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THE OCTOBER 1979 REGIME OF MONETARY CONTROL AND THE BEHAVIOR OF THE MONEY SUPPLY 1980* IN Robert L. Hetzel I. reserves Introduction In October instituted 1979, the Federal a regime of monetary by lagged-reserve reserves target. control accounting operating provides an analytical Section III monetary regime Section regime. and Il. a Section within Section this by their holdings it to a operating Banks V examines the question of the money This analysis of why the supply was so variable s6urce the level of nominal nomic analysis reserves bank deposits. begins with and for bank credit. and these two markets, specifically, with a systemwide price of reserves markets Banks market for (credit banking extension) the for or via a correspondent chasing an asset of replacing the cost the serves. deposit on the Federal along thereby quantity rate existing the * Reprinted with permission from the Journal of Money, Credit, and Banking, vol. 14 (May 1982), pp. 234-51. Copyright 0 1982 by the Ohio State University Press. Footnotes 5 and 12 have been added to the present version. The author acknowledges useful criticism from Neil G. Berkman, Marvin S. Goodfriend, Robert E. Keleher, Robert D: Laurent, Raymond E. Lombra, Bennett T. McCallum, Thomas Mayer, Frank E. Norton, William Poole, Peter A:Tinsley, Roy H. Webb, and two anonymous referees. Ken Anderson and Duane Musser did the graphics. is summarized demand possesses rate less than raises The marginal for credit the nominal Reserve influences by the shape section, reserves, increase at the rate (Figure their use of the reserves reserves, the nonpecuniary retar- for values of the discount that is, as total of the for bank operating a vertical above the level of nonborrowed Reserve By can move and, consequently, a nonborrowed-reserves window, to banks Reserve in the market As banks collectively discount Re- funds rate. determining value of nonborrowed the funds Federal of total bank deposits. schedule With of reserves The the cost of asset acquisition get, this schedule the RESERVE the price the funds rate. system reserve-supply la). FEDERAL funds considerations of term It is, therecosts. The way in which the Federal The cost of pur- is then bank, from to represent it faces, the funds either of the seller of the asset. banking the nominal of individual directly reserves. certificate or Federal quantity of bank credit outstanding the account agreement, apart its influence schedule constrains an asset by crediting, ways of acquiring altering the funds rate, the Federal system reserves, market system and, risk, and transactions serve influences bank summarize repurchase convenient through are middlemen bank in the reserves A bank purchases of microecofor many by a single price, and the return to lending. in a competitive the asset acquisition banks. the The respectively, them the cost of borrowing More fore, Framework on the determination of interest-bearing of the banking they can use the Eurodollar, is equal, structure, concentrates quantity market. Banks arbitrage the rates across these markets so that the price of obtaining reserves from each 1980. An Analytical The process its deposits. possess of deposit, of the assets. rates in these two markets extension) For example, target. the actual implementation the nominal (credit as a consequence, contemporaneous-reserve total-reserves the interest assets of rates in the reserves of interest-bearing determines regime. for purposes the interest differ, banks respond by adjusting of arbitraging II of this article for When and credit markets characterized of this regime by comparing IV describes rate of growth System a nonborrowed- the efficacy, characterized accounting and framework appraises control, Reserve lost when the seller of the asset draws down his account. increase the Federal cost of borrowing. effective cost of obtaining reserves from the window rises above the discount rate and, through arbitrage, rate. reserves BANK OF the funds rate also rises above the discount The positive relationship and the differential RICHMOND between between borrowed the funds rate 3 Figure la Figure RESERVES MARKET FUNDS BANK CREDIT MARKET RATE RD I NBR, FR is the supply funds schedule credit. Reserves rate; of BC is fhe respectively. the The positively DR the Federal stock of discount Reserve. nominal O’s denote and the discount bank particular section BR borrowing is the from reserve-demand credit. BCS and BCD Because demand in Figure of of lagged-reserve schedule predetermined the ore la by the the reserve- Required they reserves depend upon are deposits held two weeks in the past, rather than upon deposits held in the current excess reserves insensitive current to of excess through 1980 significant reveals regime, rates. For desired interest- at least at example, a re- on the funds rate and a reserves from the absence relationship Also, practically 1979 reserves value of excess week. be in the October levels of interest gression lagged statement appear between October 1979 of a statistically excess reserves and the funds rate. bank credit is downward ule is horizontal lowing changes from serves, sloping. (Figure Changes in deposits, This characteristic accounting in bank but, because the associated for the stock of The supply sched- lb). lagged-reserve reason. accounting, credit produce in required for reserves banking.system, in the first instance initially, rate such accommodation does not affect its cost of funds, the funds rate. supply schedule The accommodates in the demand for credit at the existing on bank loans because, re- by the occur with a lag of two weeks. system NBR banking bank-credit nonborrowed supply RS reserves. is the nominal and bank-credit demand schedule, markup, which is quite schedule interest reserve- LR is the system. rate on bank rate plus a .markup. variable, reflects This the transactions costs of intermedi- It reflects term structure considerations in ation. that the loan rate is for longer maturities than the funds rate. Finally, funds rate moves market rate) rates, it reflects rapidly the loan rate (in particular, money- the prime moves sIuggishly.x The analytical can be illustrated apparatus of reserves dow rises reserves. demanded accounting summarized by considering tion in nonborrowed period, borrowing by an amount reduction rises. (In rate Because reserves. 3a, RS As a result, the re- shifts leftward the unchanged RD higher funds rate. The remainder of Figure to this example.) schedule to at a 3 is in- The cost of asset acqui- sition to banks rises. The bank-credit shifts upward and intersects winto the on borrowed and intersects applicable reserve- from the discount of interest Figure 1 the quantity in a given equal in magnitude in nonborrowed effective in Figure the effect of a reduc- is fixed marginal RS’ the fact that while the in line with other supply schedule the bank-credit demand of lagged-reserve changes and thus in the demand for the fol- banking changes the window; of the serves The demand schedule in the market derives discount schedule reserve-supply accounting, is vertical. because the values. rate is shown sloping rote; RD schedule. 4 lb is drawn at the height The of the funds ECONOMIC REVIEW, 1 A fundamental issue is whether a theory of the money supply process should be organized primarily around the market for the quantity of money (New View) or primarily around the market for bank credit (Old View). The Appendix indicates how the market for the quantity of money can be incorporated into the model in the paper along either New or Old View lines. The discussion is reserved for an appendix because the method of incorporation of this market does not alter the analysis in the paper. (The discussion is simplified by the assumption that all bank deposits are checkable deposits.) JULY/AUGUST 1982 schedule at a point corresponding to a smaller the loan rate over the rate banks pay on their liaBy producing a price of reserves equal to bilities. FRo, the Federal Reserve will cause banks to alter quan- tity of bank credit and deposits29 3 An increase deposits. in the discount The increase the height of the reserve quently, the same Figure 3a, RS’ The RD remainder example.) of Figure reduce the differential discount rate in the funds schedule An increase the same increase their in to RS” rate. funds 3 is inapplicable in the discount The Federal until after the passage schedule shifts (This implication of the model is supported In principle, in the October from the target by the money mand for targeted the value particular 1). nonmonetary of checkable level of bank credit, Given schedule, supply target. the position deposits will This funds rate, FRO, given an estimate its targeted movement This procedure Reserve demand of re- with the tar- could in principle allow the Federal to set a money-supply target for a future and then specify the values for nonborrowed reserves with necessary to achieve this target (feedforward control of the money supply). It would require, however, an ability to predict shifts in the bank-credit of demand schedule dynamics 2 With a two-week lag, this reduction in bank deposits causes a reduction in required reserves and the reservedemand schedule, RD, shifts leftward. The funds rate falls. This fall causes the banking system to increase its interest-bearing assets and, as a byproduct, its deposits. The original decrease in nonborrowed reserves produces a lower level of deposits, but the approach to the lower level is, as just suggested, an oscillatory one. and an ability of the interaction bank-credit market. such requirements, Perhaps has adopted a different, targeting procedure as a feedback cedure Hi. Efficacy bility for purposes with a regime relationships of the total reserves In the latter OF control, of regime, of bank RICHMOND (D) 1979 operating target. By equal the product of the (TR) to deposits ratio 7X. determination deposits in the above total of this re- the October system and total reserves. (1) D = (&,) BANK Regime of contemporaneous-reserve reciprocal of the banking actual 1979 of monetary and a total-reserves bank deposits replacing, actual pro- IV. to contrast definition, quantity characterized The 1979 regime depends upon the predicta- accounting 4 The monetary consequences of the behavior of the discount rate depend upon the particular regime of monetary control. When the funds rate serves as the operating target, as in the pre-October 1979 regime, the behavior of the discount rate is largely irrelevant. Given the funds-rate target, changes in the discount rate change the average, but not the marginal, cost of asset acquisition to banks and do not, therefore, affect the money supply (see [6, p. 291). properly in Section Reserve less-complicated procedure). It is instructive regime the Federal (more of the key behavioral gime. and because of the difficulty of the October The efficacy, the October the the reserves conceptually control is described to understand between of fulfilling a Bank checkable deposits, the quantity relevant for determination of the money supply, equal total hank deposits minus the nonmonetary deposits of banks. The rate banks pay on their nonmonetary deposits equals the funds rate adjusted for the term-structure of interest rates (abstracting from Reg. Q). The public compares the rate on bank nonmonetary deposits with moneymarket rates and decides how much of its liquid assets to allocate to the nonmonetary deposits of banks. The nominal quantity of bank checkable deposits is then determined as a residual, that is, by subtracting the nonmonetary deposits desired by the public from total bank deposits. The variability in the demand for the nonmonetary liabilities of banks causes considerable divergence in the behavior of bank credit and the monev stock. As described in Section IV, the Federal Reser;e offsets the effect of this variability on the money supply by accommodating reserve demand due to banks’ nonmonetary deposits. RESERVE associated interval rate will imply a of the markup demand the amount geted value of the money supply. a reserves con- supply to of the reserve by estimating and excess excess for analytical of the money value, the position is derived demand value of re- of desired assuming the (see Figure FEDERAL plus an estimate prompt schedule of the reserve quired imply is associated the position Thereafter, the For the first two weeks of a de- of banks, say, BCo this level of bank credit reserves with will produce interval, venience that is implied deposits RD, is given by the predetermined quired the non- Given the public’s deposits such that its interaction schedule, targeting by the of the bank-credit the rate on bank loans, LR,. demand schedule leftward. target would be derived as follows for checkable into a position reserves. 1979 regime, is achieved. must choose its nonborrowed- desired funds rate, FRO. data presented .in [4, pp. 25-271.)’ borrowed-reserves the bank target so’as to shift the reserve supply sched- the reserve of two weeks demand Reserve until is LRo, ule, RS, to this between the funds rate and the the reserve assets market reserves rate. rate does not when of interest-bearing rate in the bank credit credit is BCo, and the deposit target (In and intersects at a higher holdings interest supply schedule and, conse- increase shifts upward the unchanged rate also lowers bank produces can definitional reserves-deposits of the nominal be summarized ratio relationship, with the by the total 5 reserves-deposits The reason replaced ratio desired by the banking that the definitional by a behavioral total reserves, system. relationship relationship can be is that, given the funds rate varies in order to bring the actual total reserves-deposits the banking system’s ratio into line with desired total reserves-deposits ratio. For example, consider an increase in total reserves that leaves the actual in excess of the desired total reserves-deposits try to sell Federal ratio. Banks collectively The fall in the cost of asset acquisition acquire interest-bearing increase bank deposits deposits ratio falls. spurs banks to assets. These acquisitions and the actual total reserves- sum, in a regime poraneous-reserve operating money, characterized accounting target, relationship device for understanding In contrast, multiplier relationship (or operationally) significant that the total reserves-deposits exist as a behavioral relationship. ratio total reserves accounting and deposits period. Recall II of how a reduction deposits. posits the description in nonborrowed in nonborrowed fall without and, consequently, between without in Section occurs, in required any significant total reserves. Despite total reserves, lowers period in which reserves any change reserve reserves For the reserve-accounting the reduction Note One way of making over a particular de- reserves change in deposits change. The practical serves deposits. The reserve by definition reserves therefore, which a reserve down toward zero nonborrowed this “multiplier,” reand produce, total in a particular edge situation would force and a reserve is with a totalto target the funds deficiency though the net source minus borrowed schedule 6 the possesses some market nor the interest for in rate would if reserve-supply elasticity. ECONOMIC base, reserves, reserves.) in the past to de(This “money- high-powered ratio is not of lagged a behavioral this “multiplier” deposits for that determine upward schedule, rate, sloping (A REVIEW, to 1979 reserves, relationships section bank is a functional regime but relating it depends of the regime- of the reserve-supply the markup of the loan rate over the funds The the bank-credit demand schedule. and influence fully There October to .nonborrowed upon the key behavioral the deposits relationship: is not a useful summary relationships the money is used in place of nonbor- The deposits of these behavioral summarized within relationships is not use- a money-multiplier frame- work. The central of the relative 1979 to a regime counting pends idea of this section October regime upon the relative relationships relationships the rate, The Evidence credit operating the markup and the key The key regime are the of the loan rate bank-credit key relationship demand in the latter is the ratio. from the 1970s demand de- of the predictability of the former ac- target, of these regimes. schedule, funds control, of contemporaneous-reserve behavioral reserve-supply is that the efficacy of monetary and a total-reserves schedule indicates that the bankIn the is not predictable. 197Os, the Federal Reserve used the funds rate as its operating target. In a regime of funds rate targeting, the reserve-supply schedule and the bank-credit supply schedule spectively, equal are infinitely to the rates). demand elastic funds above the funds rate adjusted bank interest-bearing equilibrate reserve-demand in out in [2, p. 531, al- reserves the ratios of deposits is written formula The funds cannot of the multiplier” be willing rate One week. credit neither equating of a “multiplier” statement of interest on their deficiency. nonborrowed- is the ratio week two weeks force the funds rate up to a point where banks would to default to the product reserves. total reserves-depdsits is, approxischedule a that is, a formula however, in the statement schedule. inelastic An attempt period, a razor’s surplus and and target, (or deposits) reserves total schedule interest would money the 1979 regime.) accounting operating over reserve-supply target. reserve-accounting total inelastic because of lagged- The completely operating reserves, between interest accounting. reserves the lack of a reflects reserve-demand mately completely given value of of targeting in this regime relationship lagged-reserve render is, likewise, matter, possible to write down a relationship for a regime of behavioral impossibility directly behavioral the exogenously It is, as a formal “money-multiplier” relationship a does not this point is to note the lack of a relationship not feasible in the October deposits and the money supply. is not an anaconcept. inelastic, of the behavioral accounttarget, it would interest therefore, process. operating because rowed analytical the money-supply discount current or a reserves- in a regime of lagged-reserve reserves-money first contemreserves is a useful ing and a nonborrowed-reserves lytically by a reserves-deposits, multiplier ratio. a total and rate, supply of total reserves posits in the current The process ends when the actual is reduced to the desired total reserves-deposits In will funds causing the funds rate to fall, penalty re- somewhat shifts in the bank- determine assets, (at values, and for the term structure Consequently, schedule rate deposits, simultaneously and reserves. (Reserves appear with a two-week lag. Because of lagged-reserve accounting, deposits determine the JULY/AUGUST 1982 quantity of reserves future. The this quantity rate.) Reserve In the movements left seasonal adjustment was referred Reserve that explained gime in October (This the change effort relationship of deposits ratio uniform from the behavior bank-credit liabilities, serves. If, inelastic, however, ap- unpredictability reserves. schedule in deposits interest In such a requirements of ratio would arise primarily of excess demand able changes and the does exist that the would be a predictable reserve the total reserves-deposits re- it and less predict- in a regime of the above type. assuming plied only to monetary The diffi- between to become point is made in [7, p. 9321). reserves-deposits regime, by the Federal in monetary the relationship On the other hand, the potential was seasonal variable, would be expected (This total by imperfect See [ 10, p. 1391.) the behavior able. to unsatisfactory to in statements 1979. culty of predicting This supply procedures. situation deposits invested from predicting in the money determined and the money funds rate. apart the funds in an attempt of bank deposits unsuccessful, in the supplies Reserve of staff effort the behavior weeks of targeting 197Os, the Federal amounts supply for its targeted largely two automatically as a consequence considerable predict demanded Federal Shifts in the could cause unpredict- via the effect excess the effect on excess reserves are of these shifts re- largely would be money supply in a regime with a funds rate operating neutralized. target is evidence that the bank-credit that banks have to manage their reserves that the excess reserves- demand sched- ule is not predictable. extremely variable. demand schedule dictability of are the reserve-supply Even unpredictable, however, schedule section would make possible feedback control of the money supply. money supply deviated from target, of a fixed target for nonborrowed reserves pre- of behavioral simple deposit the the deviation. rowed reserves The target could also be changed. experience under economists at the New York Trading the new operating borrowed cedure, funds of by dictable. “The federal funds rate . . . can vary widely by the borrowing rowing experience and rate developments” ticular interest is the discussion episodes in which the spread and the discount rate] basic relationship” be in accounting and Unfortunately, pirically a total-reserves this question target Reserve (see [S] ). reserves simultaneously nous variables able. with bank credit If total reserves As target, At its meetings, intervals meeting. Open endoge- between account- target offers is a poten- the prospect of the October the Federal Open of 1979 Market an intrayearly of the money supply. Com- target for From this reserves, BANK OF for either one or two targeting the current and succeeding This target is an intermediate Market FOMC vari- RESERVE relation- Procedures specifies it is not directly were to become an exogenously FEDERAL the reserve supply behavioral operating the through control. level of total reserves above, the exogenous of the target, the board staff derives a target for the average deposits and total determined (FOMC) the rate of growth em1979 discussed by operating one, this regime the target-an Furthermore, relationship, Implementation mittee used the funds rate as its operating 1979 determine of the unpredictability the central monetary Operating between In the pre-October with a funds-rate become IV. target ? be resolved with a different must schedule. Because stable improved from the operating cannot and deposits. regime, the Federal operating demand tially of contemporaneous-reserve on the basis of the past relationship total reserves of Of par- would the total reserves-deposits a regime Reserve ing and a total-reserves the funds rate departed dramatically of regime In the October ship of a regime of contemporaneous-reserve of the “distinctive [between process 1979 by its money-supply task because [S, pp. 29ff.l. How predictable ratio expectations Federal implied schedule. not only [S, pp. 28-291. the rate another unpredictable but also by past bor- by market future of the basic the October funds rate must be set indirectly Changes in the federal level itself shape an experiment impossible supply schedule is not pre- influenced that control. bank-credit Desk, however, that the reserve funds rate appear to be strongly ratio regime, in order to control the money supply with other than the crudest kind of feedback-control pro- for nonbor- indicates for a given level of borrowing. of excess reserves-deposits, in the of monetary A review procedures incentive holdings unpredictability relationships determination regime and the funds rate would vary in a way that would offset the total that renders appealing as a consequence reserves, and thus It is the demonstrated the Whenever the financial would be predictable. if it and the bank-credit upward-sloping generally, creates the potential deposits, The markup of the loan rate over the funds rate is More under Account also specifies the control Manager an initial again as an average RICHMOND of the (the target FOMC target in that System desk). The for borrowed to be achieved over the 7 intermeeting interval.5 The difference between the and borrowed-reserves targets deter- total-reserves mines the intermeeting rowed reserves. target This and it is translated for average target NBR where NBR reserves, - RR (By is shown total week. RR is required and BR is borrowed terms, “total via (2)) reserves. a projection a weekly Within the uses quently, borrowed desk reserves The Federal reserves target a particular for bor- week, nonborrowed conse- reserves and as operating interchangeably Reserve First, tar- total-reserves in order to checkable this ratio change because to offset of changes and of required the nonmonetary reservable These get for total reserves equal amounts. target nor the weekly are affected. in estimates for borrowed a projection of total reserves desk subtracts reserves, the current its target adjusted revised estimate reserves is made of the that targeting for The nonborrowed average as just described, of average will be out- interval. from this newly total reserves in order to arrive at a new target for average borrowed The weekly desk reserves As then derives a new reserves. borrowed- target. a consequence serves, by the average with a revised projection growth, over reserves neither average standing of by of financial and nonborrowed targets of alter the desk’s tar- of money-supply amount generated liabilities Consequently, In conjunction in the Estimates reserves adjustments and shifts deposits. excess reserves deviations borrowed changes reserves, nonborrowed re- of the money supply from its tar- geted path produce, reserves, of targeting via associated in borrowed in turn, movements reserves. produce of total Changes changes in in the 5 The Federal Reserve uses the language “initial assumption for borrowed reserves.” It is felt that the word “assumption,” rather than “target,” conveys more of the sense of the practice of changing this variable when misses of money-supply targets occur. 8 targets level, thereby for desk can change reserves native reserves relative lowering FOMC description the initial reserves.6* r the target for average meetings. rate can be changed.8 to the pre- or raising nonborrowed between discount It can, raise or lower the initial target borrowed average in re- target. (See of these operating The nonborrowed Finally, the [ 31 for an alterprocedures.) V. The Behavior of the Money Supply in 1980 As indicated money supply, variable within Section MlB by Figure 2, the rate of growth measured 1980. by The MlB, analytical II is used in order to explain grew rapidly from was of the extremely framework of this behavior.9 the end of 1979 through targets of Governors to the nonborrowed-reserves targets institutions. its reserve the staff of the Board makes adjustments ratio of reserves assesses in its operating meetings, the money- can also make sponse to misses of the money-supply for excess gets. each week. changes Reserve of lagged-reserve are given for a particu- the weekly target for nonborrowed then determines, this reserves the miss from Federal target the negative Given discretionary for average BR, Because The vailing to be the identity reserves rate that mitigate supply target. at FOMC identity reserves, transposing required lar statement rowed - reserves, reserves.“) accounting, reserves, ER is nonborrowed relation equal = ER is excess reserves. target, into a weekly path. It is useful to recall the reserve (2) nonbor- is an operating funds ECONOMIC REVIEW, s In setting this target. the FOMC aonears most often in 1980 to h&e taken-the target for a&age borrowed reserves that was in force going into a particular FOMC meeting and to have set the new target equal to this existing target, after an adjustment for recently observed shifts in the reserve supply schedule. For example, if the last weekly observation available indicated that realized borrowed reserves had fallen without any change in the funds rate, then the new initial target for borrowed reserves would have been set somewhat below the currently prevailing target. 7 In the face of a miss of the money-supply target, the FOMC at a given meeting will also move the nonborrowed-reserves target in-the appropriate direction by retaining the existing intrayearly target for the money supply and by adopting the target for borrowed reserves that existed going into the FOMC meeting. Consider an overshoot of the money supply. This overshoot will have caused the target for average borrowed reserves to increase. relative to the initial value set at the nrior FOMC Leaving the money-supply target path unmeeting. changed will leave the target for total reserves essentially unchanged. Subtracting-the increased target for borrowed reserves from the essentially unchanged target for total reserves will lower the target for average nonborrowed reserves, relative to the value set at the prior FOM C meeting. s The Federal Reserve could use alterations in the required-reserve ratio against checkable deposits as an operating variable. The alterations in the way required reserves are computed that have occurred since October 1979 (apart from changes mandated by the Monetary Control Act) have involved the nonmonetary liabilities of banks, however, and have been designed to control, through an excise-tax effect, the extension of credit, not The nonborrowed-reserves target has always money. been adjusted in order to offset the changes in required reserves arising from such alterations in reserve requirements. 9 The primary empirical test of the analytical model is whether it is useful in understanding the actual behavior of the money supply. Confidence in the model will come only after extended successful application of it. JULY/AUGUST 1982 Figure prevalent TARGETED AND ACTUAL BEHAVIOR OF MlB OVER 1980 forecast estimates 2 of defense invasion spending of Afghanistan rightward 6.03 of a recession, shown the Soviet 1979. in December shift in the bank-credit in Figure and by increased following (The demand schedule is 3b by the movement of BCD to BCD’.) The 6.01 president’s budget message in late January was viewed as avoiding hard choices between 5.99 defense and as pre- domestic saging spending continued and, large consequently, budget 5.97 imminent, caused near-term 5.95 rate. 11 1 12 2 3 4 5 6 - 1979 7 8 9 10 11 12 1980 As schedule, , interest, The 1979 target to fourth February values 1980, ore tively. values release range H.6, dated to 6% MlB specified of from l/9/81. fourth by The 1979 interpolated taken from percent. November plots were of 1980, 4 in cone MlB growth quarter was plotted The for for and values. the Federal logarithmic the FOMC and 1980, values ore in a consequence, shifted upward 1980. This growth ward shift in the bank-credit in turn derived from public of its estimate This optimistic of incoming derived realized The plotted. rightward of the strength revision was prompted data on the real sector, Figure described to increase, changed demand rate of An increase however, does not schedule and, funds in the bank-credit above caused in the first rate. With a bank to demand credit instance which by the ule to shift rightward. of the economy. rowed by the strength reserves, schedule, which belied the and two-week Given the target thus the rightward reserves Figure lag, the sched- for nonbor- reserve shift in the reserve schedule caused borrowed 3a a fixed and at an un- increase in deposits caused the reserve-demand RESERVES MARKET FUNDS (rightward). shifts schedule from a right- revision its banks. statistical demand schedule, an optimistic bank-credit of the nominal rate of inflation, deposits February the upward of the inflation thus, does not in itself raise the cost of reserves final respec- The Reserve to revise expectations pros- was no longer affect the position of the reserve-supply quarter base public defined as a function in the expected NOTE: the and long-term This deficits. pect, as well as the belief that recession supply demand and the funds rate 3b BANK CREDIT MARKET RATE LOAN RATE RS” BCD \ RS’ BCD’ \ RS I ’ I I NBR’, NOTE: Labels ore Reserves NBR, explained in Figure BC, BC’, Bank Credit 1. FEDERAL RESERVE BANK OF RICHMOND 9 to rise. The rise in the funds rate partially did not eliminate serve’s the overshoot intrayearly moralization money-supply of the bond affected the behavior offset, but in the Federal targets. market (The in February is reserved de- announcement of the program supply (M 1B) for later in this Federal February Reserve responded its operating reserves was lowering is shown in Figure of NBRo to NBRo’ reserve-supply to this overshoot targets and early March.lO nonborrowed vigorously lowered twice. (This 3a by the leftward shift and by the associated schedule in late The target for average from RS shift in the to RS’.) count rate was raised a percentage Figure as evidenced the nominal deposits point The dis(shown 3a by the upward shift in RS’ to RS”). annualized rate of growth 7.7 percent cent from of MlB from December December range for growth Reserve’s of MlB. The was reduced from to February to March, midpoint of the Federal in almost are functionally after tent related, specific targets The ways to produce “frequent” use of the with deposits SCRP because exactly trol by rendering 3a and 3b show schedule complicated reserves From growth March of MlB deceleration of the upward-sloping supply schedule) through May, the annualized fell to -7.4 was produced percent. rate of This monetary by the Special Credit Re- straint Program (SCRP), announced &larch 14. The immediate objective of the SCRP was to reduce the the interest percentage direct the surcharge, effect associated It with a given increased reserves points. esti- of the reserve- that, after indicates much of the increase rate (a graphical section rate differential amount of borrowed a con- between mate RD’.) monetary diagram its original schedule, sur- A scatter the funds rate and the discount reserve-demand (The to only the differential against the final level of bank credit, BCO’, only slightly above level, and the associated to by banks of the reserve-supply even less predictable.) of borrowed of three rate applied million. the behavior the deceleration. application banks, ex- in several window of $500 of its subset of member target acted was a surcharge discount in excess how- to a significant over the discount charge itself, bank credit; a monetary One feature of the SCRP points be tarReserve of nominal 14. percentage they cannot the Federal was reversed March Because and checkable of its money-supply the consequences ever, this situation of the money on target. Ordinarily, to 5.2 per- four-quarter (Figures accepts growth of bank credit for the rate of growth in by the fact that prior to the quantities geted independently. by moving and bank-credit was approximately also section.) The of credit in general particular, of the money supply, but discus- sion of this phenomenon rate of growth Re- by about three is uncertain, however, in the differential of the surcharge. how was due to the The increase could have been caused by an upward rotation of the upward-sloping section of the reserve-supply schedule 10 The documentation of this section necessarily depends upon the publicly available sources of information concerning the operating targets of the Federal Reserve. As background, it is noted that before October 1979, the operating target of the Federal Reserve was the Federal funds rate. With a lag of about a month, the public was informed, in the Record of Policy Actions, of the initial value specified by the FOMC for this operating target, of subsequent changes in the targeted value, and of the reasons these changes occurred. In October 1979, nonborrowed reserves replaced the funds rate as the Federal Reserve’s operating jarget. At this time, the Record of Policy Actions ceased reporting any information about the operating target. It also ceased to be a complete summary of FOMC policy actions due to omission of any mention of the FOMC’s initial target for average borrowed reserves . The only publicly available source of this information is the annual report of open market operations published in the Federal Reserve Bank of New York Ouarterly Review (generally) in August of the succeeding year. This report, however, is intended for a general audience, not just students of the money-supply process. It does not necessarily provide for a sharp distinction, critical for the purposeof this article, between those changes in the targets for nonborrowed reserves that should be considered as “technical” and those that should be considered as significantly influencing the behavior of the money supply. The documentation then for this section rests on the material in , but the author has exercised some judgment as to which of the changes in the targets for nonborrowed reserves listed there were significant for purposes of monetary control. 10 ECONOMIC REVIEW, due to the effect of tough on banks’ perception Federal Reserve of the nonpecuniary rhetoric costs asso- ciated with use of the discount window. In any event, the sharp increase in the funds rate produced surcharge the rate of growth reduced by the of the money supply. The growth SCRP also compelled loan growth in January of the possibility of outstanding exceeding and February, lines of credit, the guidelines. on bank market rates. loans the SCRP credit. and because banks were fearful caused Installment annual percent in both the differential 1982 The depressed Also, between the rate and money credit consequent bank deposits the psychological the public to reduce contracted rate of 7.5 percent May of This fear had the effect of from banks. supply. adjusted JULY/AUGUST loan of strong would make use and the funds in bank credit the money hold A result was to shift intermediation the money market duction to Because that corporations causing banks to increase rate banks to within 6 to 9 percent. and June, effect to reand of its use of at a seasonally in April causing and 13 the bank- credit demand schedule to shift leftward. the public became convinced value of the funds rate was below the discount antici- At least through early August, the funds rate implied shifted by the FOMC’s money-supply target was also below and the bank-credit downward Federal demand These (leftward). credit demand schedule The ending May 7 through August 20, the weekly average as reces- it lowered its inflationary sion was underway, pations Finally, that a significant depressed Reserve schedule shifts in the bank- the discount rate. the money supply. apparently did not Reserve’s operating is necessary realize for bank credit and the money schedule supply would conflict. At its March serves market. ings, the FOMC extended with the targets of previou: the target for MIB meetings. with the May meeting did the FOMC its MIB The targets.)ll borrowed reserves, resulting in combination demand for total reserves associated and in the funds rate. For for non- with the reduced August, nualized rate of 16.9 percent. acteristic lower and range for variation either borrowing limits of is the in the funds late even when most trades rate. the supply of reserves charweeks day or of fed funds, the value of are occurring. can be large enough to use the discount the generally below the discount grew at an an- in the imounts For these banks, this differential of this period is that for the statement the re- schedule funds can exceed rate at which prevailing This beyond funds window rate lies borrowing increases nonborrowed reserves even when the funds rate lies below the discount rate. The phenomenon is shown in Figure tive, but highly inelastic, schedule immediately to the nonborrowed reserves, of discount rate, DRo, hibits the relatively previous 4a by the posi- slope of the reserve-supply value 11 At its March and April meetings, the FOMC set an intrayearly target for growth of MlB designed to place MlB at the midpoint of its four-quarter target cone, shown in Figure 2, by June. At the May meeting, it set an intrayearly target for MlB designed tb achieve the midpoint of its target cone only by year-end. At the subsequent meeting in July, it set an intrayearly target for MIB designed to place MIB at the bottom of its target cone by year-end. (See the Record of Policy Actions of the Federal Open Market Committee in [l] for March, p. 110, for April, p. 118, for May, p. 123, and for July, pp. 130 and 131.) right of the existing NBRo. Above the the reserve-supply more elastic schedule ex- slope shown in the diagrams. l2 The Federal for Committee Reserve describes consultation.” 4a Figure RESERVES MARKET FUNDS upper borrowing significant that it is advantageous A distinguishing Figure representing the reserve-supply the the funds The weekly average MlB in the diagram First, the cost of borrowing with the drop in points from early April to late May. May through at banks already value of the funds rate dropped about ten percentage From it rate.12 the money supply, produced a sharp drop in borrowed reserves the Federal over this interval, tolerance FOMC’s starting begin to lower targets shown horizontal in line (Only procedures to alter in two ways the reserve-supply initiaIly that its targets and April meet- In order to understand rate. the limits as “points 4b BANK CREDIT MARKET RATE LOAN RATE RD I RS BCD I i I FR,, and FRul we the lower Bank Credit Reserves NBR, and upper limits for the funds FEBERAL rate set RESERVE by the BANK FOMC. OF Other RICHMOND labels we explained in Figure 1. 11 For the period from May 7 through August 20, the Federal Reserve reserves as an operating the reserve lost the ability section, rate target. along Over this interval, intersected demand schedule supply schedule to use nonborrowed the reserve- the latter schedule’s inelastic so that the funds rate lay below the discount (see Figure 4a). in nonborrowed In this situation, reserves, reserve-supply an increase a rightward shift of the schedule, would have forced the funds rate down to the lower limit of its tolerance thereby making the funds rate the desk’s target. A decrease in nonborrowed ward shift of the reserve-supply operating reserves, schedule, forced the funds rate up to the discount in excess range, a left- would have rate, a value At the May and July FOMC meeting), meetings the FOMC (there set minimum for growth of the money supply. Growth was targets moderately above target was to be accommodated by the desk. In fact, the money supply did grow somewhat faster than the minimum targeted the reserve-supply rightward shifts values. strongly of the schedule to shift in line with the in the reserve-demand small level schedule a very the end of July, the desk stopped raising its for nonborrowed supply of borrowed by (Toward of the money reserves, reserves. but its projections and total reserves apparently caused it to continue to target only a small amount of borrowed reserves.) As shown in Figure 2, from May through August, MlB moved from well below to the upper part of its target result, however, nipulation vagaries From reserves, of shifts in the bank-credit August to November, nualized rate of 12.9 percent. exceeded cone. was not accomplished of nonborrowed its targeted the December consequence, MlB grew values of 1979 and 1980, some- top in the summer, from of its targeted the economy the depressing effects The public reduced its estimate range. rebounded of the SCRP. of the length and the severity of the current estimate of the future rate of inflation. recession and increased its As a result of these events, the bank-credit demand schedule shifted rightward increased. Reserve, gets and bank deposits in the demand funds face schedule, eliminating, shifting reserve- caused borrowed reserves and the thereby the overshoot Federal Reserve targets nonborrowed reductions reserves, targets moderating, of the money reserves.15 extent, As but not sup~1y.l~ made discretionary only belatedly. it did not, to any meaningful for tar- of a rightward rate to increase, The The Federal by holding to its nonborrowed-reserves changes In particular, lower its targets an alternative to by the desk in the target for nonborrowed the FOMC for average could have increased borrowed reserves, the initial relative to the The desk caused targeting This desired by active ma- but rather by the demand schedule. MIB grew at an an- Money-supply from 19 FOMC at a rate late growth summer meeting. of 7.3 As a percent 13 In order to have retained nonborrowed reserves as the operating target, the Federal Reserve would have had to lower both the discount rate and its target for nonborrowed reserves (shift the RS schedule downward and leftward). In this way, the relatively elastic section of the reserve-supply schedule would again have intersected the reserve-demand schedule, so that either changes in the nonborrowed-reserves target or in the reserve demand schedule would not have forced the funds rate to the limit of its tolerance range. The Record of Policy Actions for the May FOMC meeting records a concern that further declines in short-term rates would exacerbate inflationary expectations and weaken the foreign-exchange value of the dollar [I, p. 1231. This concern can be inferred to have limited willingness of the Federal Reserve to lower the discount rate and thus to have accounted for the summer’s operating procedures. 12 in excess Beginning in its operating no June through what of what was implied by the money-supply target.ls target between the fourth quarters ECONOMIC REVIEW, Initially, however, this mechanism was a weak reed. “The rise in borrowings from frictional levels to over $1 billion between mid-August and mid-September may have been rapid by past standards, but the resulting increase in the federal funds rate of about s/8 percentage point appeared small to the market in relation to the overshoots reported weekly in the money supply” [S, p. 341. 14 15In the period from September through December, the desk reduced the target for average nonborrowed reserves in four targeting intervals for reasons unrelated to a revision in the estimated relationship between reserves and checkable deposits. Such reductions in the target for average nonborrowed reserves do not necessarily First, they do not if increase the funds rate, however. they are caused by the problem that can arise from In particular, expressing reserves targets as averages. an overshoot in borrowing in the first part of a targeting interval can cause the desk to lower its weekly target for nonborrowed reserves in order to prevent the appearance of excess reserves large enough to force a sharp drop in the funds rate. Achievement of the target for average nonborrowed reserves over the remainder of the targeting interval can then require weekly targets for nonborrowed reserves that imply little or no borrowing. In such cases, the desk may reduce the target for average nonborrowed reserves in order to keep the weekly targets for borrowed reserves from declining significantly. (See , p. 65 and the discussion surrounding the September reduction in the target for nonborrowed reserves, p. 73.) Second, a reduction in the target for average nonborrowed reserves will not increase the funds rate if a reduction in the target for average nonborrowed reserves called for by a concurrent downward revision in the estimated reservesdeposits ratio is not also effected. In such a case, the rise in the target for average borrowed reserves and in the funds rate is nullified. Finally, the effect of a reduction in the target for average nonborrowed reserves can be offset if, at the subsequent FOMC meeting, the initial target for average borrowed reserves is lowered significantly relative to the target prevailing at the time of the meeting. Reductions in the target for average nonborrowed reserves acted unambiguously to decrease growth of the money supply only after the November 18 FOMC meeting. JULY/AUGUST 1982 targets prevailing at the time of its meetings, not. Alternatively, as explained at its meetings, target for changed could have borrowed adopted reserves, its money-supply supply target after in response changes July essentially percentage-point the second instance, to three percentage of market two The budget deficits pear likely business cycle unusually tember, borrowers (on 5). In The Federal changes the inflation used banks, the bond causing cuts Starting became, market turned the blink-credit If the lenders the money in Sep- VI. sively (for example the bank-credit matched CD’s), demand by a rightward schedule for the nonmonetary nonmonetary same (see n. 3). however, funds, deposits amount must perhaps with Former have lenders placed would of banks. have temporarily, in the one of the rate of growth of the in checkable reasons were advanced of money within the the Federal maintenance reserves. and for aggregate deposits. to achieve is frequent and creates the possibility reserve RESERVE that monetary by a regime accounting relationships. of reserveaccounting control based on This situation control would be based upon contemporaneous- and a total-reserves operating target. 17 It is frequently argued that short-run control of the money supply will increase interest-rate variability. In the situation just discussed, however, if the Federal Reserve had achieved its short-run money-supply targets, it might have limited the demoralization of the bond market caused by heightened uncertainty over future inflation. Short-term interest rates would not have had then to rise as high as they did ultimately in order to control the money supply. quarter target range. (A rev&ion of the estimate of growth of NOW and ATS accounts that was coming at the expense of savings deposits accounted for haTf a percentage point of this rise [l, pp. 143, 1491.) At the November meeting, the targeted four-quarter rate of growth of MlB was left unchanged, but the initial target for average borrowed reserves was lowered relative-to its prevailing value at the time of the meeting. FEDERAL a regime of monetary of its It was con- lagged-reserve behavioral condition alteration III that tl%Ecombination targeting on the its intrayearly reserves. unpredictable enhanced primarily in path for nonborrowed has produced 16 At the July FOMC meeting, the targeted four-quarter rate of growth of MlB was set close to the lower bound of the four-quarter target range, 4 to 6% percent. “The FOMC is in fact prepared to consider that MlB measures may fall significantly short of the midpoint of their specified ranges for the year” [ll, p. 638-j. At the September and October meetings, the targeted fourquarter rate of growth of MlB was, respectively, set close to and somewhat above the upper bound of the four- to misses that a necessary nonborrowed tended in Section of their bank forces set in motion through Reserve targets employed responded of a given target target, V for One was that In the fall in par- by relying corrective the Federal operating Reserve Reserve targets in Section 1980. target. It can be inferred money-supply market, Federal as an intermediate semiautomatic by the some and Conclusions its money-supply in deposits in the bond Summary ticular, been Total on checkable at least increased activity reinforced an increased acsur- s~pp1y.l~ credit exclushift would have increased no effect toward monetary This rate. of the rate uncertainty reduced in the spring to shift in the demand schedule liabilities further the variability had ac- of banks this rightward schedule in the This public’s inflation in turn, Several to commercial demand liabilities the future impulses of the a self- growth to a signifi- who left the bond market nonmonetary increased bond market and, consequently, the unanticipated imparted via the bond market increased the to the It is conjec- above, the reduction of the money supply, uncertainty, size to ap- forecasts As argued rounding caused lia- deposits in response to money-supply celeration shift rightward. quired targets of growth for of the, federal tax difficult. and lenders was in. the delayed making discretionary of the money supply. character intermediation forecasts in the summer Also, growth last part of 1980. cant extent, unwilling to commit themselves to longterm, fixed-income securities. Borrowers who would have Reserve in its operating reinforcing rendered shift checkable tured here that this delayed response but unpredictable, activity schedule for the nonmonetary therefore was in- review in the future. pickup of economic rate and by large talk of large of significant, one schedule borrowing increased at increased. dis- points. midyear and renewed demand by a rightward resurgent surrounding participants reasons. to three of the sellers the surcharge In the third instance, creased deposits of two percentage points was imposed on “frequent” banks. The uncertainty demand of banks, instru- increasing The result was that the right- matched bilities 17, and December a surcharge partly public’s The in the discount 26, November only market thereby ward shift in the bank-credit that did occur targets money bills, the checkable of these instruments. un- raised its money- confined increases September such as Treasury least temporarily In fact, over most to overshoots.16 in operating were leaving must have purchased ments the prevailing while target. of the last half of 1980, the FOMC cretionary Others but did in note 6, the FOMC, BANK OF RICHMOND 13 APPENDIX Consider authority first a New View world. is assumed to increase The monetary nonborrowed re- by a given amount is the deposits demand schedule of the nonbank public. The bank-credit demand serves in order to lower the funds rate by an amount that produces in bank credit interest rate sched- ule will shift in order to cause the associated a reduction to LR,,’ and a reduction instruments reduction crease from in the loan rate from LRo in the rate on money market Ro to RO’ (see in the loan rate causes from BCo to BCo’. balance sheet constraint posits, deposits assumption that The Empirically, preference the magnitude Under of the slope of the in the deposits exceeds market, that of deposits of Do’ and a rate on money market instruments produce excess supply in the deposits market This excess supply causes the nonbank chase These bonds. bank-credit purchases, the loan rate deposits LR;, fall to DO, unchanged of Ro’ of ESo. public to pur- in turn, cause demand schedule to shift leftward. shift is shown in Figure deposits credit the latter demand falls to BCG‘ quantity schedule the (This 5a by the dashed line.) bank the At and lying on the of the nonbank public. The the constraint facing the monetary thority when it alters the nominal quantity Figure au- of deposits credit View primary authority the nonbank public requires of time. that penditures. Heuristically, into exercises portfolio. demand effect, for exploits this receipts hold changes in public’s money the example, the behavior same of bank public credit the time that is, with- With reference Figure 5a at the nonbank in altering its demand for money balances, money demand schedule. in their authority, altering to move without continually change monetary phenomenon balances and ex- of this role, the quan- significant The money. of money as a medium of exchange, individuals any economically the in persuading its asset to asynchronous As a consequence tity of money without liquidity in the money supply by to rearrange not as an asset, but rather was of interest The Old View starts from the perspective that is, as a buffer in the as of money. determinant New View makes alterations the monetary change market for the quantity rates over short intervals along its to the above determines a 5b DEPOSIT MARKET BANK CREDIT MARKET MONEY LOAN the same bank New be the out having primary the in the market to in- bank credit and de- from Do to Do’. produced of the bank credit demand schedule in the credit market the demand schedule 5). As a consequence relating increase Figure to produce in change MARKET RATE RATE DD BCD I I BCO R is the Other 14 labels interest ore rate explained on BC”, money-market in Figure BC’, instruments; Bank Credit D checkable D”, deposits; DD the deposit 1. ECONOMIC REVIEW, JULY/AUGUST 1982 demand schedule D’, of the nonbank Deposits public. nominal quantity horizontal of deposits line drawn at R< (the endpoint in Figure given to the market for the quantity viduals are concerned money balances. Because inflation, the bank-credit upward. Empirically, of money. Indi- Old View emphasizes, due to a liquidity preference of the normal variability in by the New View. some time may have to elapse holdings. their When this realization increase activity its real money mined in the market increase the bank-credit cash credit activity and if the public comes to anticipate will cause a higher that impinge rate of schedule as a determinant replaces as the primary the monetary authority. that to a significant on the market rather than monetary, could in the In this case, even if as an demand schedule schedule facing both of banks of shifts rates is weak, the New View View assumes to shift rightward, schedule liabilities demand as a consequence demand constraint shift See note 3.) bank-credit and the deposits The demand than the leftward matter liquidity preference of interest money in real economic the will shift New and Old View deposits demand schedule. are deter- of money. (The determined. frequently empirical in the market balances for the quantity Finally, shift and in time the nominal of the public are determined for bank credit, initial try to run down their While are demand spending will will be stimulated, the price level will rise. balances average occurs, aggregate as individuals balances. Economic desired schedule effect that is emphasized are in accord that the nonmonetary holdings of exceed rather of before they realize that their actual average money demand it is these latter shifts that the holdings about their average their money holdings, of the that is 5b) extent is relevant the bankbehavioral The Old the shocks for bank credit are real, in origin. References 1. Board of Governors of the Federal Reserve System. 67’th Annual Report, 1980. 7. 2. Burger, Albert E. The Money Supply Process. Belmont, Calif. : Wadsworth Publishing Co., 1971. Levin, Fred J. “Examination of the Money-Stock Control Approach of Burger, Kalish, and Babb.” Journal of Money, Credit, and Banking, 5 (November 1973) : 924-38. 8. Levin, Fred J., and Paul Meek. “Implementing the New Operating Procedures: The View from the Trading Desk.” In Board of Governors of the Federal Reserve System, “New Monetary Control Procedures.” Vol. 1 (February 1981). 3. Coats, Warren L., Jr. “Recent Monetary Policy Strategies in the United States.” Kredit und Kapital, (October-November 1981). 4. Goodfriend, Marvin S. “Discount Window Borrowing, Monetary Control, and the Post-October 6, 1979 Federal Reserve Operating Procedure.” Federal Reserve Bank of Richmond, 1981, processed. 9. “Monetary Policy and Open Market Operations in 1980.” Quarterly Review, Federal Reserve Bank of New York, 6 (Summer 1981) : 56-75. 5. Hetzel, Robert L. “The Federal Reserve System and Control of the Money Supply in the 1970s.” Journal of Money, Credit, and Banking, 13 (February 1981) : 31-43. 10. Volcker,. Paul A. “Statement” before the Joint Economrc Committee of the U. S. Congress, February 1, 1980. In Federal Reserve Bulletin, 66 (February 1980) : 137-43. 6. Laurent, Robert D. “A Critique of the Federal Reserve’s New Operating Procedure.” Federal Reserve Bank of Chicago, 1981, processed. 11. FEDERAL RESERVE BANK OF “Statement” before the Budget Committee, U. ‘S. Senate, July 24, 1980. In Federal Reserve Bulletin, 66 (August 1980) : 636-40. RICHMOND 15 INTEREST RATES AND FEDERAL DEFICITS , Roy H. Webb The relationship interest recent rates discussion cussants of economic rates. rates (Aunerican Journal and asserted of time and is referred The distinction deter- as a bank chairman major to reason record that high our levels.” And a trade group else, it is the spectre volume of deficit financing and financial markets.” statements rate to support their claims. tend to theory as self- or evidence Yet a casual glance at recent a clear contemporarates. In fact, that in 1975, when the deficit was were such evidence does not rule out any linkage of deficits and at the very least the data suggest of other important takes a closer look at the theoretical fiscal actions and interest reasons that a relation that actual be less drastic assumes. does exist, presenting it is useful to consider In general As a matter interval whether discussion however, the reported Federal growth to interpret due to in the price level, as well as fluctuations real output. Therefore ratio ratios of nominal variables of Federal debt to is exactly debt compares 1 indicates, 20 percent percent, in early deficit compared reported for late when considered (that debt. appears Although usually relevant Advisers [ 31) rates. are from the Council the difference government i.e., net liabilities, liabilities of of gross half explicit the value Also, substantial be more gross (data in market in 1980. holds could reported decisions of Economic between assets, it may be the case that liabilities commonly value may financial By one estimate and par value was $65 billion the Federal larger at par value market to individuals’ and thus to interest this paragraph much stated is, the price when issued), be more 33 billion distinction is made, there are Consider first the stock of ambiguities. Federal 1981 larger the $100 by itself. Once the stock-flow further of 1981 was slightly to a much In contrast, 1975. saving the deficit- since financial minus assets, relevant than In 1980, liabilities. Federal the net government were less But those figures liabilities. and implicit promises of future Fed- eral spending debt is the outstandwhereas minus the the deficit tax deficit equal to the receipts. sum for interest rates. posit insurance Note REVIEW, financial For example, liabilities have been estimated of at any point in time, ECONOMIC the demands not to mention base. Assuming in the debt. that may also affect the supplies of and an (over that there is no change in the monetary base, the deficit is just the change that the debt is a fixed number As Figure flows. in are For example, total saving ratio in the fourth quarter below ignore obligations, arithmetic, compares than figure. changes in the debt and the monetary 16 to Debt of expenditures of of time) for simplicity are likely that analysis, terms, the Federal ing volume of Federal is the volume it also points out rate effects deficit is indeed a meaningful Federal between the analysis than much of the current Before Measuring this article relation rates. Although interest the factors. In order to clarify the effects of deficits, indicates deficit tudes over time can be difficult often used to provide some perspective. the in to appraise the size of the debt or Comparisons of nominal magniover time. the at its highest level in several decades, there neither high nor rising interest rates. While existence to keep in order Street take relationship data fails to provide rates, mind how- to as a flow. is important which (Wall neous link between deficits and interest interest stock-flow stocks, while the ratio of the deficit to private similar 1 indicates The deficit, in a stock, is only meaningful over an interval and thus do not include American to as a stock. ever, being the change To many dis- [5, p. Z] ) deficit-interest evident, and is often referred deficits [S, p. S] ) Those Figure of much policy. than anything of an overwhelming haunts housing the close Banker “More asserted, are stay and market theme Federal that For example, it “[Deficits] interest deficits the central it is axiomatic mine interest put of Federal has been present from Federal affecting social security at more than $4 trillion, government-guaranteed be included in the reported loans and de- agencies. Perhaps commitments Federal debt. measure the should The prob- or not to include them points lack of an unambiguous 1982 thereby unfunded value of these spending lem of whether JULY/AUGUST assets, of the Federal up the debt. Figure 1 THE FEDERAL DEFICIT AND INTEREST RATES Percent Percent - ----- New issue --- Commercial The bond paper inflation B corporate rate federal (left rate rate minus (left the scale) contemporaneous scale) deficit as a percentage of gross private saving (right scale) 0 -10 And since the Federal base, deficit is the change 1970 in the ber of assumptions debt minus the change in the mone- the meaning of reported deficits that the deficit is estimated investment is also without actions, open to question. (see Even assuming ambiguity, other problems deficit is often compared from the National (NIPA). That any error Income estimate, residual-personal remain. and in income or spending For example, come in 1981 been underestimated estimated been an 18 percent Moreover, depreciation, But NIPA measuring Product however, precisely, underestimate one, the there depreciation there is little factors the and changes over time, Instead, assumptions necessary depreciation patterns. RESERVE may true depreciation, net saving subject a large num- information in order to widely divergent flows. concerning of various and these have magnitude FEDERAL can produce productivity of depreciation actual transactions, stock Yet such as when and why firms discard capital assets, or how value. Then flows over specific time periods. precise in- from is not a precise capital . and are ap- assumptions or net saving, depreciation [9, pp. 23-821) of capital stocks or depreciation some analysts contend that saving minus is a more relevant transstocks are also assumed saving. would of personal and Musgrave actual of capital estimates when by 1 percent do represent the magnitudes patterns to use gross Different Therefore had personal Young estimate as a is magnified which plied to each constructed Accounts is created are made in order to estimate depreciation saving taken income minus outlays. saving is estimated. consumption For with personal data, 1 1982 1 1978 1 1974 1 1 1966 1962 1958 stock of Federal tary 1 1 1 1954 to estimate Thus capital are just assets some of the capital stocks and the resulting estimates well be substantially different in turn making to even greater estimates measurement of error than gross saving. BANK OF RICHMOND 17 In short, there ambiguities eral is no easy resolution involved in comparing debt or deficit to historical alone should caution readers claims unless proponents of the many the current values. Fed- That against accepting fact strong effects, avoiding monetary The tax cut allows government and expectational higher effects.) 2 spending ; with spending fixed, the result is a rightward shift in the IS curve in Figure supply supporting data that new equilibrium despite the measurement can be meaningful .private problems level3 and a higher interest 2a. is characterized Accordingly, the by a higher price rate. detailed above. The analysis in the next section uses a simple theoretical model that abstracts from such complications. One Traditional show that interest models action9 could affect interest of this type invariably have a larger rates when the’economy capacity Thus fiscal model is used in this why deficits Conventional impact is operating than when substantial in order the IS-LM model will be used in this section kin [7, ch. a full employment 121). This model cycle by assuming j (at full capacity Perhaps The object to determine IS curve, equilibrium sloping illustrates from level and the interest commodities supplied. rate sloping such in both a point no further (3) for which the supplied. and money a macroeconomic the effect of a assume that (1) of money does not change, future. (These assumptions (4) (5) and (6) to change isolate To see rate. Then cheaply domestic demand. by lending increasing and supply. lenders markets, These any divergence more domestic could do consequently actions of foreign would tend and domestic Due to its size, however, fiscal actions can alter the nominal supplies demands interest lowering foreign in domestic in the small economy. American could borrow thereby Similarly, credit to eliminate rates borrowers in other markets, better rate in rate. for debt Nonetheless enough to alter the world a deficit of a given magnipercentage it affects interest amount than would be projected increase in the of American rates by a lesser for only the domestic economy. A well-known analysis of the impact tions in an open economy with flexible was given by Mundell of fiscal exchange . An adaptation ac- rates of his anal- 2, shows the initial impact of a fiscal expansion to be a rightward resulting in a higher domestic shift of the IS interest curve, rate and price spending does in fiscal policy is anticipated, of money is not anticipated for in the were to rise above the world Accordingly, Federal quantity purely the in the fiscal 1 This article abstracts from a persistent problem, namely the best single magnitude to describe a fiscal action. The deficit is mentioned throughout the article because of its prominence in current policy discussion. It can he a misleading indicator of fiscal policy, however (see Blinder and Solow [Z, pp. 11-331). 18 such a small economy debt. the tax cut was not anticipated, change the quantity (2) debt this, imagine that after a tax cut the domestic ysis in Figure taxes are lowered, not change, public quantity commodity markets. supply and demand and a smaller of the two curves, demand To be more specific, equates of private debt than in the stock The model can be used to illustrate Federal which stock of world for equilibrium. higher deficit. financial curve illustrates LM is called rate total well-integrated stock combinations the the is but one element in a much larger world tude represents rate for which the demand At the point of intersection supply model. of the price is equal to the full-employment the price-interest markets; changes in the graphical line in the graph, labeled the The upward interest given it is useful to think of a single world credit of using such demand for money is equal to the quantity equals the the qualitative the combinations economy element) model of fiscal actions in a small, open economy. of an that real output is fixed 2a. with Consequently, the That world rate would be unaffected (see Patin- abstracts the American (albeit an important economy that the importance world economy. version effects of shocks to the economy by observing The downward believing by fiscal actions while prices are allowed to vary. is to attempt in macroeconomic for Economy exists. the easiest way to use the model is with a graph such as Figure models in an Open deficit- maximum rate effect, on near full unemployment to illustrate interest business reason is that macroeconomic section to illustrate Rates above may overstate Theory A traditional rates. Interest ECONOMIC REVIEW, 2 By assuming no actual or anticipated money growth, the possibility of an anticipated, sustained inflation is also assumed away. That is, while a wide range of factors may cause one-time movements of the price level, as a practical matter a sustained increase in the money supply is the only source of price increases in the economy that is capable of a continual, rapid increase over a lengthy interval; accordingly, in the long run inflation is a moneBy omitting inflation, the model is tary phenomenon. simplified. But the omission of inflation also limits the model’s current relevance. 3 This analysis follows tradition by assuming that Federal taxes are lump-sum taxes. As a result, substitution effects of a tax change on the price level are not considered. JULY/AUGUST 1982 Figure QUALITATIVE 2 EFFECTS OF A FEDERAL DEFICIT 2b 2a interest Rate LM LM Price The rate rightward and price government level. shift level bonds are IS, to change only Assuming IS, as occurs the partially due economy perceived no immediate eign economies, dampen exports to a tax cut, moves be to from as described wealth, net price change point A or (2) would be more willing bonds due to the interest result in a leftward As text. The B. model a result, leftward represents a large, permanent be financed would income equilibrium from open IS, spending by current IS3 of interest occur would lower by if (1) aggre- the the spending taxes same were to or by current And if aggregate did not change, the could income of whether future taxes. values to Level econbmy. disposable regardless promising The ulti- the shift of government amount, to purchase shift in the IS curve. the in the point level rate differential. All in all, the move toward lower net exports to gate by for- a higher domestic price level would while spurring imports. At the same time, foreigners domestic from also Price Level neither debt disposable would aggregate mand, the price level, nor the interest de- rate. mate effect would be for the IS curve to shift back to its original economy, position for a small economy. however, the leftward complete to the extent large economy Deficits that the increase raised the world’s thus the interest Other For a large shift would not be of Policy A key assumption in debt of the current deficits future. supply of debt and rate. Another the future Behavior (for growth example, Figure to offset relation between (see, for holdings of government [ 1, pp. 1095-l 1181). is that consumption nent disposable by current the taxes that payments least But large if future eventual as obligations government the taxes, the present taxes. a bond, present debt ated by future world) sells its value then value That There level interest repayment price payment of (in a suitably financing see McCallum  ). deficit and Federal debt, concerns examples a fiscal impasse, inducing without Al- collecting future dismissed. in which a government caused by political the government monetary Reserve about sufficient acceleration. pressure to spend at a high taxes That to avoid a is not to say is at that any single large deficit indicates that such a fiscal impasse of Federal tax Rather, likely future debt that attention deficits are consistent should be imply levels with monetary stability. price of a How a current given RESERVE is imminent. focused on whether simplified future FEDERAL deficit in the money supply in bond. the a in the actions should not be summarily sustained will be gener- of additional Therefore, groups evidently the are historical reached is, when buyer would be equal to the current bond. perma- of future principal current service monetary can be reduced either or by future the and as on consumers’ income-which government believes is based The basic idea taxes is that a higher 3 does not reveal a simple historical behavior Barro section was that lead to higher possibility some or all of the impact of a fiscal action example, for consumer though Anticipations of the preceding would today would generate and Consumer It is also possible Effects future monetary BANK OF RICHMOND deficit might affect anticipations of and fiscal policy is thus a key issue. 19 Figure 3 THE FEDERAL Billions of 1972 ! Dollars - The federal deficit as a percentage gross private savings. (right scale) --- 65 AND HELD BY THE FEDERAL r 75 DEFICIT Amount of federal debt owned by Federal Reserve System. (left scale) FEDERAL RE6ERVE DEBT SYSTEM Percent of '\ / L .I . -j 35 55 20 45 5 35 -10 1954 If; the Federal increased. It Most 1958 Reserve were is difficult, analyses 1962 to however, based monetize to on Federal deficits, evidence’of see the 1966 such IS-LM then 1970 the behavior framework, Fed’s in this 1974 holdings of government debt would rise IS-LM model that ignores policy as simple as the model employed above or as depend upon the responsiveness complex as the major domestic question of policy formation econometric and evolution proved difficult, models, But of policy anticipations except for strongly cases. One pations in the conventional small step evade the modeling restricted is to include the has special policy model by letting anticicurrent private bond demand be affected by the perceived risk of future that inflationary would invalidate unanticipated increase higher current (3) policy. current deficit likelihood in the future, net private raising interest (such above) as the could (1) of a policy fostering thereby bond demand, the current a policy anticipations introduced the perceived inflation Thus (2) lowering and consequently In the appendix, rates ‘to a one-time government 20 Estimation the responsiveness change when deficits respect and foreign) by equation equation 6. Under is somewhat order is given to get for the change assumption responsive change an idea is to use that from a change in the Fed- that to net interest responsive,4 in the stock of Federal result in a 1 percent with response exercise while money demand is slightly cent change for bonds interest a rough estimate the to (both expression The specific rates resulting debt. demand rate and.the An interesting to calculate in interest eral net demand to the interest of money demand. anticipations) of individuals’ bond rates a 1 per- debt would only in the interest of the magnitudes rate. In involved, rate more than pre- dicted by the simple model. Back-of-the-Envelope sharply graph. whether anticipations. 1982 1978 of interest in the nominal value of debt is shown (at least, within the simple ECONOMIC REVIEW, 4 More precisely, let the interest elasticity of net bond demand be equal to 0.95, and the interest elasticity of The latter is conmoney demand be equal to -0.05. The interest sistent with many econometric estimates. elasticity of net bond demand is not often estimated; however. Since U. S. government debt, corporate debt, and foreign debt are close substitutes, a substantial interest elasticity of net bond demand appears reasonable. The exact parameter value is uncertain, however, and others may not agree as to what is reasonable. JULY/AUGUST 1982 consider a $100 billion government stock of Federal rate is 15 percent values). deficit debt is $1 trillion, (the numbers If the deficit were when the approximate reduced recent to zero, in the interest changed These rate. however, of future policy from measurement with the Federal are only and, in addi- problems (in full detail), difficult low inflation connected verifiable, deficits and anticipations and, thereby, monetary growth any risk premium in current flects the probabliity tary actions emphasized Conclusion rates serve of lending Federal borrowing only a single work, the purpose demands, do not currently element rates in the supply-demand by individuals, Federal if the importance of the current effects of current of future fiscal and monetary while simply substantially, remain. for For one, fiscal actions private sector policy designed borrowing to lower credit supply could lower interest examples interest include paid, expanding free interest, the current demand the tax Federal discussed deductibility It is appropriate to receive tax- subsidies that current and prospective to a monetary extent tary at this point policy actions. for bor- acceleration that individuals’ policy variable Iikelihood fiscal anticipations likelihood in private anticipations by a monetary rule-that high The Industry Urges Cut in U. S. Deficit.” March 4, 1982. Journal, Young, Alan, and John Musgrave. “Estimation of Capital Stock in the United States,” in Dan Usher, ed., The Measurement of Capital. Chicago: University of Chicago Press, 1980. that be accom- RESERVE American 2nd Wall Street is, an economic FEDERAL T. “Are Bond-Financed Defid Unpublished manuscript. May “Thrift and the supply Reducing could actions. Patinkin, Don. Money, Interest, and Prices. ed. New York: Harper and Row, 1965. of future money will be fostered, credit will be restricted. is will lead And to the that a high 6. Mundell, Robert. “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates.” Canadian Journal of Economics and POlitical Science (November 1963). antici- concern actions in the future. some rates of inflation of long-term plished include to consider A major monetary 5. “McGillicuddy : Deficits Do Matter.” Bunker, March 11, 1982. of rowing. pations of future in future 4. McCallum, Bennett tits Inflationary?” 1982. a and increase Recently way to restore of it is Annual Report. 3. Council of Economic Advisers. Washington: Government Printing Office, 1982. considerations lending ; thus opportunities and reducing of confidence However, “Analytical 2. Blinder, Alan, and Robert Solow. Foundations of Fiscal Policy,” in The Economics of Public Finance. Washington : Brookings Institution, 1974. can affect incentives rates. limiting the not lower interest and and implementation “Are Government Bonds Net 1. Barro, Robert. Wealth?” Jour?zal of Political Economy (November/December 1974). anticipations policy to the require- References Even to consider reducing important to see any quicker by policies. leve1 of the deficit would probably rates deficit deficit is often over- deficits on individuals’ conform that re- Since mone- frame- governments. it could be important Accordingly, degree are demands for and supplies of credit firms, and foreign stated, however, difficult rates of reduce rule listed above, it should be the design the responsiveness to the current failing to consider the important, that interest c6uld of future inflation. such a rule would not be a trivial task. for borrowing. although Thus it is easy to overstate of interest of equating and the demand or circumvent Such a rule would break any link between current ments for a monetary Interest and perceived .as being to change of fiscal actions. an- by the gen- future debt. supply that is publicly well understood for policymakers regardless in that they ignore any effect of anticipations tion, abstract calculations to achieve eral public, credible, the upper limit would imply only a 150 basis point decline illustrative, strategy nounced and the interest BANK OF RICHMOND 21 APPENDIX The purpose of this appendix ticity of the interest bond issue. money, There and bonds. are three When that clearing commodity, commodity demand $= market clears. Market by quantity authority), L is the demand of money (fixed P is the commodity for real money by the real quantity B sented as -, RP bonds of government bonds (a bond is a credible promise is the nominal market to pay $1 per (consequently and value of government thus grated H, include world (= g) unambiguously bond foreign individuals bonds. sent growth rates (i.e., market is assumed). Since is positive and JR is negative, positive. Market clearing Zn is is repre- From and Y (at and (3) its full- Small letters will repre- m = and E~,J is the $$I, of I with respect to J. (l), -p or (note (4) From p = = + LR dR k LR dR = REVIEW, LE) $ -$ZEdR ) or (3), b-r-p= (5) ( F --EL,Rr. p=b(4) --EL,R (1 +EZ,R) and (5) r = r. yields b - (1 + %R) r and therefore, (6) ER’B/Rz b-r = 1 E%,~- E=,~’ Since this model does not include continuing tion, there is no distinction interest ECONOMIC M constant. inte- sented as 22 level) Combining if an rates, take logs of (1) holding employment z R Z(Y,R) = H(Y,R) - J(Y,R> will differentiate, is repre- where H is the private real demand for bands and J is the private real supply of bonds (the private sector To look at growth and rate. Real net demand for bonds, Z, is defined as (2) Z(Y,R). Y is the where B is the number of government year forever), R is the rate of interest 1 in is the nominal price of a bond), = price level, balances, level of real output, and R is the bond interest The & (3) elasticity L(Y,R) M is the monetary in we know by Walras’ in the money market is represented (1) where the markets: supply equals the money and bond markets, Law is to derive the elas- rate with respect to government rates. JULY/AUGUST 1982 between nominal infla- and real