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THE PROMISES AND PITFALLS OF
CONTEMPORANEOUS RESERVE REQUIREMENTS
FOR THE IMPLEMENTATION OF MONETARY POLICY
Marvin Goodfriend*

1. Introduction
In October 1979, the Fed acknowledged the potential value of reserve targeting for controlling the
money stock and stabilizing the price level. It soon
became apparent that the benefits of reserve targeting
could not be realized with the lagged reserve requirement rules then in place. Consequently, in June 1982
the Federal Reserve Board decided to move to contemporaneous reserve requirements (CRR). Announcing its intention to change to CRR, the Board
said simply that it expected CRR “to improve the
implementation of monetary policy to a degree by
strengthening the linkage between reserves held by
depository institutions and the money supply.“1 This
is essentially all the Board has said about the value of
CRR for making policy. The benefits of CRR can be
more elusive than this statement suggests and more
significant as well. This article is intended to point
out the promises and pitfalls of CRR for the implementation of monetary policy.
2. The CRR Rules2
The new CRR rules have been in place since February 1984. Under CRR, reserve requirements are
computed on the basis of 14-day computation periods
that end every other Monday. Reserve requirements
must be met on a daily average basis over a 14-day
maintenance period ending every other Wednesday.
*Economist and Vice President of the Federal Reserve
Bank of Richmond. The views expressed in this paper
do not necessarily represent the views of the Federal
Reserve Bank of Richmond, the Board of Governors of
the Federal Reserve System, or other Federal Reserve
Banks.

2 See Board of Governors of the Federal Reserve System
[October 1982].

For a particular maintenance period, reserve requirements on transaction deposits are computed on the
basis of the 14-day computation period ending on the
Monday two days prior to the end of that maintenance period.3,4 Required reserves on nontransaction
deposits, e.g., certain time deposits and Eurocurrency
liabilities, are based on average deposits for the 14day computation period ending on the Monday 17
days before the beginning of the maintenance period.
In addition, vault cash eligible to be counted as reserves is based on vault cash during the 14-day
computation period ending 17 days before the beginning of the maintenance period.
Figure 1 illustrates the contemporaneous reserve
requirement rules in place since February 1984 and
the lagged reserve requirement rules in place from
September 1968 through January 1984. As the diagram indicates, the new reserve requirement rules
are not strictly contemporaneous. Even the maintenance period for transaction deposits lags the computation period by two days. However, because the
new set of reserve requirement rules are generally
known as contemporaneous reserve requirements and
3

Under CRR, reservable transaction balances include
(1) demand deposits at all commercial banks (including
those due to banks, other depository institutions, and the
U.S. government); (2) other checkable deposits (OCD)
consisting of negotiable order of withdrawal (NOW)
accounts, automatic transfer service (ATS) accounts,
telephone and preauthorized transfer accounts, credit
union share draft accounts, and demand deposits at thrift
institutions; (3) less deductions for demand balances due
from depository institutions in the United States and cash
items in the process of collection.
In general, CRR
applies only to depository institutions that file the weekly
FR 2900 report of deposits.
4

Reserve requirements under the Monetary Control Act
(MCA) of 1980 are designed to control aggregate transaction deposits. After a gradual phase-in period, under
the MCA depository institutions are required to maintain
a reserve equal to 12 percent of transaction deposits in
excess of a minimum (roughly 2.5 million dollars). In the
MCA framework, a 3 percent reserve is also required
against nonpersonal time deposits.

FEDERAL RESERVE BANK OF RICHMOND

3

Figure 1

AN ILLUSTRATION OF THE LAGGED AND CONTEMPORANEOUS
RESERVE REQUIREMENT RULES FOR TRANSACTION DEPOSITS

Contemporaneous Reserve Requirements*
(since February 1984)

*The 2-week maintenance period for nontransaction deposits and vault cash begins on the Thursday of week 5.

because this article is concerned with reserve requirements on transaction deposits, which are approximately contemporaneous, the new set of rules is
referred to as contemporaneous reserve requirements
throughout this article.
3. The Problem with Lagged Reserve
Requirements, and the Potential Benefit
of CRR for Monetary Control
Prior to October 1979, the Fed had been explicitly
using the Federal funds rate as its policy instrument.5
That is, the Fed had been setting the Federal funds
rate on a week by week basis to achieve its objectives.
But at that time, the Fed decided to move to “reserve
5

McCallum [November 1981] describes the use of an
interest rate policy instrument in a rational expectations
model.

4

targeting,” that is, to use bank reserves as its policy
instrument to control the money stock and stabilize
the price level.
Subsequently, it became apparent’ that reserve targeting could not be adequately implemented with
lagged reserve requirements. To see why, suppose
the Fed were to attempt strict control of total reserves
under lagged reserve requirements. When required
reserves differed from targeted total reserves, the
funds rate would begin to adjust to clear the reserve
market. But under lagged reserve requirements
changes in current deposits would not affect current
required reserves, so the banking system could not
adjust required reserves in response to these interest
rate movements. If the Fed were to adhere to a
targeted volume of total reserves that was inconsistent with required reserves, funds rate movements
could not efficiently clear the reserve market. Under
lagged reserve requirements, excessive and essentially

ECONOMIC REVIEW, MAY/JUNE 1984

pointless funds rate volatility would likely be associated with strict total reserve control.6
In practice, the Fed provided a mechanism for
reserve market clearing with lagged reserve requirements by allowing the volume of discount window
borrowing to adjust to funds rate movements. As a
result of this discount window policy, the Fed retained direct control of only the nonborrowed portion
of total reserves. When nonborrowed reserves supplied by the Fed were less than required reserves,
banks were allowed to borrow the difference from the
discount window. In this setup, total reserves did not
determine deposits. The Fed merely accommodated
the demand for reserves required to support deposits
on the books of banks two weeks earlier. The only
way the Fed could control deposits was by managing
borrowed reserves to manipulate the funds rate in
order to influence other interest rates and the quantity of money demanded.
The nonborrowed reserve-lagged reserve requirements operating procedure was even inferior to the
pre-October 1979 procedure in one important respect.
The principal change involved in moving to nonborrowed reserve targeting was that the Fed affected the
funds rate indirectly through the volume of borrowing it “forced” banks to do at the discount window
rather than directly as it had before October 1979.7
Discount window administration imposes a nonpecuniary cost of borrowing that rises with volume and
the duration of borrowing. The more banks are
“forced” to borrow at the window the higher they bid
up the alternative cost of reserves in the Federal
funds market, i.e., the Federal funds rate, relative to
the discount rate. The Fed varied the “forced” volume of discount window borrowing by appropriately
choosing nonborrowed reserve supply. This is how
the Fed influenced the funds rate and ultimately the
money stock. However, the relationship between a
given volume of “forced” discount window borrowing
and the spread between the funds rate and the discount rate is volatile and difficult for the Fed to
p r e d i c t . 8 In turn, the instability of the relation
between borrowing and the spread made the shortterm relationship between nonborrowed reserves and
6

McCallum and Hoehn [February 1983] and Poole
[November 1982] discuss the inefficiency of total reserve
targeting under lagged reserve requirements.
7

For more discussion of this point, see Goodfriend and
Hargraves [March/April 1983], pp. 10-11, and Poole
[November 1982, Part II], pp. 586-7.

8

Goodfriend [September 1983] explains theoretically why
this is the case.

the funds rate difficult to predict. In short, with the
post-October 1979 nonborrowed reserve-lagged reserve requirements operating procedure it was more
difficult for the Fed to control both the funds rate
and the money stock.
The major benefit of moving to CRR is that the
change could make it easier for the Fed to control
total reserves. With CRR, contemporaneous funds
rate movements could influence the demand for reservable deposits and required reserves, and more
effectively bring total reserve demand into equilibrium with total reserve supply. Under CRR, the Fed
would no longer have to make discount window borrowing opportunities available to banks to help the
reserve market clear. The Fed could simply close
the discount window to routine adjustment borrowing and target a constant volume of total reserves,
that is, the Fed could strictly control the volume of
total reserves available to support deposits of the
banking system.9,10 Essentially, CRR makes total
reserve control easier by allowing the Fed to shift
the burden of reserve market adjustment from itself
to the banking system.
9

In a growing economy, strict total reserve control could
lead to a steady deflation. To avoid such an outcome,
total reserves could be strictly targeted at a predetermined rate of growth to achieve price level stability or
moderate inflation.
10

Strict control of the monetary base (bank reserves plus
currency in the hands of the public) would yield roughly
the same benefits as those attributed to strict total reserve
targeting in this article. The difference between these
policies is that under total reserve targeting the Fed
supplies sufficient monetary base to provide the volume
of targeted total reserves plus enough additional base to
accommodate forecasted currency demand. Any unexpected movements of currency into or out of the banking
system are offset on a regular basis by appropriate
open market operations. By contrast, under monetary
base targeting the Fed simply supplies a targeted volume
. Total reserve targeting has the advantage
that it would not allow a shift in the demand for currency relative to reservable deposits to cause a contraction or expansion of deposits. But monetary base
targeting has the advantage that in times of reserve need
the banking system could attract currency to help satisfy
the need and in times of reserve abundance the public
could absorb unwanted reserves as currency, thereby
Norsomewhat cushioning short-term interest rates.
mally, the demand for currency is well-behaved so that
in practice the distinction between total reserve and base
targeting is relatively minor.
Note that the total reserve target could be defined
either net or gross of reserves not supporting transaction
deposits of the nonbank public, e.g., interbank deposit,
U. S. government deposits, and time deposits. The
relevant issues in this case are analogous to those discussed above with respect to total reserve versus monetary base targeting.
Fama [January 1980] contains a useful theoretical discussion of both total reserve control and monetary base
control.

FEDERAL RESERVE BANK OF RICHMOND

5

4. The Value of Strict Total Reserve Control
The major benefit of strict total reserve control is
that it can enable the Fed to manage the money
stock without concern for either the funds rate or the
demand for borrowed reserves. Banks have an incentive to economize on non-interest-earning excess reserves, i.e., reserves held above legal requirements, at
all but very low interest rates. By strictly controlling
total reserves, the Fed can exercise control of aggregate deposits by exploiting the banking system’s incentive to economize on excess reserves, Formally, if

11

multip1ier. The banking system’s well-defined demand for excess reserves translates into a welldefined and reasonably stable money multiplier.
Under CRR, the Fed can exploit the money multiplier to control aggregate deposits by simply exercising strict total reserve control. In turn, total
reserve and money stock control can stabilize the
price level.
In addition, strict total reserve control yields the
following important benefits. First, it frees the Fed
from having to choose a path for the Federal funds
rate from one week to the next. When the Fed makes
policy by choosing the level of the Federal funds rate
as it has traditionally done, the Fed must decide to
raise the Federal funds rate in order to maintain
control of total reserves and the money stock when
credit demands put upward pressure on interest rates.
Since these decisions are always the focus of national
debate, they are very difficult for the Fed to make at
all, let alone with appropriate timing. By contrast,
if the Fed adopted strict total reserve control, it
could maintain control of the money stock and the
price level precisely because it would not be put in a
position of having to continually make politically
sensitive decisions. Moreover, such a policy would
also leave interest rates free to adjust automatically
to regulate, and coordinate intertemporal production,
consumption, saving, and investment decisions in the
economy.
Second, in coming years political pressure to keep
interest rates down in order to help finance large
Federal government budget deficits could become a
particular problem. Such pressure amounts to an
11

Goodfriend [January/February 1982] contains a more
general discussion of money stock determination.

6

effort to shift financing of government expenditure
from explicitly legislated taxes and borrowing to the
Federal Reserve inflation tax.12 Strict total reserve
control offers good protection against such pressure.
Third, strict total reserve control is a simple policy.
It could be easily monitored by the public. Since it
is a passive policy there would be no problem guessing Fed policy intentions as there is today whenever
the Fed adjusts the funds rate. This would greatly
help the Fed to establish and maintain the credibility
of its policy commitment to control the money stock
and the price level. In turn, this should reduce
interest rate variability due to variability of expected
inflation.
5. Historical Evidence on the Feasibility of
Total Reserve Targeting
A Fed move to total reserve targeting seems to
have been delayed by doubt that the banking system
would be able to manage its reserve position at all if
the Fed did not routinely make reserves available on
demand at a temporarily stabilized Federal funds rate
or through the discount window. However, historical
evidence suggests that such doubt is unwarranted.
For example, for roughly 30 years immediately prior
to the establishment of the Federal Reserve System
in 1914, the United States was on a gold standard.
The monetary base was ultimately determined by factors affecting the U. S. balance of payments and the
world supply and demand for gold. For this reason
the monetary base was largely predetermined on a
weekly or monthly basis and could not respond immediately to reserve market conditions. The portion
of the monetary base available to serve as bank reserves was the residual after the demand for currency
was satisfied. Apart from periods of panic, the demand for currency was relatively stable, and therefore the stock of bank reserves (total reserves) was
largely predetermined on a weekly or monthly basis
as it would be today with strict total reserve targeting. 1 3
During this period, the United States did not have
a central bank. Yet banking, including reserve management, was carried out effectively throughout the
period. The overnight call money rate, a rate roughly
equivalent to today’s Federal funds rate, did not dis12

See Auernheimer [May/June 1974] and references contained therein for theoretical discussions of the revenue
from money creation.
13

For a general discussion of the monetary history of
this period, see Friedman and Schwartz [1963], Chap. 3.

ECONOMIC REVIEW, MAY/JUNE 1984

play variability too excessive for the banking system
to handle.14 Furthermore, it appears that the call
money rate often moved around considerably without
affecting longer term rates very much. ‘This last
point suggests that an increase in Federal funds rate
variability associated with strict total reserve targeting today would not translate into greater variability
in longer term rates.
The years prior to 1914 did feature a number of
banking panics, suggesting that the monetary arrangements of the period were defective. However,
such panics would most likely not have happened
with strict total reserve targeting. The panics were
characterized by widespread demand, on the part of
the public to convert deposits into currency. With
the monetary base largely predetermined, such bank
“runs” produced large declines in total reserves of the
banking system and thereby threatened the solvency
of the banks. Under strict total reserve targeting,
the Fed would simply accommodate the increased
demand for currency without letting the stock of total
reserves decline. Strict total reserve targeting would
thereby insulate the banking system from the sort of
violent liquidity crises and panics that characterized
the years preceding the Fed.
In the years before the establishment of the Fed,
the U. S. Treasury held a large cash position and
there is evidence that at times it carried out open
market operations to add or drain bank reserves in
order to stabilize interest rates on a short-term
basis.15 Such Treasury behavior was probably useful
in cushioning temporary disturbances to interest
rates. Today, under total reserve targeting the Fed
could allow Treasury open market operations to influence total reserves available to the banking system by
targeting total reserves inclusive of Treasury cash.1 6
Because the Treasury has an incentive to economize
on holdings of cash and because it would not have the
power to create monetary base, Treasury interventions in the money market would be temporary and
self-reversing. 17
14
See Macaulay [1938], pp. A141-61 for a monthly series
on the call money rate and 90-day rates from 1857 to
1937.
15

See Friedman and Schwartz [1963], pp. 125-8.

Total reserves could also be targeted inclusive of
reserves supporting Treasury deposits at banks, so that
changes in Treasury deposits would also affect bank
reserves. Of course, by targeting total reserves net of
Treasury cash and reserves supporting Treasury deposits,
the Fed would not have to allow Treasury behavior to
influence total reserves of the banking system.
16

See Lang [October 1979] for a discussion of Treasury
cash management.
17

All this is important because the Fed is usually
viewed as facing a tradeoff between short-term control of total reserves and interest rate stability. But
no such tradeoff need exist for the government as a
whole if total reserves are targeted inclusive of Treasury cash. Should it want to, another agency of the
U. S. government, namely the U. S. Treasury, could
cushion money market rates against temporary disturbances. Furthermore, the division of responsibility
for price level stabilization and temporary stabilization of money market rates between the Fed and the
Treasury would allow each to pursue its objective
more singlemindedly.
6. Excess-Reserves and Total
Reserve Control
As discussed in Section 4 above, the degree to
which total reserve control translates into control of
reservable deposits depends largely on the aggregate
behavior of excess reserves. Theory suggests that at
all but very low interest rates the volume of excess
reserves will be stable enough over time so that strict
total reserve control will provide effective control of
reservable deposits, and thereby effective control of
the price level.18
Over shorter periods of time, however, the ratio of
banks’ excess reserves to reservable deposits could
vary substantially. In fact, this should be expected
with strict control of aggregate total reserves. In
such a policy environment, reserve market, equilibrium would be maintained by free market Federal
funds rate adjustments. Increased Federal funds rate
variability would probably increase the attractiveness
of cash relative to Federal funds as an immediately
available source of funds to meet deposit withdrawals.
Consequently, banks would likely hold more excess
reserves, on average, to provide more protection
against having to meet unexpected deposit withdrawals. Furthermore, banks may not only hold a
higher average ratio of excess reserves to reservable
deposits, but in so doing banks may well allow the
ratio to fluctuate more in order to meet unexpected
deposit withdrawals, especially those anticipated to
be temporary.
Admittedly, such bank behavior would limit the
extent to which total reserve control could produce
money stock control over short periods of time. However, such money stock variability would not interfere with secular monetary or price level control if the
See Frost [July/August 1971] and Poole [December
1968] for two examples of theoretical work on excess
reserve demand.
18

FEDERAL RESERVE BANK OF RlCHMOND

7

Fed maintained strict control of total reserves. Moreover, the aggregate ratio of excess reserves to deposits would probably be negatively correlated with
interest rate movements, thereby helping to cushion
interest rate movements. Interest rate increases, for
example, by inducing banks to economize on noninterest-earning excess reserve holdings, would allow
deposit expansion which would, in turn, help mitigate
the interest rate rise. Far from being a problem for
the Fed, such variation in the aggregate excess reserve ratio would make it easier for the Fed to adhere
to strict total reserve control, and thereby increase
the credibility of a policy of secular monetary and
price level control.
A higher average volume of excess reserve demand
under strict total reserve control could, however, be a
problem for the Fed. Banks might object to strict
total reserve control because it could cause them to
tie up a greater share of their assets in non-interestearning excess reserves. Assuming that the Fed
makes available a sufficient once-and-for-all increase
in total reserve supply to satisfy the increased demand for excess reserves necessary to support an
initial level of aggregate deposits, the Fed portfolio
will increase along with the move to strict total reserve control. Since virtually all of Fed earnings on
its portfolio are simply transferred to the U. S.
Treasury, the move to strict total reserve control
could provide the U. S. Treasury with significant
additional revenue.19 The Congress and the Treasury
could view the move to strict total reserve control
as a means of raising additional revenue through the
“reserve” tax on banks. Alternatively, by allowing
the Fed to pay interest on required reserves, Congress could offset the cost to banks of holding additional excess reserves. In other words, this bank
objection to strict total reserve control could readily
be overcome with cooperation from the Congress.
7. Total Reserve Control and the
Deregulation of Interest on Deposits
In recent years, the Depository Institutions Deregulation Committee, in accord with a congressional
mandate, has removed interest rate ceilings on a wide
variety of deposit types.20 Interest rate ceilings have
See Goodfriend and Hargraves [March/April 1983],
pp. 11-13.
19

become difficult to enforce technologically, legally,
and fairly. Consequently, the trend toward virtually
complete interest rate deregulation appears irreversible. Recognizing this trend, the Federal Reserve
Board has recently recommended repeal of the existing prohibition of interest on demand deposits. In
addition, the Federal Reserve Board has recommended payment of interest on required reserve balances held at Federal Reserve Banks.2 1
These two reforms would greatly enhance the value
of strict total reserve control. In the first place, by
allowing market related interest on fully checkable
deposits and interest on required reserves, these reforms would reduce or eliminate the incentive for
financial intermediaries to create alternative means of
providing transaction services that pay market related
rates. In other words, the reforms should bring to
an end the relabeling of deposit arrangements to
avoid legal restrictions that has characterized financial innovation in recent years. Furthermore, because
the spreads between interest rates on various deposit
types should be much less sensitive to the level of
interest rates, the reforms should also lead to greater
stabilization of the volume of each deposit-type demanded and its turnover for transaction purposes.
With deregulation, it is possible that transaction accounts might contain a substantial portion of savingstype deposits. But this should not be a problem
because interest rate movements would produce only
minor shifts over time in the composition of this
aggregate.
With deregulation, even if competition induces
transaction deposit rates to move together with
market rates so that transaction deposit demand no
longer depends on interest rates, strict total reserve
control could still exert control of transaction deposits
through a money multiplier as described in Section 4.
In this case, the price level would be determined by
the public’s real demand for transaction deposits
which would primarily depend on real income. How
would the system respond to temporary disturbances? 22 Consider a disturbance temporarily creating
unwanted excess reserves. The banking system
would respond by extending new temporary loans
and aggregate deposits would rise correspondingly.
Transaction balances will only rise if prices or real
income rise, thereby affecting the quantity of transaction balances demanded. To the extent that the

20

The Congressional mandate stems from the Depository
Institutions Deregulation and Monetary Control Act of
1980 (Public Law 96-221).

21

Friedman [February 1970] contains a good discussion
of interest rate controls.

This illustration draws on the framework developed in
Goodfriend [January/February 1982].

8

See Partee [November 1983].

22

ECONOMIC REVIEW, MAY/JUNE 1984

disturbance is understood to be temporary, the public
will be willing to temporarily hold the increase in
aggregate deposits as nontransaction balances. Alternatively, if the disturbance is anticipated to be permanent and not offset by a Fed reduction of total reserves, then the price level and both transaction and
nontransaction deposits will rise equiproportionally.
In short, strict total reserve targeting remains a
workable means of price level control even with interest rate deregulation.
By contrast, the usefulness of a Federal funds rate
monetary control instrument as typically understood
could be greatly diminished if market-related rates
were paid on fully checkable deposits. As usually
understood, a funds rate instrument is effective only
if the funds rate significantly affects the opportunity
cost of holding money. If the own rate on transaction accounts is legally and effectively fixed, then
funds rate control, by affecting market interest rates,
significantly influences the opportunity cost of holding money and can be used for monetary control. But
without legal deposit rate restrictions, if competition
induces deposit rates to move together with market
rates, then the funds rate may have little effect on
deposit demand. 23 In such a situation, as typically
understood the funds rate loses its effectiveness as an
instrument of money stock and price level control.
Of course, by using the funds rate to influence the
level of interest rates and the quantity of bank loans,
it could in principle be manipulated to influence
spending and the price level. At a minimum, such
use of a funds rate instrument requires rethinking its
role in the transmission of policy. More importantly,
use of a funds rate instrument in this way would
continue to be plagued with problems similar to those
described in Section 4.
8. Fed Attitude Toward the Federal Funds
Rate in the Last Two Days of the
Reserve Maintenance Period
Under the new contemporaneous reserve requirement rules for transaction deposits, the required reserve maintenance period lags the computation period
by two days. This means that for the last two days
The payment of interest on required reserves would
lead deposit rates to move even more closely with market
rates.
Since the interest rate on currency is zero, a funds rate
instrument will still affect the opportunity cost of holding
currency. But the interest sensitivity of currency appears
to be too low to provide a practical funds rate instrument means of monetary control.
23

of the maintenance period required reserves are predetermined as they were during the entire maintenance week under the old lagged reserve requirement
rules. Since required reserves could no longer adjust
to total reserve supply, the Fed might be tempted to
hold the funds rate at an “appropriate” level-during
those two days and simply let reserve supply accommodate the demand, thereby minimizing unnecessary
funds rate volatility.
However, if banks came to expect the Fed to peg
the funds rate at an “appropriate” level on the last
two days of the reserve maintenance period, then the
benefits to strict total reserve targeting under CRR
could be seriously jeopardized. Since a dollar of
reserves held in the last two days of a maintenance
period is equivalent to a dollar held on any other day,
banks would neither pay more nor offer less than that
“end of period rate” at any time during the period.
This would mean that the funds rate throughout the
period would in effect be fixed as if the Fed had been
using a funds rate instrument explicitly. Reserve
demand would simply be accommodated at the end
of the period at the “appropriate” rate, and even
though CRR were in place, reserves would not be the
effective instrument of monetary control. In fact this
procedure would amount to another form of noisy
funds rate targeting, with possibly more interest rate
variability and poorer monetary control than under
the nonborrowed reserve-lagged reserve requirements operating procedure employed following the
October 1979 move to reserve targeting.
For CRR to be used for true reserve targeting it is
critical that the Fed establish the precedent that it
will not peg or cushion the funds rate in the last two
days of the reserve maintenance period. This is a
necessary condition to induce banks to adjust their
reserve positions on an ongoing basis throughout the
reserve maintenance period, rather than wait for the
Fed to provide them with reserves at some “appropriate” funds rate at the end of the period. In other
words, this is a necessary condition to induce banks
to manage their reserve positions in a way that could
make total reserve control work.
9. Timely Release of Aggregate Reserve
and Transaction Deposit Information
The efficiency of strict total reserve control with
CRR would be enhanced by the timely release of
aggregate deposit and reserve data by the Fed. As it
currently stands, the Fed releases money stock and
reserve data too late to be of use for banks managing

FEDERAL RESERVE BANK OF RICHMOND

9

their reserve positions.24 Such information would
help banks forecast reserve market conditions and the
Federal funds rate more accurately. Banks could
make use of better funds rate forecasts to hold reserves during that part of a maintenance period when
the funds rate is expected to be lowest. In turn, such
intertemporal arbitrage by banks would tend to
cushion funds rate movements within a given reserve
maintenance period.
To make the procedure work best, i.e., with least
cost to banks and least funds rate variability, it makes
sense for the Fed to put more resources into collecting, compiling, and publicizing information on reserve market clearing conditions each day of the
maintenance period. In this regard, the Fed might
encourage the forward Federal funds market so as to
provide hedging possibilities and aggregate information to banks. In fact, such a market might grow
substantially of its own accord should the Fed adopt
strict total reserve control.
10. Federal Funds Rate or Nonborrowed
Reserve Targeting with
Contemporaneous Reserve Requirements
Contemporaneous reserve requirements are beneficial for implementing monetary policy because they
make it easier for the Fed to control total reserves.
The value of strict total reserve control has been discussed in Section 4. At this point, it is useful to ask
what portion of the benefits of CRR could be obtained
with Federal funds rate or nonborrowed reserve
targeting.
With Federal funds rate targeting, the Fed holds
the funds rate within a narrowly specified target
band, adjusting the band gradually over time to affect
the level of short-term interest rates as desired. Reserves are merely supplied as required to support the
volume of money and credit demanded given economic conditions and the targeted level of short-term
interest rates. Consequently, with Federal funds rate
targeting, reserve requirement rules in general, and
contemporaneous reserve requirements in particular,
are virtually irrelevant to the implementation of
policy. They merely affect the timing and volume of
reserves held by banks, the size of the Fed portfolio,
Fed income, and transfers from the Fed to the U. S.
Treasury. 25
Board of Governors of the Federal Reserve System.
[January 1984a].

With nonborrowed reserve targeting, the Fed supplies a predetermined volume of nonborrowed reserves and lets the Federal funds rate and the volume
of discount window borrowing adjust to clear the
reserve market. Even with CRR, nonborrowed
reserve targeting gives the demand for discount window borrowing a central place in the operating procedure. Unfortunately, as mentioned in Section 3,
both theory and experience make clear that there
are major problems for a monetary control procedure
relying on the demand schedule for borrowed reserves.
However, in spite of these difficulties nonborrowed
reserve targeting is still favored by some because of
its supposed interest rate cushioning properties.
Even if such interest rate cushioning were desirable,
discount window borrowing is a poor means of producing it. When the funds rate falls below the
discount rate, discount window borrowing essentially
dries up, and nonborrowed reserve targeting becomes
equivalent to total reserve targeting. When the funds
rate is above the discount rate, discount window borrowing can cushion interest rate movements. However, the interest rate cushioning varies in a complicated way over time due to expectational effects and
intertemporal nonprice rationing policy at the discount window, Furthermore, rules penalizing duration of borrowing at the window introduce a needless
cycle into interest rates and reserve supply.26
In short, nonborrowed reserve targeting still introduces a pattern in interest rates due to Fed policy,
but this pattern results from Fed discount window
administration procedures rather than from explicit
management of the funds rate by the Federal Open
Market Committee. Furthermore, since the pattern
has no benefits for monetary policy, it tends to drive
the Fed to manage nonborrowed reserve supply to
better manage interest rates. Consequently, even
with CRR nonborrowed reserve targeting can not be
expected to deliver workable or credible strict reserve and monetary control. Nonborrowed reserve
targeting simply does not offer any of the benefits of
total reserve targeting discussed in Section 4.
11. Summary
Whether or not the move to contemporaneous reserve requirements makes a difference for monetary
policy is entirely up to the Fed. With Federal funds

24

See Goodfriend and Hargraves [March/April 1983] for
an extensive historical discussion of this point.
25

10

These features of interest rate cushioning due to Fed
discount window administration can be deduced from the
model in Goodfriend [September 1983]. The cycling is
due to the negativity of
in that model.

26

ECONOMIC REVIEW, MAY/JUNE 1984

rate targeting, CRR will essentially make no difference. This article has argued that the potential
benefits of moving to CRR are likewise not available
with nonborrowed reserve targeting. The promise of
CRR for implementing monetary policy can only
come with a move to strict total reserve control.
Above all, strict total reserve control promises the
Fed a means of stabilizing the money stock and the
price level without having to choose a Federal funds
rate target as it has traditionally done. In contrast
to the Federal funds rate procedure, which requires
frequents and timely adjustment by the Fed, strict
total, reserve control would be a passive policy requiring little if any month-to-month adjustment.
Total reserve control is consequently more likely to
deliver monetary control and price level stability. A
move to total reserve control would moreover offer
good protection against pressure to help finance
Federal budget deficits. In addition, strict total reserve control would allow interest rates to automatically regulate and coordinate economic decisions.
Finally, strict total reserve control could be easily
monitored by the public, which would allow the Fed
to build credibility for its commitment to price level
stability.
In the years before the Federal Reserve System,
the United States was on a gold standard and did not
have a central bank. The volume of total reserves was
largely predetermined on a weekly or monthly basis
as it would be today under strict total reserve targeting. Evidence from that period makes clear that strict
total reserve targeting is feasible. U. S. Treasury
interventions in the money market at that time prob-

ably stabilized money market rates somewhat. But
today, with total reserve targeting, the Fed could also
allow the Treasury the ability to temporarily stabilize
money market rates by targeting reserves inclusive of
Treasury cash. Moreover, this division of responsibility for price level stabilization and money market
stabilization between the Fed and the Treasury would
allow each objective to be pursued more effectively.
Apart from discussing the promises of CRR for
implementing monetary policy, this article has pointed
out some pitfalls that could prevent the Fed from
obtaining the full benefits of CRR. From the point of
view of using CRR for strict total reserve control, the
two-day lag of the maintenance period relative to the
computation period under the new CRR rules is
inefficient, because for the last two days of the
maintenance period reserve requirements are lagged
as they were before February 1984. To the extent
that the Fed deliberately stabilizes the Federal funds
rate during the last two days of the maintenance
period and banks come to anticipate this, the control
procedure will operate like Federal funds rate targeting prior to October 1979. It was also argued that
while nonborrowed reserve targeting appears to be a
reasonable alternative to total reserve targeting, in
fact, it is not likely to operate effectively. In addition,
the benefit of more timely release of aggregate reserve
market information by the Fed as an aid to bank
reserve management was pointed out. Finally, it was
recognized that banks might object to strict total
reserve control if it leads them to hold more excess
reserves, but Congress could offset this cost by paying
interest on required reserves.

References

FEDERAL RESERVE BANK OF RlCHMOND

11

“Controls on Interest Rates Paid by
Banks.” Journal of Money, Credit and Banking
(February 1970), pp. 15-33.
“Monetary Instability.” Newsweek, December 21, 1981, p. 71.
. “Monetary Policy: Theory and Practice.”
Journal of Money, Credit and Banking (February
1982), pp. 98-118.
“Monetary Policy : Theory and PracticeA Reply.” Journal of Money, Credit and Banking
(August 1982), pp. 404-6.
. “Should There Be An Independent Monetary Authority?” in In Search of a Monetary Constitution. Leland Yeager, ed. Cambridge : Harvard
University Press, 1962, pp. 219-43.
and Anna Jacobson Schwartz. A Monetary
History of the United States 1867-1960. Princeton:
Princeton University Press, 1963.
Frost, Peter A. “Bank’s Demand for Excess Reserves.”
Journal of Political Economy 7 9 ( J u l y / A u g u s t
1971), 805-25.
Goodfriend, Marvin. “A Model of Money Stock Determination With Loan Demand and a Banking System Balance Sheet Constraint.” Economic Review,
Federal Reserve Bank of Richmond (January/
February 1982), pp. 3-16.

Levin, Fred J., and Ann-Marie Meulendyke. “Monetary
Policy: Theory and Practice-A Comment.” J o u r nal of Money, Credit and Banking (August 1982),
pp. 399-403.
Macaulay, Frederick R. Some Theoretical Problems
Suggested by the Movements of Interest Rates,
Bond Yields and Stock Prices in the United States
Since 1856. New York: National Bureau of Economic Research, 1938.
McCallum, Bennett T. “Price Level Determinancy with
an Interest Rate Policy Rule and Rational Expectations.” Journal of Monetary Economics (November 1981), pp. 319-29.
and James G. Hoehn. “Instrument Choice
for Money Stock Control with Contemporaneous
and Lagged Reserve Requirements.” Journal of
Money, Credit and Banking (February 1983), pp.
96-101.
Partee, Charles T. Statement before the Subcommittee
on Financial Institutions Supervision, Regulation
and Insurance of the Committee on Banking, Finance and Urban Affairs, U. S. House of Representatives, October 27, 1983, in Federal Reserve
Bulletin (November 1983), pp. 846-52.
Poole, William. “Commercial Bank Reserve Management in a Stochastic Model: Implications for
Monetary Policy.” Journal of Finance 27 (December 1968), 769-91.

. “Discount Window Borrowing, Monetary
Policy, and the Post-October 6, 1979 Federal Reserve Operating Procedure.” Journal of Monetary
Economics 12 (September 1983), 343-56.

. “Federal Reserve Operating Procedures :
A Survey and Evaluation of the Historical Record
Since October 1979.” Journal of Money, Credit and
Banking (November 1982, Part 2), pp. 575-96.

and Monica Hargraves. “A Historical
Assessment of the Rationales and Functions of
Reserve Requirements.” Economic Review, Federal
Reserve Bank of Richmond (March/April 1983).

“How to Make Reserves Control Work.”
American Banker, October 31, 1979, pp. 4-5.

Lang, Richard W. “TTL Note Accounts and the Money
Supply Process.” Review, Federal Reserve Bank of
St. Louis (October 1979).

12

“The New Federal Reserve Technical Procedures for
Controlling Money.” Appendix to a statement by
Paul A. Volcker, Chairman, Board of Governors of
the Federal Reserve System. before the Joint Economic Committee, February 1, 1980.

ECONOMIC REVIEW, MAY/JUNE 1984

ON NONNEUTRAL RELATIVE PRICE
EFFECTS IN MONETARIST THOUGHT:
SOME AUSTRIAN MISCONCEPTIONS*
Thomas M. Humphrey

The resurgence of monetarism has been one of the
more Celebrated developments in postwar macroeconomic thought. Since Milton Friedman’s influential
1956 restatement of the quantity theory of money
[5], monetarism has become increasingly prominent
in policy deliberations and academic theorizing alike.
Matching this rise has been a corresponding revival
of interest in the monetarist view of the monetary
transmission mechanism-i.e., the mechanism or
process that links money to nominal income and
through which the economy adjusts to, monetary
changes.
This article deals with the monetarist version of
the monetary mechanism as expounded by Friedman
and his late-19th and 20th century American quantity
theory predecessors; in particular, it deals with a
key misconception concerning that view. More precisely, it examines the Austrian School’s contention
that monetarists invariably ignore relative price and
real output effects in the monetary mechanism. The
term Austrian here of course refers to those modern
followers of the monetary overinvestment business
cycle theories of Ludwig von Mises and Friedrich A.
Hayek. Those theories explain how monetaryinduced declines in the rate of interest from its real
equilibrium level stimulate overinvestment of capital
in projects that prove unsustainable once the rate
returns to equilibrium.
‘Austrians’ Antimonetarist Critique
According to at least three modern Austrians,
monetarists concentrate solely or largely on money’s
long-run neutral equilibrium impact on the general
price level and neglect or ignore the temporary nonneutral real-sector effects of monetary changes. This
allegation, which has its historical roots in von Mises’
*Paper presented at the Mises Colloquium on Austrian
Economics, Ludwig von Mises Institute of Auburn University, Auburn, Alabama, March 9, 1984.

and Hayek’s criticism of the quantity theory of
money, has received its most recent statement in
Norman P. Barry’s article on “Austrian Economists
on Money and Society” in the May 1981 issue of the
National Westminster Bank Quarterly Review. Says
Barry :
Orthodox monetarists concentrate on changes in the
general price level brought about by monetary
expansion or contraction; all prices are assumed
to move up. or down uniformly. This is maintained
partly because holistic magnitudes such as the
general price level are easily observable, and partly
because money is always assumed to be neutral
(that is an economy is more or less in equilibrium
so that the effect of monetary disturbance is not
on the structure of relative prices). [1 ; p. 23]

By contrast, Austrians, according to Barry, do not
neglect nonneutralities or relative price effects of
monetary shocks. On the contrary they emphasize
such effects and the resulting disruption of real
activity.
For the Austrians, however, the change in the
structure of relative prices is crucial and monetary
disturbance produces discoordination throughout
the economy. [1; p. 23]

Barry’s remarks are echoed by Gerald O'Driscoll
and Sudha Shenoy, who argue that monetarists, unlike Austrians,
. . . ignore, the real side of the economy and hence
the real maladjustments brought about by a monetary policy that interferes with the coordination of
economic, activities. [They] implicitly assume. that
the real side of the economy is always in some sort
of long-term equilibrium, in which money influences
only the price level or money income and not the
structure of relative prices or the composition of
real output . . . . [M]onetarists appear to be unaware of the real effects of money on the economic
system-money’s effect on individual prices and
price interrelationships and hence on the whole
structure of outputs and employments. [9; pp. 185,
193]
In short, according to O’Driscoll and Shenoy, monetarists (1) ignore “the structure of production and

FEDERAL RESERVE BANK OF RICHMOND

13

the influence of prices on production,” (2) neglect
“the microeconomics of business cycles,” and (3)
adhere exclusively to a Walrasian general equilibrium
model that fails “to find any place for money in the
pricing process” and that gives money “no role in
determining relative prices” [9; pp. 193, 194].
The purpose of this paper is to suggest (1) that
the foregoing views are mistaken, (2) that monetarists do not neglect nonneutral relative price or real
economic effects of monetary shocks, (3) that, on the
contrary, they (or at least some of them) fully incorporate these elements into their analysis of the monetary transmission mechanism, (4) that, in fact, their
concern for these effects is what motivates their advocacy of stable monetary policy (indeed, why would
they care about sharp swings in the money stock if
those swings had no real output and employment
effects), (5) that, if anything, they may recognize an
even greater number of relative prices or relative
yields than do the Austrians, (6) that, with the
possible exception of a singular Austrian concern for
the composition (as opposed to level) of real output,
there is little difference between the two views of the
monetary mechanism, and (7) that, consequently, the
notion that the Austrian view is unique is a myth.
In order to document these points, the paragraphs
below examine the writings of six prominent American monetarists or quantity theorists-namely Alexander Del Mar, Irving Fisher, Clark Warburton,
Milton Friedman, Karl Brunner, and Allan Meltzer
-to show what they had to say about nonneutralities
and relative price effects of monetary disturbances.
Before doing so, however, it should be noted that
the preceding assertions are in no way intended to
belittle Austrian views of the working of the monetary mechanism. Rather the purpose is to suggest
that many of those views-notably the notions of the
first-round injection effects of monetary disturbances,
of the misleading price signals produced by an artificial money-induced lowering of the interest rate, of
the consequent overinvestment of capital and unsustainable increase in the capital intensity of production,
and of the necessity of a depression to work off the
excess capital stock-have their exact counterparts in
at least some monetarists’ versions of the monetary
mechanism. With this in mind, let us proceed to
the first monetarist to be considered, namely Alexander Del Mar, the first director of the U.S. Bureau
of Labor Statistics and author of several important
late 19th century writings on monetary theory and
history.
14

Alexander Del Mar (1836-1926)1
The notion that quantity theorists invariably overlook or abstract from the real effects of monetary
changes is quickly dispelled by a glance at Del Mar’s
1896 volume The Science of Money. In that book
he expounded at least five ideas that constitute the
hallmarks of both the Austrian and monetarist views
of the monetary mechanism.
He distinguished, first, between static equilibrium
analysis (in which all prices vary equiproportionally
with money so that neutrality prevails) and dynamic
disequilibrium analysis (in which individual prices
adjust nonuniformly such that money exerts a temporary nonneutral impact on real variables). Static
equilibrium analysis, he said, teaches that “a doubling
of the sum of money will result in a doubling of price”
such that neutrality holds [2; p. 185]. By contrast,
dynamic disequilibrium analysis reveals that when
the money stock alters,
prices do not move together, and the change from a
large to a small currency, or vice versa, is by far
the most important economical circumstance that
can influence the [real] affairs of a nation. [2;
p. 177]

That is, monetary causes, via their differential effect
on individual prices, can have real consequences.
Second, having asserted the real significance of
money-induced nonuniform price movements, he
attempted to specify the exact sequence in which
individual prices adjust to a monetary shock. Specifically, he argued that prices adjust in the following
order :
1. Bullion. 2. Stocks and bonds. 3. Shares of incorporated companies. 4. “Staples,” or crude and
imperishable commodities. 5. Merchandise, including perishable commodities, crude articles of subsistence, etc. 6. Fabric[ated goods], such as machinery, manufactured food, articles for wear, etc.
7. Landed property, or real estate. 8. Skilled labour,
or artisans’ wages. 9. Unskilled labour, or the
wages of labourers, soldiers, seamen, etc. 10. Professional services, or the emolument of authors,
inventors, lawyers, engineers, clergymen, account:
ants, and other professional and clerical classes.
[2; p. 186]
In short, he argued that asset prices adjust faster
than raw material prices, raw material prices faster
than final product prices, and the latter faster than
the prices of productive factors.
Third, he pointed out that, because prices do not
adjust uniformly, monetary shocks necessarily distort
1

On Del Mar, see Tavlas [10].

ECONOMIC REVIEW, MAY/JUNE 1984

the structure of relative prices and thereby disrupt
production and discoordinate economic activity. As
he put it,
to increase money, or permit it to increase, is not
merely to enhance all prices simultaneously: it is
to enhance the price of some things in point of time
before others . . . [The result] is to derange and
throw into disorder all the varied and complicated
interests of society. [2; p. 188]
Similarly, to contract the money supply
is to depress the prices of certain commodities
sooner than others, and to occasion a derangement
of affairs even more perilous to society; for . . . a
[nonuniform] fall of prices hinders commerce and
depresses production, and thus deprives labour of
employment or tangible existence. [2; p. 188]

Here, contrary to Austrian contentions, is one early
monetarist’s recognition of the relative price/real
output effects of monetary disturbances. To prevent
these disturbances, he recommended that money’s
growth be stabilized at a constant rate equal to the
trend growth rate of real output, estimated by him to
be 3.3 percent per year [10; p. 18].
Finally, although he did not (like the Austrians)
discuss how monetary expansion alters the time structure of production and leads to an overinvestment of
capital, he did state that the new money causes the
real rate of interest temporarily to fall below its
equilibrium level, thereby lowering the real cost of
borrowing relative to final product prices and the
expected return on investment. The resulting rise
in actual and anticipated profit, he said, induces a
corresponding rise in the demand for loans to finance
new investment projects. Eventually the rise in loan
demand bids the real rate into equilibrium, but not
before additional new investment projects have been
started. Here is Del Mar’s recognition that the
monetary mechanism embodies an interest rateinvestment channel-the same channel emphasized in
the Austrian approach.
Irving Fisher ( 1867-l 947)
The next monetarist to be considered is Irving
Fisher, the famous monetary reformer, pioneer
econometrician, and America’s foremost quantity
theorist. A careful reading of his work reveals that
he did not neglect the relative price and resource
allocation effects of monetary changes. On the contrary, he asserted that such effects always occur
during transitional adjustment periods, periods in
which individual “prices never do move in perfect
unison” with each other or with the money stock
[3; p. 184].
Thus in Chapter 9 of his famous The Purchasing

Power of Money (1911)-a chapter devoted to a
discussion of “the dispersion of prices”-he argues
that the existence of such inhibiting factors as contractual restraints, legal prohibitions, and the inertia
of custom render individual prices sticky such that
they adjust at different speeds to monetary shocks.
The result, he noted, is to alter the structure of relative prices and therefore the pattern of real output.

Distinguishing between the long-run neutrality and
short-run nonneutrality of monetary changes, Fisher

states that
The chief conclusion of our previous study is that
an increase of money, other things equal, causes a
proportional increase in the level of prices. In
other words, the p’s in the sum EpQ tend to rise in
proportion to the increase in money. It was noted,
however, that the adjustment is not necessarily
uniform, and that if some p’s do not rise as much
as in this proportion, others must rise more. In
this connection, we observe that some prices cannot
adjust themselves at once, and some not at all.
This latter is true, for instance, of prices fixed by
contract. A price so fixed cannot be affected by
any change coming into operation between the date
of the contract and that of its fulfillment. Even in
the absence of explicit contracts, prices may be
kept from adjustment by implied understandings
and by the mere inertia of custom. Besides these
restrictions on the free movement of prices, there
are often legal restrictions; as, for example, when
railroads are prohibited from charging over two
cents per passenger per mile, or when street railways are limited to five-cent or three-cent fares.
Whatever the causes of nonadjustment, the result
is that the prices which do change will have to
change in a greater ratio than. would be the case
were there no prices which do not change. Just as
an obstruction put across one half of a stream
causes an increase in current in the other half, so
any deficiency in the movement of some prices must
cause an excess in the movement of others. [3;
p. 184, 185]

The resulting change in relative prices stemming
from these differential individual price movements
alters the composition of real output. For,
as each p changes, the “Q connected with it will
change also; this, because usually any influence
affecting the [relative] price of a commodity will
also affect the consumption of it. [3; p. 194]

This alteration in the output mix, Fisher noted,
introduces a new complication. We have in many
of our previous discussions been assuming, as was
admissible theoretically, that all the Q’s remain unchanged while we investigate the changes in the
p’s due to changes in the currency or in velocities
of circulation. But practically we can never get an
opportunity to study such a case. [3; p. 194]

In other words, monetary shocks invariably entail
relative price and real output effects. These effects

cannot be disregarded by the analyst.
could hardly put it more convincingly.

FEDERAL RESERVE BANK OF RICHMOND

Austrians

15

Real Wage/Employment Effects : Fisher’s
Phillips Curve Analysis
Of the relative prices affected by monetary shocks,
Fisher emphasized two, namely real wage rates (i.e.,
nominal wages deflated by commodity prices) and
real interest rates (i.e., nominal yields corrected for
inflation), In his seminal 1926 International Labour
Review article entitled “A Statistical Relation Between Unemployment and Price Changes”-now
recognized as the first rigorous statistical analysis of
the Phillips curve tradeoff between unemployment
and inflation,2 he argued as follows regarding the
real wage effects of monetary changes. He noted
first that nominal wages (“which are fixed sometimes
either by contract or custom, for at least a number of
months”) tend to adjust to monetary changes less
rapidly than do product prices. Thus real wages fall
when money and prices are increasing and rise when
money and prices are falling. Assuming that employers’ demand for labor (hiring) varies inversely
with real wages, it follows that monetary expansion
temporarily stimulates employment and monetary
contraction temporarily depresses it. In other words,
according to Fisher,
the ups and downs of employment are the effects,
in large measure, of the rises and falls of prices,
due in turn to the inflation and deflation of money
and credit. [4; p. 502]

Here is Fisher’s recognition of one important nonneutrality (namely the employment effect) of money.
This emphasis on the short-run nonneutrality of
money is even more pronounced in his treatment of
the real interest rate effects of monetary changes,
effects which constitute the core of his theory of the
business cycle.
Real Interest Rate Effects
With respect to these real interest rate effects he
argued as follows: Suppose the money supply increases, thereby putting upward pressure on prices.
Suppose further that the price rise is initially unanticipated and therefore is not immediately incorporated into nominal rates. Because sluggish nominal
interest rates do not at first rise as fast as product
prices, real rates fall below their equilibrium level
(the expected profit rate on new capital investment).
Businessmen, desiring to take advantage of this rate
disparity, step up their real loan demands. Assuming
2

Indeed, Fisher’s paper has been reprinted in the March/
April 1973 issue of the Journal of Political Economy
under the title “I Discovered the Phillips Curve.”

16

banks accommodate these loan demands and that the
increased real loans are used to finance new real
projects made possible by the inflation-induced overemployment of labor and other resources, it follows
that real output rises. In Fisher’s words, “Trade
(the Q’s) will be stimulated by the easy terms for
loans” [3 ; p. 61]. This is the expansion phase of the
cycle.
According to Fisher, the expansion ends when the
sluggish nominal rate finally adjusts completely to the
rate of price increase and the real rate returns to its
equilibrium level. The economy, however, does not
stabilize at this point. Instead, the rise in the real
rate precipitates a wave of business bankruptcies that
trigger fears of the soundness of banks. These fears
in turn prompt a run on banks, a drain of cash reserves, a financial crisis, and ultimately a collapse of
the money supply. Fisher explains :
With the rise of interest, those who have counted
on renewing their loans at the former rates and for
the former amounts are unable to do so. It follows
that some of them are destined to fail. The failure
(or prospect of failure) of firms that have borrowed heavily from banks induces fear on the part
of many depositors that the banks will not be able
to realize on these loans. Hence the banks themselves fall under suspicion, and for this reason
depositors demand cash. Then occur “runs on the
banks,” which deplete the bank reserves at the very
moment they are most needed. Being short of
reserves, the banks have to curtail their loans. It is
then that the rate of interest rises to a panic
figure. Those enterprisers who are caught m u s t
have currency to liquidate their obligations, and to
get it are willing to pay high interest. Some of
them are destined to become bankrupt, and, with
their failure, the demand for loans is correspondingly reduced. This culmination of an upward price
movement is what is called a crisis,-a condition
characterized by bankruptcies, and the bankruptcies being due to a lack of cash when it is most
needed. [3; pp. 65-66]

As a result of this crisis and the drain of bank
reserves, the money stock falls, prices fall, and (because the nominal rate does not adjust as fast as
product prices) real rates rise above their equilibrium
level. The result is a decline in the real demand for
loans and the level of real activity financed by those
loans. The cycle enters its depression phase, a phase
triggered by the preceding crisis and its panicinduced shrinkage of the money stock.
Fisher and Austrian Business Cycle Theory
Fisher’s analysis, appearing as it did in his 1911
The Purchasing Power of Money fully one year
before von Mises’ The Theory of Money and Credit,
presaged much of the Austrian theory of the trade

ECONOMIC REVIEW, MAY/JUNE 1984

cycle. That this is so and that Fisher (as well as
Del Mar) deserves credit for anticipating some of the
essentials of the Austrian approach is evident from a
comparison of the two views. For, contrary to the
Austrians’ contentions, such comparison reveals that
Fisher’s’ monetarist theory of the cycle is virtually
the same as the Austrian theory in several key respects. Not only did he, like the Austrians, see
monetary disturbances as the dominant cause of the
business cycle, but, like them, he also viewed the
cycle as the outcome of real reactions to the purely
monetary shocks. And like them, he emphasized the
relative price and real output effects of monetary
changes.
In particular, like the Austrians, he highlighted the
role of a disequilibrium real interest rate as a transmitter of misinformation and a discoordinator of
production. Specifically, he argued that when an
inflationary monetary injection pushes the real rate
below its equilibrium level, the result is a misleading
price signal that directs too many resources into
capital-intensive projects, projects that would not be
justified at the equilibrium rate. He even uses the
same terminology as the Austrians, speaking of “maladjustments in the rate of interest” that “beguile”
business borrowers to “overinvest” [3; p. 66]. Like
his Austrian counterparts, he recognized that depression is the necessary and inevitable outcome of
the capital overinvestment of the preceding boom.
Also, like the Austrians, Fisher recognized how
interest rate changes can alter the time structure of
production and thus the composition (mix) of output.
He did so when he stated that a money-induced
“movement of interest will tend to make the prices,”
and hence real quantities, “of different [goods] vary
in different directions or to different extents” depending upon their relative, capital intensities [3;
p. 193].
Finally, like the Austrians, Fisher maintained that
although the economy is always tending toward
steady-state equilibrium, it rarely attains it before
fresh shocks occur. Consequently, dynamic disequilibrium is the normal state of affairs. For,
While the pendulum is continually seeking a stable
position, practically there is almost always some
occurrence to prevent perfect equilibrium. Oscillations are set up which, though tending to be selfcorrective, are continually perpetuated by fresh
disturbances. [3; p. 70]

It follows that :
Since periods of transition are the rule and those of
equilibrium the exception, the [monetary] mechanism . . . is almost always in a dynamic rather
than a static condition. [3; p. 71]

Although a monetarist, Fisher here exhibits two
characteristics of the Austrian School: first, a belief
that the economy is virtually always out of steadystate equilibrium, and second, an emphasis on equilibrating processes rather than equilibrium positions
per se.
These similarities make it difficult to distinguish
Fisher’s cycle theory from the Austrians’. Moreover,
they hardly support the notion of a unique Austrian
view of the monetary mechanism.
Clark Warburton (1896-1979)
Fisher was neither the first nor the last monetarist
to stress the nonneutral relative price effects of monetary changes: he was followed in the 1940s and
1950s by Clark Warburton. It was Warburton who,
almost singlehandedly, revived and continued to use
the quantity theory of money throughout the heyday
of the Keynesian revolution at a time when research
on monetary factors was all but dead: That he fully
recognized money’s temporary relative price effects
is evident in his statement that a monetary-induced
change in the level of prices is a process which
takes a period of time, and affects prices of various items sequentially rather than simultaneously.
[This sequential adjustment occurs because] some
prices are greatly influenced by custom or contract
and move less readily than other prices; specifically, wages and contractual elements in business
costs tend to be sluggish relative to price of output.
[The result is that] the process of adjustment to
the new price level required by the changed quantity of money . . . produces price differentials,
which increase or reduce the profitability [and
[11;
hence production incentives] of business.
pp. 28, 86]

In other words, due to the lag of wages and other
costs behind prices and the resulting impact on
profits, monetary changes have real effects. Specifically,
monetary deficiency . . . is the major cause of
business depression and declining employment.
Monetary expansion at a more rapid rate than
economic progress, on the other hand; is the major
cause of business recovery and increasing employment. . . . [11; p. 87]

This statement hardly indicates a disregard of the
short-run nonneutrality of money. To prevent such
nonneutralities and their underlying monetary causes,
Warburton favored stabilizing money’s growth at a
constant rate equal to the differential growth rate
between output and velocity.
Warburton on Monetary Injection Effects
Warburton likewise stands exonerated from the
particular charge that monetarists ignore the non-

FEDERAL RESERVE BANK OF RICHMOND

17

neutral first-round injection effects of monetary disturbances (i.e., the initial real-sector effects stemming directly from the way new money enters into
the circulation). This charge stems from the Austrians’ allegation that monetarists unanimously assume that new money is distributed equiproportionally (and therefore neutrally) across cashholders as
if by helicopter drop. By contrast, Austrians contend
that new money in fact enters the economy at a
specific point and thereby temporarily raises prices
at that point relative to prices elsewhere. That Warburton, although a monetarist, adhered to this latter
Austrian view is evident from his discussion of injection effects. Monetary injections, he said,
are felt, first, in some particular part of the economy and spread from that part to the rest of the
economy through the medium of price differentials
created at each stage of adjustment. [11; p. 85]
Evidently Austrians are mistaken in holding that
monetarists invariably adhere to the helicopter model.
Milton Friedman
The preceding has documented that earlier generations of monetarists did not ignore temporary nonneutral relative price and real output effects of
monetary changes. Still, the view persists (especially
among some Austrians) that the current generation
of monetarists overlook these effects.
Indeed,
O’Driscoll and Shenoy characterize Milton Friedman’s view of the monetary mechanism as one that
“entirely ignores the microeconomic pricing process”
and that totally neglects “money’s effect on individual prices and price interrelationships” [9; pp. 191,
192].
This charge, however, is refuted by Friedman’s
own portfolio-adjustment explanation of the transmission mechanism, an explanation that stresses how
substitution out of excess money holdings into a
broad spectrum of financial and real assets changes
the relative yields of those assets and their prices
relative to the price of new output. Tracing a chain
of causation from increasing money to rising real
balances to a fall in the implicit convenience and
security yield on holdings of those real balances and
thence to cashholders’ attempts to switch into higher
yielding nonmoney assets, he argued that the result
will be a rise in the prices (fall in yields) of those
assets relative to the cost (yield) of producing them
new. This differential, in turn, will stimulate spending to produce real output of those assets. Says
Friedman of these relative price and real output
effects :
18

An increased rate of monetary growth . . . raises
the amount of cash that people and businesses have
relative to other assets. The holders of the now
excess cash will try to adjust their portfolios by
buying other assets . . . . However, as people
attempt to change their cash balances, the effect
spreads from one asset to another. This tends to
raise the prices of assets and to reduce interest
rates, which encourages spending to produce new
assets and also encourages spending on current
services rather than on purchasing existing assets.
That is how the initial effect on balance-sheets gets
translated into an effect on income and spending.
[7; pp. 24-25]

Thus, far from neglecting relative prices or yields,
Friedman recognizes a myriad of them-far more
than are recognized by Keynesians (who also employ
a portfolio-adjustment model) and probably more
than are recognized by the Austrians. Indeed he
points out that the main difference between Keynesian
and monetarist analyses of the transmission mechanism is in the range of assets and interest rates considered.
The difference in this area between the monetarists
and the Keynesians is not on the nature of the
process, but on the range of assets considered. The
Keynesians tend to concentrate on a narrow range
of marketable assets and recorded interest rates.
The monetarists insist that a far wider range of
assets and of interest rates must be taken into
account. They give importance to such assets as
durable and even semi-durable consumer goods,
structures and other real property. As a result,
they regard the market interest rates stressed by
the Keynesians as only a small part of the total
spectrum of rates that are relevant. [7; p. 25]

Friedman’s stress on a whole host of relative prices
makes him comparable to the Austrians, who also
stress these components. It should be noted, however,
that Friedman also stresses one additional relative
price effect largely ignored by Austrians, namely a
real wage/employment effect. Thus, in his famous
1967 presidential address to the American Economic
Association [6], he points out how, owing to workers’
misperceptions of inflation and the resulting lag of
nominal wages behind prices, an unanticipated monetary change can temporarily alter real wages and
thus the level of employment. In sum, far from
ignoring relative prices in the monetary mechanism,
Friedman recognizes more of them than do the Austrians.
Karl Brunner and Allan Meltzer
Other well-known modern monetarists who, like
Friedman, emphasize nonneutral relative price effects
in the monetary mechanism include Karl Brunner
and Allan Meltzer. Their contributions have recently

ECONOMIC REVIEW, MAY/JUNE 1984

been summarized by David Laidler. He states that
Brunner and Meltzer
. . . had already developed a view of the transmission of monetary impulses in asset markets that
stressed the role of relative prices as signalling
devices, and found it easy enough to extend that
line of reasoning to the markets for output and
labor services as well. [8; p. 10]

More precisely, Brunner and Meltzer argue (1)
that a monetary expansion initially lowers the implicit
convenience and security yield on real cash balances
relative to the yields on other assets, (2) that this
fall in money’s relative yield induces a substitution
out of cash balances into a broad range of noncash
assets, (3) that the resulting increased demand for
those assets lowers their yields and raises their prices,
(4) that, in particular, such substitution raises the
prices of existing real capital assets and consumer
durable goods relative to the costs of producing them
new, and finally, (5) that this price-cost differential
encourages production of those real assets. In this
way, monetary impulses spread sequentially across a
heterogeneous array of assets, temporarily affecting
relative asset prices as well as the prices of those
items relative to the prices of newly produced goods,
This view, with its emphasis on money-induced
changes in the structure of prices and thus-the composition of demand, is remarkably similar to its Austrian counterpart, which likewise stresses these
effects.

advocate some form of a constant monetary growth
rate rule. By contrast, Austrians, with their desire

to transfer monetary control from the government to
the private sector, advocate the abolition of central
banks in favor of either strict adherence to a gold or
other commodity standard or reliance on a regime of
freely competing private fiat currencies. Apart from
these and other important differences (such as the
Austrians’ desire for swift monetary deceleration
versus the monetarists’ policy of gradualism), both
schools agree that money must be stabilized and that
the pursuit of active (discretionary) countercyclical
monetary policy by unconstrained central banks is not
the way to do it. On this fundamental point, as on the
importance of relative price effects in the monetary
mechanism, the two schools are in concurrence.
References
1. Barry, Norman P. “Austrian Economists on Money
and Society.” National Westminster Bank Q u a r terly Review (May 1981), pp. 20-31.
2. Del Mar, Alexander. The Science of Money. Reprint of the second edition (1896). New York:
Burt Franklin, 1968.
3. Fisher, Irving. The Purchasing Power of Money.
Reprint of the second revised edition (1922). New
York: Augustus M. Kelley, 1963.
4.

Conclusion
The preceding paragraphs have documented that,
contrary to the contention of some Austrian writers,
monetarists did not neglect nonneutralities and relative price effects in their analysis of the monetary
mechanism. On the contrary, monetarists, like Austrians, stressed these effects. Moreover, as documented above, monetarist and Austrian theories of
the business cycle share many of the same or similar
characteristics. Because of this, the two approaches
should be seen as complementary rather than as
competing. The similarity between the two views
also casts doubt on the notion of a unique Austrian
view of the monetary mechanism.
Whatever their similarities or differences, the two
views yield the same policy insight, namely that
monetary disturbances are capable of producing
severe disruptions to the real economy and for that
reason should be avoided. True, the two schools
differ over how monetary stability is to be achieved.
Monetarists, with their disapproval of discretionary
intervention and monetary fine-tuning, generally

. “A Statistical Relation between Unemployment and Price Changes.” International Labour Review, 13 (June 1926), 785-92. Reprinted as
“I Discovered the Phillips Curve.” Journal of
Political Economy, 81 (March/April 1973), 496502.

“The Quantity Theory of
5. Friedman, Milton.
Money: A Restatement,,’ in Studies in the Quantity Theory of Money. Ed.
Milton
Friedman.
Chicago, University of Chicago Press, 1956, pp.
3-24.
6.
7.

“The Counter-Revolution in Monetary
Theory.” IEA Occasional Paper No. 33. London:
Institute of Economic Affairs, 1970.

8. Laidler, David. “Monetarism : An Interpretation
and an Assessment." Economic Journal, 91 (March
1981), l-28.
9. O’Driscoll, Gerald P., Jr., and Shenoy, Sudha R.
“Inflation, Recession, and Stagflation,” in The
Foundations of Modern Austrian Economics. E d .
Edwin G. Dolan. Kansas City: Sheed and Ward,
1977, pp. 185-211.
10. Tavlas, George S. “Alexander Del Mar, Irving
Fisher and the Quantity Theory of Money: A
Reconsideration of the Doctrinal Foundations o f
Monetarism.” Unpublished paper.
11. Warburton, Clark. Depression, Inflation and Monetary Policy: Selected Papers, 1945-53 Baltimore
:
Johns Hopkins Press, 1966.

FEDERAL RESERVE BANK OF RICHMOND

19

EQUALIZING REGIONAL DIFFERENCES IN WAGES:
A STUDY OF WAGES AND MIGRATION IN THE
SOUTH AND OTHER REGIONS
William E. Cullison
Economic theory predicts that real wage differentials across geographical areas will not persist so
long as there is free trade or free factor mobility
among the areas. Persistent real wage differentials
among regions of a country such as the United States
would therefore be puzzling because, in addition to
free trade, there is free movement of capital and
labor. It is, however, part of the nation’s folklore
that real wages are persistently lower in the South
despite a rather substantial migration into the Southern region. As Sahling and Smith (SAS) pointed
out in a 1983 study of regional wage differentials [3],
Since the beginning of this century, wages in the
South had remained not only lower than in the
North but also substantially lower than in every
other region of the country. Early studies attributed the regional differentials in money wage to
variations in the quality of the labor force, in the
industrial or occupational mix, severity of discrimination by race or sex, etc. After controlling for
these factors, wages were still observed to be lower
in the South. [3, p. 131]
Mancur Olson’s 1983 presidential address to the
Southern Economics Association, entitled provocatively, “The South Will Fall Again: The South as
Leader and Laggard in Economic Growth,” restates
this economic folklore. Interpreting the results of a
study by Charles Hulten and Robert Schwab [1],
Olson noted,
Their estimates are full of paradoxes that are
utterly inconsistent with any standard neoclassical
story. . . . The labor moves away from the high
wage regions to the relatively low-wage South and
other growing regions in large quantities; a large
part of the growth of these regions is due to increases in employment. Labor, in other words,
moves to the regions where its marginal product is
lower. [2, p. 922]

been no cartelization and free entry in the labor
markets of the Northeast and the older Middle
West the workers could in general have enjoyed
higher wages by staying at home. But if, as has
been argued here, there were cartelized supracompetitive wage levels in the older and long-stable
regions of the country, employers would not want
to take on many of the workers who would have
liked employment with them, so these workers had
no choice but to move to the South or other growing
regions to take lower-paying jobs. [2, p. 922]
Suppose, however, that real wages in actuality
were not lower in the South than in other areas.
Sahling and Smith’s 1983 study, noted briefly earlier,
also bore a provocative title, “Regional Wage Differentials : Has the South Risen Again?” Their analysis concluded that
. . . real wages for both male and female workers
are sharply lower throughout the Northeast than
for comparable urban workers in the South. Moreover, these real differentials widen between 1973
and 1978. . . . In 1978, money wages for males were
lower throughout the Northeast than for comparable workers in the South. For females, money
wages remained slightly higher in the New York
area than for comparable workers in the South but
were lower in the rest of the Northeast than in the
South. [2, p. 134]
If Sahling and Smith are correct, the migration patterns noted by Olson are quite consistent with “any
standard n&classical [economic] story.”
This article is devoted to an examination of regional wage differentials, with particular emphasis on
the South. It builds upon the work of Sahling and
Smith by testing the robustness of their results using
an alternative methodology and a less controversial
definition of the South.1 It also extends their analysis
1

Olson explains the apparent, deviation from standard economic theory by union growth and a subsequent cartelization of labor markets.
Why would workers go through the costs and upheaval of migration to move from where wages
were high to where they were low? If there had
20

Sahling and Smith included the Washington, D.C.Maryland-Virginia and the Baltimore SMSAs in the
South region. Although there were legitimate reasons
for placing those two SMSAs in the Southern region, the
inclusion led some critics to dismiss their conclusions on
the grounds that their study was biased toward higher
wages in the South. The empirical work for this study
does not place Baltimore and Washington in the Southern region.

ECONOMIC REVIEW, MAY/JUNE 1984

to 1981. The article confirms their results and concludes that, contrary to folklore and Mancur Olson,
the South is not a low wage area any longer, if it
ever was.
The article is divided into five sections. The first
describes methods of analysis. The second examines
real and nominal wages in standard metropolitan
statistical areas. The third presents empirical findings
from a broader sample of workers that includes those
who live in rural and small urban areas. The final
two sections summarize the findings and present the
major conclusions of the study.
Methods of Analyzing Wage Differentials
This section includes a discussion of the statistical
techniques used in this study and the Sahling and
Smith study. It can be skipped by readers interested
solely in statistical results rather than statistical
methods.
The Sahling and Smith (SAS) Technique Sahling
and Smith’s study was designed to compare wage
differentials of similar workers in similar jobs. Their
article thus addresses the question of whether an
individual worker in one region would be likely to
earn higher wages in a similar job in another region.
They do not attempt to explain regional differences
in the overall average wage, which can be quite different. The overall average wage differential is affected,
for example, by regional differences in occupational
and industrial mix, while the average regional wage
differential of like workers in like jobs is not.
To determine wage differentials of similar workers
in similar jobs, Sahling and Smith (SAS) used a
wage regression. They hypothesized that wages were
a function of age, education2 martial status, race,
veteran status, ethnicity (Spanish), occupation,3 industry, 4 number of jobs held, union membership, sex,
and region. Instead of including variables to represent region and sex, however, separate regressions
were run for workers of each sex who lived in each of
five regions of the country. One set of regressions
used actual dollar wages earned as the dependent
variable, another used wages adjusted for differences
2

The age groups are 14-19, 20-35., 35-64, and 65-75. The
educational groups are, no education, l-5 years, 6-9 years,
10-13 years, 14-16 years, and 17 or more years.
3

Professional, manager, sales, clerk, craftsman, operative,
laborer, or service worker.

in regional costs of living.5 Since the method used to
derive estimates of regional wage differentials from
the regressions mentioned above is complicated, the
following example of the technique may be useful.
Suppose that one is comparing the New York City
area to the South. After estimating regression equations for wages in the New York City area and the
South based upon the labor force and occupational
characteristics mentioned above, SAS computed
arithmetic means of each such characteristic for the
two areas. They then plugged each set of arithmetic
means into the regression equation for the other area
and computed a predicted wage.
Taking a particular instance, suppose the set of
means described the New York City area. When
average values of the independent variables describing workers who reside in the New York City area
are plugged into the South regression, the resulting
figure estimates the average wage that the New York
City area work force would have earned if it had
moved to the South. This estimate-is compared to
the actual average wage of workers in the New York
City area.
Similarly, the arithmetic means of the independent
variables that describe the South are also plugged
into the New York City area regression. The resulting figure predicts the average wage of the Southern workers if they had moved to the New York City
area. This predicted wage is then compared to the
actual average wage of the Southern workers.
As a result, the Sahling and Smith analysis yields
two different wage differentials for each region,
thereby raising the question of which differential is
more nearly correct. Sahling and Smith discuss this
dual differential dilemma and outline an ideal (but
Arguing
complicated) technique for resolving it.
that each differential represents an extreme case,
however, they opt for simplicity and average the two
differentials for each region.
While the exact meaning of the averaged differential is unclear, the gains from simplification presumably justify their approach. The conclusions of
their study, however, were so contrary to conventional wisdom that it seemed desirable to test the
robustness of their approach.
The Peer Group Technique This study uses an
alternative technique to adjust for regional differences in workers and jobs. This method, labelled the

4

Agricultural, mining and construction; manufacturing,
durables or nondurables ; transportation, communications
or public utilities; wholesale trade; retail trade; finance,
insurance and real estate; business services;. personal
services; professional services; or public administration.

5

The cost-of-living adjustments are from the BLS’s
release on average budgets for intermediate income
families of four for selected urban areas.

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21

peer group technique, apportions individuals into
small groups made up of their exact peers classified
by all of the criteria (except region of residence) used
by Sahling and Smith for their analysis of wage
differentials. After each peer group is determined,
the average wage of those group members who live in
the South is calculated and the wage of each nonSouthern individual is recorded as a ratio of the
Southern average wage. The procedure thus yields a
set of wage ratios for each peer group-the number
corresponding to the number of individuals in the
group who do not reside in the South. After determining the set of relative wages in every peer group,
the ratios are summed across peer groups by region,
averaged, and tested to see whether the resulting
average regional wage differentials were statistically
significantly different from one.6
This technique has an advantage over the SAS
method because the researcher knows how many
workers in any given sample are strictly comparable.
It also yields a standard error that enables the researcher to estimate the odds that a wage differential
for like workers in like jobs actually exists, i.e., is
not a result of random sampling error. It also adjusts
for all possible interaction between the regional and
the individual characteristics, something that is very
difficult to do with the SAS method.
So much for the advantages of the peer group
method. The disadvantage of the method is that it
requires a very large sample. This requirement
makes the method’s results somewhat suspect for the
studies of wage differentials in 1981 and 1983. For
that reason, this study also calculates wage differentials by the SAS method for those years.
The Data Set Data were taken from the May
1978, May 1981, and April 1983 Current Population Surveys (CPS). These monthly census surveys provide the household data on employment
status from which the Department of Labor calculates
the unemployment rate. Although the CPS surveys
are quite large, only a quarter of those surveyed are
currently asked to reveal their earnings (in 1978 all
6

In actuality, the wage data were transformed into logarithms, so the test was translated into a test to see
whether the log of the wage differential was significantly
different from zero. The standard error calculated was
the standard error of the difference between sample
means, paired observations,

workers were asked the wage question). Sahling and
Smith restricted their study to workers living in the
29 largest SMSAs in order to adjust their data for
regional differences in costs of living. As a result,
the subsamples that they eventually analyzed included
only 13,502 workers in 1973 and 13,147 in 1978.
For 1978, wage data (average hourly earnings to
be exact) were available for 45,900 workers, 16,800
of whom resided in SMSAs. The analysis of nominal
wage differentials from statewide data, discussed
subsequently, is based upon this 45,900 worker
sample, whereas the analysis of nominal wage differentials from SMSA data utilizes the 16,800 worker
sample. The sample size for the study of real wage
differentials was a smaller 13,853, because the costof-living data7 were available only for the 29 largest
SMSAs.
The usable subsample was reduced drastically in
1981 as a result of economy measures taken by the
Government. Only 15,200 workers were asked to
reveal their wages in that year. Of these, 5,600 lived
in SMSAs, and only 4,600 lived in large SMSAs.
The usable subsample in 1983 included 14,565
workers, of whom 5,407 lived in SMSAs.
Empirical Result-Workers Who Reside
in SMSAs
Chart 1 shows nominal regional wage differentials
of workers who resided in SMSAs in 1978, 1981, and
1983, and real wage differentials of workers who
resided in one of the 29 largest SMSAs in 1978 and
1981. The lines on the charts show the wage differentials as percentages of wages in the South area.
Each chart shows wage differentials calculated both
by the SAS and peer group methods, mentioned
earlier, and (for comparison) the regional differences in overall average wages. This last-mentioned
comparison is derived simply by averaging everyone’s
wages in a region and comparing that average to the
average wage in the South. The chart, of course,
only summarizes the detailed findings, which are
presented in tabular form in the Appendix.
The chart shows clearly that in 1978, regardless of
the method used, real wages in the South were substantially higher than in all other regions except the
West. This result is consistent with the SAS study.
In 1981, the last year for which a regional cost-ofliving index was published, Southern real wage rates
7

This study used the same type of cost-of-living data as
that mentioned in footnote 5. The sources were News,
Bureau of Labor Statistics, USDL 79-305 and USDL
82-139.

22

ECONOMIC REVIEW, MAY/JUNE 1984

Chart 1

REGIONAL WAGE DIFFERENTIALS OF
WORKERS WHO RESIDE IN SMSAs
(Percent of South)

FEDERAL RESERVE BANK OF RICHMOND

23

New York City area workers sampled in 1981 and
132 in 1983 had counterparts in like jobs in the
South. The smaller sample sizes may explain a very
puzzling result, namely the New York-South nominal
wage differential for males in 1981. The finding that
nominal wages for males were 10 percent higher in
the South than in the New York City area in that
year is implausible (the SAS method shows South
wages to be only 4 percent higher). The time profile
of the differential, from 101 percent in 1978 to 90
percent in 1981 to 102 percent in 1983, heightens that
implausibility. The result is indicated by the data,
however (and it is statistically significant at the 2
percent level), so it is reported here.

remained above those in the North East regions regardless of the measurement method. According to
the peer group method, real wages in the South were
higher than wages in any other region in 1978 and
1981. Chart 1 also shows nominal wages plotted for
the three years. This chart shows, surprisingly, that
nominal wages were higher in the South in 1981 than
for comparable males in the New York City, the’ rest
of the North East, and North Central areas.
These last results are similar to those found by
Sahling and Smith for 1978 reported in the quote at
the beginning of this article, although the wage differentials shown in the chart are not strictly comparable
to those found by Sahling and Smith. First, SAS
defined the South to include the Washington, D.C.Maryland-Virginia and the Baltimore SMSAs. Secondly, the nominal wage data include wages of workers from all SMSAs in a given region, not just the
29 largest SMSAs.
Table I shows the actual wage differentials estimated in the SAS study compared to the wage
differentials estimated by the peer group method for
1978. For this table Washington and Baltimore were
included in the South. As the table shows, the implications of the two methods for North-South regional
wage differentials are approximately the same. The
peer group method shows a larger Southern advantage in relative real wage payments than the SAS
results, however. Chart 1 also illustrates that relatively high nominal wages continued in the South
in 1981.
The results of the peer group analysis for 1981 and
1983 should be viewed with some skepticism, however, because of the smaller, sample sizes included.
As is shown in the Appendix, for example, only 89

More Empirical Results-Workers Classified
Into Regions From Statewide Data
This section’s analysis will be limited to nominal
wages, since cost-of-living data are not available by
state. For this analysis the data set was larger, and
workers were grouped into eight regions; the South,
the Mid-Atlantic, New England, East North Central,
West North Central, West South Central, Mountain,
and Pacific.
All of these divisions except the South and the
Mid-Atlantic regions follow Standard Census Division Codes. The South includes Alabama, Florida,
Georgia, Kentucky, Mississippi, North Carolina,
South Carolina, Tennessee, Virginia, and West Virginia. The Mid-Atlantic division includes Delaware,
the District of Columbia, Maryland, New Jersey,
New York, and Pennsylvania.
Chart 2 shows nominal wages in 1978, 1981, and
1983 in each of these regions. As in Chart 1, the
lines represent percentage wage differentials esti-

Table I

SAHLING AND SMITH DATA COMPARED TO DATA DERIVED FROM THE PEER GROUP METHOD, 1978
(Percent of South)

* Washington and Baltimore are in the South.
Sources:

24

Sahling and Smith [3, p. 134]; derived from May 1978 Current Population Survey, USDL 79-305 and USDL 82-139.

ECONOMIC

REVIEW,

MAY/JUNE

1984

Chart 2

REGIONAL WAGE DIFFERENTIALS FROM STATEWIDE DATA
RELATIVE WAGES BY REGION
(Percent of South)

FEDERAL RESERVE BANK OF RICHMOND

25

mated by the SAS and the peer group methods
compared to the overall average wage differential.
As the chart shows, overall average nominal wages
in the South are consistently lower than wages. in
other regions of the country. When the data are
adjusted to compare like workers in like jobs, however, the wage differentials narrow, and wages in the
South become relatively higher in a few regions.
In 1978, for example, wages were higher in the
South than in the West South Central, West North
Central, and New England areas, according to the
peer group comparisons. In 1981, Southern workers
earned lower nominal wages than their counterparts
in every region other than New England. In 1983,
the position of Southern wage-earners slipped relative to their counterparts in New England but improved relative to the West North Central area.
Wage differentials for comparable workers were
highest in the Pacific region in each of the three
years. The Pacific area includes California, Washington, Oregon, Alaska, and Hawaii.
The peer groups plotted on Chart 2 are not classified by union membership status, since (1) the statewide data include rural areas that are particularly
unlikely to be heavily unionized in the South and
(2) union membership status was not available on
the April 1983 CPS tape. The results of the peer
group method both with and without the union
membership criterion, however, are shown in the
Appendix.
Overview of Empirical Results
As Table A-1 shows, average real wages of SMSA
dwellers in the South in 1978, even with no adjustment to compare like workers in like jobs, were
higher than wages in every other region of the country except the West. When the peer group technique
was used to compare like workers in like jobs (see
Table A-2), real wages of SMSA dwellers in the
South were found to be higher than every other
region.
By 1981 the situation had changed slightly. As
Table A-1 also shows, average real wages of SMSA
dwellers for North Central males had moved higher
than the Southern average, although the West retained its advantage. After adjustments to compare
similar workers in similar jobs (see Table A-3); real
wages for males were higher in the South, as they
were in 1978. Real wages for Southern female
SMSA dwellers, on the other hand, were found to
be higher than wages of peers in the entire North
26

East, but only about equal to real wages of peers in
the North Central and West regions.
With respect to nominal wages, wages of males
living in Southern SMSAs in 1978 appeared to be
about equal to nominal wages for like. workers in
New York, the Rest of the North East, and the
North Central regions. Nominal wages of urban
Southern males in 1981 were higher than those of
their counterparts in every region except the West,
according to the peer group results. By 1983, nominal wages of Southern males had moved lower than
those of their counterparts in any other region, although the differentials for the New York City and
Rest of the North East areas were not statistically
significant.
Nominal wages for Southern females were significantly lower in 1978 than wages of like workers in all
regions except the North Central. In 1983, their
wages were significantly lower than their counterparts in all other regions except the Rest of the
North East.
When wages of residents of rural and small urban
areas were included in the analysis, nominal wages
of Southern male workers were not significantly
different from wages of their peers in the New England, West North Central, and West South Central
regions, although they were low relative to the other
regions, particularly the Pacific and Mountain areas.
Relative wages of Southern females followed approximately the same pattern except that their wages were
not significantly lower than their peers in Mountain
states.
Wages for males who live in the Pacific area were
found to be 20-25 percent higher than wages of comparable males in the South. Without cost-of-living
data, however, it is difficult to evaluate these relative
wage differentials meaningfully. The relative cost
of living in parts of the Pacific area, particularly in
Alaska and Hawaii, is substantially higher than in the
South, but it is difficult to speculate about the overall
difference in costs of living. One must use other
evidence to infer information about relative real
wages.
Implications of the Empirical Results
As noted at the outset, neoclassical economic theory
predicts that individuals, jobs, or commodities will
move in a way designed to equalize real wages. This
article has shown that, whether measured by the peer
group method, by the SAS method, or by a simple
averaging process, real wages for workers residing in
SMSAs in 1978 and 1981 were higher in the South

ECONOMlC REVIEW, MAY/JUNE 1984

than in all areas except the West. Table II shows,
as theory would have predicted, that the 1970-1980
population gains were highest in the South and West,
where real wages were highest, and the population
decline was largest in the New York City area, where
real wages were lowest.
Economic theory also would predict that the
Southern real wage advantage should not persist.
Consistent with this prediction, the regional real wage
differentials narrowed between 1978 and 1981 in all
categories except New York and West males. The
statewide nominal wage differentials also imply that
whatever real wage advantage that the South may
have had in 1978 was narrowed somewhat by 1983.
As noted previously, the conclusions of the analysis are not so clear-cut when one examines statewide
cost-of-living differences. However, since (1) Table
II shows that total -population increased substantially
in the South, West, and West South Central regions

between 1970 and 1980, (2) Table II also shows that
population changes corresponded roughly to real
wage differentials (according to the SMSA data) for
1978 and 1981, and (3) economic theory predicts
that workers migrate to take advantage of wage
differentials (as well as for other reasons, such as
job availability); it seems reasonable to infer that the
migration of non-SMSA dwellers is also induced by
relatively high real wage levels.
Thus, contrary to the Mancur Olson statement
quoted at the outset of this paper, this article finds
no evidence that workers have moved away from
high-wage regions to the relatively low-wage South,
and therefore no evidence of paradoxes for neoclassical economic theory. In fact, in the case of workers
who reside in SMSAs, the article found that real
wages in the South were relatively higher than in
most other regions of the country, with or without
adjustments to make jobs and workers comparable.

Table II

COMPARISON OF WAGE DIFFERENTIALS OF SIMILAR WORKERS IN SIMILAR JOBS
AND POPULATION CHANGES BY REGION

SMSA Data
New York
Rest of North East
North Central
West
South*

Percentage Change
in Population
1970-1980
- 6.04
- 1.33
2.2
15.4
27.4

Percent of South
Real Wages, 1978
Peer Group
SAS Method
Males
Females
Males
Females
74
82
89
93
100

86
87
93
97
100

80
88
92
99
100

88
93
94
105
100

Real Wages, 1981
SAS Method
Males
Females
77
93
96
95
100

90
98
102
103
100

Percent of South
Statewide Data

Percentage Change
in Population
1970-1980

Mid-Atlantic
New England
East North Central
West North Central
West South Central
Mountain
Pacific
South

- 0.48
4.2
3.5
5.2
22.9
37.2
19.8
20.7

1978
Nominal Wages
Peer Group
Males
Females
105
97
106
98
100
104
116
100

105
99
104
96
97
98
116
100

1981
Nominal Wages
Peer Group
Moles
Females
101
95
107
98
106
102
130
100

106
99
103
99
95
103
117
100

* Washington and Baltimore are in “Rest of North East.”
Sources: U. S. Department of Commerce. Census of Population and derived from May Current Population Surveys, USDL 79-305 and USDL
82-139.

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27

In a sense, it would have been more satisfying, and
made better prose, if real wages had been lower in
the South. One could then have attributed the wage
differential, particularly in the face of population inflows, to nonpecuniary factors. Nonmonetary amenities, composed of such diverse elements as climate, the
culture, southern hospitality, the literary tradition,
environmental purity, etc., have been used to explain
the “Southern Condition” in the past. 8 The finding
that workers may have had to be compensated by
higher wages to move to the South will doubtless be
unsettling to many Southerners.

References
1. Hulten, C. R., and R. M. Schwab. “Regional Productivitv Growth in U. S. Manufacturing: 195178.” American Economic Review (March 1984),
pp. 152-62.
2. Olson, Mancur. “The South Will Fall Again: The
South as Leader and Laggard in Economic
Growth.” Southern Economic Journal (April
1983), pp. 917-32.

Proving that nonmonetary amenities give a relative
advantage to the South is difficult if not impossible, but
if such were proved, it would also refute Mancur Olson
and resolve his so-called “paradox” for neoclassical economics.
8

3. Sahling, Leonard G., and Sharon P. Smith.
“Regional Wage Differentials: Has the South
?
Risen Again. ” Review of Economics and Statistics
(February 1983), pp. 131-35.
4. Steel, Robert G. D., and James H. Torrie. Principles and Procedures of Statistics. New York:
McGraw-Hill Book Company, Inc., 1960.

APPENDIX

Table A-l

AVERAGE WAGES FOR MALES AND FEMALES
1978, 1981, AND 1983
1983

1981

1978
Nominal Wages
Region†

ReaI Wages

Nominal Wages

Real Wages

Average
Wage $ Number

Average
Wage $ Number

Average
Wage $ Number

Average
Wage $ Number

Nominal Wages
Average
Wage $

Number

MALES
New York City

6.96

1306

8.45

361

6.66

1593

9.02

6.91

2721

9.13

2018

7.31

1312

1420

7.16

794

1306

Rest of North East

7.02

1733

North Central

6.98

2894

West

7.19

South

6.19

5.95

7.28

361

10.13

386

793

8.77

702

10.29

594

653

9.16

615

10.31

772

9.12

779

9.01

540

10.69

617

8.05

405

8.92

219

9.17

438

FEMALES
New York City

5.08

1003

4.33

1003

6.26

344

5.39

344

7.42

341

Rest of North East

4.69

1454

4.40

1347

6.03

685

5.81

629

6.96

592
737

North Central

4.57

2285

4.49

2139

5.90

569

5.87

538

6.70

West

4.88

1609

5.00

1032

6.28

652

6.29

445

7.50

566

South

4.16

1083

4.57

606

5.59

375

5.92

188

6.13

364

† By SMSA, South includes Atlantaω , Birmingham, Dallasω , Fort Worthω , Greensboro-Winston-Salem-High Point, Houstonω , Miami, New
Orleans, Norfolk-Portsmouth, Tampa-St. Petersburg. New York City area includes New York City SMSA ω , Nassau-Suffolk ω , Newark ω ,
Paterson-Clifton-Possaic ω . Rest of North East includes Albany-Schenectady-Troy. Baltimore ω , Boston ω , Buffalo ω , Philadelphia ω , Pittsburgh ω .
Rochester, Washington, D. C.-Maryland-Virginiaω . North Central includes Akron, Chicagoω ; Cincinnati ω , Clevelnd ω , Columbus, Denver,
Detroit ω , Gary-Hammond-East Chicago ω , Indianapolis ω , Kansas Cityω , Milwaukeeω , Minneapolis-St. Paul ω , St. Louis ω . West area includes
Anaheim-Santa Anna-Garden Grove, Los Angeles-Long Beachω , Portland, Sacramento, San Bernardino-Riverside, San Diego ω , San Francisco- Oakland ω , San Jose, Seattle-Everett. ( ω denotes real and nominal wages.)
Sources: Derived from May 1978, May 1981, and April 1983 Current Population Surveys, USDL 79-305 and USDL 82-139.

28

ECONOMIC REVIEW, MAY/JUNE 1984

Table A-2

PERCENTAGES OF AVERAGE WAGE RATES IN SOUTHERN SMSAs RELATIVE TO
WAGE RATES OF COMPARABLE WORKERS IN OTHER REGIONS OF THE COUNTRY IN 1978
UNDER TWO DIFFERENT DEFINITIONS OF THE SOUTH AND COMPARED TO PREVIOUS FINDINGS*

Sources:

Sahling and Smith [2, p. 137]; derived from May 1978 Current Population Survey and USDL 79-305.

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29

Table A-3

PERCENTAGES OF AVERAGE WAGE RATES IN SOUTHERN SMSAs RELATIVE TO
WAGE RATES OF COMPARABLE WORKERS IN OTHER REGIONS OF THE COUNTRY IN 1981*

* Figures in parentheses ore “t” statistics calculated according to definition in footnote 6.
significant wage differential.
Sources:

If t < 1.96, there is assumed to be no

Derived from May 1981 Current Population Survey and USDL 82-139.

Table A-4

PERCENTAGES OF AVERAGE NOMINAL WAGE RATES IN SOUTHERN SMSAs RELATIVE TO
WAGE RATES OF COMPARABLE WORKERS IN OTHER REGIONS OF THE COUNTRY IN 1983*

* Figures in parentheses ore “t” statistics calculated according to definition in footnote 6.
significant wage differential.
Source:

30

Derived from April 1983 Current Population Survey.

ECONOMIC REVIEW, MAY/JUNE 1984

If

t

<

1.96, there is assumed to be no

Table A-5

AVERAGE WAGES
(Regions from Statewide Data)

† Southern region includes Alabama, Florida, Georgia, Kentucky, Mississippi, N o r t h C a r o l i n a , S o u t h C a r o l i n a , T e n n e s s e e , V i r g i n i a , a n d
West Virginia.
Mid-Atlantic includes Delaware, District of Columbia, Maryland, New Jersey, New York, and Pennsylvania. Remaining
regions follow standard census division codes.
Sources: Derived from May 1978, May 1981, and April 1983 Current Population Surveys.

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31

Table A-6

PERCENTAGE OF WAGES PAID IN SOUTH BY REGIONS
DETERMINED BY STATEWIDE DATA, PEER, GROUP METHOD,
1978, 1981, AND 1983*
(Workers Not Classified by Union Membership Status)

* Figures in parentheses represent “t” statistics.
† Southern region includes Alabama, Florida, Georgia, Kentucky, Mississippi, N o r t h C a r o l i n a , S o u t h C a r o l i n a , T e n n e s s e e , V i r g i n i a , a n d
West Virginia.
Mid-Atlantic includes Delaware, District of Columbia, Maryland, New Jersey, New York, and Pennsylvania. Remaining
regions follow standard census division codes.
Sources:

32

Derived from May 1978, May 1981, and April 1983 Current Population Surveys.

ECONOMIC

REVIEW,

MAY/JUNE

1984

Table A-7

PERCENTAGE OF WAGES PAID IN SOUTH BY REGIONS
DETERMINED BY STATEWIDE DATA, PEER GROUP METHOD,
1978 AND 1981*
(Workers Classified by Union Membership Status)

* Figures in parentheses represent “t” statistics.
† Southern region includes Alabama, Florida, Georgia, Kentucky, Mississippi, N o r t h C a r o l i n a , S o u t h C a r o l i n a , T e n n e s s e e , V i r g i n i a , a n d
West Virginia.
Mid-Atlantic includes Delaware, District of Columbia, Maryland, New Jersey, New York, and Pennsylvania. Remaining
regions follow standard census division codes.
Sources:

Derived from May 1978 and May 1981 Current Population Surveys.

FEDERAL RESERVE BANK OF RICHMOND

33


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