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THE THEORY OF
MULTIPLE EXPANSION OF DEPOSITS:
WHAT IT IS AND WHENCE IT CAME
Thomas M. Humphrey

Beginning students of banking must grapple with a curious paradox:
the banking system can
multiply deposits on a given base of reserves yet none of its member banks can do so. Let the
reserve-to-deposit
ratio be, say, 20 percent and the system can, by making loans, create $5 of
deposit money per dollar of reserves received. By contrast, the individual bank receiving that
same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the
banking system's ability to multiply loans and deposits with the individual bank's inability to
do so? Fully answering this question required the intellectual efforts of at least six economists
writing in the period 1826-1921.
The story of their contributions is the story of the evolution
of the theory of the multiple expansion of deposits.

At the heart of banking theory is the notion of the
multiple expansion of bank deposits. This idea consists of two interrelated parts. The first explains how
the banking system as a whole creates deposits by
making loans equal to a multiple of its cash reserves,
the multiplier being the inverse of the reserve-todeposit ratio. The second shows how the individual
bank contributes to this expansion, not by multiplying its own deposits, but rather by making loans and
losing reserves through the clearinghouse to other
banks so that they too can expand. Taken together,
these components reconcile the banking system’s
ability to multiply loans and deposits with the individual bank’s inability to do so. For the individual
bank, far from expanding its loans by several times
any new cash deposits received, lends out only the
fraction of those deposits remaining after required
reserves have been set aside.
The preceding ideas are fairly well known. Many
economics textbooks explain why a banking system
having a required reserve ratio of, say, twenty percent can create five dollars of deposit money per
dollar of cash reserves while at the same time no individual bank can lend more than eighty cents per
dollar of deposits received. What the texts do not
explain, however, is the origin and development of
the theory. The result is to convey the impression
that the theory has always existed in its present form,
having been fully and correctly articulated from the
start. Nothing, however, could be further from the

truth. On the contrary, as Lloyd Mints notes in his
authoritative A History of Banking Theory (1945), “The
problem of the manner in which the banking system
increases the total volume of the circulating medium,
while at the same time the lending power of the individual banks is severely limited, has proved to be
one of the most baffling for writers on banking theory”
[10, p. 39]. Far from understanding how loans
generate deposits, bankers throughout the nineteenth
and early twentieth centuries insisted that banks lend
only the funds entrusted to their care and therefore
could not possibly multiply deposits. Economists, on
the other hand, often went to the opposite extreme,
arguing that individual banks were simply small-scale
versions of the banking system at large and thus could
multiply deposits per dollar of reserves just as the
system does. Both views were wrong. Not until the
1820s did a more plausible view start to emerge. And
not until the 1920s was it finally stated in a way that
fully convinced the economics profession and thus
enabled the theory to gain widespread acceptance.
In an attempt to provide historical perspective and
to show how earlier writers resolved the paradox of
a banking system doing what none of its members
could do, this article traces the evolution of the theory
between those two dates. Before doing so, however,
it reviews the essentials of the theory as a prerequisite
to identifying what earlier writers had to say about
them.

FEDERAL RESERVE BANK OF RICHMOND

3

The Theory

of Deposit Expansion

Suppose for simplicity that the banking system consists of a single monopoly bank constrained by a required reserve-to-deposit
ratio r and desiring to be
fully loaned up. Suppose further that the public never
wishes to convert deposits into currency so that no
cash withdrawals occur when deposits expand.
Because the bank cannot lose reserves through the
clearinghouse to other banks (of which there are
none) or to cashholders via withdrawal, it faces no
restriction on its ability to expand loans and deposits
other than the requirement that it hold r percent of
its deposits in reserves. Thus upon the receipt of C
dollars of new reserves it can instantly expand loans
and deposits D up to the full limit allowed by the
reserve ratio-that is, up to the amount D = (1/r)C,
where (1/r), the inverse of the reserve ratio, is the
deposit expansion multiplier. In this way the system
as a whole multiplies deposits per dollar of reserves.
Next suppose that the system consists of many
small banks, each of which loses through the clearinghouse reserves equal to the full amount of loans
made. Because of these adverse clearing balances,
no bank can safely lend out more than (1 - r) of each
dollar of deposits received, this sum being the amount
remaining after r percent has been put in required
reserve. Thus the first individual bank receiving C
dollars of new cash deposits lends (1 - r)C of that
amount after putting rC dollars in reserve. When borrowers write checks on the proceeds of the loans in
favor of recipients who deposit the checks in a
second group of banks, the latter banks gain (1 - r)C
dollars in new deposits. They in turn keep r percent
of the new deposits in reserve and lend out the remaining (1 - r) percent so that their loans equal
(1 -r)(1 -r)C. This amount they lose through the
clearinghouse to a third group of banks whose
deposits accordingly rise by (1 - r)2C, and who, after
setting aside a fraction r for reserve, lend out the remaining (1 -r)3C. And so it goes from bank to bank
in ever-diminishing amounts until excess reserves are
zero and all the new cash reserves C are absorbed
in backing deposits in the ratio of 1 to r. Summing
over the successive groups of banks in the dwindling, never-ending chain gives total new deposits
D for the system of D = [1 + (1 - r) + (1 -r)2 +
(1-r)3
+ . . . + (1 -r)n]C which, when the
number of banks n gets large, converges to the limit
D = (1/r)C, the same expression that holds for the
single monopoly bank.
In short, multiple expansion
occurs in the
multibank case because the excess reserves that form
the basis for loans, though lost to the individual bank,
are not lost to the system as a whole. They are simply
4

transferred to other banks that use them for further
expansion. As the expansion proceeds from bank to
bank, each institution retains the reserves required
to back the new deposits that brought it the extra
reserves in the first place and lends out the remainder.
The result is multiple expansion, the same as that
achieved in the monopoly case. The only difference
is that in the multibank case each individual bank
does not multiply its own deposits. Rather it creates
them for other banks by making loans and allowing
its reserves to shrink to a fraction of the initial deposit.
In a word, the banking system collectively multiplies
deposits per dollar of new reserves while the small
individual bank fractionalizes reserves per dollar of
new deposits.
Historical

Evolution

Having outlined the theory itself, we are now
prepared to trace its origin and development.
Retrospectively,
one can discern a certain logical
progression. First came the perception that deposits
are a multiple of reserves, followed by a rudimentary exposition of the lending, redeposit,
and
multiplier aspects of the expansion mechanism. Next
appeared a specification of the limits to deposit expansion and a definition of the limit value of the
multiplier. There followed an analysis of how expansion spreads from bank to bank in a multibank
system. Then came the first algebraic statement of
the theory followed by the first clear distinction between the expansion power of a monopoly bank and
a competitive bank. Finally came the persuasive
restatement of the theory that, by consolidating,
refining, and elaborating its key ideas, established it in mainstream banking analysis. Each stage
saw a different innovator-Pennington,
Torrens,
Joplin, Marshall, Davenport, and Phillips are the key
names here-advance
the theory.
Multiple Deposits Recognized
The initial step in the theory’s evolution came in
the eighteenth century when writers such as John
Law (1671-1729), Bishop Berkeley (1685-1753), and
Alexander Hamilton (1755-1804) observed that bank
deposits were several times larger than the underlying cash base and inferred from this that banks
create deposits (see O’Brien [11, p. 15]). These
writers, however, did not explain the mechanism that
works to multiply deposits. They simply assumed
that multiple deposit expansion would somehow
occur for both the individual bank and the banking
system as a whole. They failed to state that deposit

ECONOMIC REVIEW. MARCH/APRIL 1987

multiplication occurs through the successive lending
and redeposit of excess reserves. Not until 1826 was
this point made clear.
James Pennington

(1777-1862)

It was James Pennington, a British currency expert and confidential monetary advisor to the government, who advanced the theory into its second stage.
He did so with his rudimentary exposition of the
lending, redeposit, and multiplier mechanics of
deposit expansion. His contribution appears in his
1826 memorandum to the English statesman and
financier William Huskisson. There he shows (1) that
with fractional reserve banking cash deposits produce
excess reserves, (2) that such excess reserves lead
to loans, and (3) that the proceeds of the loans when
redeposited in the system augment the volume of
deposits per dollar of cash base. To illustrate these
points he argued that if banks receive a cash deposit
of which half must be held in reserve the rest will
go to purchase earning assets (loans and investments).
The sellers of these assets will, upon receiving the
cash, redeposit it in their banks thus increasing the
volume of deposits. At the end of this first round of
the expansion process, the cash reserves of the banks
will be the same as before, but the sum total of
deposits-including
the initial cash deposit plus the
additional deposits created by loan-will already be
increased by fifty percent. In his words:
of the money entrusted to their [bankers’] care. . . .if a
reserve of one half were sufficient. . . the other half would
be employed
in discounting
bills [i.e., making
to whom these adloans]. . . . But the Persons
vances . . . were made, would, for their own convenience,
deposit the money. .. in the hands of their respective
bankers, and the aggregate amount of the outstanding
[deposit] balances. . . would. . . be encreased
50 per
cent. . . .The money due to all the depositors would be
50 per cent more than it was previously to the commencement of these operations. . . [12, pp. xlv-xlvi].

Pennington did not trace the expansion process
beyond the first round. But he did indicate how the
individual bank contributes
to expansion in a
multibank system. He pointed out that as one bank
expands its loans it either recovers the proceeds in
the form of redeposits or else it loses reserves to other
banks so that they too can expand. Either way,
deposits increase. As he put it in a letter published
in Volume 2 of Thomas Tooke’s History of Prices
(1838), if, after a bank receives an initial cash deposit
and makes a loan,
a cheque be drawn upon the. . . banker for the amount
of the advance. . . . [and] be paid into his hands by some
other depositor, and placed at the credit of that other

depositor. . . the whole amount of the book credits [i.e.,
deposits] of that banker will be increased to the extent
of this new advance. And even if the cheque be paid into
the hands of some other banker, the [initial] amount of
the book credits of the banker who has paid the cheque
will not be diminished, while the book credits, as well
as the reserved fund of the banker, to whom it is paid,
will be increased by its amount [13, p. lvi].

In other words, reserves lost by one bank show up
as new deposits in another. In this way deposits
gradually multiply on the given increase in the reserve
base as it shifts from bank to bank. To illustrate, he
showed that if the first bank in a system of two identical banks lends and loses through the clearinghouse
half its initial cash reserve to the second that subsequently does the same, deposits of both banks expand although the reserve base remains unchanged
[12, pp. xlvii-xlviii].
Pennington’s failure to trace the expansion process
to its completion accounts for his failure to specify
the limit value of the multiplier. Far from defining
it as the reciprocal of the reserve ratio, he was
content merely to demonstrate that its value was
greater than one. He also denied that he viewed the
multiplier as a rigid mechanical relationship. This
view was attributed to him by Robert Torrens, who
cited Pennington as the source of the notion that
London banks always hold in the form of notes of
the Bank of England a one-fifth cash reserve against
deposits, resulting in a multiplier of five. In
correcting Torren’s misapprehension,
Pennington
said:
It never occurred to me, as appears to have been supposed by Colonel Torrens, that every million of notes
issued by the Bank of England forms the basis of five
millions of deposits; and that every million withdrawn from
circulation, by the Bank, occasions a five-fold diminution
of those deposits. On the contrary, it is perfectly consistent with my view of the subject, to suppose that the
deposit accounts of the London bankers may be materially
diminished, while the circulation of the Bank of England
is greatly enlarged, or vice versa [13, p. lii].

Pennington contended that bankers’ desired reserve
ratios (and thus the multiple relationship between
deposits and reserves) vary with the state of business
confidence. In so doing, he originated the notion
of a flexible multiplier.
Pennington’s contemporaries quickly grasped the
significance of his pioneering work. Torrens referred
to it as “a subject of the greatest practical importance”
[19, p. 12]. The Banking School likewise shared this
opinion. While not accepting his definition of deposits
as money, they used his notion of a flexible multiplier
to argue that the credit superstructure
(of which
deposits were the chief component) could expand

FEDERAL RESERVE BANK OF RICHMOND

5

and contract independently of the narrow monetary
base such that control of the base did not imply control of the superstructure.
Robert Torrens

(1780-1864)

Pennington was the first to outline the lending,
redeposit, and multiplier aspects of bank credit creation. But Robert Torrens was the first to specify the
limits to deposit expansion and to define the limiting
value of the multiplier. Torrens, a professional soldier,
newspaper proprietor, member of Parliament, promoter of schemes for the colonization of Australia,
co-discoverer of the theory of comparative advantage,
and one of the ablest monetary theorists of his generation, presented his analysis in his 1837 Letter to Lord
Melbourne. There, in a section bearing the caption
“A given amount of circulating Cash becomes the
basis of a much greater amount of Bank Deposits,”
he wrote that deposits expand until they reach that
particular ratio to reserves that bankers deem “safe
and legitimate” [19, p. 16]. In other words, the
desired deposit/reserve
ratio together with the
available quantity of reserves fixes the upper limit
to expansion. He also explained how deposits grow
up to this limit. Stressing the successive lending and
redeposit of excess reserves, he wrote that given
a reserve. . .in coin. . . more than sufficient to meet. . .
occasional demands. . . . a part of this coin would be again
advanced upon securities, and would be again returned
upon the banks, in the form of new deposits, restoring
their reserve. . .to the original sum. . .[19, p. 15].

It follows that
Whatever sums they may advance upon securities in the
morning, the same sums will be returned to them in the
evening, in the form of new deposits; and in this way the
amount of their deposits must continue to increase, until
they bear that proportion to the fixed amount of the
returning cash, which the experience of the bankers may
suggest as safe and legitimate [19, p. 16].

That is, expansion proceeds via the successive
lending and redeposit of excess cash reserves until
the desired deposit/reserve
ratio is attained.
As for the deposit multiplier itself, Torrens expressed it as the inverse of the reserve ratio. He saw,
for example, that a reserve ratio of one-tenth would
produce a multiplier of ten. Observing that
in ordinary times, one-tenth, or even one-twentieth,
of
the money deposited with a banker, is a sufficient rest
[reserve] for meeting occasional demands; and that ninetenths, or even nineteenth-twentieths,
of the sums
deposited with a bank may be lent out on securities [19,
p. 18],

6

he concluded:
I should not be arguing on an extreme case, were I to
assume that the cash originally deposited. . . with bankers,
will be successively re-issued upon securities, by the
banks, and successively returned to them, in the form of
new deposits, until the proportion between the amount
of the deposits, and the amount of the cash, is as ten to
one [19, pp. 18-19].

Here is the first clear statement of the multiplier as
the reciprocal of the reserve ratio.
In his theoretical analysis, Torrens treated the
multiplier as a potentially variable magnitude, fluctuating in value from a high of twenty to a low of
five depending on the state of business confidence
and its impact on bankers’ desired deposit/reserve
ratios. As he put it, these ratios
will necessarily vary with the variations of commercial confidence. When trade is prosperous, when few failures are
occurring, and when commercial bills are promptly paid
as they fall due, bankers might consider it safe to continue to re-issue, upon securities, the cash returning upon
them as deposits, until the proportion between their
deposits and their cash, became as fifteen to one, or even
as twenty to one. In periods of commercial pressure, on
the other hand, bankers would be disposed to contract
their liabilities, until the deposits. . . bore to their cash a
proportion, not exceeding seven to one, or even five to
one [19, pp. 17-18].

Owing to these potential multiplier fluctuations, “a
fixed amount of circulating money may be the basis
of a fluctuating amount of credit money” [19, p. 17].
Yet in his practical policy analysis he treated the
multiplier (or deposit/reserve ratio) as a more-or-lessfixed constant, arguing that control of the reserve base
constituted automatic control of the deposit superstructure.
This last idea proved especially influential. The
Currency School used it to argue that bank reserves
controlled an inverted credit pyramid (with deposits
the chief component) resting on a gold and banknote
base. Through the writings of the Currency School,
Torrens’s doctrines of deposit multiplication on a
reserve base and deposit control via that base became
sufficiently well established by the mid-nineteenth
century to be bequeathed to future generations of
monetarists (see O’Brien [11, p. 16]). In short, the
modern monetarist notion of base control derives
straight from Torrens by way of the Currency School.
Thomas

Joplin (1790-1847)

The next step in the theory’s evolution was taken
by Thomas Joplin, a British banker and co-originator
of the principle of “metallic fluctuation” around
which much of nineteenth century monetary contro-

ECONOMIC REVIEW, MARCH/APRIL 1987

versy raged. He advanced a view markedly different
from Torrens’s of the way deposits expand to the
limit set by bankers’ desired reserve ratios. As
documented above, Torrens focused on the lendingredeposit mechanism of the banking system as a
whole; he did not trace the expansion process from
bank to bank. He merely stated that banks as a group
expand loans, then recoup the proceeds in the form
of redeposits, and then expand again and again until
the limit is reached. He did not identify individual
banks nor did he mention the distribution of reserves
among them.
By contrast, Joplin explained how expansion proceeds from one bank to the next, each lending out
its excess reserve and losing it to another bank
which also expands and so on until excess reserves
are eliminated and all cash is absorbed in backing
deposits at the ratio desired by bankers. Joplin
developed his analysis in his 1841 book The Cause
and Cure of Our Commercial Embarrassments. He starts
out by establishing the limits to expansion and defining the deposit multiplier as the inverse of the reserve
ratio.
Every banker. . . has therefore the power of creating bank
money, and. . . there is no other limit to the exercise of
this power than his own prudence. . . . I apprehend that
bank money is always created by the bankers to the full
extent that prudence will permit. If one-fifth of their
deposits in cash be sufficient to meet any demand for payment by their depositors, for every thousand pounds of
cash deposited with them, they discount to the extent
of £5,000, and create £5,000 of bank money (7, pp. 33,
as quoted in Mints 10, p. 105].

He then proceeds to trace the expansion process
across a succession of banks until the limit is
reached. Assuming a reserve ratio of 20 percent, he
states that a bank receiving a new cash deposit of
£1,000 will immediately put £200 in reserves and
lend out the remaining £800. The borrowers, upon
receiving this sum,
pay the amount, we shall assume, to the credit of their
account with some other banker, who. . . finds his cash
increased £800, and his deposits £800, and he has in consequence £640 to spare, which he lends accordingly. This
again being paid into another bank, the same operation,
again occurs, and so it goes on from bank to bank until
the thousand pounds has created for itself deposits to the
extent of £5,000 [7, pp. 33-34, as quoted in Mints 10,
p. 105].

Here are all the elements found in modern textbook
treatments of the multiple expansion process: (1) the
initial cash deposit that generates excess reserves,
(2) the lending out and subsequent loss of those
reserves to other banks who repeat the process, (3)
the resulting diminution of excess reserves at each

successive bank as they are absorbed in backing the
extra deposits created by their arrival, and (4) the
cumulative rise in deposits until they reach their limit
ratio to cash reserves, at which point excess reserves
vanish. All that was missing was a mathematical statement of the process.
Alfred Marshall (1842-1924)
The mathematical statement referred to above constituted the next stage of the theory. The key name
here is that of the great English neoclassical
economist
Alfred Marshall, who provided the
algebraic basis for the theory and who used the
standard mathematical
technique to derive the
deposit expansion multiplier as the summation of a
geometrical series. Marshall used the symbol n to
denote the multiplier, defined by him as the ratio of
deposits to reserves (i.e., the inverse of the reserve
ratio). In a note scribbled in the margin of his
personal copy of Robert Giffen’s Stock Exchange
Securities (1877), he wrote:
Let it [bankers’ desired reserve/deposit ratio] be 1/n th:
Let A be the original amount of deposits without credit:

as well as if many, except that if there are many banks
n cannot be very large in any one bank, while on the other
hand if the banks pool their reserves (theoretically or practically) they count as cash what they have in the pool and
the pool lends much of that again [quoted in Eshag 4,
pp. 9-101.

He elaborates the substance of this brief note in his
evidence before the Gold and Silver Commission of
1887. He says:
I should consider what part of its deposits a bank could
lend and then I should consider what part of its loans
would be redeposited with it and with other banks and,
vice versa, what part of the loans made by other banks
would be received by it as deposits. Thus I should get
a geometrical progression; the effect being that if each
bank could lend two-thirds of its deposits, the total amount
of loaning power got by the banks would amount to three
times what it otherwise would be. If it could lend fourfifths, it will then be five times; and so on. The question
how large a part of its deposits a bank can lend depends
in a great measure on the extent to which the different
banks directly or indirectly pool their resources [8, p. 37,
as quoted in Eshag 4, p. 10].

In these passages Marshall makes three main
points. First, to find the multiplier, one simply adds
to each dollar of initial cash deposit the proportion
of that dollar that successive banks can lend as it goes
in dwindling amounts from bank to bank. In this con-

FEDERAL RESERVE BANK OF RICHMOND

7

nection it should be noted that the terms

no reserves through the clearinghouse or through cash
drain.

etc., of Marshall’s equation are the same
as the terms (1 -r), (1 -r)2, etc., which show the proportion of each dollar of initial deposit that successive
banks can lend out after required reserves have been
set aside. The resulting multiplier, Marshall notes,
is the same whether the system is composed of a
single monopoly bank or many small competing
banks. Second, the proportion of its deposits a bank
can lend is determined by its reserve ratio. If that
ratio is, say, one-fifth, the bank can lend out the
remaining four-fifths of its deposits. Third, reserve
ratios and the resulting power to lend vary by type
of bank. Small isolated banks, because of their potentially greater exposure to cash drains and adverse
clearings, will operate with larger reserve ratios than
big banks or those having ready access to a central
reserve pool.
Herbert

Joseph Davenport

(1861-1931)

The theory progressed to its sixth stage with University of Missouri economist H. J. Davenport’s
distinction between the expansion power of a single
monopoly bank versus that of a small competitive
bank in a multibank system. “Modern developments,” writes F. A. Hayek, “follow the exposition
of H. J. Davenport” [6, p. 153]. On page 261 of his
Economics of Enterprise (1913) Davenport shows that
a monopoly bank in a closed community can do what
a whole banking system can do but what a competitive bank cannot do, namely multiply loans and
deposits per dollar of cash reserves received. The
monopoly bank, he says, loses no reserves to other
banks; all checks written on it return in the form of
redeposits. Consequently the only restriction on its
ability to expand is that it keep r percent of cash
reserves against deposits. Thus upon the receipt of
C dollars of new reserves it can expand deposits D
up to the limit D = (1/r)C.
To illustrate, he shows that a new monopoly bank,
being the only bank in an isolated town and facing
a reserve requirement of 1.5percent, will, upon opening for business, engineer a 6 2/3-fold expansion of
loans and deposits per dollar of initial cash reserves
contributed by the stockholders. He then applies this
same multiplier to a cash deposit of $100,000, showing how the bank puts $15,000 in reserve, lends out
an amount equal to six and two-thirds of the remaining $85,000,
and realizes a deposit expansion
(primary plus loan-derived)
of $666,666.
The
monopoly bank, he explains, expands up to the limit
allowed by the reserve ratio for one reason: it loses
8

For the. . . customers of the bank make payments through
checks upon the bank, and these credits are deposited
in turn to the credit of other customers. . . . And if some
customers
draw out cash, other customers
will
probably receive it and return it to the bank [3, p. 261].

Having described the multiplicative power of a
monopoly bank, he turns his attention to the competitive bank. He notes that a competitive bank cannot expand to the extent of a monopoly bank since
its attempts to do so will result in reserve losses
through the clearinghouse. The competitive bank,
he says, cannot expect the proceeds of its loans to
be redeposited with it. On the contrary,
When the check drawn by the borrowing depositor may
be deposited in other banks and collected by them against
the lending bank, its granting of credits rapidly draws down
its reserves to swell the reserves of its competitors [3,
p. 263].

These reserves, he notes, go to other banks, which
also try to expand; in this way the system as a whole
ultimately expands in the same ratio as the monopoly
bank. He also suggests that when all banks
simultaneously expand their loans approximately in
balance, their reserve losses will tend to cancel each
other.
Each bank, as it, in turn lends to its customers, is losing
reserves to other banks, but is, in turn, gaining reserves
at the expense of the other banks-if at the same time
the banking activity of these other banks is maintained
[3, p. 287].

To the extent this happens, the group of banks
together can (like a monopoly bank) quickly expand
to the limit allowed by the reserve ratio.
Chester

Arthur

Phillips (1882-1976)

The theory of deposit expansion reached its zenith
with the publication of C.A. Phillips’s Bank Credit in
1921. There in the famous Chapter III entitled “The
Philosophy of Bank Credit” he stated the theory with
a power, precision, and completeness unmatched by
his predecessors. In particular, it was Phillips more
than anyone else who brought home to the economics profession the crucial distinction between the
reserve loss of a competitive bank that expands its
loans versus multiple expansion by the banking
system as a whole. In so doing, he advanced the
theory in at least three ways.
First, he refuted the view, held by Horace White,
H. D. McLeod, and other banking writers of the
time, that an individual bank multiplies its deposits

ECONOMIC REVIEW, MARCH/APRIL 1987

on a given reserve base just as the banking system
does. Not so, said Phillips. An individual bank can
not multiply deposits. For its attempts to do so by
making loans of several times the amount of new
reserves received will simply result in reserve losses
to other banks equal to the amount of the loans
made (or slightly less if a small fraction of the loans
returns to the bank as deposits). No bank, he said,
could tolerate such losses that imperiled its legal
reserve position.
Let us suppose that the Hanover National Bank of New
York acquires a deposit of $1,000,000 in gold imported
and lends $10,000,000 to its customers, an amount suggested by the approximate ratio of 1 to 10 between
not more than
reserves and deposits. . . .Perhaps
$100,000 out of all the checks drawn against the
$10,000,000
borrowed would be deposited at the
Hanover National Bank. The remainder of the manifold
loans supposedly extended on the basis of the imported
gold. . .would represent cash that the bank would lose
through unfavorable clearing house balances, an amount
that would be scattered widely among the banks of the
system. It is clear that an individual bank attempting to
lend greatly in excess of the amount of an addition to its
reserves would do so at its peril [14, pp. 37-38].

Second, he explained with greater rigor and exactness than his predecessors how the individual bank
contributes to systemwide multiple expansion even
though it cannot itself multiply deposits. “How,” he
asked, “can a given amount of cash become the basis
of manifold loans and deposits in a banking system
if the acquisition of that amount by an individual bank
has little or no multiplicative importance?” [14, p.
34]. His answer is that excess cash reserves obtained by one bank will, upon being lent out, provide another bank with excess cash with which it
expands and so on until all cash is employed in supporting deposits at the ratio of one to r.
The sudden acquisition of a substantial amount of reserve
by a representative individual bank. . . tends to cause that
bank to become out of tune with the banks in the system
as a whole. As the individual bank increases its loans in
order to re-establish its normal reserve-deposits
ratio,
reserve is lost to other banks and the new reserve, split
into small fragments, becomes dispersed among the banks
of the system. Through the process of dispersion it comes
to constitute the basis of a manifold loan expansion (14,
p. 40].

In short,
Manifold loans are not extended by an individual bank
on the basis of a given amount of reserve. Instead, as a
consequence of lending, the reserve of the individual bank
overflows, leaving only the equivalent of a fractional part
of the additional volume of loans extended, the overflow
cash finding its way to other and still other banks until
it becomes the “residualized,” yet shifting, foundation of
manifold loans and deposits [14, p. 73].

To emphasize the point, he contrasted the way the
banking system and the individual bank reach their
desired reserve-deposit
ratios-the
system by expanding its deposit denominator; the bank by shrinking its reserve numerator.
Third, he was the first to publish algebraic formulas
expressing the loan and deposit expansion potential
of both the banking system and the individual bank.
Then he used the standard mathematical technique
of summation of a series to show that aggregation
across the individual banks yields the systemwide
formulas. His formulas for the banking system are
straightforward and need only be summarized here.
According to him, a system facing a required reserve
ratio r can, upon the receipt of a new cash deposit
C, immediately expand its loans L and deposits D

where the latter parenthesized multiplier is one larger
than the former since it takes account of the initial
primary deposit as well as deposits created by loan.
His expansion formulas for the individual bank,
however, require some explanation. He noted that
the expansion power of the individual bank depends
not only on its reserve ratio r but also on the fraction k of its loans that remain with it as deposits. This
fraction, he argued, depends upon such things as
compensating balance requirements, the accumulation of balances in borrowers’ accounts in anticipation of loan repayment, and the redeposit of checks
in the same bank upon which drawn. Given these
factors, it is an easy matter to trace Phillips’s derivation of the bank’s loan and deposit expansion
formulas.
Thus for an individual bank having a reserve ratio
r and an initial cash deposit C, let k be the fraction
of loan-created deposits retained by the bank, and
L the extra loans made. Once the loans are granted
and (1 -k) of them withdrawn, final deposits (original
plus the retained fraction of those created by loan)
of C + kL must, because deposited funds are either
held in reserve or lent out, equal loans L plus required reserves r(C + kL) obtained by applying the
reserve ratio to deposits. In short, C + kL = L +
r(C + kL). Solving this equilibrium condition for
loans yields Phillips’s loan expansion formula L =

preceding definition of final deposits, results in the

where the bracketed
multipliers.

FEDERAL RESERVE BANK OF RICHMOND

terms are the loan and deposit

9

Using the preceding formulas, Phillips showed that
if cash deposits C equal $1,000, and r and k equal
10 and 20 percent, respectively, then the individual
bank can expand its loans L and deposits D by
$1,097.25 and $1,219.51. These sums are somewhat
larger that those of the hypothetical atomistic bank
of the textbooks, whose k-factor of zero reduces its
loan and deposit multipliers to (1 -r) and 1.0, respectively. On the other hand, the loan and deposit sums
of Phillips’s example are smaller than their counterparts in the case of a single monopoly bank, whose
k-factor of 1.0 yields loan and deposit multipliers

k-factor, varying as it does between one and zero,
essentially indicates the extent to which any one bank
can act as a monopoly bank, expanding loans and
deposits as if it were the banking system as a whole
(see Timberlake [18, pp. 10-12]).
Finally, in a demonstration similar to Marshall’s,
Phillips showed that the summation of the loan- and
deposit-creation
series across all individual banks
yields the multiple expansion formulas for the system
as a whole. Phillips’s definitive exposition essentially established the theory once and for all in the
form found in economics textbooks today.
The Theory

Since Phillips

Since Phillips, at least three innovations have enhanced the theory of deposit expansion. First,
economists James Harvey Rogers [15], Procter
Thomson [17], and James Angel1 and Karel Ficek
[1] incorporated
into the deposit multiplier the
public’s currency-to-deposit
ratio, c, to account for
cash drains induced by deposit expansion itself.
Using the resulting augmented multiplier expression

10

reserve ratios c and r act to limit deposit expansion,
which is therefore smaller than it otherwise would
be if limited by the reserve ratio alone. Still other
writers have incorporated time deposit and excess
reserve ratios into the multiplier thus further
diminishing its magnitude. Second, James Meade [9],
Milton Friedman and Anna Schwartz [5, pp. 784-94]
as well as Phillip Cagan (2, p. 12] have extended the
idea of the deposit expansion multiplier into the
broader concept of the money multiplier, m, relating
the total money stock (currency plus demand deposits), M, to the so-called high-powered monetary
base, B, consisting of bank reserves plus currency
held by the public according to the expression
M=mB. Third, Paul Samuelson [16, p. 283] has
observed that the small bank “expands” in symmetry
with the system, not by multiplying deposits on a
given new reserve but by fractionalizing its reserve
on a given new deposit.
But these extensions, important as they are, are
merely recent refinements made to the fundamental core of ideas laid down by Pennington and his
successors. The key ideas of that core-namely
that a fractional reserve banking system multiplies
deposits, that the mechanics of multiplication involve
the successive lending and redeposit of excess
reserves, that some crucial ratio or ratios exist to
limit the expansion, and that the individual bank contributes to the expansion process not by multiplying its own deposits but by creating them for others
when it makes loans and loses reserves through the
clearinghouse-were
already enunciated more than
a century ago. Even today, one finds these ideas
indispensable to a full understanding of how the
supply of bank money expands and contracts.

ECONOMIC REVIEW. MARCH/APRIL 1987

References
1. Angell James W. and Ficek, Karel F. “The Expansion of
Bank Credit. I.” Journal of Political Economy 41 (February
1933): 1-32.

11.

O’Brien, Dennis P. “Monetary Economics.” In Economic
Analysis in Historical Perspective, pp. 3-45. Edited by J.
Creedy and D. P. O’Brien. London: Butterworths, 1985.

2.

Cagan, Phillip. Determinants and Effects of Changesin the Stock
of Money, 1875-1960. New York: National Bureau of Economic Research, distributed by Columbia University Press,
1964.

12.

Pennington, James. “Observations on the Private Banking
Establishments of the Metropolis: First Memorandum to
Huskisson” (1826). In Economic Writings of James Pennington,
pp. xlv-li. Edited by R. S. Sayers. London: The London
School of Economics and Political Science, 1963.

3.

Davenport, Herbert J. The Economics of Enterprise. New
York: Macmillan, 1913.

13.

. “Letter Addressed to the Author by James
Pennington, Esq.,” Appendix C of Volume 2 of Tooke’s
History of Prices (1838). In Economic Writings of James Pennington, pp. lii-lxii. Edited by R. S. Sayers. London: The
London School of Economics and Political Science, 1963.

14.

Phillips, Chester
1921.

15.

Rogers, James H. “The Absorption of Bank Credit.” Econometrica 1 (1933).

4.

Eshag, Eprime. From Marshall to Keynes. Oxford:
Blackwell, 1963.

5.

Friedman, Milton and Schwartz, Anna J. A Monetary History
of the United States, 1870-1960. Princeton: Princeton University Press, 1963.

6.

Hayek, Friedrich A. Monetary Theory and the Trade Cycle
(1933). New York: Kelley, 1966.

Basil

7. Joplin, Thomas. The Cause and Cure of Our Commercial
Embarrassments. London, 1841.

16. Samuelson, Paul A. Economics.8th ed. New York: McGrawHill, 1970.
17.

8.

Marshall, Alfred. Official Papers. London: Macmillan, 1926.

9.

Meade, J. E. “The Amount of Money and the Banking
System.” Economic Journal (1934): 77-83. Reprinted in
American Economic Association. Readings in Monetary
Theory. Homewood: Irwin, 1951, pp. 54-62.

10.

Mints, Lloyd. A History of Banking Theory. Chicago: University of Chicago Press, 1945.

A. Bank Credit. New York: Macmillan,

Thomson, Procter. “Variations on a Theme by Phillips.”
American Economic Review 46 (December 1956): 965-70.

18. Timberlake, Richard H. “A Reassessment of C. A. Phillips’
Theory of Bank Credit.” Unpublished Paper.
19. Torrens, Robert. A Letter to the Right Honourable Lord
Viscount Melbourne on the Causes of the Recent Derangement
in the Money Market and on Bank Reform. London: Longman, Rees, Orme, Brown, and Green, 1837.

FEDERAL RESERVE BANK OF RICHMOND

11

THE EQUILIBRIUM APPROACH
TO EXCHANGE RATES
Alan C. Stockman*

1.

Introduction

Media reports on foreign exchange rates are filled
with discussions of “overvalued” or “undervalued”
currencies.
Stories in the financial press about
changes in exchange rates frequently state that they
affect international competitiveness and employment.
The stories often discuss relations between exchange
rates and the nation’s trade deficit or the federal
government’s budget deficit. They often state that
changes in the exchange rate hurt or benefit the
economy, and sometimes discuss policy options
available to the government.
Most of these stories are based on a particular
disequilibrium theory of exchange rates that has come
under increasing criticism in recent years. The
disequilibrium theory conflicts with available evidence
and an alternative equilibrium theory based on
simple economic principles has been developed. The
new theory has completely different implications and
policy prescriptions than the earlier theory, which
underlies most current public policy discussions. This
article summarizes the basic elements of the equilibrium approach to exchange rate behavior and the
evidence that conflicts with the older disequilibrium
theory. It argues that the equilibrium approach to exchange rates is in better accord with this evidence.
It concludes with a discussion of the implications of
the equilibrium approach to exchange rates for
economic policies.
2. Overview

of the Issues

The main argument of the paper is the following.
Economic theory predicts that real disturbances to
supplies of goods or demands for goods cause changes
* Associate Professor of Economics, University of Rochester, and a
Visiting Scholar at the Federal Reserve Bank of Richmond. The author
wishes to thank Marvin Goodfriend, Thomas M. Humphrey, Anatoli
Kuprianov and Torsten Persson for helpful comments.

12

in relative prices, including the “real exchange rate”.l
In a wide variety of circumstances, these changes in
the real exchange rate are partly accomplished
through changes in the nominal exchange rate.
Repeated disturbances
to supplies or demands
thereby create a correlation between changes in real
and nominal exchange rates. This correlation is consistent with equilibrium in the economy, in the sense
that markets clear through price adjustments. This
is the basis for the “equilibrium approach” to exchange
rate changes, and it has several important implications about exchange rate changes. First, exchange
rate changes are not “causes” of changes in relative
prices, but part of the process through which the
changes occur in equilibrium. Second, the question
of whether a change in the exchange rate-or more
general exchange rate volatility-is
“good” or “bad”
for the economy is not correctly posed because the
exchange rate is an endogenous variable. The right
question is whether the underlying disturbances to
the economy are “good” or “bad,” so (of course) the
answer varies with the disturbance. Third, the correlation between nominal and real exchange rates is
not exploitable by government policy in the sense
that attempts by the government to affect the real
exchange rate by changing the nominal exchange rate
(e.g. through foreign exchange market intervention,
a return to fixed exchange rates, or “target zones”
for exchange rates) will fail. Fourth, there is no simple relation between changes in the exchange rate
and changes in “international competitiveness”
or
employment. It is incorrect, according to the theory,
to blame decreased “competitiveness”
on the exchange rate. It is equally incorrect to expect that (by
itself) an alternative exchange rate system such as
fixed rather than floating exchange rates will affect

1 The real exchange rate is defined in this paper as the relative price
of foreign goods in terms of domestic goods. This relative price is also
known as the terms of trade. There are other definitions of the real
exchange rate, involving relative prices of nontraded and traded goods.
Equilibrium models of exchange rates with nontraded goods include
Helpman and Razin (1982), Stockman (1983). Stockman and Dellas
(1986), and Stulz (1986).

ECONOMIC REVIEW, MARCH/APRIL 1987

competitiveness.
Fifth, there is no simple relation
between the exchange rate and the balance of trade
or the current account of the balance of payments.2
Trade deficits do not “cause” currency depreciation,
nor does currency depreciation by itself help reduce
a trade deficit. Sixth, government budget deficits do
not necessarily cause currency appreciation (even if
they cause trade deficits). Finally, changes in exchange rates are not related in any simple manner
to changes in international interest rate differentials
(which may be affected by government budget
deficits).
Many of these implications of the equilibrium approach may appear surprising. They conflict with
claims that are commonly made in the financial press.
But, according to the equilibrium view of exchange
rates, many of the assumptions and statements commonly made in the media about exchange rates are
simply wrong. This article will explain why.
Some of the propositions stated above may also
appear at first to conflict with experience. But, this
paper will argue, the experience that appears to conflict with these propositions is only selective. More
generally, the evidence is consistent with the implications of the equilibrium approach and fails to support the older, alternative theory.
The alternative “disequilibrium” theories of the exchange rate are based on sluggish adjustment of
nominal prices. According to the disequilibrium view,
nominal disturbances can cause changes in real exchange rates: changes in nominal exchange rates are
naturally translated into changes in real exchange rates
because of slow prices adjustments. This view of exchange rate changes underlies most popular accounts
of exchange rate changes and policy discussions in
the media. It implies that the correlation between
real and nominal exchange rate changes is exploitable
by government policy (e.g. by establishing “target
zones” for exchange rates or intervening in foreign
exchange markets in some other manner). It implies
that currencies may become “undervalued” or “overvalued” relative to equilibrium, and that these disequilibria affect international “competitiveness”
in
ways that are not justified by changes in comparative
advantage (adjusted for government policies such as
tariffs, regulations, etc.). Some versions of the disequilibrium approach also imply systematic relations
between the exchange rate and the trade deficit (or

the current account deficit), e.g. they imply that the
current U.S. deficit will be reduced eventually by a
fall in the value of the dollar, with a “hard landing”
or “soft landing” occurring under various conditions
that can perhaps be affected by government intervention in foreign exchange markets.
Econometric testing of these models is in its infancy, but there is some evidence that supports the
equilibrium models. According to the disequilibrium
approach, a change in the real exchange rate occurs
in response to changes in the nominal exchange rate
because of slow nominal price adjustment. But as
prices eventually adjust toward their new equilibrium
levels, the real exchange rate should adjust back
toward its equilibrium value. Monetary disturbances,
then, should create temporary movements in real exchange rates. Initial increases in the real exchange
rate should be followed by decreases within a few
years as nominal prices readjust to equilibrium.3 According to many of the disequilibrium models such
as Dornbusch (1976), monetary disturbances should
also create temporary movements in nominal exchange rates.4
But statistical evidence indicates that changes in
real exchange rates tend to be nearly permanent (on
average), or to persist for very long periods of time.
The evidence also indicates that changes in nominal
exchange rates-even
very short-term day-to-day
changes-are
largely permanent (statistically). This
persistence is inconsistent with the view that nominal
shocks, or even temporary real shocks, cause most
of the important changes in exchange rates. Instead,
it is consistent with the view that most changes in
real exchange rates are due to real shocks with a large
permanent component. Because changes in real and
nominal exchange rates are very highly correlated and
have similar variances, it is also consistent with the
view that most changes in nominal exchange rates
are due to largely permanent real disturbances.
This paper discusses the basics of the equilibrium
models, their implications, and their relation to
existing evidence.5 Section 3 presents a simple model
3 Because nominal price sluggishness is also thought by many economists
to be responsible for aggregate business fluctuations, the time involved
for the real exchange rate to revert back to its equilibrium level following a disturbance should be similar to the time it takes for recovery from
recessions. This argument suggests that the temporary changes in real
exchange rates would tend to last, on average, no more than a few years.

4 For further discussion, see Obstfeld and Stockman (1985).
2 Thecurrent account equals the trade balance adjusted for any difference
between exports and imports that can be paid for by income earned
from ownership of foreign assets. For example, a country that is a net
creditor earns income from loans it has made in the past, and could use
this income to pay for a perpetual trade deficit. A country that did this
would have a trade deficit but a balanced current account.

5 This paper bypasses a number of associated technical issues, such
as the use of optimizing models or the introduction of money into the
optimization process. Discussions of these technical issues are often confused with discussion of the basic economic points of the equilibrium
models of exchange rates. There is no necessary reason to connect them,
so the technical points are left aside here.

FEDERAL RESERVE BANK OF RICHMOND

13

on which the remainder of the article builds. Some
modifications of the mode are discussed in Section
4. Section 5 discusses some evidence on exchange
rates, Section 6 discusses relations between the
exchange rate, the balance of trade and some other
economic variables, and Section 7 discusses some
additional evidence about exchange rates. Finally,
Section 8 concludes and raises some policy issues.
3.

A Simple Model of Exchange

Rates

This section will develop a simple core model of
the exchange rate and discuss its properties. Subsequent sections will discuss some additional features
that can be added to this model. The simplest model
(from an example in Stockman, 1980) embodies the
assumptions described below as A0-A6. The role of
these assumptions is to clarify the exposition of the
equilibrium approach to exchange rates. Most of
these assumptions can be dropped without altering
the main points of this article. One very important
assumption that cannot be dropped without changing many of the results is discussed in Section 4.3.
The first five assumptions are:
A0. There is only one period of time, so
there is no borrowing or lending. (This assumption will be dropped in Section 6.)
A1. There are two countries, domestic and
foreign, that are identical except for the differences spelled out in the other assumptions.
A2. There are two goods. The domestic
country produces good X (only), while the
foreign country produces only good Y. Output
in each country is fixed each period (perfectly
inelastic) due to fixed input supplies and technology. Both goods are perishable. There is
perfect competition among producers.
A3. The two countries trade so that households can consume both goods. There are no
barriers to trade, transportation
costs, or
transactions costs. Households in each country
have the same tastes, expressed
here as
systems of indifference curves between X and
Y (see Figure 1). Both goods are normal.6

6 A person’s indifference curves describe his own tastes. Each curve
shows the various combinations of goods that the person could consume
without being either happier or less happy. Higher indifference curves
represent greater happiness. A “normal good” is one that people want
to buy more of (given its price) when their incomes rise.
14

A4. Households
equally wealthy.7

in the two countries

are

The world supplies of X and Y can be divided by
world population to obtain per capita supplies xS and
yS, shown in Figure 1 along with some of the indifference curves.8 Assumptions A3 and A4 state that
households in both countries have the same tastes
and resources. So all households will consume the
same amounts of both goods. In equilibrium, each
household consumes the quantities xS and yS,
represented by point A in the figure. Because supplies of the goods are perfectly inelastic (i.e. completely insensitive to price changes), tastes for goods
affect equilibrium prices but not quantities. The
equilibrium relative price of the two goods is determined by the slope of the indifference curves at point
A. In particular, the relative price of good Y in terms
of good X,
equals the absolute value of the inverse of the slope of the indifference curve passing
through point A. Flatter indifference curves represent higher equilibrium relative prices of Y. Steeper
indifference curves passing through point A represent lower relative prices of Y. The relative price of
Y,
is the real exchange rate (see footnote 1).
Nominal exchange rates become part of the model
when money supplies and money demands are incorporated in the model. The nominal exchange rate
is the price of foreign money-say
poundsmeasured in terms of domestic money-say
dollars.
Assumptions about the money supply and the demand for money in each country are required.
AS. The nominal supplies of domestic
foreign moneys, dollars and pounds, are
noted by MS and M*S and are fixed by
governments
(or central banks) of the
countries.
A6. The
dollars, is
(la)

demand

for

domestic

and
dethe
two

money,

Md/px =

where Md is the nominal quantity of dollars
demanded, px is the nominal dollar price of
good X, and a represents the real demand for
7 Assumption A4 simplifies the description of the model but is not essential. The assumption is useful in drawing Figure 1 because it implies
that consumption in both countries can be represented by the same point
in the figure.
8 Assumption A1 implies that the two countries have equal populations.
Denote these by N, so there are 2N people in the world. Let xS be the
(world) per capita supply of X, so total production of good X is 2NxS.
Similarly, total world supply of Y is ZNyS, and yS is the per capita supply.

ECONOMIC REVIEW, MARCH/APRIL 1987

dollars (in terms of good X), which is treated
as exogenously fixed. Similarly, the demand
for foreign money, pounds, is

where py*is the nominal price of good Y measured in terms of pounds and
is the real
demand for pounds, measured in terms of Y;
is also exogenously fixed.
In equilibrium, money demands and supplies must
be equated. Setting MS = Md and M*S = M*d in
(1) gives solutions for nominal export prices (or GDP
deflators) px and py*:

Figure1
Y

YS

The nominal exchange rate enters into the model
because the relative price of Y in terms of X (which
is minus the slope of the indifference curve passing
through point A in Figure 1) is

where e is the nominal exchange rate, i.e. the dollar
price of one pound. Notice that the dollar price of
the foreign good Y is given by arbitrage in goods
markets at px = epy* Similarly, the pound price of
the domestic good X is px* = px/e. Substituting (2)
into (3) gives an equation for the exchange rate:

This is the key equation determining the nominal
exchange rate. The model can be modified and made
more realistic in many ways, but some essential
features of (4) will continue to describe exchange
rates. This solution has several features, some of
them more obvious than others. First, increasing the
domestic money supply by k percent raises domestic
prices by k percent and leads to a k percent rise in
the exchange rate, which means a k percent depreciation of the dollar. Second, an increase in
lowers
domestic nominal prices and the nominal exchange
rate (i.e. leads to dollar appreciation). Changes in
foreign money supply or foreign money demand have
the opposite effects on the nominal exchange rate.
A third key feature of (4) is that it involves the
relative price, or real exchange rate,
Given the
nominal supplies of moneys, Ms and M*S and given
the real demands for moneys measured in terms of
the goods produced in each country, a! and CY, an
*
increase in the relative price of imports, r,,, raises
the nominal exchange rate. Recall that an increase
in n,, means a flattening of the indifference curve

XS

X

passing through the point in Figure 1 that corresponds
to the (per capita) supplies of goods. There are two
possible ways in which an increase in the relative
price of imports can occur: a change in demand or
a change in supply. (1) Demand may change because
tastes change so that the indifference curve passing
through point A becomes flatter. Or (2) the supplies
of X or Y may change, so that the new supplies are
represented by a point in Figure 1 at which the indifference curve is flatter, such as point B (resulting
from a rise in the supply of X) or point C (resulting
from a fall in the supply of Y).
When a change in supply or in demand occurs, it
may affect foreign.wealth, domestic wealth, or both.
To determine the effects of a change in demand or
supply, we must take into account its effects on
wealth in each country. For example, suppose
domestic output rises exogenously (because of an increase in domestic productivity). The domestic firms
that produce the additional output may be owned entirely by people in the domestic country. Alternatively, if foreign households also own shares of stock
in domestic firms then the rise in domestic output
would also raise foreign wealth-because
foreigners
would share in the additional dividends or capital
gains from shares of domestic firms. Even if onb
domestic households own domestic firms, an exogenous rise in domestic output will lower the relative
price of the domestic good. If its price falls only a
little then the domestic country will be wealthier than
before-it
has more goods to consume or sell. But
if the price of domestic output falls very much then
the domestic country will be less wealthy than before:

FEDERAL RESERVE BANK OF RICHMOND

15

e.g. owning ten apples each worth one banana may
be worse than owning eight apples each worth two
bananas. In either case, foreign wealth rises because
foreigners are able to buy domestic goods at a lower
relative price. So, for a concrete discussion, we need
to make an assumption about how changes in demand or supply affect the distribution of wealth. Tentatively we assume:
A7. People in both countries hold exactly
the same fractions of their wealth in the stock
of any firm (so foreigners own as much of
domestic firms as domestic residents do, and
the same applies to foreign firms).
Assumption A7 implies that a change in supply or
demand for goods affects wealth by an equal amount
in both countries, because shares of firms are
equally owned by both countries. Then foreign and
domestic wealth are equal after as well as before any
change, so foreign and domestic consumption will
be discussed in Section 4.1.
The effects on the exchange rate of changes in
demands or supplies of goods can now be summarized. Consider in turn changes in each of x’, y”,
tastes for goods, cr, and (Y*, holding money supplies
and the other variables fixed.
(a) An increase in the supply of domestic goods
raises (lowers) the relative price of foreign (domestic)
goods and thereby depreciates the dollar (raises e).
The physical quantity of exports also rises, as consumption of the good rises in both countries.9 An
observer, seeing that dollar depreciation is associated
with a fall in the relative price of domestic exports
and an increase in the volume of exports, might conclude that the domestic country had become “more
competitive” as a result of the depreciation of the
dollar. But this interpretation is confused. The change
in the exchange rate does not cause changes in relative
prices or the quantity of exports. The change in
the exchange rate is itself a restlb of an underlying
economic change which also affects other prices and
quantities. The distinction is important not only for
an accurate understanding of the economy but also

9 In Figure 1, the increase in supply of domestic goods is represented
by a shift from point A to point B. The original budget line of domestic
(and foreign) households goes through point A and is tangent to the indifference curve touching point A. The new budget line goes through
point B and is tangent to the indifference curve touching point B. The
new, flatter, budget line represents a higher relative price of Y, the foreign
good. Equation (4) implies that, because money supplies and money
demands are unaffected,
the exchange rate e rises, so the dollar
depreciates. The quantity of domestic exports obviously rises: foreign
households consume more of the domestic good (at point B) than before
(at point A).
16

for intelligent policy decisions. An observer whlo
mistakenly believes that the “increase in competitiveness” (fall in the relative price of domestic
exports) and increase in export volume was caused
by a currency depreciation might be tempted to
recommend that a further currency depreciation be
engineered by increasing the domestic money supply
or altering other policies so as to reduce domestic
money demand. But, as noted in (d) below, these
policy changes would affect the exchange rate without
altering “competitiveness” or the quantity of exports.
(b) An increase in the supply of foreign goods
lowers their relative price and appreciates domestic
money (lowers e). The volume of domestic imports
also rises. An observer, who witnesses a simultaneous
dollar appreciation, decline in “competitiveness” in
the sense of a rise in the relative price of domestic
exportables in terms of foreign goods, and rise in the
volume of imports, might mistakenly believe that the
change in the exchange rate was the cause. He might
recommend a rise in the money supply or othe:r
policies that reduce domestic money demand in orde:r
to mitigate or reverse the dollar’s appreciation. But,
while those policies may succeed in depreciating the
dollar, they would fail to change relative prices (such
as the real exchange rate) or the volume of imports.
(c) An increase in the demand for domestic goods
and fall in the demand for foreign goods appreciates
the dollar. (The demand for foreign goods falls
because any change in the demand for domestilc
goods must be accompanied by a reduction in the
demand for something
else, given household
budgets.) A shift in tastes away from foreign good,s
toward domestic goods is represented by a steepening of all the indifference curves, as shown in Figure
2. Given supplies of goods at point A, this impliels
a rise in the relative price of domestic goods.‘0 This
might be termed a fall in domestic “competitiveness:”
by some people, although the volumes of exports and
imports would be unaffected if the change in tastes
occurs in both countries equally (as assumption A3
states).” As before, it would be a mistake to conclude that the rise in the relative price of domestic
goods was caused by the appreciation of the dollar.
Instead, they are both results of an underlying change
in demand.
I0 In Figure 2, the indifference curve going through point A becomes
steeper at that point due to the change in tastes. Assumption A7
implies that the budget lines of all (domestic and foreign) households
continue to go through point A, but rotate so that they are tangent to
the new indifference curve. So the relative price of the domestic good,
X, rises. All households continue to consume at point A.
‘I Section 6.5 discusses a change in tastes in one country alone. In that.
case, volumes of exports and imports are affected. Also see Section 4.1.

ECONOMIC REVIEW, MARCH/APRIL 1987

Figure 2

return, by international portfolio diversification.) To
keep the discussion simple and concrete, we add a
stronger assumption than is necessary for the results.
Assume A7 is replaced by the assumption

Y
I

y

I
\

:
I
‘*

I
I
\

A8. (i) Firms in each country are owned
entirely by households in that country. (ii) The
utility function is homothetic, i.e. if a person’s
income rises and the relative price of goods
does not change, then the fraction of his
income that he spends on each good does not
change.12

\\

\\

\\
\

\\

X

(d) A rise in the domestic money supply or a fall
in the domestic demand for money causes dollar
depreciation. But relative prices and trade volumes
are unaffected because nothing in Figure 1 changes.
It is not possible to discuss trade deficits with this
model, because the model includes only a single time
period. A dynamic model is required for analysis of
such issues as the connections between exchange
rates and trade imbalances, interest rates, international capital flows, and budget deficits. The model
is expanded in Section 6 so that these issues can be
discussed. But there are a number of other important points that can be made without the complications of a dynamic model.
4.

Two Modifications

of the Model

This section discusses two possible modifications
of the model presented in Section 3. Section 4.1
contains a discussion that will be useful in Section
6; Section 4.2 develops a modification that will be
used in Section 5. Section 4.3 discusses a very important assumption made in the equilibrium theory
of exchange rates. Unlike the other assumptions of
the model, it cannot be changed without altering
many of the results.
4.1 Wealth Redistribution Efects

Suppose assumption A7 is dropped. An alternative assumption is required to replace it. One alternative is that only
domestic households own shares in domestic firms
and only foreign households own shares in foreign
firms. (This assumption leaves open the question of
why households fail to achieve the gains that could
be obtained, in terms of lower risk for the same

Assumption A8 implies that changes in the international distribution of wealth can occur, but they
do not affect the equilibrium relative price. If wealth
is redistributed from the foreign to the domestic country, then the fall in foreign demand for each good
is exactly offset by the rise in domestic demand for
that good, leaving the total world demand (and the
equilibrium relative price) unaffected. In the figures,
A8 implies that all of the indifference curves have
the same slope along a line coming out of the origin.
With assumption A8, the discussions above regarding changes in supplies of goods continue to
apply, with one caveat: one country may end up
wealthier-and
so may consume more-than
another.13 This is illustrated in Figure 3. Assume there
are N households in each country, so world population is 2N. World per capita output of the domestic
good is x”; its total output is 2Nxs. Each of the N
domestic households owns 2x” of the domestic goods
before international trade takes place. An increase
in domestic productivity raises total domestic output from 2Nx’ to ‘ZN(x’+A). So the per capita
supply of X rises from x” (point A in Figure 3) to
x” +A (shown as point B). The budget line of a
domestic household now goes through point G in
Figure 3. Domestic households consume at point D
and foreign households consume at point F. Average
world consumption is at point B (as it must be, since
total demand must equal total supply).
The discussion above regarding a change in demand for goods also requires only one modification:
‘a That is, the refatiw amounts of X and Y consumed
relative price but not on income.

depends on the

I3 An increase in the supply of domestic goods will raise exports, as
before, but it is possible that the domestic country might reduce rather
than increase its own consumption of the good. This can occur if the
price of the domestic good falls sufficiently, as in Figure 6 below. If the
utility function is Cobb-Douglas,
i.e. if people always spend some fixed
fraction of their incomes on each good, regardless of the relative price,
then the countries end up equally wealthy after the change in domestic
output, just as if assumption A7 rather than A8 had been invoked. In
that case, budget lines for all households go through point B in Figure 1.

FEDERAL RESERVE RANK OF RICHMOND

17

exports would probably reinforce the views of some:one who thought that the appreciation of domestic
money caused the fall in competitiveness.
But it
would continue to be a mistake to think that the
nominal exchange rate change caused the changes
in the real exchange rate and the volumes of exports
and imports: all are results of an underlying change
in households’ preferences for goods. l4

Figure 3

4.2

An Alternative SpeciJication of Money Demand

Suppose assumption A6, which specified that money
demands are given by (l), is replaced by
A9. The demands for domestic
money are given by
(1’) Mdlp, = f(Y)
xs

xs +A 2xS

2(xS +A)

X

volumes of exports and imports may be affected.
If the demand for domestic goods rises (and the
demand for foreign goods falls), then the rise in the
relative price of domestic goods raises domestic
wealth and reduces foreign wealth. This is illustrated
in Figure 4. Initially, all domestic households consume at point A. The budget line going through point
A is tangent to the indifference curve at that point.
Then tastes change, and all indifference curves get
steeper. In the new equilibrium, domestic households
consume at point D and foreign households consume
at point F. The volume of domestic exports falls and
the volume of domestic imports rises. The fall in

and

and foreign

M*dlpf

= f*(y).

This assumption states that real money demand
in each country (in terms of that country’s output
good) is a function of the country’s real income
measured in the country’s output good. A special
case of (1’) occurs if real money demands are
given by
(5)

Mdlp, = ax”

and

M*d/pJ = (boy”

so that money demand in each country is a function
of that country’s GDP (gross domestic product).
Then CY
and CY*can be thought of as the inverses
of the velocity of money in each country.
With assumption A9, equilibrium nominal prices’
and the equilibrium exchange rate are given by
(2’) pX = M”/f(xs) and p: = M*“/f*(y”),
and

Figure 4

To determine the effects of changes in supplies
or demands, we again invoke assumption A7 (rather
than A8). Replacing the money demand specification (1) with (1’) leaves the previous analyses of
changes in money demands or supplies unaffected.
The effects of changes in the demands for foreign
versus domestic goods are also exactly the same as
in the previous analyses. But the effects of changes
in the supplies of goods are now more complicated.
An increase in the supply of domestic goods has
two analytically separate effects. First, it raises ?r,

X
18

i4 It might be more realistic to replace assumption A8 by the assumption that people in each country tend to buy relatively more of their
own country’s goods. Except under very peculiar conditions, the analyses
in this article will continue to apply with few modifications. An exception is discussed in Section 6.7. Goodfriend (1979) addresses some
related issues associated with wealth redistributions.

ECONOMIC REVIEW, MARCH/APRIL 1987

as before. Given pXand pJ, (3) shows that this raises
e, that is, it depreciates the dollar. This can be
called the “relative price effect” of an increase in
domestic output. The magnitude of the relative price
effect (given the change in supply) is greater when
the demand for the good is more inelastic, i.e. when
the elasticity of substitution between foreign and
domestic goods is smaller (see footnote 1.5). This
occurs when the domestic and foreign goods are poor
substitutes for each other. Second, an increase in
domestic output raises the demand for money and,
as (2’) shows, reduces the dollar price of domestic
goods. Given the relative price n,, this reduces the
exchange rate e, that is, it appreciates the dollar. This
can be called the “money-demand effect” of an increase in domestic output.
The “relative price effect” and the “money demand
effect” push the nominal exchange rate in opposite
directions in response to an increase in domestic
output. Whether the exchange rate rises or falls
depends on the relative sizes of these effects. The
nominal exchange rate rises-as
before-if
and
only if the relative price effect dominates the money
demand effect, i.e. if and only if the inverse of the
elasticity of substitution
between foreign and
domestic goods is smaller than the income elasticity
of the demand for money.15 In the special case of
(S), the income elasticity of the demand for money
is one.
Let k denote the income elasticity of money demand. Then the money demand effect alone implies
that the exchange rate (and each domestic nominal
price) falls k percent for each one percent rise in outIs The income elasticity of money demand measures the degree to which
people want to hold more money when their income rises. The elasticity
of substitution between foreign and domestic goods measures the degree
to which people are willing to substitute one of the goods for the other.
The elasticity is larger as people are more willing to switch from one
good to another as one of them becomes more expensive. The income
elasticity of the demand for money is k = x’f ‘(x’)/f(x’), where f ’ is the
derivative of f. The elasticity of substitution is defined as minus the
elasticity of x/y with respect to the relative price of x, along an indifference curve. So the elasticity of substitution is defined as

Then, in response to a change in domestic output x, holding foreign
output y fixed, the elasticity of the real exchange rate with respect to
domestic output is
(xl~,)dn,/dx

= l/e,

and the elasticity of the nominal exchange rate with respect to domestic
output is
(x/e)de/dx

= (xlp)dp/dx

+ l/c,

because (2’) implies that dp’ldx
= -k. So
(x/e)de/dx

= (I/e) -k.

= 0. But (2’) also implies that (x/p)dpldx

put. If foreign and domestic goods are sufficiently
poor substitutes for each other, then the elasticity
of substitution between the two goods will be less
than l/k. Then its inverse is larger than k, so a one
percent rise in supply of the domestic good reduces
its relative price by more than k percent. This
effect alone raises the exchange rate by more than
k percent. Combining these two effects, the exchange
rate rises.
4.3 An Important Assumption The
models
described above have the essential feature that the
demand for money in each country is fixed in terms
of that country’s output, as in (l), (I’), or the special
case (5). Equation (5) implies that the nominal demand for money is proportional to nominal GDP.
If, instead, the nominal demand for money were proportional to the nominal value of consumption (with
the same factor of proportionality, (Yor a*), then the
demands for moneys would be

(5’) Md = cr(p,x” + ep,v)

and

M*d = a *(pXxs/e + p,f”).
In this case, a change in the demand for goodsholding fixed money supplies and (Yand (Y -would
alter 7rY before, but not the nominal exchange rate.
as
Equations (5’) imply that pXx” + ep,y and p,x”/e +
pYv = (p.& + ep,$+e are both unaffected by the
change in demand. Consequently, e is unaffected.
So the change in the relative price r,, occurs through
a change in pX and p:. For example, a shift in demand away from foreign goods and toward domestic
goods lowers 71; = ep,‘/p, by lowering p,’ and
raising pX (while the weighted average of the two,
pXx” + ep:y”, stays fixed). An increase in the
supply of the domestic good now leaves the exchange
rate unchanged. It raises -/r,, the real exchange rate.
But (5’) implies that p.& + ep,f” and e are unchanged, so pi rises and pXfalls, with e unchanged.
Evidently, a very important feature of the models
in previous sections is that the demands for money
in the two countries are appropriately expressed
in “real” terms in terms of different bundles of
goods. In other words, there are measures of “real”
money demands in each country that are invariant
to shifts in demand across goods or in supplies of
goods, and these invariant measures of real money
demands differ across countries. This issue seldom
arises in macroeconomic discussions of other issues,
but it is extremely important in the economics of exchange rates. The remainder of this article returns
to the assumption A9. It is not at all unrealistic that
money demands differ across countries in ways

FEDERAL RESERVE BANK OF RICHMOND

l

19

similar to the assumptions made in earlier sections,
such as (1’). Consumption bundles differ across countries particularly when allowance is made for nontraded goods and the nontraded components such
as retail services, local inventories, transportation,
etc., that are embedded in the retail prices of even
ostensibly “traded” consumer goods.
5.

Some Evidence on Actual Exchange Rates

At this point it is useful to view a plot of real
and nominal exchange rates and other prices, as in
Chart 1. The chart shows the nominal exchange rate
e, the real exchange rate n,, and the ratio of GNP
deflators p,Yp,, where p: is the foreign GNP deflator
and pX is the US GNP deflator. The chart graphs
quarterly data for Canada, Britain, and Germany
(versus the United States) from the early 1970s when
exchange rates were allowed to float. The qualitative
features of the plot apply also to other pairs of countries with flexible exchange rates.
Notice that the nominal exchange rate and the real
exchange rate move together fairly closely. Most
variations in exchange rates-at
least among countries with reasonably similar rates of inflation (e.g.
OECD countries in the recent past)-are associated
with roughly equal variations in the relative price of
foreign and domestic goods. This implies that the
main source of disturbances to exchange rates must
be something-like
the changes in supplies or
demands for goods discussed above-that change the
relative price, and not disturbances that affect only
nominal variables (like changes in money demand
or supply).
Of course,
much of macroeconomics is devoted to studying various possible
effects of changes in money supply or demand on
real variables such as output and relative prices. But
these effects of monetary policy on real variablesif they are important-are
temporary (or at least contain large temporary components). As we shall see,
most of the evidence indicates that changes in
nominal and real exchange rates are approximately
(statistically) permanent, which is difficult to explain
on the basis of temporary real effects of monetary
disturbances. Another feature of Chart 1 is that the
exchange rate varies much more than the ratio of
nominal GNP deflators. (This feature also holds for
other country pairs and time periods.) It is convenient to call this feature of the data the “excess
variability of exchange rates,” though this should not
be presumed to imply that this variability is bad in
any sense, or indicative of a problem with the operations of markets. It is simply a feature of the data
whose interpretation is yet to be determined. This
20

feature can easily be explained with the model from
Section 3 above, consisting of equations (Z), (3), and
(4). Variations in supplies or demands for goods-holding MS, M’“, 01, and cy* fixed-affect
r,, but not
pXor p,Y,so all changes in r,, occur through changes
in the exchange rate. But the modified model from
Section 4.2, consisting of equations (21, (3), and (4’)
can explain the excess variability of exchange rates
only under certain conditions. Shifts in demand between foreign and domestic goods change the exchange rate but not the ratio of nominal GDP
deflators, so these shifts in demand can explain the
excess variability of exchange rates without any additional assumptions. But shifts in supplies of good:s
only create excess variability in the exchange rate if
the elasticity of substitution between foreign and
domestic goods is smaller than the inverse of twice he
income el’asticity money demand. I6 A one percent rise
of
in domestic output lowers the domestic nominal GNP
deflator by k percent, where k is the income elasticity
of money demand. If the elasticity of substitution in
consumption is l/k, then a one percent increase in
domestic output reduces the new equilibrium relative
price of domestic goods by k percent. Since p* is
unchanged, the k percent fall in plep’ occurs
automatically by the k percent fall in p, without any
change in the exchange rate. This explains why the
‘direction of the exchange rate change depends upon
whether the elasticity of substitution is larger 01
smaller than l/k. Even if the elasticity is smaller than
l/k, in order to obtain a larger percentage change
in the exchange rate than in the ratio of GNF’
deflators, it is necessary that the relative price effect
not only be larger than the money demand effect (in
order to counteract it completely), but more than
double its size. So demand disturbances can clearly
explain the excess variability of exchange rates with
this model, but supply disturbances can do so only
if the elasticity of substitution between foreign and
domestic goods is particularly small.17
None of these results depend on whether assumption A7 or A8 is invoked. However, if both A7 and
A8 are violated, then supply or demand changes
affect the international distribution of wealth and alter
relative prices. In that case, the exact conditions
discussed here would have to be modified.
‘6 A rise in domestic output by one percent lowers p by k percent,
according to (21, where k is the income elasticity of money demand.
Footnote 15 implies that the percentage change in e exceeds k percent
if and only if (l/d-k
> k, which requires thar the elasticity of substitution is smaller than Yzk.
I7 See Obstfeld and Stockman (1985). Stockman and Dellas (1986)
discuss the issue in the context of a model that also includes nontraded
goods.

ECONOMIC REVIEW, MARCH/APRIL 1987

Chart 1

RATIO
Exchange

OF GNP DEFLATORS,.AND

EXCHANGE

CANADA

1970-1976

Rates

NOMINAL
Exchange

RATES

1976-1985

Rates

110
120 _

“OE

./

I

-------

e

70 -

,.‘b”/p
80

.C-.-.,
p*/p

I

1970

I

I

1

1972

I

1974

I
60 s
1976

1976

I
I
1978

I
1
1980

I
I
1982

I

I

1984

GERMANY
Exchange

1974-1980

Rates

Exchange

-

70

I980- 1985

Rates

60

30 -

30

1974

I

I

1976

I

I

1978

I

_

I

GREAT
Exchange

1974-1980

Rates

20r

1980

I
1980

I

I
1982

I

I
1984

BRITIAN
Exchange

Rates

1980-I 985

240 - --4
200 160 120 -.+
80 ='
1974

/#.C

_.eC--------*
.e.--I

I
1976

I

I

1978

I

1980

1980

FEDERAL RESERVE BANK OF RICHMOND

1982

1984

21

6.

The Exchange Rate and the
Balance of Trade

If the model described in Section 4.2 (or the one
from Section 3) is used to describe the world in each
of a series of time periods, then it is possible to
discuss the balance of trade, international capital
flows, the effects of government budget deficits, and
other related issues. This section discusses the operation of the model when nations are able to borrow
or lend, i.e. to have trade deficits or surpluses. It then
examines the relations between nominal and real exchange rates and the balance of trade in response to
various exogenous disturbances.
Suppose there are two time periods rather than
one. (The extension to more periods is straightforward.) The two-period intertemporal model can be
described by repeating the model from Section 4.2
at each time period. Make assumptions Al, AZ, A3,
and A4. At each date there are fixed supplies of the
domestic and foreign goods. The real exchange rate
7r,,is equal to (minus) the slope of the indifference
curve passing through point A in Figure 1, just as
before, at each date. Nominal prices and the exchange rate at each date are given by (2’) and (4’).
The equilibrium balance of trade, and the effects
of various exogenous disturbances, depends on how
the international distribution of wealth is affected by
exogenous disturbances. (This issue also arose in the
one-period models discussed in previous sections,
but trade was always balanced in those models.) If
a change in supply or in demand in the first period
raises domestic wealth more than foreign wealth, then
the domestic country will begin the second period
with greater wealth than the foreign country. Assumption A4 (which postulated equal initial wealth) will
not apply in the second period. If we make assumption A7 then both countries remain equally wealthy
at all times. This corresponds to the model in Lucas
(1982). On the other hand, if international trade in
financial assets is limited in some effective way, then
we may make assumption A8 and changes in supplies or demands may redistribute wealth, which corresponds to the model in Stockman (1980).
We adopt assumption A8 for the remainder of this
section.‘* Then the relative price of the two goods
is always the slope of the indifference curve passing
through point A, but one country may consume more
of both goods than the other, because (even if the

I8 Assumption Al implies that households discount future utility at the
same rate. The results in this section also assume additively separable
utility in first- and second-period
consumption with a time-invariant
instantaneous utility function.

22

countries begin with equal wealth) an exogenous:
disturbance may affect domestic and foreign wealth1
differently.
We now consider a series of exogenous disturbances, and in each case examine the effects on the
real exchange rate, the nominal exchange rate, the
balance of trade, and related variables.
6. I

A Permanent Increase in Domestic Pductivity

If domestic output rises equally in both the first and
second periods, then the relative price of the
domestic good falls in both periods. The nominal exchange rate rises, i.e. the dollar depreciates, if the
relative price effect dominates the money demand
effect, as discussed in Section 4.2. Foreign wealth
rises (as discussed in Section 4.1) because foreign
households can import domestic goods at a lower
relative price. Domestic wealth rises unless the fall
in the relative price of the domestic good is very
large. The case in which domestic wealth rises is
illustrated in Figure 3, which describes both time
periods (since they are the same). Whatever happens
to the distribution of wealth and relative consumption levels, international trade is balanced. l9
6.2

A Temporay Increase in Domestic Pr-oductk&y

Suppose domestic output rises exogenously in the
first period only. Then its relative price falls in the
first period. Whether the nominal exchange rate rises
or falls depends-as
discussed in Section 4.2-on
whether foreign and domestic goods are good or poor
substitutes in consumption
and on the income
elasticity of the demand for money. If the goods
are poor substitutes and/or the income elasticity of
the demand for money is low, then the relative price
effect of the change in output on the exchange rate
dominates the money demand effect. Then the exchange rate rises (the dollar depreciates). Whether
the domestic country has a balance of trade surplus
or deficit in the first period also depends on the
degree of substitutability of domestic and foreign
goods. Suppose the goods are sufficiently good
substitutes that a one percent increase in domestic
output reduces its relative price by less than one percent as in Figure 3 (the elasticity of substitution is
greater than one). Then the domestic country will
have a balance of trade surplus in the first period,
and the foreign country will have a deficit. The
domestic trade surplus results because the temporary
increase in domestic output raises domestic income

I9 The balanced-trade result is not robust to slight changes in the assumptions about tastes, but there is little theoretical presumption that the
domestic country should have either a surplus or a deficit.

ECONOMIC REVIEW, MARCH/APRIL 1987

more than proportionally to foreign income. The firstperiod budget lines of both countries rotate as in
Figure 3 because of the relative price change. The
budget line of the domestic country rotates through
point G in Figure 3 because the domestic people own
the firms producing the domestic good. The foreign
budget line rotates through point E, so the domestic
budget line lies above the foreign budget line: the
domestic country has greater income at date one. If
it were not possible to borrow or lend, then the
domestic country would consume at point D and the
foreign country would consume at point F in Figure
3. In the second period, with output back to point
A, both countries would consume at point A.
But it is possible to borrow and lend, i.e. it is possible to have a trade deficit or surplus. Both countries
would like to save some income from period one for
consumption in period two. But it is impossible for
the world to save in this way because the goods are
perishable. The domestic country sees a larger drop
in its income and consumption from the first period
to the second than does the foreign country. So there
is a mutually advantageous trade: the domestic country will have a balance of trade surplus (lend to the
foreign country) and the foreign country will have
a trade deficit (and borrow). The equilibrium is shown
in Figure 5. In the first period, the budget line of
the domestic country shifts in while the budget line
of the foreign country
shifts out. Domestic
households consume H in the first period while

foreign households consume I. In the second period,
this is reversed: the home country has a trade deficit
(paid for by principal and interest received as
foreigners pay off the loan) and the foreign country
a trade surplus. Second-period domestic consumption is at point J while second-period foreign consumption is at point K.
If foreign and domestic goods are sufficiently poor
substitutes that a one percent rise in domestic output reduces its relative price by more than one percent (the elasticity of substitution is less than one)
then the situation described above is reversed:
domestic income is lower than foreign income in the
first period. This situation is illustrated in Figure 6.
In the absence of borrowing and lending opportunities, domestic consumption would be at point D
and foreign consumption would be at point F. With
the opportunity to borrow or lend, the foreign country
will have a trade surplus and the domestic country
will have a trade deficit in the first period. Domestic
households will consume at point H in the first period
and foreign households will consume at point 1. In
the second period, domestic consumption is at point
J and foreign consumption at point K.
Summing up: a temporary increase in domestic
output

causes,

temporarily,

real exchange

preciation (a fall in the relative
goods), and nominal exchange
the relative price effect dominates
effect. This rise in the nominal

Figure 5a

Y

Figure 5b

Time PeriodOne

rate de-

price of domestic
rate depreciation if
the money demand
exchange rate can

Time PeriodTwo
Y

\

FEDERAL RESERVE BANK OF RICHMOND

23

Figure 6b

Figure 6a

Time PeriodTwo

Time PeriodOne
Y

X

be accompanied by either a trade surplus or a trade
deficit. Trade deficits and exchange rate depreciation do not necessarily go together.
6.3

A Temporq

Increase in Demand for Domestic

G&M& Suppose the demand for domestic goods rises
in the first period because of a temporary change in
tastes. (A change in government spending-another
reason for a change in demand-could
be modeled
as a change in supply.) Indifference curves in the first
period shift so that they are steeper than before at
every point. Figure 7 illustrates the equilibrium after
the shift in indifference curves. Without the shift,
equilibrium consumption for each country would have
been at point A. Point A still shows the per capita
supplies of goods, but the increase in the relative price
of domestic goods-due
to the increase in demandraises domestic income and reduces foreign income.
The domestic country’s budget line rotates through
point C and the foreign country’s budget line rotates
through point E. If borrowing and lending were not
possible, the domestic households would consume
at point D while foreign households would consume
at point F.
But borrowing and lending is possible. The
domestic country has temporarily high income and
would like to save some of it; the foreign country
has temporarily low consumption and would like to
borrow. So the domestic country has a trade surplus
and the foreign country has a trade deficit. In the
24

first period, the domestic country consumes at point
H while the foreign country consumes at point I. In
the second period, the domestic country consumes
at point J and the foreign country at point K. The
temporary trade surplus in the domestic country is
associated with real and nominai appreciation, i.e.
the relative price of the domestic good rises and the
nominal exchange
rate falls (domestic
money
appreciates).
If there had been a temporary fall (rather than rise)
in demand for the domestic good, this would have
created a temporary real and nominal depreciation
and a (temporary) trade deficit. In this case, depreciation and trade deficits go together, and as time passes
the domestic currency appreciates while the deficit
is eliminated. Despite this relation between currency depreciation and the trade deficit, it would be
incorrect to say that the depreciation caused the
deficit (or vice versa). Both were results of the
underlying change in demand for goods. It would also
be impossible for government policy to reduce the
trade deficit by monetary policies or similar attempts
to stabilize the nominal exchange rate.
6.4 An Ekpected Future Increase in Demand for
Domestic Goods Suppose the increase in demand for

domestic goods-discussed
in Section 6.3-occurs
in the second period rather than the first. Suppose
it was also expected (in the first period) to occur.
Figure 7 will again illustrate the equilibrium a&/z an

ECONOMIC REVIEW, MARCH/APRIL 1987

Figure

7a

Figure 7b

Time PeriodTwo

Time PeriodOne

X

impotiant mod&ation: the panel labeled “period one”
in Figure 5 will apply to period two, while the panel
labeled “period two” will apply to period one. In the
first period there is no exogenous change in demand
or supply. But the expectation of a future increase
in demand for the domestic good raises expected
future domestic income. Similarly, the change in demand lowers expected future foreign income. The
domestic country will want to borrow in the first
period while the foreign country will want to lend.
That is, the domestic country will have a trade
deficit in the first period (and consume at point J)
and the foreign country will have a trade surplus (and
consume at point K). But relative prices and the
nominal exchange rate will be unaffected by expectations of the future. In the second period, domestic
real and nominal appreciation will accompany a
domestic trade surplus. Second period domestic
(foreign) consumption is at point H (point I) in
Figure 7.
If the model were modified in some realistic ways,
the real and nominal exchange rates would change
in the first period. The expectation of an increase
in the relative price of the domestic good in the future
would tend to increase its price now (e.g. if it can
be stored over time, or if households can substitute
consumption of the domestic good now-while it is
still cheaper-for consumption of the good later when
it costs more). This increase in the relative price
of the domestic good would occur partly through a

fall in the nominal exchange rate in the first period
(just as if the original change in demand had occurred in the first period). With this modification of the
model, the first-period trade deficit would be
associated with real and nominal appreciation. The
size of the first-period appreciation would depend on
the degree to which suppliers and demanders can
substitute goods over time.
A second modification would reinforce the nominal
(though not the real) appreciation associated with the
first-period trade deficit. An expected fall in the future
nominal exchange rate (dollar appreciation) makes
dollars less costly to hold now. If the demand for
money were sensitive to its holding cost (the nominal
interest rate), then the first-period real demand for
dollars would rise by an amount that depends on the
interest-elasticity
of money demand. This would
reduce the nominal exchange rate (and all nominal
prices) in the first period, and reinforce the nominal
appreciation associated with the trade surplus. Comparing the results in Sections 6.2, 6.3, and 6.4, it
is clear that a trade deficit can be associated with
either real and nominal depreciation or real and
nominal appreciation, depending on the original
disturbance (and, in some cases, on the magnitudes
of certain parameters).
6.5 An Increase in Demand by the Domes&- Country Onl’y In the examples of changes in demand

discussed above, households in both countries change

FEDERAL RESERVE BANK OF RICHMOND

2.5

their tastes. Suppose, instead, that only the domestic
household increases its demand for the domestic
good, due to a temporary change in tastes in the first
period. As in the case of a worldwide change in tastes
(Section 6.3), the relative price of the domestic good
rises in the first period. This occurs through a fall
in the nominal exchange rate. So the domestic country experiences real and nominal appreciation in the
first period. But, in contrast to the results of Section
6.3, the domestic country can experience either a
trade deficit or a trade surplus. Whether the real and
nominal appreciation is accompanied by a surplus or
deficit depends on which of two effects dominates.
On the one hand, the rise in the relative price of
domestic exports in the first period creates a temporary increase in domestic real income and a temporary decrease in foreign real income (as in Figure
7). As in Section 6.3, this tends to create a domestic
trade surplus in the first period. But there is now
another force that may tend to create a trade deficit.
If the change in tastes by domestic households
represents an increased demand for domestic goods
in the first period at the expense of a/L other goods,
including foreign goods in the first period and both
goods in the second period, then domestic demand
for both goods in the second period falls. The
decrease in demand for second-period goods tends
to create a domestic trade deficit in the first period.
As a result, the domestic country can have either a
trade deficit or surplus to accompany its real and
nominal appreciation.20
6.6 A Domestic Government Budget Deficit Suppose the government of the domestic country cuts
nondistorting (lump sum) taxes in the first period
without changing government spending in either
period, (i.e. the government
makes lump sum
transfers to domestic households, financed by borrowing). The government raises nondistorting taxes
in the second period to pay off principal and interest
on the debt. The “Ricardian-equivalence proposition”
(Barro, 1981) states that under certain conditions the
deficit will not affect interest rates or consumption.21
Under those conditions, people save the entire tax
cut, buy the bonds issued by the government, and
use the interest on the bonds to pay the higher future
taxes. Among the conditions for Ricardian equiva-

2o A borderline case occurs with time-separable Cobb-Douglas utility
(an elasticity of substitution equal to one), in which case trade is balanced
each period.
*I Roughly, those conditions
ning horizon for households,
taxes.

26

are: perfect capital markets, a long planrational expectations, and nondistorting

lence in this model are that households fully anticipate
the higher second-period taxes, and view those taxes
as a liability with present value equal to the current
tax cut. In that case, households do not gain wealth
from the tax cut because liabilities rise as much as
current taxes fall. Under the conditions for Ricardian
equivalence, an increase in the government budget
deficit has no effect on the real or nominal exchange
rate or on the trade balance.
A more interesting case arises when the conditions
for Ricardian equivalence are violated. To simplify
matters, assume that households are shortsighted:
in the first period they entirely ignore the higher taxes
that will be imposed in the second period. Assume
that households ignore the future taxes because they
fail to understand that the government must raise
future taxes to pay the additional interest (and principal, in this model) generated by the debt issued
in the first period. Then the deficit makes domestic
households feel wealthier, because they get the current tax cut but ignore the higher future taxes.
Under these assumptions, domestic households
will spend part of the tax cut and save the rest for
future spending. In the new equilibrium, both foreign
and domestic households buy the debt issued by the
domestic government. Because money supplies and
money demands are unchanged, p and p* are unaffected by the deficit. 22The interest rate rises because
the increase in the quantity of loans demanded by
the government exceeds the increase in the quantity of loans supplied by domestic households who
save part of the tax cut. That is, the increase in demand for goods in the first period raises the relative
price of first-period goods in terms of second-period
goods. This relative price is just the real interest rate
(plus one). So the higher government budget deficit
raises the real interest rate. In addition, the budget
deficit causes a trade deficit, because domestic
households use the tax cut to buy more imports and
to buy more domestic goods (that would otherwise
have been exported).
But the budget deficit does not cause a change in
either the real or nominal exchange rate, under
assumption AS. Domestic households raise demands
for both goods in the first period in such a way that
their relative price is unaffected. Because p and p*
are also unaffected, so is the nornina exchange rate.
aa If the demand for money depended on the nominal interest rate, then
the increase in the interest rate would reduce money demand in both
countries, as world interest rates rise. Then p and p’ would both fall.
If they fell by the same percentage,
then the implications for the
exchange rate would be the same as if p and p’ were both fixed.

ECONOMIC REVIEW, MARCH/APRIL 1987

The equilibrium is illustrated in Figure 8. The tax
cut makes domestic households feel wealthier and
raises domestic demand for goods to point B. Then
world demand for first-period
goods exceeds
supply. The real interest rate rises to induce increased
saving (lower demand for first-period goods). As all
households reduce demand for goods in the first
period, an equilibrium is reached at which domestic
households (who feel wealthier than foreign households) consume at point D and foreign households
consume at point F. The domestic country is borrowing to consume more than point A in the first
period. When the domestic country repays the foreign
country in period two, domestic consumption is at
point J and foreign consumption is at point K.
The real and nominal exchange rates could change
if domestic and foreign preferences
differed. If
domestic households had a preference for domestic
goods (and vice versa), then the relative price of the
domestic good would rise in the first period. Given
P and P*, this rise in plep’ would occur through a
fall in e. So if households in each country have a
relative preference for their own country’s good,
then an increase in the domestic government’s budget
deficit would raise interest rates, cause a domestic trade deficit, and lead to real and nominal
appreciation.z3
23 Note that this result has nothing to do with the issue of whether foreign
and domestic assets are good (or perfect) substitutes or not, or with the
effect of a budget deficit on relatiwe interest rates across countries.

6. 7 A Shzj? in Desired Asset Holding It is frequently stated that a change in the preferences of
investors to hold interest-bearing assets denominated
in dollars or pounds affects the exchange rate. If these
assets are not perfect substitutes, it is reasonable to
assume that households’ demand for each type of
asset rises with its own rate of returns and falls with
the rate of return on the other type of asset.
Begin with an initial equilibrium in which interest
rates in the two countries are the same. Then suppose that foreign households change their preferences
for assets in the first period: they wish to hold more
assets
denominated
in pounds
and fewer
denominated in dollars. As foreigners attempt to buy
pound-denominated
assets
and sell dollardenominated assets, the relative price of these assets
changes. In the new equilibrium, the interest rate on
dollar-denominated assets is higher and the interest
rate on pound-denominated
assets is lower. These
interest rates must change until people are willing
to hold the existing asset supplies. Because this shift
in preferences for assets does not increase or decrease
the demands for either good or for either money,
the
real and nominal exchange rates are left unchanged.24
If foreign and domestic assets are imperfect
substitutes then the effect of a budget deficit differs
24 If money demands depend on interest rates then nominal prices p
and p’, and the nominal exchange rate, e, may be affected by the change
in asset demands. But-as long as demands for or supplies of goods are
unaffected-the
real exchange rate is unaffected.

Figure 8b

Figure 8a

Time PeriodTwo

Time PeriodOne

FEDERAL RESERVE BANK OF RICHMOND

27

slightly from the analysis in Section 6.6. The
domestic government is assumed to issue dollardenominated debt when it has a budget deficit. This
increase in the supply of dollar assets lowers the
relative price of those assets in terms of other assets,
i.e. the domestic interest rate rises relative to the
foreign interest rate. In this case, a domestic government budget deficit raises the interest differential
between dollar- and pound-denominated
assets (and,
as before, causes a trade deficit). However, under
,assumption A8 the real and nominal exchange rates
remain unaffected. It is only if tastes differ across
countries, with households in each country having
a relative preference for their own country’s goods,
that the domestic country experiences
real and
nominal appreciation.
7.

Additional

Evidence

and Issues

The typical behavior of real and nominal exchange
rates was graphed in Chart 1. Statistical evidence
indicates that changes in nominal exchange rates and
real exchange rates tend not to be followed quickly
by other changes that either reinforce or reverse the
original change. The evidence shows the changes
in real and nominal exchange rates are either
statistically permanent (in the sense that, on average,
they are not reversed or reinforced), or highly persistent in the sense that the exchange rate takes a
long time to begin returning toward its original
level.z5 Huizinga (1987) finds evidence that the real
exchange rate begins to reverse its previous changes
only after four to seven years. His evidence
covers a period of only twelve, years; studies over
longer time periods sometimes find even larger
amounts of persistence,
and the uncertainty in
statistical estimation is large enough that, with a few
exceptions, the evidence is consistent with completely permanent changes in the real exchange rate.
The evidence similarly indicates that changes in the
nominal exchange rate are either permanent or highly
persistent. As argued in footnote 3, this degree of
persistence appears to be too large to explain on the
basis of disequilibrium models that postulate sticky
nominal prices. Many macroeconomists believe that
sticky nominal prices play a major role in business
cycles (though there are clearly controversies about
this). The length of time over which the economy
recovers from recessions would provide a rough
estimate of the time it takes the overall price level
*s Papers that have documented these facts include (among many others)
Roll (1979), Adler and Lehmann (1983), Meese and Rogoff (1983a,
b, and 1985), Wasserfallen and Zimmerman (19854, Hsieh (1985),
Hakkio (1986), and Huizinga (1987).

28

to adjust to its new equilibrium following a disturbance. This estimate would suggest a period of two
to three years. In fact, because there are many
reasons for business cycles to persist once they have
begun, two to three years is probably an upper bound.
Disequilibrium theories of exchange rates, based on
sticky nominal goods prices, predict that real and
nominal exchange rates should return toward thei.r
equilibrium levels when nominal goods prices do.
This means that they predict systematic changes in
real and nominal exchange rates that are not found
in the data. The equilibrium theory of exchange rates,
on the other hand, is consistent with this evidence
if the underlying disturbances to the economy are
permanent or highly persistent.
Evidence from the forward exchange market also
suggests that changes in exchange rates are expected
to be roughly permanent, or highly persistent. Many
foreign currencies are traded like commodities on
organized futures markets and on forward markets.
The futures prices and forward exchange rates move
roughly the same amount as spot exchange rates do.
While the forward exchange rate may contain a risk
premium and so deviate from the market’s expectation of the future nominal exchange rate, that
premium is unlikely to move systematically so as to
mask any expected changes in exchange rates. So
available data indicate that people expect changes
in exchange rates to be highly persistent rather than
temporary as the disequilibrium theories imply. This
finding of persistence
is inconsistent
with the
disequilibrium models of exchange rates, but is
consistent with equilibrium models that incorporate
permanent (or highly persistent) real disturbances.
A recent study by Campbell and Clarida (1987) also
shows that there is little evidence of any relation
between exchange rate changes and real interest rate
differentials across countries of the kind that many
disequilibrium models predict. Finally, there is only
a little evidence to support the contention that
government budget deficits per se cause exchange
rate changes of the kind predicted by the disequilibrium models or the equilibrium model of Section
6.6, though there is some evidence that variables such
as government purchases affect exchange rates as the
equilibrium models might suggest (Evans, 1986).a6
Major questions remain unanswered by current
research. Attempts to explain exchange rates empirically using economic “fundamentals,” i.e. variables
predicted by a theory to have important effects, have
a6 Feldstein (1986) argues that budget deficits affect exchange rates.
See also Stockman’s comments (1986). Evans (1986) presents evidence
that government spending rather than deficits affects exchange rates.

ECONOMIC REVIEW. MARCH/APRIL 1987

generally performed poorly (see, e.g. Meese and
Rogoff, 1983a). But the equilibrium approach to exchange rates suggests that the trade balance, output,
and other “fundamental” economic variables are not
systematically related to the exchange rate in any particular direction, as explained in Section 6. Whether
a trade deficit, or increase in domestic output, is
associated with depreciation or appreciation depends,
according to the theory, on the underlying disturbance. But if real disturbances cause changes in
nominal and real exchange rates, then what are these
disturbances? Can we identify specific examples of
underlying changes in technology, tastes, etc. that
cause exchange rate changes? While similar questions
also remain unanswered
for other economic
phenomena
such as changes in stock prices or
business cycle phenomena, further attempts to identify the important exogenous disturbances seems
essential.
Another unresolved question involves the explanation for a different fact: the variability of real exchange
rates has been much greater when a country adopts
a policy of floating nominal exchange rates than when
it pegs (fixes) its nominal exchange rate (as under
the old Bretton-Woods
system that preceded
widespread floating beginning in the 1970s). While
the explanation is straightforward from the viewpoint
of the disequilibrium models, any explanation consistent with an equilibrium model must be more
subtle. Indeed, this evidence is sometime cited in
support of the disequilibrium models and as contradicting the equilibrium models (e.g. by Mussa,
1987). There are many conditions-not
all very
realistic-that
the economy must meet for the
nominal exchange rate system to be totally irrelevant
for real exchange rates .z7 One condition requires that
all other government policies, including tariffs and
quotes on international trade, restrictions on international financial markets, and fiscal policies, are the
same under both exchange rate systems. If they are
not, then the behavior of real exchange rates may
differ under the two systems even if the equilibrium
models are right. These
issues are currently
unresolved.
8.

Policy Implications

Clearly the equilibrium theory of. exchange rates
has radically different policy implications than do
disequilibrium theories .28 First, the government
cannot affect the real exchange rate simply by
changing the nominal exchange rate, e.g. with policies
such as foreign exchange market intervention, target
a7 Stockman

(1983) discusses

these conditions.

zones, etc. Policies like “talking down (or up) the
dollar” may affect the nominal exchange rate because
they signal a willingness to pursue policies that
affect it; they affect the e&exchange rate only if they
signal a willingness to pursue policies that affect it.
Unfortunately, those policies generally include protectionist measures that reduce overall economic
welfare.
Second, the equilibrium models imply that changes
in the exchange rate do not “cause” or “reduce” inflation. Clearly, the exchange rate is an endogenous
variable. Moreover, if most changes in exchange rates
among countries with similar inflation rates are due
to real disturbances to supplies of goods or demands
for goods, then changes in the exchange rate may
not even be particularly good signals of inflation.
Exchange rate changes would not be particularly
helpful in formulating monetary policies designed to
maintain price stability or low inflation.
Third, the choice of fixed versus flexible exchange
rates is, by itself, not important for real exchange
rates, the trade balance, etc. The choice of an exchange rate system can then be made on the basis
of whether one system provides more discipline to
policymakers, or whether one would force a country to maintain a higher (or lower) inflation rate than
it would like. Similarly, foreign exchange market intervention, “target zones” for exchange rates, and
similar policy proposals should be judged on two main
criteria: (i) how they would affect inflation, and (ii)
how they would affect government incentives to pursue other policies.
Fourth, and perhaps most important, the government should not invoke protectionist restrictions on
trade in goods or financial assets as a response to
changes in exchange rates. “Undervalued” or “overvalued” currencies are not the issue; exchange rates
are only reflections of underlying market conditions
and government policies. Variability of exchange rates
is no more inherently undesirable than variability
in a person’s mood throughout a day, and both reflect
underlying conditions and policies. The main contribution of the equilibrium theory of exchange rates
is to suggest an explanation for exchange rate
behavior that is consistent with the notion that
markets work reasonably well if they are permitted
to. If so, the theory can help us avoid the substitution of folly for wiser policies.
*s Most of the research in this area has concentrated attention on positive
economics rather than on policy. Additional papers that have used
equilibrium models or ideas from them include Helpman (1981).
Helpman and Razin (1982, 1984). Hsieh (1982), Sachs (1983),
Stockman (1985), Stockman and Hernandez (1987), Stockman and
Svensson (1987) Stub (1986). and Svensson (1985). Other discussions
of these ideas can be found in Krueger (1983) and Obstfeld and Stockman
(1985); a related discussion appears in Friedman (1953).

FEDERAL RESERVE DANK OF RICHMOND

29

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Meese, Richard, and Kenneth Rogoff. “Empirical Exchange Rate
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Barre, Robert. “Public Debt and Taxes.” In Money, @ecrations,
Businesc CycIes. New York: Academic Press, 1981.

-.

and

Campbell, John, and Richard Clarida. “The Dollar and Real Jnterest
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Dornbusch,
Rudiger. “Expectations and Exchange Rate Dynamics.”
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&onomy 84 (December 1976): 1161-74.
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and P. Kenen. Amsterdam: North-Holland,
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Marvin. “Exchange Rate Policy and the Dual Role of
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“The Roles of Savings and Investment in Exchange Rate
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Hsieb, David. “The Determination
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Exchange

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of Real Exchange Rates.” Carnegie-Rochester
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“Was It Real? The Exchange Rate-Interest
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Rates and Actual Pokes. Carnegie-Rochester
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Meltzer. Amsterdam: North-Holland,
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30

ECONOMIC REVIEW, MARCH/APRIL 1987

IPC OR TOTAL DEPOSITS?
THERE IS A DIFFERENCE!
Donald L

“This probably sounds like a basic question,
but. . . .” Some variation of this introduction often
is a prelude to a discussion of how to report bank
concentration for bank merger or bank holding company application purposes. Other than applications
to form one-bank holding companies, most applications to acquire banks or bank holding companies
require information on market concentration. The
prospective applicant usually knows about such things
as market tables and Herfindahl-Hirschman
Indices.
The question is, should the market table be constructed from total deposits or IPC deposits?
Tactful attempts to explain that the Federal
Reserve System prefers total deposits for purposes
of competitive analysis tend to provoke the objection that “other agencies” emphasize IPC deposits.
The caller is referring, of course, to the U. S. Department of Justice, the Office of the Comptroller
of the Currency (OCC)’ and the Federal Deposit Insurance Corporation (FDIC).
This article attempts to clarify the distinction between IPC deposits and total deposits. Then it will
show the effect of using the alternative deposit definitions to measure concentration
in selected Fifth
District banking markets. The expanding role of thrift
institutions as competitors of banks also will be
discussed.
Deposits of Individuals, Partnerships
Corporations (IPC Deposits)

and

Normally the largest subset of a bank’s deposits,
this IPC category represents exactly what the name
signifies. Most of the locally limited customers who
provide a basis for the concept of a banking market
are included here, although a large percentage of IPC
deposits may be held by customers with access to
national markets.
Josephine

0. Hawkins

provided

expert research

Weiker

The most commonly used source of deposit information for specific banking markets is the Summary of Deposit data published annually by the
FDIC. (This information is included in a publication
entitled Data Book-Operating Banks and Branches.)
One computes total IPC deposits for each institution by combining the two classifications of IPC
Transaction
Accounts and IPC Nontransaction
Accounts for each geographic location.
Total Deposits
In addition to IPC deposits, total deposits encompass a variety of bank creditors who may not be
effectively restricted to the local banking market. An
important group of depositors, duly reported in the
Summary of Deposits, are those holding “public
funds” including federal, state and municipal governments. The deposits of these public bodies are often
characterized as “political” deposits.
A reason for excluding governmental units from
local banking markets is that they may have access
to a national funds market. In practice, however,
numerous state and local laws limit political deposits
to the taxing jurisdiction and thus to specific banking markets. By contrast, large corporations often
have far greater access to national markets through
use of cash management services.
Other non-IPC categories not listed separately in
the Summary of Deposits include deposits of foreign
governments, commercial bank deposits, and certified and offrcers checks. Bank deposits are the major
item in this group. While banks occasionally maintain correspondent relationships with competitors,
self-interest determines that most accounts will be
maintained with correspondent banks located outside the respondents’ markets.
Basis for Determining

Market Structure

As mentioned in the introduction, the Fed traditionally favors total deposits2 when evaluating

assistance.

1 Since 1985, the OCC has incorporated a “Quick Check Merger Screen”
in its application process which defers to Federal Reserve market
definitions. IPC deposit information must be included, however, as a
part of all applications which fail to pass the initial screen for material
competitive issues.

2 A study prepared at the Board in 1965 based on data from the Distribution of Bank Deposits by Counties and Standard Metropolitan Areas
for 1956 and 1960 concluded that concentration ratios computed from
IPC deposits produced “. .essentially the same results” as concentration ratios derived from total deposits [Flechsig, 19651.

FEDERAL RESERVE BANK OF RICHMOND

31

Results in the Fifth District’s
Top Ten Markets

structural relationships whereas the Department of
Justice and other bank regulatory agencies prefer to
use IPC deposits. This distinction may be more
apparent than real in terms of practical results. As
an example, the following section will show that in
the top ten markets in the Fifth District concentrated
markets remain concentrated whether classified by
total deposits or IPC deposits. Unconcentrated
markets on the basis of total deposits do not become
concentrated when limited to IPC deposits.
The trend to include all or a portion of the deposits
held by thrift institutions in banking markets,
however, has the potential to modify some relationships as thrifts evolve toward becoming full competitors of banks. Correspondent banking currently
is not a routine function of thrift institutions. Nor have
thrifts developed the capital structures which would
facilitate the ability to compete aggressively for public
funds despite the removal of some legal barriers to
such deposits in recent years. In fact, the Federal
Home Loan Bank Board (FHLBB) does not even
report IPC deposits for savings and loan associations.
Any market table constructed from publicly available
data must perforce focus on total deposits at thrifts.

Table

Non-IPC deposits are a comparatively small but
material part of large banking markets in this District.
Within a narrowly defined product definition limited
to commercial banks, non-IPC deposits range from
a low of 4.3 percent
in the unconcentrated
Washington, D. C., market to a high of 15.0 percent in the concentrated Richmond, Virginia, area
with a weighted average for the ten markets of 7.7
percent (Table 1).
Recalling that thrifts report only total deposits, it
follows that expansion of the product market to include thrifts would tend to reduce the relative
significance of non-IPC deposits. Non-IPCs as a percent of aggregate bank and thrift deposits in the top
ten markets range from 2.4 to 11 .O percent with a
mean of 4.7 percent. Washington again has the
smallest proportion with only 2.4 percent, but the
greatest percentage of non-IPCs is now identified with
the Winston-Salem, North Carolina, market at 11 .O
percent (Table 2).

1

TOP TEN BANKING MARKETS
FIFTH DISTRICT
June 30, 1985
(Dollar amounts in thousands)

Total Bank
Deposits

Total Bank
IPC Deposits

Non-IPC
Deposits
as a
Percent of
Total
Deposits

$22,172,280

$21,210,219

4.34

11,547,840

10,608,132

8.14

5,266,793

4,811,986

8.64

5,067,217

4,304,988

15.04

3,682,253

3,379,413

8.22

2,596,404

2,214,065

14.73

North Carolina

2,202,738

2,026,739

7.99

Columbia,

South Carolina

1,930,330

1,685,142

12.70

Charleston,

West Virginia

1,880,521

1,764,152

6.19

Greenville,

South Carolina

1,429,134

1,333,277

6.71

$53,338,113

7.68

Washington,
Baltimore,
Charlotte,
Richmond,

D.C.
Maryland
North Carolina
Virginia

Norfolk-Portsmouth,
Winston-Salem,
Raleigh,

Total

32

Virginia
North Carolina

$57,775,510

ECONOMIC REVIEW, MARCH/APRIL 1987

Table 2

TOP TEN BANKING MARKETS
FIFTH DISTRICT
June 30, 1985
(Dollar amounts in thousands)

Total
IPC Deposits

Non-IPC
Deposits
as a
Percent of
Total
Deposits

$38,985,147

2.41

19,536,585

18,596,877

4.81

6,817,605

6,362,798

6.67

7,529,874

6,767,645

10.12

6,349,866

6,047,026

4.77

3,476,383

3,094,044

11.00

BANKS AND THRIFTS
Total
Deposits

Washington,
Baltimore,

D.C.

$39,947,208

Maryland

Charlotte,

North Carolina

Richmond,

Virginia

Norfolk-Portsmouth,
Winston-Salem,

Virginia
North Carolina

2,986,878

2,810,879

5.89

Columbia,

South Carolina

3,142,144

2,896,956

7.80

Charleston,

West Virginia

2,241,979

2,125,610

5.19

Greenville,

South Carolina

2,841,265

2,745,408

3.37

$90,432,390

4.68

Raleigh,

Total

North Carolina

$94,869,787

The market tables confirm that alignment of
market structure often is not affected by the use of
IPC deposits as an alternative to total deposits. But
there are exceptions. For example, consider the Richmond, Virginia, market when all thrift deposits are
included (Table 3). Here the four largest institutions
are commercial banks. Now refer to Table 4 where
the Richmond bank/thrift market structure is determined by total IPC deposits. Under this alternative,
the first and second ranked banks in the area have
swapped places and the four largest depository institutions now include a savings and loan association.
One usually constructs market tables for the purpose of measuring concentration in terms of deposit
concentration ratios and the Herfindahl-Hirschman
Index (HHI). The HHI may be defined simply as
the sum of the squares of the respective market
shares of all participants in the market. For example, to determine the contribution to the HHI by a
bank with 12 percent of the deposits in a given
market, simply multiply .12 times .12 times 10,000
which equals 144. Then add the comparable data
computed for all other banks in the market to
obtain the HHI. (See Tables 3 and 4 for practical

illustrations of the technique.) Following the U. S.
Department of Justice’s publication in 1982 of its
Merger Guidelines based on the HHI, this statistic
has become a widely accepted measure of concentration. Justice’s guidelines for bank acquisition permit an increase of 200 in a concentrated market’s
HHI which is equivalent to combining two banks
with respective market shares of 10.0 percent.
As depicted in Table 5, calculation of the HHI on
the basis of IPC deposits will reduce the indicated
levels of concentration for the first nine markets in
the District by amounts ranging from just one for
Baltimore, Maryland, to 498 for the Winston-Salem,
North Carolina, market. Note, however, that the
HHI for the Greenville, South Carolina, market
actually registered an increase of 44. By contrast,
the ten-market average change in the HHI was a
decrease of 78. This means that, on the average, two
banks with respective market shares of 6.24 percent
could merge in the composite market measured by
IPC deposits without exceeding the HHI for the
market based on total deposits.
Adding thrift deposits to the markets reduces
absolute levels of concentration,
but deletion of

FEDERAL RESERVE BANK OF RICHMOND

33

Table 3

RICHMOND,

VA, RMA BANK/THRIFT

MARKET

June 30, 1985
(Dollar

Rank

amounts

in thousands)

Total
Deposits

Bank

Virginia

Bank

$1,372,240

HerfindahlHirschman
Index

Cumulative
HerfindahlHirschman
Index

18.22

332.11

332.11

Percent
of Total
Deposits
in Market

1

United

2

Bank of Virginia

1,216,014

16.15

260.80

592.9 1

3

Sovran Bank,

1,142,387

15.17

230.17

823.08

4

Central

Fidelity

5

Heritage

6

Investors

7

Virginia

8

Dominion

9

Franklin

NA

529,363

7.03

49.42

872.50

S&LA

525,600

6.98

48.72

921.23

S&LA

355,135

4.72

22.24

943.47

FS&LA

346,580

4.60

21.19

964.66

296,630

3.94

15.52

980.17

277,946

3.69

13.63

993.80

249,016

3.31

10.94

1004.74

190,365

2.53

6.39

1011.13

189,627

2.52

6.34

1017.47

173,566

2.31

5.31

1022.78

136,807

1.82

3.30

1026.08

132,456

1.76

3.09

1029.18

Bank

Bank of Richmond,

NA

FS&LA

10

Southern

11

Citizens

S&LA,

12

Security

FS&LA

13

First Virginia

14

Colonial

15

Lincoln

16

Cardinal

S&LA

103,226

1.37

1.88

1031.06

17

Pioneer

FS&LA

52,624

0.70

0.49

1031.55

18

Virginia

First Savings,

52,592

0.70

0.49

1032.03

19

Consolidated

43,205

0.57

0.33

1032.36

20

Dominion

41,988

0.56

0.31

1032.67

21

First FSB of Virginia

33,233

0.44

0.19

1032.87

22

Bay Savings

24,478

0.33

0.11

1032.97

23

Virginia

21,301

0.28

0.08

1033.05

24

The Suburban

11,600

0.15

0.02

1033.08

25

Union Bank & Trust Co

5,447

0.07

0.01

1033.08

26

Peoples

4,177

0.06

0.00

1033.09

27

First National

2,271

0.03

0.00

1033.09

Total

Notes:

Bank
FA

Bank-Colonial

S&LA
S&LA

FSB

Bank & Trust Co

FS&LA

Bank,

Capital

FSB

Bank
Bank

Bank of Virginia
Bank,

Louisville

Market

$7,529,874

The three bank concentration
The four bank concentration
THRIFT

34

DEPOSITS

WEIGHTED

ratio is 49.54
ratio is 56.57
AT 100.00

100.00

percent.
percent.
PERCENT

ECONOMIC REVIEW, MARCH/APRIL 1987

1033.09

1033.09

Table 4

RICHMOND,

VA, RMA BANK/THRIFT

MARKET’

June 30, 1985
(Dollar amounts in thousands)

Rank

Percent
of Total
Deposits
in Market

HerfindahlHirschman
Index

Cumulative
HerfindahlHirschman
Index

$1,154,202

17.05

290.86

290.86

1,122,280

16.58

275.00

565.86

871,753

12.88

165.92

731.78

Total
IPC Deposits

Bank

1

Bank of Virginia

2

United

3

Sovran Bank,

4

Heritage

S&LA

5

Central

Fidelity

6

Investors

7

Virginia

8

Franklin

9

Dominion

Bank of Richmond,

10

Southern

Bank

11

Citizens

S&LA,

12

Security

FS&LA

13

First Virginia

14

Colonial

15

Lincoln

16

Cardinal

17

Virginia

Bank
NA

525,600

7.77

60.32

792.10

413,535

6.11

37.34

829.44

S&LA

355,135

5.25

27.54

856.98

FS&LA

346,580

5.12

26.23

883.20

277,946

4.11

16.87

900.07

249,197

3.68

13.56

913.63

245,152

3.62

13.12

926.75

190,365

2.81

7.91

934.66

189,627

2.80

7.85

942.51

168,413

2.49

6.19

948.71

S&LA

136,807

2.02

4.09

952.79

S&LA

132,456

1.96

3.83

956.62

S&LA

103,226

1.53

2.33

958.95

Pioneer

FS&LA

52,624

0.78

0.60

959.55

18

Virginia

First Savings,

52,592

0.78

0.60

960.16

19

Dominion

41,988

0.62

0.38

960.54

20

Consolidated

38,600

0.57

0.33

960.87

21

First FSB of Virginia

33,233

0.49

0.24

961.11

22

Bay Savings

24,478

0.36

0.13

961.24

23

Virginia

21,128

0.31

0.10

961.34

24

The Suburban

11,261

0.17

0.03

961.36

25

Union Bank & Trust Co

5,447

0.08

0.01

961.37

26

Peoples

3,949

0.06

0.00

961.37

27

First National

71

0.00

0.00

961.37

100.00

961.37

961.37

Bank

FS&LA
NA

FA

Bank-Colonial

FSB

FS&LA
Bank & Trust Co

Bank,

Capital

FSB

Bank
Bank

Bank of Virginia
Bank,

Louisville

$6,767,645

Total Market

Notes:

The three bank concentration

ratio is 46.52

percent.

The four bank concentration ratio is 54.29

percent.

THRIFT

PERCENT

DEPOSITS

WEIGHTED

AT 100.00

1 Total IPC deposits for banks and total deposits for thrifts.
FEDERAL RESERVE BANK OF RICHMOND

35

Table 5

TOP TEN BANKING MARKETS
FIFTH DISTRICT
June 30, 1985
HHI
Eased on
Total Bank
Deposits

Change

Percent
of Change

D.C.

816

807

-9

-1.10

Maryland

1254

1253

-1

-0.08

3126

3003

-123

1998

1983

-15

-0.75

2270

2210

-60

-2.64

4969

447 1

-498

- 10.02

1481

1451

-30

- 2.03

Washington,
Baltimore,
Charlotte,

North Carolina

Richmond,

Virginia

Norfolk-Portsmouth,
Winston-Salem,
Raleigh,

HHI
Based on
Total Bank
IPC Deposits

Virginia
North Carolina

North Carolina

- 3.93

Columbia,

South Carolina

1905

1871

-34

- 1.78

Charleston,

West Virginia

1430

1380

-50

-3.50

Greenville,

South Carolina

1475

1519

Average

- 77.6

Change

non-IPC deposits yields changes in the HHI comparable to results already observed when IPC deposits
are considered for banks only. IPCs reduce the tenmarket average HHI by 76 when thrifts are added
to the product market compared with a reduction of
78 in the HHI when the market is restricted to banks.
This average includes reductions in HHIs for specific
markets ranging from 6 in the Washington market
to 437 for Winston-Salem.
Greenville
again
represents an exception with an increase in the HHI
of 52 (Table 6).
It is widely recognized that thrifts may not be
fully comparable to commercial banks in all respects
despite the enactment in recent years of legislation
which enables thrifts to accept demand deposits
(NOW accounts) and grant commercial loans. Others
suggest that one hundred percent of thrift deposits
is the relevant standard because thrifts have the
potential to become full competitors of banks. The
Board of Governors’ pragmatic approach to this reality
usually has been to permit the inclusion of 50 percent of the deposits held by thrifts for the purpose
of determining concentration in a banking market.
On the other hand, the U. S. Department of Justice
elects to calculate separate indices for “wholesale”
and “retail” markets. Justice includes one hundred
percent of thrift deposits in the retail market, while
36

44

2.98
- 3.74

only twenty percent of thrift deposits are added to
the wholesale market.
Table 7 demonstrates the effect of weighting thrift
deposits at 50 percent in the District’s largest
markets. This approach produces the greatest variation in the HHI when IPC deposits are compared
with total deposits. The mean reduction in HHI after
removing non-IPC deposits from the market is 96
under this alternative.
The increase in concentration for the Greenville, South Carolina, market due
to using IPC deposits shows the risks inherent in
making sweeping generalizations
about banking
markets. Banks in the market hold approximately
50.3 percent of total bank/thrift deposits, but only
48.6 percent of total IPC depositsThe smaller banks
in the market apparently have managed to attract a
disproportionately
large share of non-IPC deposits.
The first and second largest depository institutions
in the market are thrifts. These two organizations
hold 43 2 percent of total deposits and 44.7 percent
of total IPC deposits.
Conclusion
Analysts usually include at least a portion of thrift
deposits when measuring banking market structure.
The only thrift deposit category currently reported

ECONOMIC REVIEW, MARCH/APRIL

1987

Table 6

TOP TEN BANKING MARKETS
FIFTH DISTRICT
June 30, 1985
HHI
Based on
Total
Deposits of
Banks and
Thrifts

HHI
Based on
Total IPC
Deposits
of Banks
and Thrifts

D.C.

371

365

-6

Maryland

522

501

-21

1946

18 .o

- 136

- 6.99

1033

961

-72

-6.97

Virginia

1038

993

-45

-4.34

North Carolina

2948

Washington,
Baltimore,
Charlotte,

North Carolina

Richmond,

Virginia

Norfolk-Portmouth,
Winston-Salem,
Raleigh,

North Carolina

Columbia,

South Carolina

251

Percent of
Change

- 1.62
-4.02

-437

- 14.82

1017

993

-24

- 2.36

1062

1036

-26

- 2.45

-43

- 3.87

Charleston,

West Virginia

1112

1069

Greenville,

South Carolina

1324

1376

Average

Change

Change

52
- 75.8

Table

-3.93
6.13

7

TOP TEN BANKING MARKETS
FIFTH DISTRICT
June 30, 1985

HHI Based
on Total
Bank Deposits
and 50 Percent
of Thrift
Deposits

HHI Based
on Total
Bank IPC
Deposits and 50
Percent of
Thrift Deposits

D.C.

466

453

Maryland

725

Washington,
Baltimore,
Charlotte,

Virginia

Norfolk-Portsmouth,
Winston-Salem,
Raleigh,

- 13
-26

Percent
of Change

-2.79
3.59

Virginia
North Carolina

North Carolina

2401

2257

- 144

1339

North Carolina

Richmond,

Change

1258

-81

- 6.05

1333

1261

-72

- 5.40

3691

3187

- 504

1138

1099

-39

- 3.43

-6.00

- 13.65

Columbia,

South Carolina

1235

1173

-62

- 5.02

Charleston,

West Virginia

1221

1170

-51

-4.18

Greenville,

South Carolina

1082

1110

Average

28
- 96.4

Change
FEDERAL RESERVE BANK OF RICHMOND

2.59
-6.59
37

by geographic location, however, is total deposits.
This constitutes a persuasive reason for continuing
to evaluate market concentration on the basis of total
deposits despite the attraction of IPC deposits. Combining total deposits of thrifts with total IPC deposits
of banks may overemphasize the market concentration attributed to thrift institutions. Proponents of
thrifts as full competitors of banks do not attempt
to claim that thrift deposits should be weighted more
heavily than deposits held by commercial banks when
assessing competitive relationships.

Our review of large banking markets in the Fifth
Federal Reserve District tends to confirm that nonIPC deposits are more significant relative to the structure of some markets than for others. Whenever HHI
statistics for banking markets begin to approach the
by the Merger
critical range as determined
Guidelines, both applicants and bank regulatory agenties may find it constructive to review the market
in terms of alternative deposit definitions as well as
to explore the underlying causes of those differences.

References
Daskin, A. J. “Aggregate Concentration
and Geographic
Diversification in U.S. Commercial Banking, 1970-1982.” Journal of Economics and Business 37 (August 1985): 237-51.
Decision Research Sciences, Inc. f985-2986 Branch Dit~ctorj and
Summary ojDeposits. Blue Bell, PA., 1985.
Federal Deposit Insurance Corporation.
and Branches. June 30, 1985.

Data Book-Operating Banks

Flechsig, Theodore
G. Banking Market Stmctwe d Perfbrance in
Metmpofitan
Arzur. Washington: Board of Governors of the Federal
Reserve System, 1965.
Gilbert, R. A. “Bank Market Structure and Competition.” Journal of
Money, Cn?dt and Banking 16 (November 1984): 617-60.

Rand McNally & Company. Commercial A&r and Ma&&g
Chicago: Rand McNally & Company, 1985.

Guide.

Tayloe Murphy Institute. “Branch Deposits in Financial institutions in
Virginia.” University of Virginia: The Colgate Darden Graduate
School of Business Administration.
June 30, 1985.
Watro, Paul R. “Thrifts and the Competitive Analysis of Bank Mergers.”
Federal Reserve Bank of Cleveland, EconmicRe&w (Winter 1983),
pp. 13-32.
Welker, Donald L. “Thrift Competition:
Does it Matter?” Federal
Reserve Bank of Richmond, Econo& Re&w 72 (January-February
1986): Z-10.
Whitesell, William E. ‘The Bank Merger Act of 1966: Pax,
and Prospects.” Federal Reserve Bank of Philadelphia,
I&&w (November 1968), pp. 3-9.

Present
BusinRc

Keely C. and Gary C. Zimmerman. “Determining Geographic Markets
for Deposit Competition in Banking.” Federal Reserve Bank of San
Francisco, E.conomic I&v& (Summer 1985), pp. 25-45.

Yanni, Joseph A. “Managing the Competitive Factors in a Merger.” Issues
in Bank Regulon’on 7 (August 1983): 7-10.

Mote, Larry R. “Competition in banking: What is known? What is the
Evidence?’ Federal Reserve Bank of Chicago, BusinessConditions
(February 1967), pp. 7-16.

Yesley, Joel M. “Defining
the Product Market in Commercial
Banking.” Federal Reserve Bank of Cleveland, .%ncm~Ret%%e (JuneJuly 1972), pp. 17-3 1.

38

ECONOMIC REVIEW, MARCH/APRIL 1987


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