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Reflections

on the Strategy

of Monetary

Policy

Remarks by Robea P. Black, President, Federal Reseme Bank of Richmond,
before the Annual Convention of th Maryland Bankerx Association,
White Su&w-

Springs, West Virgirzia, May 18, 2990.

Introduction
It’ a particular pleasure to be with you this
s
morning at your annual convention. I want to focus
my comments today on monetary policy. This seems
like a natural subject for a Federal Reserve Bank
official to address. Some of you may be disappointed
by my choice, however, since there are a number
of other topics I could tackle that might strike you
as more pressing such as the current concern about
a possible credit crunch, progress toward the resolution of the problems in the thrift industry, deposit
insurance, or prospective changes in our banking and
financial structure. We at the Federal Reserve are
naturally interested in all these matters. Our most
important responsibility at the Fed, however, is to
manage the nation’ monetary system and, in pars
ticular, the rate of growth in the supply of money.
Moreover, by discharging this fundamental responsibility effectively we may well be able to facilitate
resolution of the seemingly more immediate issues
I just mentioned as well as others. In fact, it can be
argued that some of our more immediate problems,
such as the thrift crisis, may have been brought on
in part by past monetary policies that in retrospect
were less than optimal.
A More Useful Conception of
Monetary “Policy”
The first thing I want to stress is the time frame
I have in mind when I talk about monetary “policy.”
When many, and perhaps most people, think of the
Fed and monetary policy, they focus almost automatically on interest rates and where they are
headed and how our actions may affect them in the
near future. Since the day-to-day operating lever we
use in conducting monetary policy is the federal funds
rate, many people equate changes in the funds rate
with changes in monetary policy. For example, the
press typically refers to an increase in the rate as a
“tightening” of monetary policy.
This is definitely not what I have in mind when
I think of monetary policy, and I shall argue later in
my remarks that equating changes in the funds rate
and other money market indicators with changes in
FEDERAL

RESERVE

monetary policy has been a particularly misleading
practice and has contributed to many of the problems
we have experienced over the last 30 years. Instead,
when I speak of monetary policy, I am talking about
both the longer-run objective the Federal Reserve
is trying to achieve in the economy through its
monetary actions and the timetable and set of procedures for attaining that objective.
To understand the distinction I am making, consider the setting of the prime rate by your bank.
Obviously, the “policy” of your bank is not simply
to set the prime rate at a certain level. Your policy
embraces your larger goal of achieving a certain rate
of return on assets or equity over a particular time
horizon. To help in reaching this goal, you maintain
the prime rate at a certain spread above your cost
of funds. Clearly, changes in the prime are just part
of a larger set of procedures designed to achieve the
ultimate goal of a target return on assets or equity.
Similarly, changes in the funds rate have to be considered in the context of the larger strategy of
monetary policy.
A Brief Historical Review
The principal questions I want to address this
morning are (1) what is an appropriate monetary
policy for the Federal Reserve and (2) how far have
we come in developing such a policy? I shall begin
with a brief review of the major monetary developments over the last 30 years and, on the basis of this
review, make some general observations about how
policy has worked over this period and how it has
affected inflation and the economy. With these
generalizations in mind, I shall then summarize my
view of an appropriate monetary policy in the sense
in which I have just defined the term and conclude
with an assessment of the progress we have made
in putting such a policy in place.
My historical review necessarily will be very brief
and oversimplified, but even a quick review suggests
some strong generalizations about an appropriate
monetary policy. Think back if you will to the late
1960s when large increases in federal spending on
social programs and defense put strong upward
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3

pressure on interest rates. In this period the Fed was
sometimes slow to let the funds rate and other shortterm interest rates rise enough to reflect these
pressures. Consequently, money growth accelerated,
which resulted in a sharp increase in the rate of
inflation. The System eventually responded. to the
higher inflation by pushing the funds rate up over
three percentage points in 1969, and the recession
of 1970 followed.
Roughly this same sequence was repeated two
more times in the 1970s. In 1972, an expanding
economy put upward pressure on interest rates. The
Fed allowed the funds rate to adjust upward modestly
before the end of the year, but in retrospect the
increase was not enough to prevent money growth
and inflation from rising strongly. The System
responded to the accelerating rate of inflation by
raising the funds rate five percentage points in 1973,
and the economy again fell into a recession. Of
course, the rise in oil prices during this period undoubtedly affected both the inflation rate and the
general economy, but it seems clear with the benefit
of hindsight that our failure to let short-term interest
rates rise more freely in 1972 was also a factor since
it made a much sharper increase unavoidable the
following year.
The third episode, and one I’ sure you all
m
remember quite well, occurred in the late 1970s. In
this period rapid economic growth again put upward
pressure on interest rates, yet the funds rate remained
essentially constant from late 1975 through mid1977. Throughout this period, of course, the System
was justifiably concerned about the lingering effects
of the huge increases in oil prices in 1973 and 1974,
and we naturally wanted to do whatever we could
with monetary policy to help minimize the damage
these increases might inflict on the economy. Even
so, looking back it seems evident that our reluctance
to let the funds rate adjust upward for such an extended period helped set the stage for the sharp
acceleration in both the rate of growth of the money
supply and inflation that followed. We began to raise
the funds rate in late 1977 and continued to raise
it through 1978, but our actions came too late and
were too restrained. Money growth remained high
and inflation continued to accelerate. Ultimately, in
a crisis atmosphere, the funds rate moved up by about
eight percentage points in late 1979 and early 1980,
and the relatively mild recession of 1980 ensued.
This was followed by a brief recovery and then by
the much deeper and more protracted recession of
1981-1982,
4

which was very costly in terms of lost
ECONOMIC

REVIEW,

jobs and output. About the only good thing one can
say about the performance of the economy in the
early 1980s is that the rate of inflation was cut
roughly in half. The rate remained in a range of 3
to 5 percent throughout the remainder of the 1980s.
These developments in the late 1960s and 1970s
highlighted the link between excessive money growth
and inflation and led to a number of changes in our
procedures that involved setting more explicit goals
for the growth of the money supply and working to
control this growth more closely in order to achieve
these goals. In 1970 the FOMC first began to set
explicit short-run targets for money growth, and as
the decade progressed the use of the money supply
as a target became more firmly institutionalized. In
1975, in response to a congressional resolution, we
began to announce quarterly targets for the growth
rates of several so-called monetary aggregates-the
various “M’ with which you are all familiar. The
s”
Humphrey-Hawkins
Act of 1978 improved our procedures by requiring us to set money growth targets
on a calendar-year basis. Earlier we had set fourquarter-ahead targets each quarter, so that by the time
we reached the end of a target period we were already
working on a new target with a new time frame.
These steps were all in the right direction, but even
after Humphrey-Hawkins
was passed there was still
a flaw in the targeting procedure, which is usually
referred to as the “base drift” problem. Base drift
arises under our procedure because the base for the
target set each year is the acwilevel of the monetary
aggregate in the preceding period rather than the
taeet level in that period. Consequently, any target
miss in the preceding period is forgiven when a new
target is set, and the base for the new target “drifts”
either upward or downward. Consequently,
the
longer-term growth rate of money over a period of
several years can be well above any of the individual
annual target rates if the actual growth rates persistently exceeded the target rates. This is exactly
what happened in the late 1970s. The upward base
drift in this period, along with our tendency to raise
the funds rate rather gradually when money growth
first accelerated in 1977 and 1978, were major
factors contributing to the subsequent double-digit
inflation.
Some General Observations About Past Policy
This brief review of events over the last three
decades points to several generalizations which have
influenced my thinking on what constitutes an
appropriate monetary policy. The first and most
JULY/AUGUST

1990

obvious point is that the level of the federal funds
rate and the direction of changes in the funds rate
are not reliable indicators of monetary policy. A particular level of the rate could be consistent with a
relatively restrictive stance or a relatively easy stance
depending on what else is happening in the economy
and the financial markets. The funds rate increased
in 1968, in 1972, and in 1977 and 1978. Yet in
retrospect it is clear that policy in each of these
periods was not too tight but too easy. Consequently, money growth accelerated.
We also know from our experiences over this
period-if
we did not know it before-that
rapid
money growth inevitably leads to an acceleration of
inflation. Just as inevitably, pressures eventually
mount both inside and outside the Fed to take
aggressive action to bring this inflation under control. In each of the three episodes I reviewed, these
actions unfortunately were followed by recessions.
Another generalization suggested by our experience
over the last 30 years-and
one that I believe is extremely important-is
that expansionary monetary
policies and high rates of inflation do not lead to faster
economic growth. To put it in the jargon of economists, there is no trade-off between inflation and
longer-run economic growth. On the contrary, persistently high rates in inflation have generally been
associated with relatively low rates of real economic
growth.
A fourth conclusion, which has been a major disappointment for me, is that the development of our
monetary targeting procedures beginning in the
early 1970s was not sufficient to prevent us from
making some of the same policy errors in the late
70s we had made twice before in the preceding 15
years or so. As I suggested earlier, upward base drift
in our money supply targets probably contributed to
the very high trend growth in the monetary aggregates in the late 70s. And our reluctance to adjust
the funds rate upward as promptly as we might have
when the indications of excessive money growth and
rising inflation first became available was probably
also a factor. Together these two factors largely
neutralized the institutional improvements we made
in this period.
A final general observation suggested by our experience over the last 30 years is that despite our
strong desire at the Fed throughout this period to
hold inflation under control, the record unfortunately
makes it clear that we were less than fully successful.
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RESERVE

There has been a noticeable tendency, on average
and in retrospect, to follow policies that have
allowed the price level to creep upward. This same
tendency has been apparent in many other industrial
countries over the same period. No statistic better
illustrates this tendency than the&&Cd increase in
the price level since 1965. Economists have devoted
much effort in recent years to trying to understand
the reason for this experience.
One popular explanation in the academic literature,
sometimes referred to as the “time inconsistency”
problem (or in layman’ terms, “changing your
s
mind”), runs along the following lines. Suppose that
a central bank commits itself to an anti-inflationary
monetary policy and that this commitment is credible to the public. The bank may well have every
intention of fulfilling this promise at the time it is
made. (I am assuming here that the bank is not legally
or constitutionally bound to fulfill its commitment.)
Subsequently, however, the bank will see that the
credibility of its promise gives it an opportunity to
stimulate real economic activity temporarily by surprising the public with an unexpectedly expansionary
policy-that
is, an unexpected acceleration in the
growth of the money supply. The bank may find it
exceedingly difficult to resist the temptation to exploit this opportunity even if it wishes to keep inflation low. To the extent that central banks succumb
to this temptation in practice, their behavior, in combination with the public’ ability to form expectations
s
of policy actions that are correct on average, inevitably leads to inflation. The extent to which this
notion applies to our own experience in the United
States is not entirely clear yet, but the idea probably
deserves further thought and research.
A second explanation for the apparent inflationary
tendency in our policy over time is the one-sided
political pressures brought to bear on policy. Government officials and others routinely exhort the Fed
to follow “easier” policies, by which they mean lower
short-term interest rates. These exhortations arise
because many people believe (1) that the Fed can
“trade off’ a higher rate of inflation for more economic
growth and (2) that the Fed determines the rate of
interest independently of the rate of inflation and
other economic conditions. As I have already suggested, both these beliefs strike me as misguided.
A particularly damaging misperception among some
government leaders is the one I mentioned at the
beginning of my remarks: namely, that a rise in the
federal funds rate represents a “tighter” monetary
policy. As the experience of the 1960s and 1970s
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5

illustrated time and time again, this misperception
has frequently led observers to conclude that the Fed
is following an excessively “tight” policy when in fact
the reverse has been true.
Let me state and then underline my conviction that
the FOMC has never conxiouly made decisions on
the basis of political considerations. Political pressures are always present, however, and it seems
possible that at times these pressures may have had
some effect on policy at the margin. In any case, the
key point is not why monetary policy has had an
inflationary tendency over the last three decades, but
that in fact it has had this tendency, and I think it
would be hard for anyone to dispute this point.
Suggestions for Improving Monetary Policy
In view of our experience over the last three
decades, what can we do to improve monetary policy
in the longer-run, strategic context I discussed at the
beginning of my comments? As I see it, the most
important lessons from our experience over this
period are that price stability should be the primary
objective of monetary policy and that a specific
timetable should be set for achieving it. As many of
you know, Congressman Stephen Neal, Chairman
of the Subcommittee on Domestic Monetary Policy
of the House Committee on Banking, Finance, and
Urban Affairs, has introduced a Resolution that would
instruct the Fed to make price stability its overriding
goal and direct the Fed to achieve this goal within
five years. I recently testified-in favor of this Resolution, as did Chairman Greenspan and three other
Federal Reserve Bank presidents.
A further lesson from our experience is that our
procedures for controlling the growth of the money
supply need to be improved. My own view is that
setting targets for money growth that cover periods
not of just one year but several years would help us
greatly in our efforts to achieve longer-run price
stability. Obviously, we must then hit the targets
consistently. Persistent overshoots of the annual
targets must not be allowed to cumulate as happened in the late 1970s. A big step forward in this
regard is the recent development of a statistical model
by the staff of the Board of Governors that provides
an early warning to the FOMC as to whether its
policies are working to increase longer-run inflationary
pressures or decrease them. This is the so-called “P*
model” that you’ probably seen discussed in the
ve
financial press. In my judgment, a multi-year procedure for setting money supply targets guided by
something like the P’ model would provide a reliable
6

ECONOMIC

REVIEW,

and powerful strategic framework for moving toward
full price stability.
A final lesson suggested by our experience is that
if we want to hit our monetary targets and achieve
price stability, we will have to be prepared to adjust
the federal funds rate (or whatever other operating
instrument we may be using) promptly at the first
signs of excessive money growth and incipient inflation. I call this willingness to move the funds rate
up promptly “erring on the side of restrictiveness.”
The 1960s and 70s suggest that the risks of policy
errors are asymmetric. Increases in the funds rate can
be reversed quickly if they turn out to be inappropriate. In contrast, failure to let the funds rate rise
in a period when market forces are naturally putting
upward pressure on interest rates can raise inflation
expectations and put even greater upward pressure
on rates. As this process proceeds, an ever-increasing
upward adjustment in the funds rate becomes
necessary to bring it in line with market forces. In
this situation we risk losing control of the rate of
growth in money and inflation. In short, we need to
act be&m inflation gets out of hand rather than after.
Prospects for Monetary Policy
My greatest hope is that a policy of the kind 1 have
just outlined will be put in place soon. I am generally optimistic regarding the prospects for such an
outcome, although realism requires a note of caution.
My optimism reflects positive recent developments
in each of the three areas I just reviewed. Firs, there
is a growing consensus within the Federal Reserve
System and among members of the FOMC that price
stability should be the overriding goal of monetary
policy. I can say without qualification that, as a group,
the current members of the FOMC and nonvoting
presidents are the most dedicated inflation fighters
I have seen since I have been associated with the
Committee. Moreover, the view that price stability
should be the primary goal of monetary policy is
now shared by at least some members of Congress.
The introduction of the Neal Resolution and the
public discussion of its provisions represent considerable progress, even if the Resolution is not
enacted in the near-term future. Second, while we
have not changed our procedures for setting annual
money supply targets, we are paying more attention
to longer-run money growth and its implication for
inflation. The development of the P’ model I mentioned earlier reflects this emphasis. Fina& I believe
there is a growing recognition within the Fed that
the goal of price stability requires us to adjust the
JULY/AUGUST

1990

funds rate or other operating instrument more
promptly before inflation accelerates. Twice in the
1980s-in
1984 and again in late 1988 and early
1989-we let the funds rate increase substantially
even though inflation was not rising rapidly at the
time. Each of these times we were criticized by some
for being too “restrictive,” but I am convinced that
these actions contributed to the relatively stable
inflation and surprisingly persistent economic growth
we have enjoyed over the last seven years.
Having said this, I have to acknowledge in all
candor that my optimism regarding our ability to
pursue a policy aimed at achieving true price stability is a cautious optimism at this point. It is
cautious because a large part of the general public
and many government leaders are still relatively
unconcerned about inflation. I was shocked to read
of a recent poll showing that 82 percent of the
members of the National Association of Business
Economists do not favor the objectives of the Neal
Resolution. The majority of those surveyed apparently believe that the cost of reducing inflation
below its current 4 to 5 percent trend rate would be

FEDERAL

RESERVE

too great because the public has become so accustomed to inflation at about this rate. I cannot agree
with this conclusion. Nothing in our experience over
the last 30 years indicates that we can maintain
inflation at a steady 4 to 5 percent rate indefinitely.
If we accept a 4 to 5 percent rate as tolerable, I am
confident it will be only a matter of time before we
are faced with a much higher rate. Further, I believe
that a gradual reduction in the rate over a relatively
long but well-defined period of time could be accomplished without unacceptable
costs to the
economy.
In conclusion, the Federal Reserve has made
considerable progress toward developing and implementing an appropriate monetary policy aimed at
attaining price stability and the strong growth in
production and jobs that go with it. We still have a
great deal of work to do in developing public and
Congressional support for this policy, however, and
we obviously must succeed in this effort because
without this support the policy itself will surely fail.
I hope that you will support our efforts to achieve
this important goal.

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The EMU: Forerunners

and Durability

Robeti F. Gaboyes

The European Community
is stepping tentatively toward a European Monetary Union (EMU)
that would replace most of Western Europe’ curs
rencies with a single money, perhaps called the European Currency Unit (ECU). * No previous monetary
union ever involved such a large portion of the world
economy or resulted in the disappearance of so many
major trading currencies.
Historical
evidence
presented here suggests that a durable monetary
union requires that one monetary authority control
policy for the entire union and that it have sufficient
power to enforce the agreement on the member
nations.
For non-Europeans, transacting business with entities in a European Monetary Union would be quite
different from dealing with entities in today’ separate
s
nations, each with its own currency. Furthermore,
dealing with a stable, apparently permanent union
would be very different from dealing with a precarious
union poised to break apart at the seams. A number
of possible effects of an EMU on the world economy
have been expressed by its supporters, including: [ 11
Giscard d’
Estaing ( 19691~~ 17- 18) argued for an EMU
on the grounds that its currency would rival the dollar
as the medium of international exchange and thus
capture some of the financial rewards of issuing a
reserve currency. Johnson (1973/pp95-96), however,
thought the dollar was too entrenched to be easily
challenged; [Z] Many hope an EMU will increase
European
(and world)
output
[see Cooper
(1973/p252) for a contrary view]; [3] An EMU could
lower European (and world) inflation [see Cohen
(1981) for a contrary view].

One effective currency: There must either be
a single currency or several currencies, fully and permanently convertible into one,another at immutably
fixed exchange rates (say, 10 francs = 1 pound), thus
acting as a single currency.
One effective exchange rate: There can be
only a single exchange rate (and thus, one exchange
rate policy) between the union currency and external currencies. For example, if both France and Germany use ECUs, then France cannot have an exchange rate of 1 U.S. dollar per ECU while Germany’ rate is 2 U.S. dollars per ECU. If they did
s
set rates in this way, free convertibility would mean
that someone could make limitless profits by paying
France 1 dollar for an ECU, then selling the ECU
to Germany for 2 dollars, then using the 2 dollars
to buy 2 ECUs from France, then selling the 2 ECUs
to Germany for 4 dollars, and so on. Eventually,
either the exchange rate differential would evaporate,
exchange controls would have to be imposed, or
France would run out of ECUs.
One monetary policy: Nations joining a
monetary union give up the power to conduct independent monetary policies. Monetary policy consists of controlling the quantity of money (or at least
its high-powered component) via open market operations, rediscounting, reserve requirements,
credit
controls, intervention in foreign exchange markets,
and exchange controls. Under an independent
monetary policy the individual country decides its
rate of inflation by controlling nominal money growth,
nominal interest rate, or exchange rates.

In a monetary union, two or more countries
agree to a jointly managed monetary policy. Allen
(1976/pp4-5) lists three minimal conditions for a
monetary union:
r The ECU currently exists (defined as a weighted basket of
European currencies) but only serves as a unit of account. The
ECU described in this paper would be a full-fledged money,
serving also as the medium of exchange and store of value. At
this writing, West Germany and East Germany have just
formed a monetary union as a step toward political reunification.

8

ECONOMIC

REVIEW,

I.

HISTORY OF MONETARY UNIONS
Monetary unions appear to have existed as far back
as Ancient Greece and certainly existed in medieval
Europe (Nielsen/1937/p.595). This section examines
historical examples of monetary unions, paying
special attention to the causes that led to a union’
s
demise.
JULY/AUGUST

1990

Monetary Unions That Failed
Colonial New England: Until around 1750, a
monetary union existed in the New England colonies
(Lester/1939/pp7-8).
The paper money of each of
the four colonies (Connecticut, Massachusetts Bay,
New Hampshire, and Rhode Island) was accepted
as legal tender by the others, even for taxpayments.
The union lasted nearly a century and relied on the
economic dominance of Massachusetts,
whose
monetary policy was foollowedin lockstep by the other
colonies. The three smaller colonies eventually grew
to challenge Massachusetts’ economic primacy (see
s
population data in HSUS/1975/p1168)
and began to
overissue. currency in the 1730s and 1740s
(McCusker/l978/ppl3
l-35). Regional monetary
cooperation deteriorated, and in 175 1, Massachusetts
redeemed its paper money, resumed a silver standard, and ceased accepting the other colonies’ paper
money.
Latin Monetary Union3 In the mid-1860s
France, Belgium, Switzerland, Italy, and Greece
formed the Latin Monetary Union, considered by
some to be the first international effort to regulate
exchange rates (Wisely119771pSl). Member countries could mint unlimited quantities of certain gold
and silver union coins, all of which were legal tender
across the union. Each country could mint limited
quantities of smaller-denomination (subsidiary) silver
coins, but these were legal tender only in the individual issuing country. Subsidiary coins had a lower
silver content than the union coins. Despite the coins’
lower intrinsic value, public offices in one country
were required to accept up to 100 francs in the other
countries’ subsidiary coins on individual transactions,
a loophole that helped destroy the union.
The union money supply was to be determined
by the market. The central banks promised to
freely exchange gold and silver for coins. This
bimetallic standard soon began to strain the union
by forcing the central banks to guarantee that the
ratio of gold to silver prices (per unit weight) would
remain fixed. But, the relative values of gold and silver
were determined in world markets, and the Latin
Union was too small to determine world prices.
The union overvalued silver which the members attempted to force on each other, eventually forcing
the suspension of silver convertibility and a move to
a de facto gold standard. Outstanding silver coins
remained legal tender, and subsidiary coins were
treated virtually as legal tender.
2 Much of the technical and chronological detail of this section
comes from Nielsen (1937/pp596-98).
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At this point, the subsidiary coins became the
union’ principal problem. Their intrinsic value was
s
less than their face value, and the union members
went back and forth in repealing and reenacting the
legal tender status of specific countries’ subsidiary
coins (Nielsen/1937/p597).
World War I created
enormous financing needs, and some members introduced paper standards and began depreciating their
currencies. Despite theoretical limitations on the
production and movement of subsidiary coins, these
low-value pieces were overissued and continually
flowed into whichever country had the least
depreciated money. Finally, in late 1920, the
members began refusing to accept not only each
others’ subsidiary coins, but also the overvalued
silver union coins. The Latin Union ceased to exist
as a practical matter, though it continued in name
until the late 1920s. The Latin Union was said to
have “decreed one common currency without
setting up a common monetary policy (Fratiani and
Spinelli/1984).” Alternatively, the Latin Union can
be said to have decreed a common monetary policy
but left each national central bank to police its own
compliance.
Scandinavian Monetary Union: In the 1870s
Sweden,
Denmark,
and Norway formed the
Scandinavian Monetary Union under which, like the
Latin Union, gold coins of each country circulated
freely as legal tender in all three countries (see
Lester/ 1939/pp 176-8 1). Subsidiary coins also circulated across borders as legal tender, and by
1900, banks in all these countries also accepted
each member
country’
s
banknotes
at par
(Nielsen/1937/p598).
By 190.5, the union was considered so complete that exchange rates ceased
being quoted.
As long as limited stocks of gold restrained the
production of money, the union worked well. In the
end, though, World War I financing needs led many
countries to inflate their currencies and dump gold
at the same time Scandinavia was maintaining a
fixed Krone gold price. The depreciated currencies
were then used to purchase gold at official (cheap)
rates; the gold was then exchanged for Scandinavian
currency, which was less depreciated than that of
other countries. Scandinavia was required by the
union agreement to issue currency to buy the gold
flowing in, thus causing the Scandinavian money
supplies to rise with world inflation. Eventually, the
countries losing gold were forced off the gold standard, but not early enough to prevent inflation in
Scandinavia.
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9

In 1916, Sweden gave the King the right to
exempt the central bank and mint from their
obligation to purchase gold at a fixed price
(Lester/ 19391~~ 17587), a policy recommended by
Knut Wicksell and Gustav Cassel. For a time,
Denmark and Norway believed themselves exempt
from Sweden’ gold embargo and, because their curs
rencies were more depreciated than Sweden’ they
s,
began shipping gold to Sweden as the rest of the
world had done previously. In 1917, Sweden prohibited unlimited gold shipments from the other
union members, largely eliminating the purpose of
the union.
Gold convertibility placed a limit on Scandinavian
money supply growth (though the limit became unacceptably high once other countries began leaving the
gold standard). Without convertibility, the only control on money issuance was the resolve of the central banks, and this proved to be weak. All member
countries’ subsidiary coins were still legal tender
across the union, so Denmark and Norway began
shipping large quantities of these small coins to
Sweden, just as the Latin Union members had
shipped to whichever member had the strongest currency at a given time. Finally, in 1924, shipment of
subsidiary coins was prohibited, effectively terminating the union.
East African Currency Area: Under British
colonial administration, monetary policy was generally
carried out by a nrrrenq board, an agency that stood
ready to change the colonial currency for foreign currency, and Sterling in particular. Under such an arrangement, in 1922, British East Africa (Kenya,
Uganda, and Tanganyika, plus Zanzibar in 1936)
adopted a common currency, the East African shilling (Pick/1971/pp257,566,586).
After independence
East Africa remained part of the Sterling Area that
guaranteed local currency convertibility into pounds.
Explicit and implicit British subsidies to the emerging nations were sufficient to offset their desires for
independent monetary policies. In 1966, Kenya,
Uganda, and Tanzania (the merger of Tanganyika
and Zanzibar) each adopted its own local shilling, but
all three remained legal tender across the region
(Cowitt/1989/p99), and all remained convertible into
pounds. Depreciation of the pound in the late 1960s
and early 1970s led to the dismantling of the Sterling Area in 1972. Without the Sterling Area constraints on national monetary policies, the three East
African national monetary authorities were free to
pursue increasingly independent policies. In 1977,
the East African Currency Area ended as each
10

ECONOMIC

REVIEW.

country pursued a different rate of inflation and the
values of the currencies diverged.
Monetary Unions That Endure
Zollverein (German Customs Unionk3 Despite efforts at political unification, in 18 15 the
German Federation was composed of 39 separate
independent states, each with its own standards for
coinage (some gold, some silver) and for weights and
measures. Many coins were debased, and there were
paper moneys, though none was legal tender. The
Congress of Vienna in 18 15 removed restrictions on
labor mobility, but the myriad coins made trade and
factor movements difficult and expensive.
In 1834, the Zollverein (Customs Union) was
founded with the intention of reducing cross-border
transactions costs. In 1838, most of the states agreed
on two monetary standards (the Thaler and Gulden),
leaving states free to pick one or the other. In 1847,
the central bank of the Kingdom of Prussia (with twothirds of the German population and territory) was
given primary central banking responsibility for most
of the states of the Federation.
In 1857, the
Zollverein outlawed gold as a monetary standard
across the union, effectively putting-the entire union
on a silver standard.
Prussia’ stewardship of the monetary union held
s
the arrangement together through the time of German unification in 1871. The Prussian bank then
evolved into the Reichsbank, which survived until
World War II, and was supplanted by the institutions
that grew into today’ Bundesbank. Thus, a vestige
s
of this union still survives in the deutsche mark. Two
factors seem responsible for the union’ durability
s
prior to political unification: [ 1) Prussia had the size,
power, and will to enforce compliance with the agreement on the smaller states; and [Z] the enactment
of consistent metallic standards depoliticized the currency by removing the princes’ ability to debase their
coinage (Holtfrerichl19891~237).
CFA Franc Zone: The CFA (Communaute
Financiere Africaine) Franc Zone encompasses most
of the former French colonies of West and Central
Africa, plus one former Spanish colony. The CFA
Zone is one of the most successful modern monetary
unions, having held a large number of geographically, politically, ethnically,
and economically
disparate nations together for over 30 years.

3 Most of this account is taken from Holtfrerich
JULY/AUGUST

1990

(1989).

A common currency, the CFA franc (equal to l/SO
of a French franc since 1948) circulates across the
region and has endured the departure of colonial
administration and the establishment in the early
1960s of the modern monetary authorities. There
are two central banks, responsible for monetary
policy in two different groups of countries.4 Member
nations of each central bank pool their reserves in
the French Treasury. There are few exchange controls on converting CFA francs into French francs,
though there are some trade and capital controls.
Convertibility is guaranteed by an overdraft privilege
at the French Treasury.
The CFA Zone has proven successful by a number
of measures. Its inflation has been much lower than
in surrounding countries, largely because the Zone’
s
rules sharply limit the amount of credit the banking
system can extend to national governments. By the
early 198Os, however, that limit was being circumvented by lending to parastatals (state-owned
enterprises), which were not technically government
entities. Recently, the viability of the Zone has been
called into question because of its $600 million combined overdraft and fears that the whole system might
remain permanently in deficit @T/3-2 1-901~4).
France is crucial to the union, still exercising considerable authority over policies and playing a large
role in the individual countries’ economies through
direct assistance and by subsidies that protect these
economies from outside competition. Despite Africa’
s
tendency to reject all things colonial, the gains from
continued association with the French apparently are
viewed as outweighing the negatives of granting
France power over the region’ monetary policy.
s
France has been able to maintain its influence in the
area because its economic size (relative to that of the
Zone) makes it the dominant partner. The total CFA
franc money supply is less than 3 percent of the
French money supply.
Belgium/Luxembourg: Belgium and Luxembourg maintain separate currencies (Belgian francs
and Luxembourg francs), linked at par and legal
4 The West African Currency Union (Banque Centrale des Etats
de I’
Afrique de I’
Ouest) covers roughly the same area as the
former French West Africa. It includes Benin, Togo, Cste
d’
Ivoire, Senegal, Mali, Niger, and Burkina Faso. The Central
African Currency Union (Banque des Etats de PAfrique Centrale)
annroximatelv covers what was French Eauatorial Africa and
Cameroon, phrs Equatorial Guinea, a former Spanish colony.
Members include the Central African Reoublic. the Coneo.
Cameroon,
Gabon, Chad, and Equatorial Guinea. fid
Comoros, a republic in the Indian Ocean, is part of a broader
Franc Zone, but has its own currency, the Comoros Franc.
FEDERAL

RESERVE

tender in both countries (Cowitt/1989/pp56 l-67;
Pick/ 197 l/p3 11). Monetary policy is effectively
under the control of Belgian monetary authorities,
though a joint agency manages exchange regulations.
Switzerland/Liechtenstein: The Swiss franc
is the currency for both countries (Cowitt/1989/~~689-93; Pickl19711p292).
Monetary policy for
both countries is managed by the Swiss National
Bank.
France/Monaco/Andorra: Both Monaco and
Andorra (along with French colonies) use the French
franc, with French authorities in full control of
monetary policy (Cowitt/ 19891~593). Andorra also
uses the Spanish peseta.
Italy/San MarinoNatican City: Vatican City
issues its own Vatican lira at par with the Italian lira
(Pick/1971/p590),
with both legal tender in both
countries. San Marino also uses both the Italian and
Vatican lire and mints some coins of its own. Italian
authorities effectively control the monetary policies
of the Vatican and San Marino.
U.S./Liberia: In 1944, the Liberian dollar was
pegged to the U.S. dollar at par. In fact, U.S.
banknotes were made legal tender and have remained
the country’ only circulating paper money, with
s
Liberian coins minted for use as small change. In the
early 198Os, Liberia, while it had no currency of its
own and thus no printing presses to run, circumvented the discipline imposed by its use of the U.S.
dollar. It began minting large quantities of S-dollar
coins, using them to pay the military and the civil
service. Since Liberia has no exchange controls, the
principal result was in line with Gresham’ Laws
the Liberian coins drove out much of the supply of
U.S. currency in the country.
U.S./Panama: With its founding in 1904,
Panama pegged its currency, the balboa, to the U.S.
dollar. U.S. currency and coins are legal tender and
constitute the bulk of circulating money. The Banco
National de Panama issues balboas but is not a central bank; it maintains no control over the country’
s
money supply.
II.

POTENTIALGAINSFROM
MONETARYUNION
Nations do not surrender the privilege of creating
money without having good reason to do so. Friedman argued that floating exchange rates (which are
BANK

OF RICHMOND

11

necessary if countries are to pursue different rates
of inflation) are the exchange rate regime most compatible with a free market and free trade (Friedman/1982/pp67-69). National monetary sovereignty
is the usual regime for reasons of history and politics,
as well as for purely economic reasons.
To help understand why European countries might
join a monetary union, this section examines the gains
which might accrue to members of a union. This section includes a discussion of three theories of optimum currency areas-a term for areas which some
theory holds oaghf to form monetary unions.
Benefits of a Monetary Union
A group of countries may conclude that the benefits
of monetary union outweigh the benefits of monetary
independence. Benefits of a union include:
Cheaper cross-border trade: With separate
currencies, every international transaction entails
calculating an exchange rate, enduring exchange risk,
and changing currency one for another. Under a
union, such costs disappear.
Wider access to markets: By eliminating the
extra costs associated with cross-border trades, industries with economies of scale may be able to produce at efficiently high levels.
Increased seigniorage: When someone accepts
a U.S. dollar created by the U.S. government, he
has effectively lent the government one dollar’ worth
s
of resources interest-free. Subtracting out printing and
administrative costs yields the profit to the government from money creation or seigniorage. The smaller
the economy covered by a currency, the less inducement for foreigners or locals to hold deposits and conduct business in that currency. For a firm doing
business across Europe, the dollar in 1990 may be
a more attractive transactions medium than either
the French franc or the deutsche mark, simply
because the dollar has wider acceptance across a
greater number of markets. Because of its wider
market access, though, an ECU in 1994 may be more
attractive to the same firm than the dollar. If so, there
would be an inducement to switch one’ currency
s
holdings from dollars to ECUs, and Europe, not the
U.S., would get the seigniorage.
Political divisiveness: EMU proponents argue
that separate currencies foster economic nationalism.
A major motivation for an EMU is a widespread belief
that a common currency will help solidify the Continent’ political bonds.
s
12

ECONOMIC

REVIEW,

Theories of Optimum Currency Areas
The above list of advantages of monetary unions
does not provide a coherent, manageable theory explaining which areas should form monetary unions
and which areas are likely to form them. Ideally, one
would like a simpler theory that captured all these
factors. Preferably, the theory would specify a single
variable that simultaneously decreases the advantages
and increases the disadvantages of monetary independence. In fact, there are at least three major
theories of optimllm ncrreng areas, each positing a
different principal reason monetary unions form. The
reasons include:
Factor Mobility: This is the extent to which
factors of production (labor, capital) are free to
move across borders (Mundell/ 1968/pp 177-86). For
example, workers can move freely throughout the
United States. Suppose the demand decreases for
Northern products and workers to produce them and
increases for Southern products and workers. Wages
or employment would fall in the North and rise in
the South. Workers will migrate to the South to
benefit from higher wages or employment. In the
end, wages in the two regions will equalize once more
as migration makes labor scarce in the North and
plentiful in the South.
Now, suppose it is the demand for Mexican goods
that drops relative to those of the U.S. If Mexico can
conduct an independent,
expansionary monetary
policy, it may be able briefly to stimulate its depressed
economy or at least chosen sectors of the economy.
It can print money, thus taxing holders of currency
to redistribute their wealth to the unemployed. Or,
it could devalue the peso, stimulating the economy
(or parts of the economy) by simultaneously making
all Mexican goods cheaper to U.S. buyers. The
perceived ability (real or not) to stabilize an economy
by using monetary policy is often given as a reason
for maintaining an independent monetary policy. If,
however, labor can move freely across borders, then
Mexico has no more need for monetary independence than does Dinwiddie, Virginia.
Even if monetary policy can stimulate real activity in a closed economy, capital mobility makes such
stimulation impossible in an open economy. Suppose Mexico is depressed and the U.S. booming, and
interest rates are equal in both countries. If Mexican
authorities use monetary policy in an effort to
stimulate domestic production,
this will exert
downward pressure on Mexican interest rates. If
those holding capital in Mexico cannot freely move
JULY/AUGUST

1990

their assets to the U.S., then monetary policy may
have some stimulative effects. If, however, there is
capital mobility, downward pressure on Mexican
interest rates will only drive assets abroad without
having any stimulative effects. Similarly, the Federal
Reserve Bank of Chicago cannot stabilize Midwestern
employment by lowering interest rates. If it did,
assets would flee to the other Districts thus instantaneously equalizing interest rates again. Thus, the
existence of labor and capital mobility reduces the
attractiveness of pursuing an independent monetary
policy (Mundell/ 19681pp 177-79).
Internalvs. External Transactions: McKinnon
(1963) saw optimum currency areas in a given region
as defined not by factor mobility, but rather by the
ratio of transactions a&/& the individual countries
to transactions bemeen the countries. An appreciation of the mark against the franc will increase the
prices the French pay for German goods. If France
buys so much from Germany that such an exchange
rate move will be viewed by Frenchmen as a rise in
their own price level, then, by McKinnon’ criterion,
s
France and Germany ought to form a monetary
union. On the other hand, if Mexico buys little from
Malawi, then a rise of the Malawi kwacha against the
Mexican peso will not be seen by Mexicans as a rise
in the price level. Thus, by McKinnon’ reckoning,
s
Mexico and Malawi do not belong in the same
monetary union because changes in the pesolkwacha
exchange rate will change the Mexican or Malawian
price levels imperceptibly or not at all.
Political Cohesion: Kindleberger (1973/pp42434) saw optimum currency areas as defined by a
region’ sense of political community. Simply put,
s
if French are French first and Europeans second, and
Germans are Germans first and Europeans second,
then they ought to have separate currencies. If they
are Europeans first and French or Germans second,
they ought to have a single currency. Throughout
history, he notes, almost every country has had its
own currency and none, he asserts, has had different
currencies for different regions (though one could
argue with this, looking at examples like state-issued
moneys in the nineteenth-century
U.S.).
III.

STABILIZING
FACTORS INAN EMU
Theoretical gains from a monetary union are only
realized if the agreement setting up the union can
be enforced upon the members. As with any contract, there must be enforcement mechanisms built
FEDERAL

RESERVE

into the agreement which constrain the members’
actions to serve the good of the group. This section
seeks to identify institutional differences between
those unions which failed and those which still endure. Then we ask whether such conditions exist in
today’ Europe.
s
Surrendering Monetary Independence:
Institutional Arrangements
The effects of a European Monetary Union on the
U.S. depend crucially on whether the union seems
stable or transient. This section looks at the institutional forms a union can take, catalogued by the
number of currencies circulating within the union and
by the domain of the central bank or banks. This
will help in later sections to identify the specific forms
that seem to encourage stability, based on historical
evidence.
First, institutional arrangements
can
include:
Unionwide Currency: The ECU, for instance,
would circulate in every member country;
Separate Currencies: Instead
ECU, a European Monetary Union
francs, marks, pounds, etc., would
culate in all union countries at fixed

of adopting an
could agree that
each freely cirexchange rates.

Second, union monetary policy can be set by:
One Unionwide Central Bank: This supranational institution would set policy for all members;
One National Central Bank: The central bank
of one country (say, Germany) could by mutual agreement set policy for all members;
Multiple National Central Banks: Each country would have its own central bank, required to
follow a policy consistent with union agreements;
Multiple Nonnational Central Banks: Different regions of the union would have separate central banks, but the borders of their regions would not
follow national boundaries, as the Federal Reserve
Districts do not follow U.S. state boundaries. [See
the accompanying piece, “A Yankee Recipe for a
EuroFed Omelet,” for a discussion of this possibility.]
Whichever arrangement is chosen, in a successful,
lasting monetary union money moves with little or
no restriction, and people must be indifferent between any two banknote portfolios of equal value and
between any two deposit accounts of equal value
BANK

OF RICHMOND

13

bringing rates of inflation closer together. However,
the EMS is not a monetary union-no one pretends
that exchange rates will not change.

(they are generally not indifferent as to how they
divide their holdings between banknotes
and
deposits). Under a union subject to periodic exchange
rate realignments, no one will be indifferent to the
national makeup of his currency and deposits. Under
the supposedly fixed exchange rates of the Bretton
Woods arrangement (which had some characteristics
of a monetary union), people cared a great deal about
whether their pockets were filled with dollars or
pounds because the possibility of a devaluation or
revaluation of, say, the pound against the dollar meant
big gains or losses, depending on which currency
gained and which lost and where the holder of currencies lived.

Incentives for Monetary Restraint
Table I catalogues the monetary unions by the
two criteria (number of currencies, domain of central banks) presented in the above discussion of
institutional arrangements. In each case, monetary
restraint was imposed on members by some factor
that limited political authorities’ influence over
monetary policy. Such restraint was provided either
by a viable metallic standard or by the presence of
a single authority with the power to impose its will.
In this admittedly limited number of cases, multiple
currencies do not appear to threaten the arrangement.
The Luxembourg franc, Vatican lira, San Marino lira,
Liberian dollar, and Panamanian balboa have not
been overissued to the point of threatening the
respective
union (though Liberia has recently
pushed its arrangement somewhat).

Since 1978, most of the European Community
countries have been members of the European
Monetary System (EMS), an agreement to limit exchange rate movements
and to harmonize the
member nations’ economic policies. It has given rise
to the European Currency Unit (ECU), a common
unit of account. The EMS has had some success in

Table

I

Single or
Multiple
Currencies

Money Supply
Under Control of

Money Supply
Restrained
by

Restraining
Factor
Failed Because of

New England

Multiple

Individual

Massachusetts*

Growth

Latin Union

Multiple

National

Banks

Gold, silver in coins

Silver depreciated,
limited
bimetallism
continued
Some members left gold
standard during WWI
Subsidiary coin loophole

Multiple

National

Banks

Gold standard

Collapse of world gold
standard during WWI
Subsidiary coin loophole

National

Banks

Convertibility
under
Sterling Area

Convertibility
broken with
Sterling Area collapse

National

banks

Prussia*
Metallic

Monetary

Union

Scandinavian

Union

East African

Currency

Zollvereina

Area
Multiple

colonies

of smaller

colonies

standards

Belgium/Luxembourg

Multiple

Belgiumb

Belgium*

Switzerland/Liechtenstein

Single

Switzerland

Switzerland*

France/Monaco/Andorra

Single

France

France*

Italy/San

Multiple

ItalyNaticanc

Italy*

Marina/Vatican

CFA Franc Zone

Single

Multinational

U.S./Liberia

Single

United

Statesd

banks

United

States*

U.S./Panama

Single

United

State9

United

States*

Notes:
* Economic dominance of one member enabled it to enforce restraint
a Evolved into today’ deutsche mark
s
D Luxembourg has some power over foreign exchange regulation.
c San Marina issues no currency. but mints its otin coins.
d Liberia and Panama theoretically
have independent
currencies (the Liberian
minted sufficient coins to threaten its arrangement with the U.S. dollar.

14

ECONOMIC

dollar

REVIEW,

France*

and the Panamanian

JULY/AUGUST

balboa).

1990

but in practice

only mint

coins.

Liberia

has in recent years

The four failed unions were each composed of between three and five countries of similar economic
size. In each case, overissue of money was initially
restrained by factors which separated the money from
the political authorities. In each case, the depoliticizing factor disappeared, leaving the individual political
jurisdictions free to determine their own money supplies, and leaving monetary authorities vulnerable to
political pressures. Members preyed on their partners by issuing excessive amounts of money, which
union members were forced to accept.

power in the region, however, it does not dominate
Western Europe, since its Gross Domestic Product
is only about l/4 of the total Common Market GDP
(perhaps 30% or more if estimated East German
GDP is added). It has been suggested that all of
Western Europe similarly assign Germany power over
the joint money stock; this seems unlikely due to
political reasons.

These observations accord with what cartel theory
would suggest. A monetary union is a cartel whose
product is money instead of oil or coffee or diamonds.
Like all cartels, members of a monetary union must
restrict output or suffer declining joint profits (in this
case, seigniorage). As with other cartels, restricting
production depends on maintaining an agreement
among members on how to share the profits. Over
time, cartels generally break down because at some
point, members allow pursuit of individual selfinterests to override pursuit of the cartel’ common
s
goals. Salin (1984/pp 196-2 14) describes the current
European Monetary System as a cartel.

As mentioned above, it is unlikely that any member
of a European Monetary Union will emerge as a
sufficiently dominant force in the union to enforce
a monetary cartel. Further, it seems unlikely that
Western Europe would give sole power of monetary
policy to some large (but not dominant) member,
such as Germany. Without such a dominant member,
other factors would have to emerge to solidify the
union.

The exception to this rule is the cartel which has
one member with both the motive and the economic
power to impose the agreement on all the other
members. OPEC held together because Saudi Arabia,
with one fourth of world production, was willing and
able to expand and contract its production in response
to changing world demand and supply conditions.
Furthermore, the Saudis enjoyed sizable international
reserves, out of which current expenditures could be
financed, if necessary. When other members of
OPEC violated their agreement by overproducing,
the Saudis could threaten to expand their production to punish the cartel, and this threat was
credible. Similarly, France has economic and
noneconomic reasons for wanting the CFA Franc
Zone to survive, giving it the ability and desire to
keep the system operating, and the member countries and the multinational central banks are fully
aware of France’ special position.
s
One of the major obstacles in the way of an EMU
is the lack of a dominant member to serve as the
union’ enforcer. Liechtenstein
s
completely surrendered its monetary policy to the Swiss National
Bank. The German Bundesbank has been suggested
for a similar role in a European Union. Now, the
advent of a German Monetary Union should give
Germany an even larger percentage of the Western
European economy. While it is the largest economic
FEDERAL

RESERVE

Other Factors Encouraging
Permanent Union

Some proponents of a European Monetary Union
hope to model their system on the U.S. Federal
Reserve, with national central banks becoming the
equivalents of Federal Reserve District Banks, which
constitute a sort of monetary union. Money circulates
unrestricted throughout the U.S., and nobody cares
whether the bills bear the seal of the Richmond Fed
or the Cleveland Fed or any other regional Federal
Reserve Bank. This situation suggests asking what
steps are required to create such a system in Europe,
and what obstacles could prevent Europe from
developing as cohesive a system as the Federal
Reserve.
Emergence of Europe as a Political Community: The more Europeans begin to think of
themselves as Europeans rather than Dutch, Italians,
Greeks, etc., the stronger the EMU will be. The
Common Market’ founders dreamed of a United
s
States of Europe. Some of Europe’ current leaders
s
appear to support subordinating nationalism to continental interests. The willingness of their constituents to go along is less certain. There are many
barriers to overcoming ancient nationalistic tendencies. Linguistic, religious, political, and cultural
differences still separate the nations of Europe.
A Common European Fiscal Policy: It has
been argued that one reason for the solidity of the
United States as a currency area is the size of the
federal government compared with state and local
governments. This size makes possible fiscal transfers
from booming regions to depressed regions. These
BANK

OF RICHMOND

15

fiscal stabilizers, it is argued, reduce demands for
monetary stabilization of regional economies. Tower
and Willett (1976/p25) write that independent fiscal
policies within a currency area are likely to be
of a “beggar-my-neighbor”
character, leading to
inefficiencies.
The fiscal tools of the Common Market (eg, the
Common Agricultural Policy, the Customs Union)
are small but have grown in importance. Still, the
present-day Common Market has limited ability to
tap the wealth of, say, Germany, to ameliorate
economic difficulties in, say, Greece or Ireland.
This limitation has been cited as an obstacle to a successful EMU (Leigh-Pembertonl19891p6).
Ingram
(1973/p@, though, recalls that the federal government was small compared with the states until the
New Deal. An explicit agreement to transfer spending powers from the national governments to the
European Community, plus explicit agreement to use
such power to smooth regional disturbances, would
help solidify an EMU by reducing the need for
regional monetary stabilization policy. Such regional
issues might be important if labor migration were
judged to have pecuniary or nonpecuniary costs.
Again, the problem arises that such agreements often
fail during downturns affecting the whole union.
It is often stated that a monetary union requires
fiscal harmonization or else divergent national policies
will strain the monetary accord. In one sense, this
claim is an overstatement. The monetary union really
UT common
requires e&v- fiscal harmonization
knowledge that monetary policy cannot later be
used to correct a member’ fiscal policy errors. In
s
other words, if the central bank of a monetary union
is willing to bail out individual nations whose obligations cannot be met, then fiscal policies will have
to be harmonized. If, however, each nation knows
the central bank will not subsidize its desire to
live beyond its means, then that will by itself
“harmonize” policies. In the United States, for
example, overextended states and localities have had
no guarantee, traditionally, that the U.S. Treasury
(and, indirectly, the Fed) would bail them out.
Europe 1992: The U.S. is a common market in
the sense that goods, labor, and capital circulate
with limited interference. The Europe 1992 Project
is aimed at making Western Europe a similarly united
market, rather than a collection of national markets
with numerous barriers. The Project aims to create
a common legal framework, common product standards, and a free flow of goods and factors across
16

ECONOMIC

REVIEW,

borders. If the aims are achieved, the European Community will certainly become more of an optimum
currency area. As is true with the political unity of
the continent, though, it remains to be seen whether
Europe 1992 will succeed. The legal traditions of the
countries are vastly different. Noneconomic factors
(eg, fear of terrorists and criminals) may reduce the
actual mobility across borders. Further, it remains
to be seen whether the countries of Europe will give
up their often subtle barriers to free trade.
Nonnational Central Banks: There is strong
pressure in Europe to retain the existing central
banks, with each responsible for its own nation’
s
monetary policy. Allen (1976/pll)
wrote that it
would be difficult to persuade these institutions,
each with a long history of independence and power,
to simply disappear. Yet, as this paper has shown,
multiple central banks encourage the dissolution of
a monetary union. A possible compromise between
retaining and abolishing national central banks would
be to retain the national banks, but redefine the boundaries over which they have authority. This idea is
pursued in the accompanying article “A Yankee
Recipe for a EuroFed Omelet.”
.IV.

CONCLUSIONS: CANTHE EMU FLY?
A successful monetary union requires that the
countries involved gain from the union agreement,
and it requires institutions which enforce the agreement once it is reached. The theoretical motives
behind a monetary union (factor mobility, crossborder transactions within the community, political
cohesion) appear to be increasing. In all successful
historical unions examined, monetary policy was in
the hands of a single monetary authority or, where
there were several central banks one was sufficiently dominant to impose the agreement on other
members. “Self-regulating” standards (eg, metallic
content of money) enforced by multiple authorities
did work for a time in several cases. In each case,
though, financial pressures and weakening of the
self-regulating mechanism eventually led members
to violate their union agreements. In each of the four
failed unions examined, members destroyed the
union by overissuing their moneys.
According to the criteria set forth in the optimum
currency area literature, Western Europe’ motives
s
for forming a monetary union are increasing. The
factors of production are increasingly mobile within
the community as controls are being dropped on
JULY/AUGUST

1990

movements of humans and capital. Transactions
occurring &ween European Community members are
increasing, compared with transactions wholly wit/zh
individual member nations. The region’ sense of
s
political community, while still sharply limited, nevertheless seems to be rising as numerous political
leaders preach the virtues of continental over national
interests.
However,
no centralized
EMU enforcement
mechanism appears to be on the horizon. The ECU
(or permanently tied separate currencies), being fiat
money, will not even have a temporarily selfregulating standard, as the Latin and Scandinavian
Unions had in gold and silver. Several decades of

experience with exchange rate mechanisms like the
current European Monetary System’ have met with
s
only limited success because economic pressures
induce individual members to pursue domestic selfinterests over the common good. To be sure, inflation rates in the EMS have converged (and exchange
rates stabilized). But during this period, Western
Europe has experienced no extraordinary strains,
such as war or prolonged recession. Even the
moderate economic difficulties of the 1970s were
sufficient to ruin several earlier arrangements. A
permanent EMU would likely require either a
supranational monetary authority (possibly with some
degree of decentralization) or the delegation of all
authority to the German Bundesbank.

References
Allen, Polly Reynolds. Organization and Administration of a
Monetary Union. Princeton Studies in International Finance
No. 38. Princeton: Princeton University, 1976.

Ingram, James C. Th Case for European Monetary Integration.
Essays in International Finance, no. 98. Princeton: Princeton University, April 1973.

Cohen, Benjamin J. Tke European Monetary System: An Outsider’
s
%rw. Essays in International Finance, no. 142. Princeton:
Princeton University, International Finance Section, Department of Economics, June 1981.

Johnson,

Cooper, Richard N. “Implications for Integration of the World
Economy.” In European Monetary ffn$ication: and Its Meaningfor the UnitedStates. Lawrence B. Krause and Walter S.
Salant, editors. Washington: The Brookings Institution,
1973.
Cowitt, Philip P., ed. 1986-1987 h%&i Currency Yearbook.
Brooklyn, NY: International Currency Analysis, Inc., 1989.

Harry. “Narrowing

Washington:

The Brookings Institution,

Times. “Costs

to Paris of African franc zone fuels
devaluation debate.” By Mike Hubbard. March 21, 1990,
P4.

Fratianni, Michele and Franc0 Spinelli. “Italy in the Gold Standard Period, 1861-1914.” In A Retmspective on t/e Classical
GoldStandard,
1821-1931. Michael D. Bordo and Anna J.
Schwartz, eds. Chicago: University of Chicago Press, 1984.
Friedman, Milton. Capitahm andFreedom. Chicago: University
of Chicago Press, 1962. Reissued, 1982.
Giscard d’
Estaing, Valery. “The International Monetary Order.”
In Monetary Problems of t/e InternationaL Economy. Robert A.
Mundell and Alexander K. Swoboda, eds. Chicago: The
University of Chicago Press, 1969.
Histoticaol Statistics of the United States: Colonial Emes to 1970.

U.S. Department of Commerce,
September 1975.

Bureau of the Census.

Holtfrerich, Carl-Ludwig. “The Monetary Unification Process
in Nineteenth-Century
Germany: Relevance and Lessons
for Europe Today.” In A European Central Bank?: Penpectives on Monetary Unlnifcation ajier Ten Yeon of the EMS.
Marcello de Cecco and Albert0 Giovanni, eds. Cambridge:
Cambridge University Press, 1989.
FEDERAL

RESERVE

Rate Bands.” In

1973.

Kindleberger, Charles P. Intemational Economics, Stk edition.
Homewood, Ill.: Richard D. Irwin, Inc., 1973.
Leigh-Pemberton,
Robin. “Europe 1992: Some Monetary
Policy Issues.” Federal Reserve Bank of Kansas City
Economic Rewie~, September/October
1989:3-8.
Richard A. Monetary Experimenrs: Early American and
Recent Scandinavian. New York: Augustus M. Kclley, 1970.

Lester,

(Originally published
Financial

the Exchange

European Monetary Un~&ation: and Its Meaning for tke United
States. Lawrence B. Krause and Walter S. Salant, editors.

by Princeton

University,

1939)

John J. Money and Exchange in Europe and America,
A Handbook. Chapel Hill: University of North
Carolina Press (for the Institute of Early American History
and Culture, Williamsburg, Va.), 1978.

McCusker,

2600-1775:

McKinnon,

Ronald

I.

“Optirnum

Currency

American Economic Review 53. (September

Areas.” Th
1963): 717-25.

Mundell, Robert A. International Economics. New York: The
Macmillan Company, 1968.
Nielsen, Axel. “Monetary Unions.” In Euqclopedia of th Social
Sciences. New York: The Macmillan Company, 1937.
Stdillot, Franz. All tke Monies of the Word: A
of CurrenGy Vahes. New York: Pick Publishing
Company, 197 1.

Pick-Rent

Chvnicle

Salin, Pascal. “Monetary Europe Today: A Cartel of Central
Banks.” In Currenq Competition and Curemy Union. The
Hague: Martinus Nijhoff Publishers, 1984.
Tower, Edward and Thomas D. Willett. Tke Theory of @imum
Curemy has and Exckange Rate Flesibility. Special Papers
in International Economics No. 11. Princeton: Princeton
University, 1976.
Wisely, William. The Politicai Hhry
Wiley & Sons, 1977.
BANK OF RICHMOND

of Money. New York: John

17

A Yankee Recipe for a EuroFed

Omelet

Robert F. Craboyes

This piece previoz~~iyappeared on the Editorial Page of
The Wall Street Journal/Europe, Aqpst I, 2990.

The architects of the European Monetary Union
(EMU) face a dilemma in trying to balance the
advantages of decentralized administration against the
dangers of nationalism. In this respect, the American
model suggests a way to stabilize the EMU by
disengaging it from everyday politics.
The map of the twelve U.S. Federal Reserve
districts is an odd-looking thing. Politically and
economically dissimilar states are lumped together.
Some states are split in two. No state is by itself a
Fed district. These boundaries make it difficult to
easily identify district interests in the way one can
speak of urban interests or Texas interests or Rust
Belt interests, and this is precisely what is interesting
and stabilizing about Fed districts.
One state’ interest groups can easily organize
s
support for a pork-barrel policy to benefit that state
at the expense of the rest of the country. Fed district
lines, though, discourage beggar-thy-neighbor politics
by scrambling the usual coalitions constructed along
state lines. Suppose a pressure group wished to
lobby the Cleveland Fed for a policy detrimental to
neighboring districts (say, lax credit approval standards by Cleveland’ discount window).
s
The pressure group would have to garner support
in Ohio, Pennsylvania, Kentucky, and West Virginia,
four states with markedly different interests. Ohio
lies completely within the Fourth District, so a consensus there might be attainable. Half of Pennsylvania, though, lies in the Philadelphia Fed’
s
district, so that state’ interest groups would be hesis
tant to support a policy harming eastern Pennsylvania
but helping Kentucky, Ohio, and West Virginia, as
well as western Pennsylvania.
Similarly, half of
Kentucky is in the St. Louis Fed’ domain. Few West
s
Virginia pressure groups would join the coalition,
since only a tiny piece of West Virginia is in
Cleveland’ district.
s
On occasion, however, a consensus can arise in
one Fed district, pitting it against the other districts.
18

ECONOMIC

REVIEW,

For example, a districtwide recession can lead to
one-sided pressures on that district’ Fed (which may
s
have a representative on the Federal Open Market
Committee)
to support looser credit conditions
nationally. The decentralized Fed, though, reduces
the frequency of such demands reaching Washington
by requiring that such pressure must filter through
debate at the district level before it reaches the
Federal Open Market Committee. This structure
slows down the deliberative process enough that
policymakers at the highest level do not have to
respond to every ephemeral economic disturbance.
So, decentralization assures that disparate voices
will be heard, while the jagged district boundaries
assure that these voices will be organized through
channels other than the usual political ones organized along state lines.
The Fed’ ragged district lines offer powerful
s
advice to the budding European Monetary Union insulate a EuroFed from nationalistic pressures by

4th FEDERAL

RESERVE

(Cleueland

DISTRICT

Fed)

Plus portions of Pennsylvania, West Virginia,
and Kentucky in Neighboring Fed Districts

‘
8ih
DISTRICT
SfYkidu~
JULY/AUGUST

1990

5ih
DISTRICT
Rickond

Dls%m
Philaccl

hia
2

scrambling its districts’ borders. Rename the
Bundesbank the Frankfurt EuroFed, but let it represent only part of Germany plus part of France, with
a governing board coming from both to control any
tendency to favor only Germany. Rename the Danmarks Nationalbank the Copenhagen EuroFed, and
let it represent Denmark plus some parts of Germany
not under the Frankfurt EuroFed, and so on with
all the other central banks.
In other words, design EuroFed districts that break
up nationalistic pressures rather than exacerbate
them, yet which still confer the other benefits of
decentralized administration. Entangling member nations at the district level would also make secession
from the EMU an administrative nightmare (like
unscrambling an emu’ egg, so to speak), and that
s
would bolster confidence in the EMU on world
markets.
A glance at the map shows that drawing twelve
scrambled districts for twelve countries is harder than
drawing twelve scrambled districts for fifty U.S.
states. Some districts might inevitably have distinct
economic interests. Undoubtedly, it would take complex negotiations to design the borders and the
regional EuroFeds’ voting structures. Supplemental
measures might be needed to adequately insulate the
EuroFeds from oolitical logrolling. Like the district
Feds, EuroFeds might be-well-&ved
by different

7

Paris

FEDERAL

classes of directors representing,
say, industry,
labor, national governments, the banking sector,
etc. To prevent any one nation from dominating a
EuroFed, each district’ board could include members
s
from other countries on a rotating basis, for example, giving the London EuroFed board a succession of members from Greece, Portugal, Belgium,
and so on.
The goal is to insure that national political coalitions do not easily or quickly translate into EMU
pressure groups, making money just one more log
to roll (eg, I’ voter tighter credit if you’ vote
ll
ll
higher wine subsidies).
National politics would certainly inject itself into
the process of drawing lines. For example, would
Britain allow Northern Ireland to fall within the
Dublin District? As difficult as these negotiations
would be, scrambling monetary boundaries at the
founding of the EMU would recognize and deal up
J+VWwith an ugly reality - nationalism has been
ripping European institutions apart for centuries. The
point here is that the EMU’ founders can choose
s
to face that reality now and put it behind them. Or,
they can simply string the existing central banks
into a loose confederation, with each bank representing purely national interests. Then they will be
sure to face the reality every day as long as the union
survives.

Scrambled
EuroFed
Districts

m

RESERVE

BANK OF RICHMOND

19

Fifth District

Bank Performance

John R. Walter and Doria/d L. WeIke+

PREFACE
The final four years of the 1980s were difficult for
banks in the U.S. Between 1986 and 1988 problems
in the agricultural and oil sectors led to losses and
numerous bank failures. The nation’ largest banks
s
suffered losses as income was set aside in 1987 and
1989 to deal with problems in portfolios of loans to
less developed countries (LDCs). Losses in real
estate loan portfolios, due to weak real estate
markets, had a significant negative effect on bank
earnings in 1989. In addition, concerns for future
bank earnings were raised by regulators and bank
analysts because of banks’ increased lending for highly
leveraged corporate takeovers.
Despite the difficulties of banks nationwide, Fifth
Federal Reserve District commercial banks as a group
were able to maintain historically high profit rates
throughout the years 1986 through l989.2 While
770 U.S. banks failed between January 1986 and
December 1989, only two were Fifth District banks.3
District banks almost completely eliminated their
modest LDC debt exposure by selling these loans
in the secondary market during 1988. Still, the
outlook for District banks on other fronts may not
be so sanguine. Thus, while the degree of exposure
of District banks to highly leveraged loans is difficult
to determine, real estate lending could limit the future
profits of District banks because such loans grew as
a percentage of all loans. Most ominously, nonperforming real estate loans expanded rapidly during
1989.
Fifth District commercial banks maintained a high
profit rate during 1989. They outperformed banks
in the rest of the United States by holding down
interest costs, noninterest costs, and provisions for
1 Valuable research assistance was provided by Marc D. Morris.
2 The Fifth Federal Reserve District includes Maryland, Virginia,
North Carolina, South Carolina, the District of Columbia, and
most of West Virginia. The District of Columbia is referred to
as a “state” in this study.
3 Data on number of bank failures: 1986-88 figures from “Seven
Years of Failures,” American Bat&r, January 1, 1989; 1989 figures
from Federal Deposit Insurance Corporation,
Division of
Research and Statistics. Figures include assistance transactions.

20

ECONOMIC

REVIEW,

loan losses, and by paying out less in taxes. Fifth
District banks also added enough equity capital
during the year to improve their capital ratios. Their
nonperforming loans grew to a high level by Fifth
District standards but remained well below the
average experienced
by banks elsewhere in the
nation. Banks outside the District suffered a significant decline in profits due to a large increase in
prqvisions for loan losses during the year.
The next section gives the nonbanker an introduction to a bank’ balance sheet by discussing the
s
structure and adjustments to Fifth District banks’
balance sheets that allowed them to maintain strong
Drofits in 1989. The third section then reviews, in
hetail, Fifth District banks’ income and expense
results.

ANINTROOU~TI~NT~

THE

BANKBALANCESHEET
An annual review of bank performance begins with
the end of the preceding year. Balance sheet data
appearing under the caption 1988 in Table I refer
to summed figures for all banks in the Fifth Federal
Reserve District at the close of business on Friday,
December 30, 1988, the last business day of the year.
Comparable information for 1989 is recorded for
Friday, December 29, 1989. [NOTE: Data will
be denoted as follows: Table I, line a = (Ia).]
first item on the balance sheet, cash and
institutions (Ia), a
has
different meaning for banks than for other types of
businesses. Most businesses regard cash (currency
and coin) and deposits as sterile assets to be kept
to a bare minimum consistent with operating requirements. Banks also prefer to minimize currency
and coin holdings, but tend to view their deposits
at other “correspondent” banks as working balances
to help pay for the services correspondents provide
them. Thus a $369 million reduction in cash and
deposits in other financial institutions from year-end
1988 to year-end 1989 could mean District banks
held less cash in their vaults, but could also mean
they required fewer or less costly services from
The

deposits in other financial

JULY/AUGUST

1990

Table

I

Balance Sheet of Fifth District Banks
($Millions)
Assets
a Cash and deposits
b Investment

1388

institutions

securities

c Loans & Leases-Total
(=d+e+f+g+h+D
d
Home mortgage
e
Commercial
real estate
f
Business
Consumer
E
Agricultural
i
Other
j Less: Allowance for loan and lease losses

34,523
32,506
1,331

12,963
(1,856)

y
Source:

8,996
15,151
4,217
5,241

2,913
1,720
100
961
(138)

11,259

1,080

17;192
27,933

63,06 1

34,011

28,816
5,776
27,096
11,103

214,988

15,069

-m-v)

Reports of Condition

814

6,304
8,765

profits and reserves

Total equity (=w+x

9,361

230,057

Total liabilities (=n+o+p+q+r+s+t+u)

Consolidated

(369)

10,179

Liabilities
NOW accounts
Money market deposit accounts
Savings and consumer time deposits
Demand deposits
Time deposits with denominations
over $100,000
Deposits in foreign offices
Fed funds purchased
Other liabilities

Equity
w Stock
x Undivided

163,702
33,485
39,764
40,872
34,226
1,431
13,924
(1,994)

Change

8,547

Total assets(=a+b+c+j+k+D

v

52,215

37,960

I Other assets

n
o
p
q
r
s
t
u

21,047

148,551
29,268

k Fed funds sold

m

1989

21,417

43,220

in other financial

255,591
18,172

28,753
71,953
33,883
31,145
5,930
36,469
12,392
238,697
6,893
10,001

16,894

25,534
981
820
8,892
(128)
2,329
154
9,373
1,288
23,709
589
1,236
1,825

and Income.

correspondents, or chose to pay fees for services in
lieu of holding correspondent balances. Available data
are not sufficient to determine the relative importance
of the three explanations.
Investment securities (Ib) refers to Fifth District
banks’ investments in U.S. government securities and
municipal securities (debt issued by state and local
governments). U.S. government securities can be
sold quickly if cash is needed. They also have no
credit risk or risk of default, since the federal government backs them. Most municipal securities are considered to have minimal credit risk and, in addition,
provide a source of tax-exempt income. Banks in the
Fifth District increased their holdings of government
securities by nearly $9 billion in 1989.

District banks lent about $15.2 billion more in
1989 than they received in repayments from their
FEDERAL

RESERVE

borrowing customers (Id. Inevitably, banks make
some loans that are never fully repaid. They provide
for this credit risk with an allowance for loan and
lease losses (Ij) which is deducted from total loans
and leases (Ic) to arrive at a figure for the net loans
that are believed collectible. Among Fifth District
banks during 1989, the increase in the allowance for
loan losses of only $138 million relative to additional
loans of $15.2 billion suggests a relatively high degree
of confidence that the loans will be repaid.
The balance sheet does not show the amount
actually charged off as loan and lease losses in 1989.
To derive this amount, it is necessary to use the
income statement (Table II) as well as the balance
sheet. The income statement shows that provision
for loan and lease losses(IIn) totalled $79 1 million
at the end of 1989. The $791 million plus the balance sheet figure of $1,856 million in end-of-1988
BANK OF RICHMOND

21

Table

II

Income Statement of Fifth District Banks
($Millions)
lntefest

1988

Income

a Interest

on balances

b Interest

and fees on loans and leases

c Interest
d Interest

and dividends on securities
income from trading accounts

e Income

from fed funds sold

f

with depository

institutions

426
14,776

3,474
71
610

19,356

Total interest income ( = a + b + c f d + e)

1989

442
17,911
3,925
168

838
23,284

Interest Expense
g Interest

on deposits

h Expense
i Interest

8,988

of fed funds

11,378

j Interest

on mortgage

on subordinated

19

indebtedness
notes

74

Total interest expense( = g + h + i + j + k)

m Net interest income ( = f - I)
n Provision

8,670

341

k Interest

I

2,830
496
20
87
14,614

7,978

on borrowings

11,181

1,956

purchased

for loan and lease losses

735

791

o Noninterest

income

2,518

2,836

p Noninterest

expense

6,951

7,540

q Gains or losses on securities

50

r Income

before taxes (=m-n+o-p+q)

s Income

taxes

t Extraordinary

u
Source:

Reports

816

19

of taxes

2,223

of Condition

for loan and lease losses (Ij) indicates
that $2,647 million was available in 1989 to absorb
loan and lease losses. Inasmuch as the year-end
allowance for losses was $1,994 million (Ij), chargeoffs less recoveries and adjustments during 1989 must
have been $2,647 - $1,994 = $653 million.
Federal legislation requires every depository institution (commercial banks, savings and loan associations, savings banks, and credit unions) to hold
reserves in the form of vault cash or deposits with
one of the twelve Federal Reserve Banks. These required reserves are in proportion to certain classes
of the institution’ deposits. A depository institution
s
with reserves in excess of the required amount may
lend these fed funds to other institutions that have
inadequate amounts of required reserves. Such loans
show up on the lending bank’ balance sheet as fed
s
ECONOMIC

4
2,441

and Income.

allowance

22

3,252

656
income-net

2,860

Net income (=r-s+tI
Consolidated

77

REVIEW,

funds (Ik). Fed funds are generally lent oversold
night, and the rate they earn changes
supply and demand.

daily with

The remaining asset category in Table I is other
assets (Il). This category consists mainly of buildings
and equipment including automated teller machines
and computers. It also includes prepaid expenses
such as insurance premiums and magazine subscriptions. In 1989, Fifth District banks added more than
$1 billion, net of depreciation expense, to other
assets.
The liabilities section of the balance sheet shows
that Fifth District banks obtained funds from a variety
of sources. The first item in this category, NOW
accounts (negotiated order of withdrawal accounts)
(In), is a relatively new type of checking account that
JULY/AUGUST

1990

pays interest. The Depository Institutions Deregulation and Monetary Control Act of 1980 allowed
banks and other depository institutions nationwide
to offer NOW accounts. Before 1980 only depository
institutions in the New England states had been
allowed by Congress to offer such accounts. Bank
depositors added just under $1 billion to their NOW
accounts in District banks in 1989.
Between 1979 and 1982 money market funds
(MMFs) offered by investment companies grew
rapidly at the expense of deposits in depository
institutions. Interest rate ceilings limited the rates
depository institutions could pay on deposits to levels
below rates paid on MMFs. To allow depository
institutions to compete with investment companies
money market
deposit accounts
for deposits
(MMDAs) (10) were authorized December 1982.
Like MMFs offered by investment companies,
MMDAs offered by banks and other depository institutions pay a market-determined
rate of interest
and provide limited check writing privileges.
MMDAs offer a safety advantage: they are insured
by the Federal Deposit Insurance Corporation
(FDIC), an agency of the federal government, while
MMFs are not.
Innovative banking products have augmented but
not replaced savings and consumer time deposits
(1~). These traditional savings accounts include
passbook savings accounts, “statement” savings accounts (which do not require passbooks), and small
certificates of deposit, which are deposits left with
the bank for a specified period. Savings and consumer
time accounts continue to represent the largest single
component of bank liabilities in the Fifth District.
In fact, depositors expressed their approval of these
accounts at District banks by depositing $8.9 billion
more than they withdrew in 1989. A portion of this
increase in savings was provided by interest accumulated on balances carried over from 1988. This builtin growth factor makes savings deposits particularly
attractive to banks.
Table I shows that demand deposits Uq) continued
to supply nearly $34 billion to banks in the District.
Balances of these non-interest-earning
checking
deposits were down slightly (by $128 million) from
the previous year. Contrary to popular belief, demand
deposits do not represent a source of “free” money
because banks must supply costly check-clearing and
bookkeeping services to holders of these deposits.
As is the case for all deposits, what matters is the
differential or “spread” between the interest and
FEDERAL

RESERVE

noninterest costs associated with deposits and the
yields on the banks’ earning assets. This yield-cost
spread remained positive and large in 1989, a period
characterized by interest rates that were relatively
high from a historical perspective.
The deposits described up to this point tend to
be those attracted mainly from a bank’ local coms
munity or service area. In contrast, funds in time
deposits with denominations over $lOO,&IO (It-) may
come from anywhere in the world. These large certificates of deposit (CDs) are frequently referred
to as “hot money” because they may move from one
bank to another in response to interest rate changes
of less than one-tenth of one percent. Large
denomination time deposits provide a ready source
of available funds to banks confronted with strong
loan demands. When loan demands diminish, the
bank lowers its rates on these deposits as they mature
and the deposits move to other institutions paying
higher rates. Large time deposits provided $2.3
billion of additional funds to Fifth District banks in
1989.
Only a few banks in the District engage in foreign
operations to the extent of maintaining offices
overseas. For this reason, deposits in foreign oftkes
(Is) is a relatively minor source of funds. Less than
$0.2 billion was added to deposits held in foreign
offices during the past year.
Fed funds purchased
(It) or borrowed is the
mirror image of fed funds sold on the asset side of
the balance sheet. Since fed funds are generally borrowed for no more than one day, the rate a bank pays
on such borrowings varies daily with the fed funds
market rate. Fifth District banks, therefore, elected
to fund more than 14 percent of their assets with a
liability that was extremely sensitive to interest rate
movements. Nearly $9.4 billion was added to fed
funds borrowing in 1989.

The difference between fed funds sold (Ik) of
$9.4 billion and fed funds purchased (It) of $36.5
billion, $27.1 billion, was supplied to Fifth District
banks by depository institutions in the rest of the
nation. Generally, large banks tend to be net buyers
of fed funds while small banks tend to be net sellers.
The last category of liabilities, other liabilities flu),
is a catchall category that includes diverse items such
as accounts payable, income taxes payable, and even
subordinated term debt. Subordinated debt, while
included in other liabilities, resembles capital since
it helps protect depositors from losses. Specifically,
BANK

OF RICHMOND

23

in the event of a bank failure, subordinated debt is
not repaid until the bank’ depositors are repaid.
s
A relatively small but indispensable source of funds
to a commercial bank is equity, sometimes called
equity capital or shareholders’ investment. Total
equity (Iy) rose about $1.8 billion at Fifth District
banks in 1989. About $1.2 billion was a result of
undivided profits and reserves (Ix) or earnings retained in the business after paying dividends of $1 .O
billion. The banks also issued more stock (Iw) than
they retired, realizing roughly $600 million from stock
sales to investors. The increase enabled District
banks as a group to produce an equity capital-to-assets
ratio of 6.6 percent, a ratio significantly higher than
the average for all U.S. banks. In general, the higher
the equity-to-assets ratio, the sounder the bank.
The structure of the balance sheet and changes
made to the structure have important consequences
for income and expense. Measures of Fifth District
banks’ performance, in other words their income and
expense results, are highlighted below.

MEASURES

OF

BANK PERFORMANCE

Net Interest Margin
(gross interest

revenue

- gross interest

Shifts in asset and liability compositions:
Accounting for some of the increase in gross interest
revenue (IIIa) were increased holdings of securities
(Ib), an earning asset, and decreased holdings of cash
and deposits in other financial institutions (Ia) which
earn no interest income. District banks also increased
the share of federal funds (It) in their liability structure relative to other interest-bearing deposits and
demand deposits. Cost per dollar of fed funds borrowings was less than those of most other sources
of funds (VIIID.
Comparison of Fifth District banks with the
average U.S. bank: Fifth District banks produced higher net interest margins (111~)than did
their counterparts throughout the country (IVc) by
holding down gross interest expense(IIIb, IVb).
Comparatively low interest expenses resulted from
District banks’ lack of dependence on foreign office
deposits, greater use of savings, NOW, and MMDA
deposits, and, importantly, from the lower rates paid
on equivalent types of accounts.

expense)4

1989 compared with 198%see
Table III:
Fifth District banks’ net interest margin (111~)declined by four basis points as gross interest revenue
(IIIa), expressed as a percentage of average assets,
rose by 85 basis points, while gross interest expense
(IIIb) rose 89 basis points.
Reason interest income and expense rose:
Interest rates fell through most of 1989, but over the
year, still averaged 150 basis points higher than in
1988.
Why expenses grew faster than income:
The greater increase in gross interest expense (IIIb)
resulted in part because District banks’ liabilities were
more sensitive to interest rate movements than were
assets.
Differences by size category: Small District
banks (assets less than $100 million) and mediumsized District banks (assets of $100 million to $1
4 All ratios through the remainder of the paper are expressed
in percentage terms. As an example: at Fifth District banks
net interest margin, (gross interest revenue - gross interest
ex#ense)laverage
assets, was 3.61 percent in 1988 and 3.57
percent in 1989, so that it declined by 3.61 - 3.57 = 4 basis
points.
24

billion) actually imprwednet margins 1989 over 1988.
Their asset and liability interest rate sensitivities were
less pronounced than at large District banks where,
on average, net interest margin declined.

ECONOMIC

REVIEW,

Loan and Lease Loss Provision
1989 compared with 1988: Loan and lease loss
+ average assets (IIId) declined slightly
on average at Fifth District banks to the lowest level
since 1983.5

provision

Growth of troubled loans: The ratio past-due
loans + total loans was at its highest
level in recent years as charge-ofi
+ total loans
declined at District banks.6

and nonaccrual

Declining allowance for loan losses: For all
District banks allowance for loan losses + past-due
and nonaccrual loans declined from 144 percent to
5 Loan and lease loss provision is an expense charged against
income each year and added to allowance for loan and lease
losses-a contra-asset account-from which charged-off loans are
subtracted. Provision for loan and lease losses is the bank’
s
estimate of the portion of loans and leases that will not be
collected.
6 Past-due loans here and throughout the article are those for
which the borrower is 90 days or more late on scheduled
payments. Nonaccrual loans are those that are no longer accruing interest on the bank’ books because the bank believes that
s
thi loan is not likely to be repaid. Charged-off loans are those
loans that have been removed from the bank’ balance sheet
s
because of the bank’ view that they are not going to be repaid
s
by the borrower.
JULY/AUGUST

1990

Table

III

Income and Expense as a Percent of Average Assets1
Fifth District

Commercial

1986-89

Banks,

1986

1987

1988

1989

8.63

8.23

8.74

9.59

4.98

4.62

5.13

6.02

c Net interest margin* ( = a - b)

3.65

3.61

3.61

3.57

d Loan and lease loss provision
e Noninterest income*

0.40

0.50

f Noninterest

3.28

1.11
3.17

0.33
1.14

0.32

1.10

3.14

3.09

0.15

0.07

0.02

0.03

Item
a Gross interest

revenue*

b Gross interest

expense*

g Securities

expense*
gains

1.16

h Income before taxes ( = c - d + e - f + g)

1.23

1.12

1.30

1.34

i

Taxes

0.23

0.25

0.30

0.34

j

Other3

0.00

0.00

0.01

0.00

k ROA: Return on assets4( = h - i + j)

1.00

1.01

0.34

0.88
0.47

1.01

I

0.48

0.41

0.66

0.41

0.53

0.60

m

Cash dividends
Net retained

declared

earnings

15.87

n ROE: Return on equity5
------------------o Average

assets (!$ millions)

p Net income

13.83

----

.---

--

181,133

($ millions)

-----_

_-

203,376

1,817

----

221,614

242,587

1,775

733

15.59
----- .--

1,022

15.38

2,234

2,449

q Loan and lease loss
provision

($ millions)

732

788

r Loan and lease charge-offs,
net of recoveries
s Percent

($ millions)

533

660

8.3

10.3

10.1

12.1

Discrepancies due to rounding error. With the exception of row s, data for each year include only those banks that were operating
at the beginning of the year. The resulting figures may not agree precisely with their counterparts in Table II where figures include
data from newly formed as well as existing banks.

1 Average

assets are based on fully consolidated

volumes

2 Figures in these rows differ from those published
3 Includes
4 Return

745

of banks with net income

less than or equal to zero
Note:

727

extraordinary

items and other adjustments

at the beginning

and at the end of the year.
definitions.

after taxes.

divided

by average assets.

5 Return on equity is net income divided
beginning and at the end of the year.

by average equity.

Source:

on assets is net income

outstanding

in previous years due to changed

Consolidated

Reports of Condition

Average equity

is based on fully consolidated

volumes

outstanding

at the

and Income.

113 percent. The sources of this fall were growth
in past-due and nonaccrual loans and smaller provisions for loan losses relative to loans in 1989 than
in 1988. Allowance + past-due and nonaccrual loans
at Fifth District banks, was at its lowest level in the
past several years.
Description of allowance for loan losses:
Allowance for loan losses acts as a buffer from which
FEDERAL

RESERVE

loan charge-offs are subtracted. It protects a bank’
s
capital against loan losses. The higher a bank’
s
allowance for loan losses relative to loans or nonperforming loans, the more secure the bank, other things
equal.
Differences by size category: While District
banks of all sizes experienced growth in past-due and
nonaccrual loans relative to total loans, only at large
BANK

OF RICHMOND

25

Table

IV

Income and Expense as a Percent of Average Assets’
All U.S.

Commercial

Item

Banks,

1986-89

1986

1987

1988

1989

8.37
5.03

8.22
4.88

8.85
5.36

9.84

c Net interest margin* ( = a - b)

3.34

3.35

3.49

3.48

d Loan and lease loss provision

0.76
1.26
3.17
0.13

1.24
1.39
3.26
0.05

0.53
1.46
3.29

0.92
1.54
3.34
0.02

0.81
0.19
0.01

0.29
0.18
0.01

0.63
0.33
0.31

0.11

a Gross interest
b Gross interest

e Noninterest
f Noninterest
g Securities

revenue*
expense*

’

income*
expense*
gains

h Income before taxes ( = c - d + e-f + g)
i

Taxes

j

Other3

k ROA: Return on assets4( = h - i + j)
I
m

Cash dividends
Net retained

declared

earnings

6.35

0.01

0.33
0.03

0.79
0.30
0.01

0.83
0.44
0.39

0.50
0.44
0.07

1.88

13.50
----

8.03
- - - ---

0.36
-0.24

1.13

n ROE: Return on equity5
-------------------

10.22
------

o Average

2,799

2,926

2,994

3,138

($ billions)

17.4

3.3

24.8

15.8

q Loan and lease loss
provision ($ billions)

21.3

36.3

15.9

28.8

r Loan and lease charge-offs,
net of recoveries ($ billions)

16.1

16.0

17.7

21.4

20.6

18.2

13.8

11.8

assets ($ billions)

p Net income

s Percent

of banks with net income

less than or equal to zero
Note:

Discrepancies due to rounding
at the beginning of the year.

For footnotes
Source:

see Table

Consolidated

error. With the exception

of rows, data for each year include only those banks that were operating

ill.
Reports of Condition

and Income.

banks did provision for loan losses relative to assets
decline. Small banks increased provisions relative to
assets above their 1988 level, while medium-sized
banks maintained a constant ratio.
Comparison of Fifth District banks with the
average U.S. bank: On average, in 1989, U.S.
banks increased loan loss provisions (IVd) 81 percent over their 1988 level while Fifth District banks’
average increase was only 7 percent, slower than
District asset growth. Less District income was consumed by provision for loan losses and profits were
higher. Allowance for loan losses t past-due and
nonaccmcal loans was still considerably greater at
District banks in 1989 than at the average U.S. bank.
26

----

ECONOMIC

REVIEW.

Likewise, while past-due and nonaccrual loans +
total loans increased in 1989 at District banks, it was
still only approximately one-thirdthat for the average
for all U.S. banks. District banks’ charge-ofi + total
loans was between one-third and one-half the U.S.
average.
Growth of troubled real estate loans: As real
estate values stagnated or fell in many regions of the
country in 1988 and 1989, real estate loan losses
began to grow throughout the nation atid in the Fifth
District. Past-due and nonaccrual real estate loans
increased quickly at District banks in 1989, growing by 72 percent. Since District banks began 1989
with far fewer past-due and nonaccrual real estate
JULY/AUGUST

1990

Table V

Return On Assets and Equity
Fifth District

Banks

(Percent)
Small’

ROA: Return on assets1

Medium

Large

Total

1987

1.05

1.06

0.82

0.88

1988
1989

0.96
0.88

1.14
1.13

0.98
1.00

1.01
1.01

ROE: Return on equity*

1987

11.14

13.31

14.50

13.83

1988
1989

10.15
9.12

14.36
13.85

16.90
16.83

15.59
15.38

Note:

Data for each year include

1 See footnote

4, Table

* See footnote

5. Table

only those banks that were operating

at the beginning

of the year.

III.
III.

Table VI

Bank Performance

Measures by Fifth District State-1989
(Percent)
DC

b ROE
c Nonperforming

loans and leases

d Net charge-offs
e Number

of banks

Medium-Sized

NC

SC

0.92
9.76
1.35

0.61
5.51
1.32

0.83
7.85
1.04

0.96

0.97

9.76

10.97
2.08

0.42
11

a ROA

MD

0.04
0.42
1.23

Small Banks

0.20
47

0.37
38

0.48
60

0.45
128

0.63
126

0.80
10.72

1.28
16.72

1.11
12.70

1.09

0.90

1.92

0.50
13

0.34
43

0.49
37

0.91
0.22

1.10
18.07
1.01
0.44

10

4

1.08
18.55
0.80
0.49
8

0.87
13.28
0.91
0.70
1

1.10
16.97
0.88

1.03
12.01
1.92

0.46
179

0.56
164

f ROA

0.96

1.12

1.22

13.06
1.29

13.59
0.71

13.23

0.23
7

0.24
39

loans and leases

i Net charge-offs
j Number

1.44

WV

Banks

g ROE
h Nonperforming

VA

of banks

1.15
0.33
21

Large Banks

0.75
14.99
1.18
0.49

k ROA
I ROE
m Nonperforming

loans and leases

n Net charge-offs
o Number

5

of banks

0.91
14.00

1.41
0.58
12

1.04
17.67

Total

0.75
13.92
1.20

p ROA
q ROE
r Nonperforming

loans and leases

0.45
23

s Net charge-offs
t Number
Notes:

of banks

0.94

13.66
1.30
0.50
98

1.04
16.78
0.93

0.23
69

1.01
14.79
1.03
0.46
77

Banks not operating at the beginning of 1989 and those West Virginia banks headquartered
outside the Fifth Federal Reserve District are excluded
from these totals. Nonperforming
loans and leases are loans and leases past due 90 days or more and those not accruing interest, as a percent of total
loans. Net charge-offs are loan and lease charge-offs,
net of recoveries, as a percent of loans.
FEDERAL

RESERVE

BANK

OF RICHMOND

27

Table

VII

Average Rates of Return on Selected Interest-Earning
Fifth District

Commercial
(Percent)

Banks,

1988

1987

1986

Item

Assets

1986-89
1989

Total loans and leases

10.63

10.05

10.52

11.47

Net loans and leases1

10.77

8.30

10.19
7.61

10.66
8.01

11.62
8.58

9.78

9.25

9.84

Total securities
All interest-earning
Note:

assets

Data for each year include

only those banks that were operating

at the beginning

1 Net loans and leases are total loans and leases net of the sum of allowance

Table

of the year.

for loan and lease losses and allocated

transfer

risk reserve.

VIII

Average Cost of Funds for Selected Interest-Bearing
Fifth District

10.78

Commercial

Banks,

Liabilities

1986-89

(Percent)
1986

a Interest-bearing
b

deposit

Large certificates

c

Deposits

d

Other deposits

e Subordinated
f Fed funds

in foreign offices

notes and debentures

g Other
h
All interest-,bearing
Note:

1988

1989

6.12
6.65
6.69
5.97

6.59
7.43
7.05
6.34

7.49
8.91
9.15
7.04

8.48

accounts

of deposit

1987

6.77
7.07
6.40
6.74

Item

9.21
5.87
7.34
6.13

8.85
7.16
7.76
6.72

10.33
8.91
9.05
7.79

6.92

5.19
6.76

liabilities

Data for each year include

only those banks that were operating

loans than was average for all banks, past-due and
real estate loans + total loans for District
banks was still only one-third of the ratio for all U.S.
banks at the end of 1989. Growth in the share of
real estate loans during 1989, from 43 to 45 percent
of all loans, suggests that District banks’ losses could
be even greater in 1990.
nonaccwul

Noninterest Income and Expense
1989 compared with 1988: Fifth District banks
had a two basis point improvement in noninterest
income + average assets (IIIe) and a five basis point
decline in noninterest expense + average assets
(IIIf); large District banks were responsible for most
of both.

at the beginning

of the year

laneous forms of noninterest income. Other miscellaneous noninterest income includes income sources
such as rental fees on safe deposit boxes, proceeds
on the sale of travelers checks, and fees on credit
cards issued by the bank. Service charge income
relative to assets was unchanged at large banks. The
decline in noninterest expense at large banks resulted
from declines in salaries expense, bank premises
expense, and other miscellaneous noninterest expenses. Other miscellaneous noninterest expenses
includes such expenses as federal deposit insurance
premiums, advertising costs, and management fees
paid by subsidiary banks to their parent bank holding
companies (discussed below).

Composition of change at large banks: The
improvement in noninterest income at large District
banks was the result of increases in fiduciary income,

Changes at small and medium-sized banks:
No change in noninterest income occurred at small
District banks as compared to 1988; noninterest
expense increased because salaries and bank premises
expense increased relative to assets. Medium-sized

foreign exchange trading income, and other miscel-

banks suffered a decline in noninterest

28

ECONOMIC

REVIEW,

JULY/AUGUST

1990

income from

the previous year, which was partially offset by a
decrease in noninterest expense.

Comparison of Fifth District banks with the
average U.S. bank: Compared with Fifth District
banks, the average U.S. bank had a larger improvement in noninterest income (IVe), but much of the
increase was largely offset by increased noninterest
expense (IVO. The average U.S. bank had a small
increase in service charge income but a significant
improvement in other forms of noninterest income
including income from fiduciary activities, gains on
trading accounts, and other miscellaneous forms of
noninterest income. Salary expenses relative to assets
at the average U.S. bank increased only slightly but
most of the increase in noninterest expense was in
the category of miscellaneous noninterest expenses.
As in past years, the average U.S. bank produced
a significantly higher level of noninterest income
than the average Fifth District bank (IVe, IIIe), but
also a higher level of noninterest expenses (IVf, 1110.
In 1989, less expense remained after netting noninterest income from noninterest expense at U.S.
banks than at Fifth District banks, providing a
profit advantage for the average U.S. bank.
Management fees in noninterest expense:
Banks owned by bank holding companies (BHCs)
often pay fees to their BHCs in return for services
provided by the BHCs. These fees are not reported
by banks separately but are lumped together with
several different expenses as other noninterest expenses. Bank holding companies (firms owning the
stock of one or more banks), do however, report
management fees as a line in their income statements.
Management fees for banks owned by BHCs headquartered in the Fifth District amounted to about .12
percent of assets in 1989 and 13 percent of net income, levels little changed from 1988. Because
management fees, relative to net income, are significant, they are important to track. Because they can
only be derived from BHCs’ reports, however, and
since BHCs headquartered in the Fifth District own
banks in other Federal Reserve Districts, it is impossible to determine how the fees affect Fifth
District bank performance. Reporting bank performance on a state or Federal Reserve District basis will
become more and more difficult in the future as banking organizations continue to expand across state
boundaries.
Taxes
1989 compared with 1988: Taxes + average
assets (IIIi) increased at Fifth District banks. On
FEDERAL

RESERVE

average, District banks’ tax rate (taxes + pre-tax
up slightly from 1988.

income) was 25 percent,

Differences by size category: Small and
medium-sized District banks paid higher tax rates
than large District banks, though the variance among
size classes was not great.
Comparison of Fifth District banks with the
average U.S. bank: Fifth District banks’ tax rate
was considerably lower than the average U.S. banks.
The average rate paid by U.S. banks was 38 percent. While rates paid by U.S. banks in the small
and medium-sized categories differed little from the
rates paid by Fifth District banks of the same sizes,
the average large U.S. bank had a rate almost twice
as high as the average large District bank. Fifth
District banks on average derive a higher proportion
of their income from federal income-tax-free assets
such as municipal securities and loans to municipalities than does the average U.S. bank. Small and
medium-sized District banks differed little from
equivalent-sized banks throughout the nation, but
large District banks were significantly more dependent on tax-free income than were their counterparts
elsewhere in the nation.
Profits
1989 compared with 1988: Return on assets
(ROA) (IIIk), net income + average assets, for the
average of all Fifth District banks was unchanged
between 1988 and 1989 at 1.01 percent. Profits
measured by return on equity (ROE) (IIIn), net
income + average equity, declined at Fifth District
banks in 1989 relative to the 1988 level, as District
banks added to equity.
Differences by size category-see Table V:
Small District banks’ average ROA fell rapidly in
1989, as it had in 1988, because of higher levels of
provision for loan losses, noninterest expenses, and
taxes. While medium-sized District banks’ 1989
ROA declined slightly from 1988 due to a decline
in noninterest income and an increase in taxes, they
remained the strongest ROA performers, outperforming small and large District banks by a considerable margin. Only large District banks were able
to improve on their 1988 ROA in 1989. This was
the result of higher noninterest income and significant declines in provision for loan losses and
noninterest expenses.
Comparison of Fifth District banks with the
average U.S. bank: The average U.S. bank experienced large declines in both ROA (IVk) and
BANK OF RICHMOND

29

ROE (IVn) in 1989 since almost 54 percent
of their income before taxes and provision
for loan losses was set aside for current or
future loan losses. On the other hand the per-

Table

IX

Equity to Asset Ratios’

cent of banks with net income less than or
equal to aen, throughout the nation (TVs) fell

Large

Medium

Small

Fifth District

Total

9.41

7.92

5.56

6.31

1987

9.63

8.00

5.70

6.41

1988

9.68

7.92

5.91

6.55

1989

10.01

8.19

5.95

6.61

1986

8.31

6.94

5.50

6.17

1987

8.55

7.22

5.18

6.02

1988

8.69

7.21

5.58

6.27

5.42

again in 1989 for the fourth year in a row
to a level below that for the Fifth District
(111s)where the percent was up in 1989.
The higher level in the Fifth District was
the result of a higher proportion of newly
formed banks. With new banks removed, the
percentage of banks with losses was lower
in the District than for the U.S.

1986

6.20

All U.S. Banks

7.47
8.92
1989
Profits by Fifth District state-see
Chart, Table VI, and Table IV: ROA
1 End-of-year equity divided by end-of-year
assets. Equity capital is common stock,
was, on average, higher in each of the Fifth
perpetual preferred stock, surplus, undivided profits, and capital reserves.
District states (VIP) than it was for the
U.S. (IVk). Banks located in Virginia (VIP)
produced the highest Fifth District ROA for the
medium-sized
banks throughout the nation imsecond year in a row. Washington, D. C. banks (VIP)
proved their equity ratios in comparison to 1988, but
trailed the group but continued their improvement
still lagged Fifth District banks in the same size
since 1987.
categories. Large U.S. banks, on the other hand,
suffered a significant decline in equity + assets.
Capital

1989 compared with 1988-see Table IX: As
was the case in 1988, Fifth District banks added to
capital during 1989.
Differences by size category-see Table IX:
While the 1988 increase in capital was mostly due
to increases at large banks, in 1989, SZV& and
medillm-sixed banks also added significantly to
equi@ + assets. Small District banks added to equity
capital by issuing common stock and increasing
surplus. Medium-sized
banks increased equity
relative to assets through increases in common stock,
surplus, and retained earnings. Large banks added
to equity relative to assets simply by retaining a
significant amount of earnings.
Retained earnings and dividends-see Table
III: At Fifth District banks, retained earnings (IIIm)
were increased at the expense of dividends (1111).
Comparison of Fifth District banks with the
average U.S. bank-see Table IX: In 1989, Fifth
District banks improved their equity-to-assets ratio
in comparison with the average U.S. bank, in which
equity + assets fell during the year. Small and

30

ECONOMIC

REVIEW,

Chart

RETURN

States

tDC
/

4

00

1984

JULY/AUGUST

ON ASSETS

Banks in Fifth District

Percent

1985

1990

1986

1987

I-

1988

1989

Real Output

and Unit Labor Costs as

Predictors

of Inflation

Ya.sh P. Meha *

Two popular inflation indicators
commonly
monitored by analysts are the pace of real economic
activity and the rate of growth of labor costs. It is
widely believed that if the economy grows at a rate
above its long-run potential or, if the rate of growth
of labor costs exceeds the trend rate in labor productivity, then inflation will accelerate. These beliefs
derive from the “price markup hypothesis” implicit
in the Phillips curve view of the inflation process.
This view assumes that prices are set as a markup
over productivity-adjusted
labor costs and that they
are also influenced by demand pressures. It assumes
further that the degree of demand pressure can be
measured by the excess of actual over potential
output (termed the output gap). Thus, the Phillips
curve view of the inflation process implies that past
real output (measured relative to potential) and past
growth in labor costs (adjusted for the trend in productivity) are relevant in predicting the price level.

The empirical evidence presented here finds that
unit labor costs have no incremental predictive value
for inflation, but the output gap does. This result
holds even after one allows for the influence of money
and interest rates on inflation. However, the evidence
reported here also implies that the output gap helps
predict inflation only in the short run. In the long
run the rate of inflation is given by the excess of M2
growth over real growth, which is consistent with the
Quantity Theory of Money.
The plan of this paper is as follows. Section I
presents the price equations used in this paper and
discusses how tests of Granger-causality and multistep forecasting are employed to test predictive value.
Section II presents empirical results, and Section III
contains concluding observations.
I.

THEMODELANDTHEMETHOD
This paper evaluates the role of unit labor costs
and the output gap in predicting inflation by examining the predictive value of these factors using tests
of Granger-causality and multi-period forecasting.
Since testing for Granger-causality amounts to examining whether lagged values of one series add
statistically significant predictive value to inflation’
s
own lagged values for one-step ahead forecasts, this
test is also termed as the test of “incremental predictive value”. Since other macroeconomic
variables
such as money and interest rates can add substantial predictive value [see, for example, Hallman,
Porter, and Small (1989) and Mehra (1989b)], the
“incremental predictive values” of unit labor costs and
the output gap are also evaluated when these other
variables are included. In addition, the contribution
of these factors over longer forecast horizons is also
studied.
l Vice
President and Economist. The views expressed in the
article are solely those of the author and are not necessarily those
of the Federal Reserve Bank of Richmond or the Federal Reserve
System.

FEDERAL

RESERVE

1. Specification of the Price Equation
A Price Equation Consistent with the Phillips
Curve: The view that systematic movements in
labor costs and the output gap can lead to systematic
movements in the rate of inflation derives from
price-type Phillips curve models’ [see, for example,
Gordon (1982, 1985), Stockton and Glassman
(1987), and Mehra (1988)]. A price equation incorporating this view could be derived from the following
set of equations:
Apt = Apt- 1 + al Awt + a2 gt + at,
ar>O;a2>0

(1)

r The Phillips curve model was originally formulated as a wage
equation relating wage inflation to the unemployment gap, defined as the difference between actual and natural unemployment. Subsequently, this equation has been transformed into
a price equation relating actual inflation to lagged prices and the
output gap [See Humphrey (19854. Hence, the term price-type
Phillips curve is used here.
BANK

OF RICHMOND

31

Awt = Awt-l
g, = gt-1 +

+ ezt

(2)
(3)

e3t

where all variables are in natural logarithms and where
pt is the price level; wt, productivity-adjusted
labor
costs; gt, output gap; and elt, e2t, and e3t, serially
uncorrelated random disturbance terms. Equation (1)
describes the price markup behavior. Prices are
marked up over productivity-adjusted labor costs and
are influenced by cyclical demand as measured by
the output gap. Equations (2) and (3) describe
stochastic processes for wage inflation and output gap
variables. It is hypothesized that these variables follow
a random walk.2
Substituting
Apt = Apt-1

(2) and (3) into (1) yields (4):
+ al Awt-1

+ azgt-1

+ Elt

(4)

an inflation equation incorporating this long-run relationship accurately predicts inflation during the last
three decades. This inflation equation is of the form:
Apt = Apt-1

- bl (pt-1

+ b2 ARt-1

An Expanded Price Equation: Recent
research on M2 demand suggests that the velocity
of M2 is stationary. The rate of inflation in the long
run is therefore determined by the rate of growth in
money over real output.3 Mehra (1989b) shows that
2 These assumptions are made simply to highlight the causal role
of labor costs ind outptit gap in influencing inflation. They
imply that the two variables are exogenously determined. As
a result, the reduced form equation for inflation [see equation
(4) in the text] implies unidirectional causality from these
variables to the rate of inflation. Alternatively, one could assume
that both variables are also influenced by inflation. In that case,
one might find causality running in both directions [see, for
example, Mehra (1989a)].
3 This result is illustrated as follows. The hypothesis
velocity is stationary can be expressed as:
V2, = pt + yt - M2t = C?Y
+ct

An inflation equation that includes variables from
both price-type Phillips curve and Quantity Theory
of Money models could be written as:
Apt = Apt-1

+ al Awt-1

(9

(ii)

Equation (ii) implies that the long-run price level is given by the
excess of M2 over y. Equivalently, the rate of inflation in the
long run is given by the excess of M2 growth over real growth.

32

- r;t-1)

+ azgt-1
+ b2 Ah-l.

(6)

An interesting empirical issue is whether labor cost
and output gap variables still help predict inflation
once one includes variables suggested by the Quantity Theory of Money.
2. Implementing Tests of Predictive Value
The predictive value of labor costs and the output gap is evaluated using two procedures. The first
is the Granger-causality test, which tests the additional contribution a variable makes to one-step ahead
forecasts based on inflation’ own past behavior. Such
s
contributions are examined in price equations, such
as (4) and (6). The second procedure evaluates the
predictive contribution of a variable over forecast
horizons of 1 to 3 years.
Testing for Granger-causality: A variable X2
Granger-causes a variable Xl if lagged values of X2
significantly improve one-step ahead forecasts based
only on lagged values of Xl. To test such causality,
one estimates the following regression:

that M2

where all variables are in their natural logarithms and where pt
is the price level; y,, real output; M2, the M2 measure of money;
sy, a constant term; and 6, a stationary random disturbance term.
(Ycan be viewed as the long-run equilibrium value of M’ velocity.
2
Equation (i) says that MT velocity in the long run never drifts
permanently away from CY.
This equation can be alternatively
expressed as:
pi = ;Y + M2, - yt +~t

(5)

where it is the long-run equilibrium price level (in
logs) defined as M2t - yt and where Rt is the nominal
interest rate. Equation (5) states that lagged values
of M2 velocity (pt - 1 - M2t - 1 + yt - 1) and changes
in the interest rate are relevant in predicting inflation.

- bl (m-1
where Elt is (elt + alezt + azest). Equation (4) says
that inflation depends upon its own past behavior as
well as upon the past behavior of the labor cost and
output gap variables. If (al, a2) # (0,O) in (l), then
past values of the output gap and labor costs make
a statistically significant contribution to the explanation of inflation as in equation (4). Equivalently, these
variables Granger-cause inflation.

- ;,-I)

Xlt = a +s:~s

Xlt --s +sEICs X2t --s + Et (7)

and then determines, by means of an F test, whether
all C, = 0. The superscripts nl and n2 above the
summation operators refer to the number of lagged
values of Xl and X2 included in regression (7), and
et is a serially uncorrelated random disturbance term.
If an F test finds that estimated C, # 0, then X2
Granger-causes Xl. Equivalently, X2 has an “incremental predictive value” for Xl.

ECONOMIC REVIEW, JULY/AUGUST

1990

In order to implement this test several decisions
have to be made. How many lagged values of Xl
and X2 should be included in (7)? Should variables
be in levels or differences? Should other variables
besides Xl and X2 be included? The answers to such
questions are important since the choice can affect
the outcome of Granger-causality tests.
Lag lengths were selected using the “final prediction error criterion” (FPE) due to Akaike (1969). The
FPE criterion is:
FPE (k) = E

C?

(8)

where k is the number of lags; T, the number of
observations used in estimation; and oz, the residual
variance. The procedure requires that the equation
be estimated for various values of k, FPE be computed as in (8), and the value of k be selected to
minimize FPE. In the empirical search the maximal
value of k was set at eight.
F statistics computed from regressions like (7)
do not have standard F distributions if regressors
happen to have unit roots and are thus nonstationary
[see Stock and Watson (1989)]. To guard against that
problem, all variables used here were first tested for
unit roots. The test used, one proposed by Dickey
and Fuller (1981), involves estimating the following
regression:
Xlt

= CY+ p TR

+s;lds

+ p Xlt-1

AXlt-,

+ Et

(9)

where Xl is the variable being tested for a unit root;
TR, a time trend; A, the first difference operator;
and e, a serially uncorrelated random disturbance
term. TR is included because the alternative
hypothesis is that the variable in question is stationary
around a linear trend. If there is a unit root in the
variable Xl, the coefficient p should be one.
Two test statistics that test the null hypothesis
p = 1 are usually computed. One is the t statistic computed as ((p^- l)/s.e.(i)), where s.e.(i) is the estimated standard error of p^. The other statistic is
T(P - 1). If the computed values of these statistics
are too large, then one rejects the null hypothesis
that variable Xl has a unit root. Since these statistics
have non-standard distributions, relevant critical
values are tabulated in Fuller (1976). If a variable is
found to have a single unit root, then it enters in first
differenced form when performing Granger-causality
tests. Otherwise, it enters in level form.
FEDERAL

RESERVE

It is also known that causality inferences between
two variables, say inflation and output gap, are not
necessarily robust to inclusion of other macroeconomic variables that could influence inflation. In order
to ensure that the inferences are robust, causality tests
are performed, including an oil price shock variable
as well as dummies for President Nixon’ price cons
trols. In addition, causality tests are performed including the macroeconomic variables suggested by
the Quantity Theory view of the inflation process.
Testing for Long-Term Forecast Performance: The predictive value of labor costs and the
output gap in inflation models is also evaluated with
estimations and long-term forecasts conducted over
a rolling horizon as in Hallman, Porter, and Small
(1989). In particular, the forecast performance of
competing inflation equations is compared over the
period 1971 to 1989. The forecasts and errors were
generated as follows.
Each inflation equation was first estimated over an
initial estimation period 1954Ql to 1970Q44 and
then simulated out-of-sample over 1 to 3 years in the
future. For each of the competing equations and each
of the forecast horizons, the difference between the
actual and predicted inflation rates was computed,
thus generating one observation on the forecast
error. The end of the initial estimation period was
then advanced four quarters, to 1971Q4, and the
inflation equations were reestimated,
forecasts
generated, and errors calculated as above. This procedure was repeated until it used the available data
through the end of 1989. The relative predictive
accuracy of the inflation equations is then evaluated
comparing the forecast errors over the different
forecast horizons.
Data: The data used are quarterly and cover the
sample period 1953&l to 1989Q4. The price level
(p) is measured by the implicit GNP deflator;
productivity-adjusted labor costs (w) by actual unit
labor costs (computed as the ratio of compensation
per hour to output per hour in the non-farm business
sector); output gap (g) by the ratio of real GNP to
potential output; money by the monetary aggregate
M2; the nominal interest rate (R) by the 4-6 month
commercial paper rate, and oil price shocks by the
ratio of the producer price index for fuels, power,
and related products to the producer price index.
Two dummies are used for President Nixon’ price
s
4 The whole sample period covered in this article is
1953Ql-1989Q4. The estimation begins in 1954 because past
lags are included in the inflation equation.
BANK OF RICHMOND

33

controls. The first is for the period of price controls
and is defined as one in 1971Q3-1972Q4 and zero
otherwise. The second dummy is for the period immediately following price controls and is defined as
one in 1973&l-1974524 and zero otherwise. All the
data used are taken from the Citibank data base,
except the series for potential GNP which is a series
prepared at the Board of Governors and given in
Hallman, Porter, and Small (1989).
Potential output measures the economy’ long-run
s
capacity to produce goods and services. It is therefore
determined, among other things, by the trend growth
in productivity, the labor force, and average weekly
hours; factors which could be considered “real” as
opposed to monetary. Figure 1 graphs the measure
of potential output prepared at the Board of Governors. Actual output is also shown. As can be seen,
actual output does diverge from the potential in the
short run. However, over the long period these two
series stay together.
Some analysts [see for example, Gordon (1985,
1988)] have tested the price markup hypothesis
using not actual but cyclically adjusted unit labor costs
data. The reasoning is that actual unit labor costs tend
to get pushed around by the strong cyclical nature
of productivity growth. The price markup hypothesis
states that firms look through cyclical movements in
productivity and apply markups to long-run, trend,
or normal unit labor costs. Hence, the proper
measure of unit labor costs should be a trend
measure.

Figure

ACTUAL
Trillions of

AND

Quarterly

1

POTENTIAL

GNP

Data 1953-l 989

Dollars

Potential

GNP

r------I

I
l&3:1

I
196O:l

I
197O:l

I
198O:l

I
1989:4

One trend measure (denoted as pwl) is generated by applying the Beveridge-Nelson procedure to
actual unit labor cost data. The other trend measure
(denoted as pw2) is the ratio of compensation per
hour to the “permanent” component of output per
hour, the latter being generated by the above decomposition procedure.
Il.

EMPIRICALRESULTS
In order to investigate this possibility, two trend
measures of unit labor costs were generated using
the procedure given in Beveridge and Nelson ( 198 1).
The Beveridge-Nelson procedure assumes that a time
series in question contains a stochastic trend component plus a cyclical component. The stochastic
trend component is modeled as a random walk with
drift. The procedure then extracts this random walk
component, which is referred to as the “permanent”
or the “trend” component of a series.5
s Quite simply, the permanent component of a series is defined
as the value the series would have if it were on its long-run path
in the current time period. The long-run path in turn is generated
by the IonE-run forecasts of the series. (This is to be contrasted
with the standard linear time trend decomposition procedure,
in which the long-run path is generated by letting the series follow
a deterministic time trend). The Beveridee-Nelson orocedure
consists of fitting an ARMA model to fast daerences of the series
and then using the model to generate the long-run forecasts of
changes in the series. The permanent component of a series in
the current period is then roughly the current value of the series
plus all forecastable future changes in the series (beyond the mean
rate of drift).

34

ECONOMIC

REVIEW,

Unit Root Test Results: Table 1 reports unit
root test results for the price level (pt), unit labor
costs (wt), and the output gap (gt). The top panel
in Table 1 reports results of unit root tests performed including a constant and a time trend [see
equation (9) of the text]. As can be seen, these
results are consistent with the presence of a unit root
in all the variables [see tl and T(P - 1) statistics in
Table I].
The statistical inference about the presence of a
unit root in a series can be sensitive to whether or
not the time trend or constant is included. Since the
estimated coefficients on the time trend and constant are not always statistically significant [see t
values on a! and @in Table I], the unit root tests were
repeated excluding the trend and constant. Such unit
root test results are reported in the lower two panels
of Table 1. As can be seen, these results tell a
somewhat different story about the output gap. In
JULY/AUGUST

1990

Table

I

Unit Root Test Results for Nonstationarity,
Constant
01

Xt

Price level (pt)
Unit labor costs (wJ
Output

and Trend

gap kJ

(pt)

.03
-.Ol

(2.6)
(1.4)

.16

(.7)

.oo

Includ&d

P

.12
.15

.ooo

gap CgJ

-1.20
-1.47

4
3

f.8)

.92

2.8

-10.44

2

Excluded

1.0

(.I)

.16

.Ol

4

1.0

.35

.07

3

.93

Constant

Price level

2.83*

-9.0

(pt)

1.0

1.6

.04

.99

1.0

Output

.93

2.85* *

gap &,I

This table
regressions

presents results of testing for nonstationarity
of the form:
n
xt = a + BTR +sEldrA~,-s
+P xtel

2

and Trend Excluded

Unit labor costs (w,)

Notes:

na

1)

2.5
1.7

.003(2.6)

Output

Tb-

.99
.99

f.3)

Unit labor costs (w,)

t1

P

(2.6)
(1.9)

-.02
Trend

Price level

1953Ql-1989Q4

in time

series data.

In particular,

unit

5

-.19

root test results

3

-9.o**

2

are reported

from estimated

where x is the time series in question; TR, a time trend; A, the first difference operator: n, the number of first differenced
lagged values of x
include
to remove serial correlation in the residuals; and U, 0, d,, and p are parameters. The variable x has a unit root and is thus nonstationary
if p= 1. The statistic tl is the t statistic and tests the null hypothesis p= 1 (the 5 percent critical value is 3.45 with the trend; 2.89 without the
trend, and 1.95 without the constant; Fuller (19761, Table 8.5.2).
The statistic Tb1) also tests the null hypothesis p= 1 (the 5 percent critical
value is - 20.7 with the trend; - 13.7 without the trend; and - 7.9 without the constant; Fuller (1976), Table 8.5.1).
The reported coefficient on
the trend is multiplied
by 1000.

d

a. The value of the parameter n was chosen by the “final prediction
indicate the presence of serial correlation in the residuals.
l

*

* significant
significant

error”

criteron

due to Akaike

(1969). The Ljung-Box

Q-statistics,

not reported,

do not

at .05 level
at .lO level

particular, these test results do not support the
presence of a unit root in the output gap. In sum,
these results together suggest that in performing
Granger-causality tests the output gap regressor may
enter in levels6 whereas price level and unit labor
costs variables need to be differenced at least once.’
6 In view of this ambiguity about the presence of a unit root in
output gap, I also discuss Granger-causality test results when
the output gap regressor enters in first differenced form.
7 I also investigated the presence of a second unit root in the
price level and unit labor costs data. The unit root tests were
performed using first differences of these series. The test results,
however, appear sensitive to the nature of tests used and/or to
the treatment of time trend. In view of these ambiguous results,
I report results using first as well as second differences of these
series wherever appropriate.
FEDERAL

RESERVE

Granger-causality Results: Table II reports
results of testing for the presence of Granger-causality
running from the output gap and unit labor costs to
the price level. Both actual and trend unit labor costs
are considered. Moreover, Granger-causality is tested
using the price specification of the form (6). The
results are presented for the whole period 1953Ql1989Q4 as well as for the subperiod 1953Ql1979Q4.
In panel 1, the price level and unit labor costs
regressors are in first differences and the output
gap is in levels. In panel 2, the price level regressor
is in second differences but other regressors are as
in panel 1. F statistics presented in panel 1 test the
null hypothesis that the output gap and labor costs
BANK

OF RICHMOND

35

Table

II

F Statistics for the “Incremental Predictive Value”
of Unit Labor Costs and Output Gap Variables
Variable

Sample
1955Q2-1989Q4
F Statistics (do

Lag
(nl, n2)

X

Period
1955Q2-1979Q4
F Statistics (dfl
n2

Panel 1:

Apt = a + itIbi Apt-i + iCldi Xt-i

(4,l)
(4,l)
(4,l)
(4,l)

Aw

Apwl
Apw2
g

.19

.38
.03
.25
3.42*

(1,127)

.oo
.15
3.72**

(1,127)
(1,127)
(1,127)

(1,861
(1,861
(1,861
(1,861

n2

Panel 2:

A2pt = a + i!IA’
pt-i

is

Panel 3:

+ &di xt-i

1.16
(1,127)
.26
(1,127)
.97
(1,127)
9.46***(1,127)

(4,l)
(4,l)
(4,l)
(4,l)

Aw

Apwl
Apw2

.16 (1,871
.02 (1,871
.16 (1,871
3.85**(1,87)

Apt = a + igIbi Apt-i + f, AR,-1
n2
+

Apwl
Apw2

g

f2 (Pt-1

2.24
.oo
2.15
2.51

(4,2)
(4,l)
(42)
(4,l)

Aw

regressors have no predictive value for the rate of
inflation. The null hypothesis in panel 2 is that such
regressors have no predictive value for explaining
changes in the rate of inflation. As can be seen, F
values are small for labor costs regressors but large
for the output gap variable. These results suggest that
the output gap does help predict the price level
whereas unit labor costs do not.

-

fit-11

+

C di Xt-i
i=l

1.86
.18
1.72
1.13

(2,124)
(1,125)
(2,124)
(1,125)

(2,841
(1,851
(2,841
(1,851

These results do not change when the price equation is expanded to include the variables suggested
by the Quantity Theory of Money [see equation (6)
of the text]. The relevant F statistics are presented
in panels 3 and 4 of Table II. As can be seen, F values
remain large only for the output gap regressor, though
even this result is sensitive to whether the price level
regressor is in first or in second differences. The
monetary variables, however, remain significant when
the output gap regressor is included in the price
regression. Overall, these results indicate that output gap does have predictive value for the rate of
inflation.*
Results on Long-Term Forecast Performance: Table III presents evidence on the incremental predictive value of the output gap9 for longterm forecastsi in three benchmark inflation models.
The first model considered is an autoregressive model
(hereafter termed Autoregressive) in which current
inflation depends only on its own past behavior. In
particular, it is postulated that changes in inflation
follow a fourth-order autoregressive process:
Apt - Apt-1

Panel 4:

A34

= a + z bi A’
Pt-i

= a +,glbs

(Apt-s

+ f, AR,-r

i=l

- Apt-s-

1) + et.

(10)

n2
+

(4,l)
(4,l)
(4,l)
(4,l)

Aw
Apwl

Apw2
g

Notes:

***
*

l

*

36

f2 (Pt-1

-

Et-11

.Ol
(1,125)
.03
(1,125)
.oo
(1,125)
7.16***(1,125)

+

C di xt-i
i=l

.08
.30
.15
2.68*

(1,85)
(1,851
(1,851
(1,851

This table reports F statistics to test whether labor cost and output
gap variables have incremental
predictive value for changes in
the price level or the rate of inflation. w is actual unit labor costs;
pwl and pw2, two measures of the permanent component of unit
labor costs (see text); and g, the output gap. The lag lengths
ml, n2) were selected by the “final prediction error criterion” due
to Akaike (1969). df is the degrees of freedom parameter for the
F statistic. All regressions were estimated
including four lagged
values of an oil price shock variable and dummies for President
Nixon’ price controls.
s

significant
significant
significant

at .Ol level
at .05 level
at .lO level
ECONOMIC

REVIEW,

The second model chosen is given in Mehra (1989b).
This model, which includes variables indicated by
the Quantity Theory of Money (hereafter termed
QTM), postulates that changes in inflation depend
8 This conclusion needs to be tempered by the fact that the
output gap regressor when entered in first differenced form
usually does not Granger-cause the rate of inflation.
9 I do not report results for unit labor costs variables because
such variables generally are not statistically significant in inflation regressions. Moreover, these variables do not appear to
make any contribution toward improving long-term forecasts of
inflation.
lo The relative forecast evaluation is conditional on actual values
of the right-hand side explanatory variables. Hence, the forecasts
compared are not “real-time” forecasts. However, the multi-step
forecasts generated are dynamic in the sense that the own
lagged values used are the ones generated by these regressions.
JULY/AUGUST

1990

Table

III

Summary Error Statistics from Alternative
Inflation

Model

One Year Ahead

Inflation Models

Two Year Ahead

Three Year Ahead

ME

Autoregressive
Output

RMSE

ME

MAE

RMSE

ME

MAE

RMSE

- .46

Autoregressive

MAE

1.14

1.50

- .69

1.41

1.91

- .97

1.77

2.27

1.00

1.20

.19

1.07

1.35

.28

1.27

1.51

1.17

1.46

plus

.09

Gap

- .44

QTM plus Output

Gap

.96

1.20

-.64

1.08

1.34

-.03

QTM

.78

1.01

-.03

.77

.98

.oo

.86

1.04

.99

1.16

.99

1.27

.15

1.11

1.34

P-Star
Notes:

.Ol

.06

-.79

See the text for a description of the models. The forecast errors that underlie the summary error statistics displayed above are generated in the
following manner: Each inflation model was first estimated over 1954Ql-1970Q4 and forecasts prepared for 1 to 3 years in the future. The end
of the initial estimation period was then advanced four quarters to 1971Q4, and each model was reestimated
and forecasts prepared again for 1
to 3 years in the future. The procedure was repeated through 1986Q4 for the J-year forecast horizon; 1987Q4 for the 2-year, and 1988Q4 for
the l-year. For each model and for each forecast horizon, forecasts were compared with actual data and the errors calculated.
The error statistics
are displayed above. This procedure is similar to the one followed in Hallman, Porter, and Small (1989). ME is mean error; MAE, mean absolute
error; and RMSE, the root mean squared error.

on its own past values, the lagged change in the
nominal rate of interest, and the lagged level of M2
velocity. In particular, this benchmark inflation
equation” is:
Apt - Apt-1

= a +silbs

(Apt-,

- c (pt-1

+ yt-1

+ d ARt-1

- Apt-s-d
- M&-d

+ et

(11)

where all variables are in natural logarithms and where
yt is real GNP. All other variables are as defined
before. For comparison, results using the P-Star
model given in Hallman, Porter, and Small (1989)
are also presented. The P-Star equation implicitly
includes the output gap as one of the regressors. In
particular, this equation could be expressed as:

Apt - Apt-1

= a +sclbs

(Apt-s

+ f gt + h(pt-r
- M&-l

- Apt-s-d
+ yt-1

- Vi)

where al! variables are as defined in this paper and
where V2 is the equilibrium M’ velocity [see page
Z
12 in Hallman, Porter, and Small (1989)]. One obtains the P-Star equation by deleting the nominal rate
and adding the output gap in equation (11).
11The lag lengths in equations (10) and (11) were also chosen
by the “final prediction error criterion”.
FEDERAL

RESERVE

Inflation equations (10) and (11) are estimated with
and without the output gap variable, and their relative
performance in predicting the rate of inflation over
1 to 3 years in the future is evaluated. The forecasts
are generated as described earlier in the paper. Table
III reports summary statistics for the errors that
occur in predicting the rate of inflation during the
1971Ql to 1989524 period. As can be seen by comparing the mean and the root mean squared errors
(ME and RMSE), the output gap reduces forecast
errors considerably. This improvement is evident in
each of the three forecast horizons. For example, for
the QTM equation the mean error in predicting the
one year ahead inflation rate is - .4 percentage points.
This error rises to -.8 percentage points as the
forecast horizon extends to three years in the future.
Adding the output gap regressor to the QTM equation virtually eliminates the mean error in each of
the three forecast horizons. Furthermore, the root
mean squared error declines anywhere from 16 to
30 percent when the output gap regressor is included in the price regressions. The QTM model
with the output gap variable yields predictions of
inflation that are even better than those generated
by the Board’ P-Star model (compare RMSE in
s
Table III).12
The out-of-sample inflation forecasts are further
evaluated in Table IV, which presents regressions
of the form:
12The output gap regressor entered in fast differenced form does
not contribute much to improving long-term forecasts of inflation.
BANK

OF RICHMOND

37

Table

Out-of-Sample
Inflation

Model

Autoregressive

Autoregressive

plus

(1.1)

Gap

QTM plus Output

.Ol

Gap

t.8)
P-Star

-.3
t.31

**

2.5

.87

.98

1.7

b

.64

.63

.86

(9.4)

.80
(5.9)

-.2
t.2)

1.0
(8.9)

-02

1.0

.08

.97

-.25

1.0

1.23

t.21

1.1
(6.6)

2.3

1.8
(1.9)

2.0

-.5
l.5)

b

.52

.20

F

6.5**

(3.0)
.73

1.74

(4.6)
.98

3.45*

*

(6.9)

-.39

1.1

t.5)

.07

(9.5)

-.2

a

(1.9)

(8.1)

l.4)

(7.4)

4.5**

(4.2)

1.3
(1.6)

F

(6.9)

-.35
t.3)

1.1

.24

.84

(6.1)

The table reports statistics from regressions of the form At+, = a + b P, 5, where A is the actual rate of inflation; P, the predicted: and s (= 1,
2, 3), number of years in the forecast horizon. The values used for A and 6 are the ones generated as described in Table 3. Parentheses contain t
values. The F statistic tests the null hypothesis (a,b) = CO,11 and has the standard F distribution.
See notes in Table 3.

Significant

at .05

level.

A t+S = a + b Pt+,

+ et, s = 1, 2, 3

(12)

where A and P are the actual and predicted values
of the inflation rate and where s is the number of
years. If these forecasts are unbiased, then a =0 and
b = 1. The letter F denotes the F statistic that tests
the null hypothesis (a,b) = (0,l). As can be seen
from Table IV, these F values are consistent with
the hypothesis that inflation forecasts from the price
regression with the output gap regressor are unbiased. That is not the case, at least over some
forecast horizons, with the forecasts derived from the
particular regression that excludes the output gap
variable.
III.

CONCLUDINGREMARKS
An important implication of price-type Phillips
curve models is that prices are determined by the
behavior of labor costs. If so, then labor costs should

38

a

(1.6)

(7.2)

-.l
t.21

F

(5.9)

.83

QTM

Notes:

.78

Three Year Ahead

Two Year Ahead

b

.92

(1.1)

1971-1989

Forecast Performance,

One Year Ahead
a

Output

IV

ECONOMIC

REVIEW,

help predict the price level. The empirical evidence
reported in this article does not support this
conclusion.
The level of the output gap, defined as the difference between
actual and potential’ output,
however, does help predict the price level. In fact,
the “incremental predictive” contribution of the output gap remains significant even after one allows for
the influence of monetary factors on the price level.
These results suggest that the Phillips curve model
does identify one empirically relevant determinant
of the rate of inflation, namely the behavior of the
output gap.
The output gap regressor appears to be a stationary
time series, whereas the price level is nonstationary.
The statistical nature of these two time series thus
implies that the output gap could not be the source
of “permanent” movements in the price level. Hence,
the contribution the output gap makes to the prediction of inflation is only short run (cyclical) in nature.

JULY/AUGUST

1990

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BANK

OF RICHMOND

39

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