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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 [9], 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 [9], 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

[6]. 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

[4] ).

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


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