the difference between original cost
depreciation of capital actually reported by business
and replacement cost depreciation.
Businesses have
no such depreciation
option for purposes of tax
computation, however, and many observers argue
that accelerated depreciation methods that are acceptable currently do not adequately reflect replacement costs. General agreement on the need for a
more appropriate
accounting method for physical.
assets is accompanied, however, by controversy over
the “best” accounting technique to accomplish this
purpose.3
The appropriateness
of inflation-adjusted
values
for financial liabilities is even more controversial4
Some analysts argue that an inflation-adjusted
tax
3 Alternative
techniques
are discussed
in some of the
See, in
references
listed at the end of this article.
particular,
[2, 3, 4, 5, 7, 8, 10, 15, 19, 20, and 21].
4 A major
point
of controversy
over this subject
is
whether
profits are to be measured
(and taxed)
on an
accrual or on a realization
basis. At issue is the point at
Should income be
which income should be registered.
acknowledged
at the time the market value of an asset
(liability)
increases
(decreases),
or only when
these
changes in value are actually converted
into cash? Present accounting
practices
embody a combination
of these
principles.
For discussion
of the issues involved,
see
[5, 9, 15, 16, and 21].
This and other issues in the
inflation
accounting
literature
are complex
and beyond
the scope of this article.

ECONOMIC REVIEW, JULY/AUGUST 1978

system must recognize as taxable income the accrued
capital gain on the decline in the real value of net
corporate debt caused by inflation [e.g., see 1, 16,
21]. Inflation adjustment of financial liabilities has
not received as much attention as adjustments for
physical assets and no allowance for debt revaluation
is presently incorporated or required in the National
Income Accounts or corporate income statements.
Table II gives the Commerce Department’s estimates of the overstatement of corporate profits due
to inflation since 1972.5
Total corporate profits
before and after taxes are shown along with official
estimates of adjustments
necessary for inventory
profits and underdepreciation
of fixed capital. According to these figures, inventory profits and underdepreciation led to an overstatement
of corporate
profits for tax purposes by $150 billion over the last
six years. The IVA corrects for over two-thirds of
this total overstatement although underdepreciation
has become the larger factor over the last three years.
Subtraction of dividends paid to stockholders from
after-tax profits reveals that the burden of the inflation distortion is borne by retained earnings.6 This
burden is actually understated
by the figures in
Table II, which are in current dollars and, therefore,
do not reflect the erosion of the purchasing power of
these funds.
In effect, then, inflation raises the tax burden on
business, depriving investors of the ability to recover
the real value of used-up physical capital without
being taxed on that recovery. Fellner, Clarkson, and

Moore feel inflation introduces “unlegislated taxation
of capital” and “reduces the incentive to invest” [6,
p. 3]. The combined effects of inflation, namely, increasing effective tax rates on capital7 and the erosion of an important source of funds available for
investment, therefore, have adversely affected business investment in recent years.
Table III shows that the experience of nonfinancial
companies has been even worse than that evidenced
for all corporations.
Excluding financial companies,
the greatest distortion in business profits occurred
in 1974 when inflation hit double-digit levels. For
that year alone, after-tax profits and retained earnings of nonfinancial companies were overstated by
$43.3 billion. In 1974, nonfinancial companies actually paid out in taxes and dividends more than their
realized earnings.
The LIFO accounting method yields adjustments
in reported earnings equivalent in size to the IVA
when physical inventories are increased or unchanged
and something less than the IVA when physical inventories are liquidated.8 The
size of the IVA and
the behavior of aggregate real business inventories
suggests the application of LIFO accounting to all
inventories could perhaps have reduced reported aggregate corporate profits by as much as $90-$100
billion over the 1972-1977 period.
Proportionate
reductions in taxes and dividends paid could have
7 Considerable

of

evidence has been presented
that supports
the view that the net effect of inflation has been that the
annual net return on capital, defined as the sum of inflation-adjusted
profits and the actual net interest paid, has
been subject
to higher
effective
corporate
income
tax
rates the higher the rate of inflation
[e.g., 6, 11, and 20].

of an estimate
of reduction
in real indebtedness due to inflation,
it has been claimed,
reduces
the
overstatement
of internally
generated
funds in corporate
accounts
[21].

8 When physical
stocks
decline
during
an inflationary
period, an IVA is required
also for a portion
of inventories valued on a LIFO
basis, since some inventories
sold are not carried at replacement
cost but in terms of
prices of prior periods
[13].

5 These figures include no attempt
corporate
debt for inflation.
6 Inclusion

to adjust

the value

FEDERAL RESERVE BANK OF RICHMOND

21

significantly improved actual cash flow. Corporations, it appears, had a powerful incentive, therefore,
to utilize the LIFO option during the last several
inflation-plagued years.
The

Switch to LIFO
A significant increase in
the use of LIFO inventory accounting has, in fact,
taken place in recent years.
The Department
of
Commerce estimates that the proportion
of total
manufacturing
inventories valued on a LIFO basis
doubled in 1974 and has stabilized at approximately
33 percent since that time.” Table IV shows the
results of an annual survey of inventory valuation
methods used by 600 major U. S. companies. Over
50 percent of these companies used LIFO for some
portion of their inventories in 1974, more than twice
the number reporting LIFO usage in prior years.
This proportion has increased slightly since 1974.
Nevertheless, many firms do not make use of LIFO
at all and most who do only apply it to a portion of
their inventories.
The interesting question, in light
of the apparently large tax-saving and liquidity benefits accruing to LIFO users, though, is why the large
majority of firms still value inventories with accounting methods that do not remove the effect of inventory price changes. Apparently, other considerations
have limited the switch from FIFO to LIFO.
LIFO’s Disadvantages

There are several consequences of using LIFO that appear unattractive to
management thereby prompting firms to retain usage
of historical cost methods of inventory accounting.
Perhaps the most important consequence is that
earnings per share reported by LIFO firms are
usually lower than they would be through alternative accounting methods.
Per share earnings or
earnings on total assets remain important performance yardsticks for management and stockholders.
LIFO accounting may lead to smaller dividends to
stockholders and smaller bonuses and salary increases
to corporate management since each are usually tied
to profit performance.
Management, as well as
owners, therefore, may be reluctant to switch to
LIFO unless the firm has a strong underlying liquidity need.
Secondly, LIFO’s potential benefits to individual
firms may be reduced or even eliminated during
periods when inventory prices are falling. Certainly,
on an aggregate basis, inventory prices have risen
uninterruptedly
in the 1970’s. Some materials and
9 Source: John C. Hinrichs,
merce, Bureau of Economic
justed terms,
percent [141].

22

the figure

U. S. Department

of Com-

Analysis.
In inflation
adis probably
now in excess of 40

commodities

(e.g.,

agricultural

products),

however,

have been subject to large declines in price at times.
In the case of falling inventory prices, LIFO charges
the lower priced items to cost of goods sold-resulting in higher profits, higher taxes, and less cash
flow than FIFO accounting.10
In brief, the use of
LIFO during times when inventory prices are falling
may overstate taxable profits, thereby increasing tax
liabilities at a time the firm can least afford it.
A third factor perhaps limiting the potential benefits of LIFO to some individual companies is operational when inventories are liquidated.
When inventories are being drawn down and LIFO is used,
cost of goods sold include some inventory purchased
and carried on the firm’s accounts at earlier (lower)
prices. LIFO would still report lower profits and,
therefore, result in tax savings and an improved
realized cash position compared to FIFO when inventories are liquidated.
The discrepancy between
reporting methods, however, is reduced in this situation. The incentive to switch to LIFO is partially
reduced, therefore, for firms carrying excessive inventories.
Management presumably weighs the pluses and
minuses of alternative
accounting techniques and
assesses their likely impacts on firm operations.
Though LIFO has obviously reduced tax liabilities
and improved cash flow for many firms in the inflationary 1970’s, it does not necessarily follow that all
firms would be similarly benefited.
In addition, the
adverse impact LIFO has on reported profitability
is apparently judged by many firms to be too high a.
price to pay far improved corporate liquidity. These
10 This situation
could result in an inverse
relationship
between sales and reported
profits.
If sales increased
to
the point where
higher-priced
inventory
began
to be
used up, these additional
sales would actually
produce
lower profits
if the product
price fell with the cost of
inventory.
Only if inventories
are liquidated
would the
resultant
capital losses on inventory
stocks be realized.
Conversely,. when
inventory
inflation
exists,
inventory
liquidation is
a prerequisite
to the realization
of capital
gains on inventory
stocks.

ECONOMIC REVIEW, JULY/AUGUST 1978

firms, accordingly,
LIFO.

have decided

Impact of a Switch to LIFO
tories and I/S Ratios
The

not to switch

on Ending

to

Inven-

method by which
inventories are valued affects the reported book value
of inventory stocks and, thus, I/S ratios. Since I/S
ratios are sometimes used by managers and analysts
as a measure of the adequacy of inventories relative
to the level of sales, recognition of the accounting
impact is essential. Sales reflect current period prices
while the book value of ending inventory can report
either earlier, lower prices (LIFO) or more current,
higher prices (FIFO).
LIFO accounting would
report lower inventories and I/S ratios than FIFO
with the same size of physical inventories. During an
inflationary period, therefore, LIFO results in a
downward bias in I/S ratios.
The impact a switch from FIFO to LIFO will
have on the value of ending inventories depends on
the following factors: (a) the rate of inventory price
change, (b) the percentage of total inventories valued
on a LIFO basis, (c) the length of time LIFO has
been used, and (d) the change in the physical stock
of inventories.
Regarding the first of these factors, LIFO and
FIFO will report identical inventory stocks in a
non-inflationary
environment.
If inventory has not
experienced price increases, the book value of inventories and I/S ratios will not differ whether FIFO
or LIFO is used. This would be true for individual
firms or for the aggregate economy. Periods of price
stability, however, have not been evident in recent
years. As prices rise, other things remaining constant, LIFO accounting results in relatively smaller
reported inventory stocks and, therefore, smaller I/S
ratios than FIFO.
The greater the inflation experienced, the larger will be the discrepancy between
accounting methods.
The proportion of total business inventories valued
using LIFO also affects the book value of reported
inventories.
Given inventory price inflation, the
larger the percentage
of LIFO
inventories,
the
greater the downward bias in the I/S ratio.
It
follows, therefore, that if a significant portion of
aggregate inventories are switched from FIFO to
LIFO,
the divergence
is enlarged following the
switch. This will adversely affect the direct comparability of inventory levels and aggregate I/S ratios
over time.
The length of time LIFO accounting has been
used for a portion of inventories is another factor
that complicates comparisons of I/S ratios over time.
With inventory inflation, the discrepancy in reported

inventories between FIFO and LIFO is cumulative.
Some LIFO inventories may continue to be carried
at purchase prices prevailing several years earlier.
Those inventories will differ from replacement cost
in relation to inventory price increases experienced
in each of the intervening years.
Finally, the change in physical inventories during
the period affects reported inventory stocks and I/S
ratios. If inventory stocks are increasing or remain
unchanged, physical inventories do not turn over
and LIFO inventories may reflect inventory prices
incurred several years earlier.
Only if inventory
stocks are being liquidated are some of the low price
LIFO
inventories
removed from balance sheets.
FIFO inventories are not affected in this manner.
A shift in inventory accounting methods alone,
therefore, can result in sizable differences in reported
inventories across several inflationary years. Table V
illustrates the magnitude of the effect of a change in
inventory accounting on reported inventories of a
sample of department stores that maintained dual
inventory records from 1940-1947.”
The average
annual reduction in ending inventories due to LIFO
accounting was 4.6 percent.
Further, the use of
11This
the

was
1970’s.

a period

FEDERAL RESERVE BANK OF RICHMOND

of serious

inflation,

comparable

to

23

LIFO resulted in a 27 percent cumulative reduction
in the book value of inventories over the eight-year
period.
Although
the proportion
of inventories
valued by LIFO in this sample is considerably higher
than presently applicable to the business sector as a
whole, the example clearly illustrates the extent to
which a switch to LIFO can alter the book value of
inventories over time.
The exercise presented in Table VI cautions against
the intertemporal
comparison of I/S ratios when
LIFO accounting is used for an increasing proportion of inventories.
The inventories switched from
FIFO to LIFO in 1974 alone are estimated to have
reduced corporate profits by $9 bil1ion.12 This represented approximately
3.4 percent of total business
inventories that year.
Assuming total inventories
using LIFO doubled in 1974 (as they did in the
manufacturing sector, see footnote 9), a rough estimate of the annual downward bias resulting from
LIFO use prior to 1974 might approach three percent if inventory price increases were comparable.
Table VI, however, is constructed assuming that the
inventories already carried under LIFO prior to
1974 necessitate an annual upward adjustment of 1
percent in reported inventories to remove the downward bias in I/S ratios that LIFO inventories cause
in an inflationary period.
Similarly, following the
switch to LIFO in 1974, a 2 percent annual adjustment in inventories is assumed necessary for 1975
1977.13
Reported I/S ratios, shown in Chart 1 and Table
VI, suggest that businessmen were maintaining fairly
lean levels of inventories relative to sales in 1977
when compared to earlier years. The table reveals,
however, that the adjusted series describes an enAdjusted I/S ratios are,
tirely different situation.
in fact, considerably higher than in 1972-1974. This
exercise suggests that recently reported levels of
business inventories may not be as lean as historical
comparisons of unadjusted I/S ratios indicate. The
last column in Table VI also shows a different picture from unadjusted ratios when all inventories and
sales are reported in constant 1972 dollars.14 Com12 John
Bureau

C. Hinrichs,
of Economic

U. S. Department
Analysis.

of

Commerce,

13 These
assumed
adjustments
are for demonstration
purposes
only and do not claim to exactly adjust
I/S
ratios for LIFO’s
effects.
The adjustments
are thought
to be conservative
estimates,
however.
Smaller
adjustments in 1972-1973 and 1975-1977 than 1974 reflect lower
rates of inflation,
14 The

first and last columns
do not report
identical
figures for 1972 because some inventories
under column 1
are reported
using
lower
(pre-1972)
inventory
prices
while sales are in 1972 dollars.

24

parisons of unadjusted
I/S ratios over extended
periods, therefore, should be interpreted with caution
following the switch to LIFO accounting.
FIFO, LIFO, and Inventory
Investment
Recognition of the increased proportion of business inventories valued using LIFO, in addition, may contribute to understanding
the large swings in inventory
investment that have occurred in the first and fourth
quarters of recent years.
Undoubtedly,
the recent
quarterly pattern of sales (strong in fourth quarters,
relatively weak in first quarters) has been a prime
determinant of the pattern of inventory investment.
Larger-than-expected
fourth quarter sales might lead
to an involuntary reduction in inventory stocks in the
Conversely,
same quarter.
weaker-than-expected
first quarter sales might result in involuntary inventory building.15
Financial considerations
that are
affected by inventory accounting decisions, however,
may also affect the decision to invest in inventories.
This section will examine whether any financial
incentive is present that may induce firms to alter
their quarterly inventory investment pattern.
Table
VII presents the operation of a hypothetical firm with.
three alternative assumptions concerning changes in.
inventories.16 In addition, in each case the statements,
are presented using FIFO and LIFO inventory
The firm is assumed to
valuation for comparison.
have revenue of $200 from the sale of 10 product
units and a beginning inventory of 8 units valued at
$64. Increases in the cost of inventory are assumed
15Some firms apparently
use LIFO
only in the fourth
For the remainder
of the year they report
quarter.
monthly inventory
stocks using the FIFO method.
This
may contribute
to the swing in inventory
investment
from quarter
to quarter
[14].
16Table VII assumes
other than purchasing

ECONOMIC REVIEW, JULY/AUGUST 1978

the firm
inventory.

has

no production

costs

to occur during the period. Three different levels of
inventory purchases are assumed : (I) seven units,
reducing ending inventory to five units, (II) ten
units, leaving ending inventory unchanged at eight
units, and (III) twelve units increasing ending inventory to ten units.
Within this framework, the
impact of FIFO and LIFO accounting on ending
inventory, cost of goods sold, profit, taxes, and cash
flow can be examined.
Table VII demonstrates that FIFO allocates the
highest cost inventories to ending inventory in the
balance sheet and the lowest cost inventories are
charged against revenues in the income statement.
LIFO allocates inventories in reverse manner, with
high cost inventories applied to cost of sales and the
low cost inventories remaining in ending inventory.
Consequently, in each case of assumed inventory
purchases, ending inventories and I/S ratios are
smaller with LIFO than with FIFO.
Conversely,
the cost of sales is larger with LIFO than with
FIFO.
In each instance, reported profits and taxes
using FIFO are higher than those using LIFO.
A
portion of FIFO profits, however, are tied up in
inventory and the cash is not available unless inventories are liquidated. The higher taxes paid on these
inventory profits result in a less favorable cash flow
position for the firm if it uses FIFO inventory valuation compared with the use of LIFO.
It is in this
respect that LIFO is claimed to more accurately

reflect profits available for distribution as dividends
or to be put into retained earnings.
With FIFO inventory accounting, the firm’s reported profits and taxes are not altered by the inventory purchase decisions depicted in Table VII.
Its
end-of-period cash position, however, is significantly
improved by limiting its inventory investment-at
least until after the statement closing date.
This
action may be necessary, for instance, to pay dividends to stockholders.
Greater flexibility is provided the LIFO user.
Both profits and cash flow improve as the firm limits
inventory purchases.
A LIFO firm desiring to
maximize reported earnings, reward shareholders
with sizable dividends, and/or in need of internally
generated cash would have a strong incentive to
limit inventory investment.
On the other hand, the
firm could reduce its tax liability by additional investment in inventories, although this action would
reduce reported profits and cash flow.
Inventory
behavior, therefore, affects the cash
position of the firm under both accounting methods.
FIFO firms with end-of-year cash needs could, in
part, satisfy those requirements by limiting inventory
investment. A similar incentive is present for LIFO
firms, although, at any given level of physical inventory, cash flow is already enhanced by the use of
LIFO itself.
LIFO firms are provided an extra
incentive for limiting inventory, however-improve-

FEDERAL RESERVE BANK OF RICHMOND

25

ment in reported profitability.
It may be expected,
then, that LIFO firms are especially likely to postpone inventory purchases until after financial statement closing dates. The incentives to limit inventory
stocks, of course, would not induce a firm to reduce
inventories to the point where sales were adversely
affected by shortages.
The switch to LIFO inventory accounting, by
reducing taxes, has generated additional cash flow
for American business. To gain perspective on the
relative magnitude of this potential boost to cash
flow, it is contrasted with the gain resulting from a
reduction in the corporate income tax rate to 45
percent from the hypothetical 50 percent applied in
Table VII. Using case II (where physical inventory
levels are unchanged), the tax rate reduction reduces
taxes and increases after-tax
profits by approximately 10 percent while it increases retained earnings by approximately
38 percent ($26 to $35.80).
This is considerably less than the firm’s percentage
gain in cash from switching from FIFO to LIFO
(from $26 to $44, almost 70 percent) .17 LIFO

reduces effective corporate taxes by approximately
24 percent in this case. Since LIFO reduces beforetax profits, it reduces taxes and increases cash flow
for the individual firm to a greater extent than a
small reduction in the corporate tax rate.
Summary

tion-adjusting
controversial
chooses)

the “best”

corporate

financial

topic, business

during inflationary
be attractive
liabilities

is a

can (if it so

inventory

profits

LIFO

may not

Though

to all firms, most firms can reduce tax

and significantly

accounting

retained

for infla-

statements

presently

periods.

flow through its use.
LIFO

method

eliminate inflation-related

improve

Potentially,

could result

corporate

a major

the corporate

effects of a switch to LIFO
intertemporal

gain in

a bigger boost

than a modest

income tax rate.

reduction

Examination

accounting

comparisons

cash

switch to

in a larger

earnings and might provide

to business investment

it renders
17 The results of comparisons
between tax rate reductions
and a switch to LIFO
are highly dependent
on assumptions concerning
the firm’s operation
and the inventor?
inflation
it faces.
The comparison
results
in the text
are for demonstration
purposes
only and should not be
generalized.

Though

in

of other

suggests that
of inventory-

sales ratios hazardous and may increase the quarterto-quarter variability of inventory investment.
Failure to recognize these effects may impair forecasts of
inventory investment and, therefore, GNP.

References

1. Aaron, H.
American

2.

“Inflation

Economic

The
pp. 193-

and the Income Tax.”

Review,

(May

1976),

Baxter,
W. T. “Accountants
and Inflation.”
Bank Review, (October
1977), pp. l-16.

Standards
Board.
“Adjustment
of Historical
Depreciation
Costs
for Inflation.”
Proposed
Standard
No. 413, October
9, 1975.

4.

Fabricant,
S. Toward Rational Accounting
In An
Era of Unstable Money, 1936-1976.
Report No. 16,
National
Bureau
of Economic
Research,
December
1976.

5.

Fellner,
W.
“Comments
on Inflation
Accounting
and
Nonfinancial
Corporate
Profits
: Phvsical
Assets.”
Brookings Papers on Economic Activity,
(3: 1975), pp. 599-604.

26

; Clarkson,
Taxes for Inflation.
American
Enterprise
Research,
June 1975.

Financial
Accounting
Standards
Board.
“Proposed
Statement
of Financial
Accounting
Standards,
in Units
of General
PurFinancial Reporting
chasing
Power.”
FASB
Exposure
Draft, December 1974.

8.

Fox,
H., and
Lang,
F.
“Lifo’s
Charms
Harms.”
Quarterly
Review of Economics
Business, (2: 1975),
pp. 36-45.

Lloyds

3. Cost Accounting

6.

7.

K.; Moore, J.
Correcting
Domestic
Affairs
Study 34,
Institute
for Public
Policy

and
and

on Inflation
Accounting
9. Gramlich,
E. “Comments
and
Nonfinancial
Corporate
Profits
: Physical
Assets.”
Brookings Papers on Economic Activity,
(3 : 1975), pp. 604-608.
10.

Neal, A. “Immolation
of Business
Capital.”
vard Business
Review,
(March-April 1978))
75-82

11.

Nordhaus,
W.
“The Falling
Brookings Papers on Economic
pp. 169-217.

12.

Pigou,
mica,

Share
of Profits.”
Activitu. (1: 1974).

Capital
A. “Maintaining
(August
1941), p. 271.

ECONOMIC REVIEW, JULY/AUGUST 1978

Harpp.

-I

Intact.”

.

Econo-

13. Rottenberg, I. “Inventories and the Inventory
Valuation Adjustment.” Quarterly GNP Estimates

17. Stevenson, J. Methods of Inventory Valuation and

BEA Staff Paper No. 25, U. S. Department of
Commerce, Bureau of Economic Analysis, October 2, 1974, pp. 29-33.

Banking conducted by the American Bankers Association, Rutgers University, June 1952.
18. Tatom, J. “Inventory Investment in the Recent
Recession and Recovery.” Review, Federal Reserve
Bank of St. Louis, (April 1977), pp. 2-9.
19. Touche Ross and Co. Current Value Accounting,

Revisited in a Double-Digit Inflationary Economy,

14.

; M. Foss; and G. Fromm. “Improving
the Measurement of Business Inventories.” American Statistical Association Proceedings, 1977, pp.

15. Shoven, J., and Bulow, J. “Inflation Accounting
and Nonfinancial Corporate Profits : Physical
Assets,” Brookings Papers on Economic Activity,
(3: 1975), pp. 557-611.
16.

. “Inflation Accounting and Nonfinancial Corporate Profits: Financial Assets and Liabilities.” Brookings Papers on Economic Activity,
(1: 1976), pp. 15-66.

Their Effect on Balance Sheets and Operating
Statements, Submitted to the Graduate School of

Economic Reality in Financial Reporting, A Program for Experimentation, 1975.

20. van Furstenberg, G. “Corporate Taxes and Financing Under Continuing Inflation.” Contemporary
Economic Problems. Edited by W. Fellner. American Enterprise Institute for Public Policy Research,
1976, pp. 225-54.
21.

, and Malkiel, B. “Financial Analysis
in an Inflationary Environment.” The Journal of
Finance, (May 1977), pp. 575-92.

The E CONOMIC R EVIEW is produced by the Research Department of the Federal Reserve Bank of
Richmond. Subscriptions are available to the public without charge. Address inquiries to Bank and
Public Relations, Federal Reserve Bank of Richmond, P. O. Box 27622, Richmond, Virginia
23261. Articles may be reproduced if source is given. Please provide the Bank’s Research Department with a copy of any publication in which an article is used. Also note that microfilm copies of
the E CONOMIC R EVIEW are available for purchase from University Microfilms, Ann Arbor, Michigan 48106. The identification number is 5080.

FEDERAL RESERVE BANK OF RICHMOND

27


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102