View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

PERFORMANCE

ISTICS OF

C

HIGH-EARN1

INORITY

Bruce J. Summers

and James F. Tucker”

One of the interesting
developments
on the
American
banking scene during the post-World
War II era has been the increased interest shown
by minority groups in the ownership
and operation of commercial
banks.
Of the 81 minority

black banks, for example, is made by Brimmer
[7; p. 3S2].
IVevertheIess,
it is also true that a
great deal of variability exists -w&in the ranks of
minority
banks when it comes to successfully

banks

The primary objective
of this study is to analyze
those factors that lie behind the successful
operation of minority banks.

in existence

at year-end 1975, only 8 were
operating in 1945. Fifteen more opened between
1946 and 1969, while 58 date from 1970. Although
there were only 81 minority
banks among the
14,400 commercial banks in operation at the close
of 1975, the net increase in minority banks since
the beginning of this decade amounts to over 250
percent, while the increase for nonminority
banks
Of the 81 banks
amounts to only 12 percent.
identified as minority institutions,
47 were owned
by blacks and ‘27 were classified
as HispanicAmerican,
with the remainder
being distributed
among Chinese-American
(3), American
Indian
(Z), Asian-American
(l), and Multiracial
(1) minority groups.
Two of these 81 banks were actually organized
as nonminority
banks, but were
later taken over by minority interests.”
The

sudden

banking
attention,

largely

nomic aspects
as unique
provide

in

has

because

of minority

banking

services

minority-owned

attracted
banking
These
primarily

population,

cumstances

and the special

they

are related

occupied

tional

economy.

nomic

position

face

by minority
The

close

of blacks

considerable

the financial

in the industry.

minority
position

proliferation

institutions

are recognized
organizations
to the nation’s
business

the

cir-

to the special

groups

tie between
and

and eco-

in the nathe eco-

operation

of

*The
authors
are grateful
to Richard
Rosenbloom
and Peggs
Nuckols for computational
assistance.
Jacqueline McDaniel, Data
Base Analyst in the Division of Research and Statistics. Board of
Governors of the Federal Reserve System, coordinated and supplied
source data.
I A hank is recognized as minority-owned
when 50 percent or more
of its common stock is owned or controlled by individuals belongina
OXBE of the Commerce Department.
to racial minority groups.
and the Treasury Department, which is responsible for administration of the Government’s Minority Bank Deposit Program, officially
designate minority banks. A recent amendment to the rules governing the Minority Bank Deposit Program allows a bank to qualify if:
more than 50 percent of the bank’s stock is owned by women; a
majority of tbe bank’s board consists of women: and women hold a
significant
number of management
positions.

FEDERAL

RESERVE

dealing

with these unique business

circumstances.

There
are, no doubt, many reasons
for the
sharp acceleration
in the establishment
of minority banks during the 1970’s.
Based on interviews with persons instrumental
in organizing
a number of these banks, however, three factors
emerge as being central to the decision-making
process leadin g to application
for a bank charter.
The first of these involves an increased
awareness by minority
group entrepreneurs
of the
profitability
of commercial
banking.
Indeed, the
success of existing minority banks became widely
publicized during the late 1960’s and early 1970’s,
and there was reason to believe that economic advances being made by minorities
provided an
even more advantageous
market for banking services.
The second factor concerns the improved
environment
for seeking and obtaining bank charters.
Doubtlessly
a part of the change in this
environment
reflected
the momentum
of civil
rights legislation
passed during the middle and
late 1960’s.
Likewise,
this was the period when
minority groups began to achieve greater political influence at both the state and national levels,
and this influence,
at times, proved effective
in
iiopening the door” to the chartering agencies and
breaking
bottlenecks
for charter
applications
previously
submitted.
The third factor focuses
on the then growing
belief that locally-owned
commercial
banks could provide a stimulus
to
economic
development
in the minority
community. Although some have questioned the ability
of minority banks to perform this function successfully
(see Brimmer
[T; p. 399]),
organizers
of minority banks did in fact envision a significant role for their institutions
in the development
of minority business enterprise.
BANK

OF RICHMOND

3

The operating characteristics
of minority-owned
banks have been the focus of a number of studies
[2, 3, 4, 5, 6, 7, 8, 11, 13, 141.
Most studies of
minority
bank financial
performance
sidered bank operating
characteristics
parative
context.
Using
nority banks have usually
other

group

of banks

have conin a com-

this methodology,
mibeen compared to some

consisting

of nonminority

institutions,
sometimes
taking
the form of all
commercial
banks
or all nonminority
banks.
Brimmer
[7], for example, compares the performance of black banks with that of all insured commercial banks and all member banks of the Federal Reserve
System.
Other studies have also followed the relative
performance
methodology
but have been more
selective
in choosing comparative
sample groups
of banks.
In a companion to the Brimmer
article
mentioned above, Irons [ 111 views the operating
characteristics
of 18 black banks against a paired
sample of 20 nonminority
banks and a national
average
of similarly
sized banks.
Kohn
[13]
compares
the performance
of 6 minority
banks
(5 of which are located in the Tenth
and 1 in
the Eighth
Federal
Reserve
District)
with that
of two groups of nonminority
banks:
43 established member
banks and 32 new commercial
banks, all located in the Tenth Federal
Reserve
District.
Boorman
[2] and Boorman
and Kwast
[4] compare
8 minority
banks established between 1963 and 1965 with a paired sample of nonminority
banks.
These two articles
isolate the
behavior of newly formed banks.
There are, of course, widely recognized
problems with
aggregating
together
all minority
banks, or for that matter all commercial
banks,
for comparative
purposes.
Even when adjusted
by size, age of operation,
and location, it is difficult to get a meaningful
sample group for comparing the operating
characteristics
of minority
and nonminority
banks.
This is due to minority
and nonminority
banks serving communities
that
are quite different in terms of their social and economic makeup.
It would seem, therefore,
that
there is something to be said for intragroup comparisons of minority
banks.
Limited
intragroup
comparisons
of minority
banks have been made, notably as part of studies
by Leavitt
[14] and Boorman
[3].
In these
studies, both authors attempt to distinguish
between newly formed and mature minority banks.
Leavitt
deals exclusively
with black banks and
constructs
test groups
on the basis of age (all
black banks three years old versus all black banks
4

ECONOMIC

REVIEW,

over three years old) and charter classification
(national and state-insured
black banks).
Boorman makes the most serious attempt
at overcoming the problems associated
with intergroup
bank comparisons,
but his discussion is limited to
citing the differences
between
the newer and
older minority banks. Perhaps most importantly,
Boorman
explicitly
recognizes
13; p. 2781 tha.t
i‘
. . . other factors indicate
that there may be
significant
differences
in performance
among the
minority
banks themselves.”
It is this central
idea-that
performance
comparisons
of minority
banks can be most useful when made with other
minority
banks-that
lies at the base of this
study.
Segmenting
Minority
Banks
For
Comparison
This article undertakes an intragroup
comparison
of minority
bank performance
characteristics.
Groups are identified
for comparison
from all
minority-owned
commercial
banks in existence as
of December
31, 1975, i.e., the universe
of m.inority banks.
The key advantage
of an intragroup comparison
is that uncontrollable
differences between
groups
are neutralized
to the
greatest extent possible.
At points in the analysis
where a benchmark
would be useful, however,
reference
wilI be made to standards
maintained
by commercial
banks generally.
There are a number of possible ways to segment minority banks into groups for comparative
purposes.
As already mentioned, several previous
studies [3, II] have emphasized
age of operation
and type of charter.
Other possible selection criteria include location,
size, and perhaps
even
racial composition.
Using nonfinancial
criteria
as a basis for sample selection, however, involves
inherent bias.
The problem is that the use of
such nonfinancial criteria involves a presupposition
that the chosen basis for sample selection
is in
fact a critical determinant
of operating
performance. The dangers inherent in this approach are
avoided here by concentrating
on strictly
financial characteristics
as a guide to selecting
minority bank groups for comparison.
Two groups of banks are selected
from .the
universe, with a four-year consolidated
return on
investment
(CROI)
as the critical selection
factor. Return on investment
is used because of its
importance
as a basic performance
index in the
eyes of both financial
analysts
and private
investors.
A four-year
consolidation
procedure
is
followed in order to insure that the banks selected ior the comparison
groups,
hereafter
re-

NOVEMBER/DECEMBER

1976

ferred to as the “high-earning”
and the I$-esidual”
groups, have demonstrated
earnings performance

The cutoff point for a CR01 that places a bank
in the high-earning
category is set at 10 percent,
a commonly
used rule for evaluating
business
performance.
On this basis, 11 of the 44 banks
are selected for the high-earning
group.
These
banks are listed in Table I.
The remaining
33
banks constitute
the residual group.

that can be considered
sustainable
over time.2
The period of consolidarion
includes
the years
1972-75.
Of the 81 minority
banks in existence
as of
December
31, 1975, 45 had been in operation at
least four years or longer.
Thus, the universe of
banks available for selection based on a four-year

Nonfinancial
Characteristics
As Table I shows,
the high-earning
banks constitute
a fairly diverse
group. Nine of the eleven (82 percent) are blackowned, while 33 of the 33 residual banks (76 per-

consolidation
automatically
is reduced from 81 to
45. In addition, one of the 45 banks is further
eliminated
due to its basic lack of coriformity

cent) are black-owned.
-4s is also the case ior the
residual banks, most of the high-earning
banks
are located ir. large metropolitan
areas, although

with the rest of the banks making up the universe.3
The comparison
groups, therefore,
are
chosen from among these 44 remaining
minority
banks.

the Northeasr
is conspicuously
absent (three of
the banks in :he residual group are located in the
Sew York
City area, while one is located
in
Boston).
Three of the high-earning
banks, however, are Iocared in cities with populations
less
than 100,000. In terms of total assets at year-end
1975, the high-earning
banks range in size from
$8.3 miliion to $56.3 million, the mean size being
$26.5 million.
The residual banks have a smaller

2 Sustainabilit4- implies some degree of stability, too.
A coefficient
of variation
(i.e., the standard deviation of ROX divided by the
mean) has been computed for each of the I1 banks in the highearnina group. with a resulting range of 0.11 to 0.67.
Based on
only four
years of performance
data, these coefficients
are not
suspiciously
large.
In addition, the variation
is being measured
around high mean values of ROI.
3This bank has been owned by minority stockholders for only 5 of
its 20 years of existence. It had total assets at December 31, 1975, of
$133 million, placing it far beyond the normal size range of the
remaining
minority banks.

Table I

ELEVEN HIGH-EARNING MtNORIfY

Bank

Industrial Bank of
Washington
United National
Washington

Charter Class and
Federal Reserve
Membership Status

Location

Nome

BANKS1

Washington,

D. C.

State

Washington,

D. C.

National

nonmember

Esiablishment
Date

7ofal Assets
12-31-75
5 Thousands

Minority
Type

a-i a-34

40,082

Black

8-31-64

30,846

Slack

41,199

Slack

8,340

Black

21,063

Black

Bank of

Mechanics
Bank

& Farmers

First

Bank

Highland
Sank
South

N. C.

State nonmember

3-l-08

Danville,

Va.

State nonmember

9-a-i a

Chicago,

State

Durham,

111.

State nonmember

Chicago,

Ill.

State member

l-1 -72

20,024

Black

State nonmember

1-5-69

11,636

HispanicAmerican

a- 16-63

12,974

Slack

Community

Side Sank’

Centinel

Taos,

Bank

Riverside

National

N. M.

Houston,

Sank

Tex.

National

7 l-9-70

Sank of Finance

Los Angeles,

Calif.

State

nonmember

39,032

Black

Cathay

Los Angeles,

Calif.

State

nonmember

4- 19-62

56,317

ChineseAmerican

State

nonmember

5-3 l-68

10,485

Black

liberty

Sank

1 Banks with
’ Minority

Seattle,

Bank of Seattle
four-year

shoreholders

consolidated
gained

return

controlling

Wash.

on invesiment
interest

of IO percent or better.

5-l -72.

FEDERAL

RESERVE

BANK

OF RICHMQND

Il-16-64

mean size of $18.7 million, with a range of $4.5
million to $62.4 million. While the average size

is the case, it would seem that there is a good
possibility
that earnings differentials
are essenti-

high-earning group bank is about 40 percent larger
than the average size residual group bank, there
is nonetheless
no simple
association
between

ally the result
differences

larger size and higher profits.
Indeed, 4 of the 11
high-earning
banks fall below the average size of
the residual group banks, and the operating economies enjoyed by a $26 million bank over an $18
million bank are certainly not great.
Eight of the high-earning
banks (73 percent)
are state nonmember
banks, 2 are national banks,
and onIy 1 is a state member bank.
Among the
residual banks, on the other hand, 19 (57 percent)
are state nonmember
banks, 13 (41 percent)
are
national banks, and, again, there is but one state
member bank.
This breakdown
seems particularly interesting
in view of the well-known
argument that membership
in the Federal
Reserve
System is a relatively
costly alternative
to nonmembership,
inasmuch
as reserve balances
held
with the Federal Reserve Banks are noninterest
bearing.
Although
the high-earning
banks, and
to a lesser extent the residual banks, favor state
charters
and nonmember
status in the Federal
Reserve System, it should be pointed out that this
pattern is changing somewhat.
It will be recalled
that 36 of the 81 minority banks in existence
at
year-end 1975 were not included in the final selection process, inasmuch as they were not in operation for four years or more. Of these 36 newer
banks, 23 have national
charters,
12 are state
nonmembers,
and 1 is a state member.4 The shift
in interest to national bank charters
is probably
related to the liberalized
application
procedure
toward minority
banks adopted by the Comptroller of the Currency in the early 1970’s.

of management

would

appear

earning

‘One of these 36 banks. a Mexican-American
institution.
failed in 19’76.

6

nationally

ECONOMIC

chartered

REVIEW,

sheets

group.

Capital Position
Table II provides a summary of
the capital positions of the high-earning
and residual minority
bank groups.
The high-earning
group, as the table illustrates,
is somewhat
less
heavily
capitalized
than the residual
group for
each of the two measures shown.
Interestingly,
the same measures
computed for all commercia.1
banks in the U. S. on a four-year
consolidated
basis fall above the summary
ratios for equit:y
capital and reserves
and between
the summar,y
ratios for total capital accounts.
For all commercial banks, equity capital and reserves
as a percent of risk assets is 8.4, while total capital accounts as a percent of risk assets is 9.0.
The comparison
group of 11 high-earning
minority banks has been selected
on the basis of
return on investment,
and the possibility
exists
that some of these banks could have achieved a
high return by sacrificing
capital adequacy.
For
the group, this is not necessarily
the case.
At
7.5, the ratio of equity capital and reserves
to
risk assets is below that of all commercial
banks
and the residual minority bank group, but is nlot
extremely
different.
As the capital
adequacy
ranges show, there is a great deal of variabili,ty
between banks within groups;
this is especially

Table

II

CAPITAL POSITION
Four-Year

Consolidation
Eleven
High-Earning

Measure

Thirty-three
Residual

Equity capital and reserves/
Risk assets1
Group

Financial
Characteristics
Both the high-earning
group and the residual group have an eclectic
makeup, but their overall nonfinancial
characterInasmuch
as this
istics are not that dissimilar.

Such.

balance

and income statements,
and it is the purpose of
this section to examine and compare important
financial
ratios for the two groups.
As will become clear below, balance
sheet management
does indeed explain
the success
of the high-

With respect to age, the high-earning
and reThe mean ages
sidual banks are quite similar.
for the two groups are, respectively,
21 and 16
Both groups can be considered
mature
years.
from the standpoint
of experience
and market
representation.
As Table I shows, the variation
in age among the high-earning
banks is considerable ; 2 of the banks date from 1970, while 3 were
established
prior to World War II.

differences.

on bank

Range
Total

7.5
within

capital

group

account/Risk

4.3to11.7
assets1
8.0

Group
Range

a.2
2.6 to 29.6

within

group

’ Risk assets = total
Treasury securities.

NOVEMBER/DECEMBER

1976

assets -

9.7

5.0 to 11.7

2.0 to 29.6

cash and due from

banks -

W. S.

true within the residual group. Only one bank in
the high-earning
group, whose capital ratios show

Table

SOURCES OF FUNDS

up as the bottom end of the ranges in Table II,
is seriously
undercapitalized.
Conversely,
none
of the high-earning
banks is seriously
overcapitalized.
There are several overcapitalized
banks
within

the residual

Sources of Funds
to be a great deal

group,

Ill

Selected Categories,

Four-Year

Eleven
High-Earning

Measure

however.

Thirty-three
Residual

Total demand deposits/
Total liabilities

77.0

63.4

15.0

20.4

3.6

8.4

Demand deposits of states and local
gov./Total
demand deposits

deposits as a percent of total liabilities
for the
high-earning
and residual groups equals, respectively, 41.3 and 43.3. The respective
percentages
for total time and savings deposits to total liabilities are 55.7 and 51.7.
These ratios suggest
that the residual group is in a relatively
more
than
the high-earning
advantageous
position
group, inasmuch as low-cost demand deposits comprise a larger proportion of the balance sheet and
high-cost
time and savings deposits comprise
a
smaller proportion.
-4 closer inspection, howevert
suggests that this apparent relative advantage
in
favor of the residual bank group is more than
outweighed
by other adverse factors.

Totol time and savings
Total liobiiities

deposits/
55.7

51.7

IPC time deposits/
Total time ond savings deposits

30.7

34.9

Savings deposits/
Total time and savings deposits

56.8

43.0

U. S. Government time deposits/
Total time and savings deposits

2.1

4.0

Time deposits of states and local
gov./Total
time and savings
deposits

9.8

18.8

10.2

16.0

0.6

0.9

large denomination time deposits
(over $lOO,OOO)/Totol
time and
savings deposits
Federal funds purchases/
Total liabilities

While the residual group does enjoy a slightly
greater proportion
of demand deposits to total
liabilities
than the high-earning
group, a fairly
large share of these demand deposits is in the
form of liabilities
to governmental
bodies.
Only
63.4 percent of the demand deposits of the residual group is due to private accounts, as compared
to 77.0 percent for the high-earning
group.
This
has several implications.
First, government
deposits are encumbered in the sense that they limit
a bank’s ability to allocate funds to the various
available uses; these deposits must be secured by
holdings of U. S. Treasury,
or municipal,
securities. Second, large holdings of governmental
deposits relative to private deposits may reflect a
special dependence on such a source of funds. To
the extent that it does, it means that a bank may
be overly protected and less inclined to compete
This, clearly, is an undefor private business.
The residual group
sirable long-run
situation.
is a heavier holder of U. S. Government
(20.4
versus
15.0 percent)
demand deposits,
and of
state and local (8.3 versus 3.6) demand cleposits,
as a proportion of total demand deposits.

the case of demand deposits, the residual bank
group holds a greater proportion of U. S. Government, and state and local, time deposits to total
time and savings
deposits than does the highearning group.
Xore importantly,
however, savings deposits account for a much lower proportion of total time and savings deposits
for the
residual group (43.0 percent)
than for the highearning group (56.S percent).
Savings accounts,
of course, are traditionally
viewed as being themost stable and, in the long run, relatively
low
cost, form of deposits.
Their strength on a bank
balance
sheet also suggests
a high degree of
market penetration
for consumer
business.
It
could be argued that the benefits accruing
from
large savings deposit balances are offset to some
degree by the higher activity
levels, and thus
higher
costs,
associated
with these
balances.
These costs are largely recoverable,
however, by
the imposition
of service charges tied to account
activity levels.
The residual group does display a clear advantage over the high-earning
group with respect to
solicitation
of private time deposits.
Private time
deposits as a percent of total time and savings
deposits equals 34.9 for the residual group versus

The advantage to the residual group evidenced
by its lower dependence on time and savings deposits is, again, more apparent than real.
As in
RESERVE

43.3

U. S. Government demand deposits/
Total demand deposits

types of deposits that provide the minority banks
in the two groups with their major source of
funds.
As Table
III indicates,
total demand

41.3

IPC demand deposits/
Total demand deposits

At first glance, there appears
of similarity
regarding
the

FEDERAL

Consolidation

BANK

OF RICHMOND

7

30.7 for the high-earning
a greater
aggressiveness

A very significant
difference in the asset portfolios of the two groups arises in the case of
municipal investments.
At 11.2 percent, the ratio

group. This may reflect
on the part of banks

within the residual group to bid for large denomiThe ratio of such deposits (those
nation deposits.
greater than $100,000)
to total time and savings
deposits is 16.0 for the residual group and only
10.2 for the high-earning
group.
groups exhibit
a very low
Both comparison

of state and local government
securities
to total
assets for the high-earning
group is almost double

dependence
on purchases
of Federal
funds as a
source of funds, as evidenced
by their ratios of
Federal funds purchased to total liabilities.
Reliance on borrowed funds is also extremely
low for
both groups and is, therefore,
not even shown in
Table

Sales of Federal
funds, as a percent of total
assets, equal 5.6 for the high-earning
group and

III.

Table IV summarizes uses of
Uses of Funds
funds for the two groups of minority banks.
It
is immediately
evident that there exist a number
of major differences
between
groups.
To start
with, it seems as if the residual group places a
higher premium on portfolio
liquidity than does
the high-earning
group.
Cash balances
and deposits at other commercial
banks as a percent of
total assets equals 11.9 and 10.1 for the residual
groups, respectively.
Also, the
and high-earning
residual group allocates
a much greater share of
funds to holdings of U. S. Treasury
securities and
a somewhat
greater share to holdings of securities issued by U. S. Government
agencies.

Table

IV

USES OF FUNDS
Selected Categories,

Four-Year

Meclsure
Cash and due from
Total assets
U. S. Treasury
Total assets

Consolidation

Eleven
High-Earning

Thirty-three
Residual

banks/
10.1

11.9

securities/
9.9

12.6

Obligations of U. S. Government
agencies/Total
assets

12.0

12.4

Obligations of states and local
government/Total
assets

11.2

5.8

5.6

7.0

45.4

42.4

48.8

29.9

61.1

65.4

0.5

2.8

26.3

38.2

22.7

27.5

Federal
Other

funds

sold/Total

loans/Total

assets

assets

Real estate loans/Other

loans

Single-family
real estate loans/
Real estate loans
loans to financial
Other loans

institutions/

Commerdol and industrial
Other loans

loans/

Loans to individuals/Other

loans

Credit card loans/
loans to individuals
Bank premises/Total

8

assets

1.9

1.0

2.1

3.1

ECONOMIC

REVIEW,

the 5.8 percent of the residual group.
This sug
gests that the high-earning
group is much more
sensitive
to the need for sheltering
income and
that, as is the case for commercial
banks generally, tax-free municipal securities
provide an important avenue for this.

7.0 for the residual group.
This probably
is :a
further
indication
of the higher priority
given
liquidity and security by the residual group.
It
may also, however, reflect the attractiveness
of
higher Federal
funds yields in recent years.
A
highly liquid bank is able to shift into Federal
funds sales much more readily than the less liquid
bank.
Rates on Federal funds are very volatile,
however, and ease of investment
in Federal funds
is hardly a good reason for maintaining
an extremely
liquid balance sheet.
High earnings in
one investment
period can easily be offset in
subsequent
periods of generally
increased
banking system liquidity and lower interest rates.
The high-earning
and residual groups devote
about an equal amount of resources to loans; the
ratio of other loans to total assets for the two
groups is 45.4 and 42.4, respectively.
These ratios
lie in what may be considered a very conservative
range, so far as bank performance
generally
is
concerned, and provide evidence that both groups
are essentially
conservative
users of available
funds.
Although
the high-earning
and residual
groups seem to take roughly the same approach
to managing
total loans as a proportion
of total
assets, they are not at all similar regarding
the
types of loans made.
While
the high-earning
group is much more heavily committed
to real
estate lending, the residual group is much more
oriented to business
and consumer
lending.
Real estate loans (or all loans secured primarily
by real estate),
account for 48.8 percent of total
other loans (i.e., all loans excluding Federal funds
sold and securities
purchased
under agreements
to resell)
made by the high-earning
group, but
only 29.9 percent for the residual group.
To the
extent
that they make real estate
loans, both
groups are heavily oriented to single-family
mortgage loans, probably the most secure type of real
estate loan that can be made.
The high-earning
group is generally
in a better position to make

NOVEMBER/DECEMBER

1976

Table

adopted management
mize its involvement

V

EXPENSES
Selected Categories,

Four-Year

Consolidation

Eleven
High-Earning

Measure

Thirty-three
Residual

As a percent of totol
operating expense:
Employee salaries,
and benefits

wages,
27.3

27.2

41.3

34.8

Net occupancy expense

4.7

5.4

Furniture

2.7

2.9

5.3

9.2

17.2

18.9

Interest

paid on deposits

Provisions
Other
Total

and equipment
for

loan losses

operating

operating

expense

expense/Totaf

assets

6.2

6.9

real estate loans, being able to match this Iongterm use of funds with a large base of stable
savings deposits.
The residual bank group makes up for its much
iower relative involvement
in real estate lending
by activity
in other areas.
The residual group,
for example,
makes 2.8 percent
of total other
loans to other financial
institutions,
versus 0.5
percent for the high-earning
group.
More important, however, is the heavy degree of involvement by the residual group in business lending,
with 38.2 percent of total other loans falling in
the commercial
and industrial
category,
versus
only 26.3 percent for the high-earning
group, This
is an especially
important finding in view of the
fact that minority banking has been thought of as
a special source of capital to the minority business community
1121. Clearly, the high-earning
group has decided that the risks inherent in minority business lending, which have been shown
to be significant
[ 151, are so great as to be
avoided to a fairly extreme degree. The cautious
approach taken by the high-earning
group toward
lending to minority businesses
has recently been
articulated
by the president of one of the eleven
banks within the group.z
In this instance,
it is
pointed
out that minority
banks take a more
cautious approach toward lending in the minority
business community
than many majority
banks.
In the area of consumer lending? the residual
group is again significantly
more active than the
high-earning
group.
The ratios of loans to individuals to total other loans for the two minority
bank groups
are 27.5 and 22.7, respectively.
iigain,
the high-earning
group seems to have

lending.
While both groups have a low level of
participation
in revolving
credit to consumers,
the high-earning
group is almost twice as active
in this speciaiized
area.
Before
leaving
the asset side of the balance
sheet, it is interesting
to note the extent to which
bank funds are tied up in investment
in bank
premises.
-4t 2.1 percent, the ratio of bank premises to total assets for the high-earning
group is
about one-third less than the 3.1 percent of the
residual group.
This means, in effect, that the
high-earning
group operates
with considerably
less overhead than does the residual group, and
the funds freed up from investment
in fixed assets
can be applied to earning uses.
Both groups, it
might be mentioned, have a greater investment
in
fixed assets than is typically the case in the banking industry.
All insured commercial
banks, on a
four-year consolidated
basis, have a bank premises to total assets ratio of 1.6 percent, and all
banks with less than $50 million in assets have a
ratio of 1.7.
Expenses
o-szd Income
Tables V and VI sumthe expense
and income
marize,
respectively,
characteristics
of the high-earning
and residual
group is shown
groups. In brie:, the high-earning
to be more efricient with regard to both control of

Table VI

INCOME
Selected Categories,

Four-Year

Consolidation

Eleven
High-Earning

Thirty-three
Residual

53.3

Measure

52.2

7.5

a.3

As a percent of total
operating income:
Interest

and fees on loans

Income on Federal funds
Trust

department

sold

income

1.5

Other

operating

As a percent of interest
on investments

a.5

1.2

2.1

30.0

income

interest and dividends
investments

1.4

7.8

Service charge income

28.4

en
and dividends

Income on Lt. 5. Treasury

securities

31.9

38.2

Income on obligations of U, S.
Government agencies

35.8

42.0

Income on obiigations
loco1 governments

23.0

i 2.8

7.0

6.8

Total

“blinocit4’ Banker Warns Sane Btrnks OverLendins,”
Am&can Bmke?, Mw 13, 1956.

GJoseph D. Hutnmn,
eager on Minority

policies designed to miniin a more risky area of

FEDERAL RESERVE BANK

operating

income/Total

Operating income Total assets
Net income/Equity
ond reserves

OF RiCHMOND

of states and
assets

operating expense/

0.8

-0.1

capital
12.6

-2.3

9

expenses
and generation
of income.
clusion is based on the total operating

This

con-

expense

to

total asset and total operating
income to total
asset ratios shown in the tables. The high-earning
group incurs expenses equal to 6.2 percent of total
assets and generates
income equal to 7.0 percent
of total assets; its spread of gross income over expenses amounts to 0.8 percent of total assets. The
residual group incurs expenses equal to 6.9 percent of total assets and generates
income equal
to 6.8 percent of total assets.
In the case of the
residual bank group, therefore, expenses exceed gross
income, and an operating loss equal to 0.1 percent
of total assets results.
For comparative
purposes
it is interesting
to note that for all insured commercial banks the spread of gross income over
on a four-year
expenses,
consolidated
basis,
While
amounts
to 1.0 percent
of total assets.
generating
less income in relation to total assets
than the high-earning
group, at 6.6 percent, expenses to total assets for all insured commercial
banks is also much lower, at 5.6 percent.
These basic indexes of management
performance ultimately,
of course, affect the profitability
of the two groups, as shown in Table VI.
Consolidated
return
on investment
for the highearning group is a very respectable
12.6 percent,
while that for the residual group is -2.3
percent.
An analysis of group expenses provides a way
of determining
the nature of the differences
between the high-earning
and residual
groups on
this important
factor leading
to CROI.
Both
groups devote an almost equal proportion of total
operating
expense
(keeping
in mind that their
operating
expense as a proportion
of total assets
differs)
to employee remuneration
; the percentages are 27.3 for the high-earning
group and 27.2
This is the second most
for the residual group.
important
expense item in the commercial
banking industry,
and the equality
between
groups
suggests
that the labor market conditions
they
Interest
expense on deface are about equal.
industry
expense
posits is the bi ggest banking
and, as the source of funds analysis
undertaken
the high-earning
group
above would suggest,
allocates
a much greater proportion
of total exThis is due to the highpense to this category.
earning
group’s
heavier
reliance
on time and
savings deposits as a source of funds.
Previous
analysis
also suggests
that overhead
expenses
for the high-earning
group should be
less than those for the residual group, and this
turns out to be the case. Net occupancy
expense
for the high-earning
group is only 4.7 percent of
10

ECONOMIC

REVIEW,

total expenses, as compared to 5.4 percent for the
residual group. Equipment
expense for the highearning group is also a somewhat lower proportion of total expenses than for the residual group,
at 2.7 and 2.9 percent, respectively.
Loan loss provisions,
which are treated as a
current operating
expense, are significantly
different
for the two groups.
Such provisions
amount to only 5.3 percent of total.expenses
for
the high-earning
group, but increase to 9.2 percent for the residual group.
This one expense
category
is so high for the residual group as to
almost eliminate the advantage it has due to low
deposit costs.
The high loan loss expense is,
most likely, associated
with the higher proportions of business
and consumer
loans made by
the residual group.
It is interesting
to note that
the four-year
consolidated
loan loss expense for
all insured commercial
banks is 4.2 percent, considerably
below that of even the high-earning
group.
Interest
and fees on loans as a percent of total
operating
income for the two groups is roughly
the same, at 53.3 percent for the high-earning
group and 52.2 percent
for the residual
group.
This, however,
is not what one would expect
given the composition
of their loan portfolios.
The high-earning
group is relatively
heavily invested in illiquid,
but relatively
low risk, real
estate loans.
Conversely,
the residual group is
relatively
heavily invested in more risky business
and consumer
loans.
If, as would be expected,
the residual
bank group were compensated
for
the increase
in risk associated
with its business
and consumer
lending,
then such a premium
would be reflected
in higher interest income on
loans. This is clearly not the case. Both groups
have about the same proportion of income derived
from loan interest and, while their total loan portfolios equal about the same percentage
of assets,
the risk distribution
is quite different.
The residual group should be charging
higher
interest
rates on loans in order to compensate
for the
additional
risk, which is reflected
in its high.er
expense for loan losses.
In practice,
however,
the rate of return on loan portfolio
(computed
from interest and fees on loans/total other 1oan.s)
is almost identical for the two groups.
The rates
of return on loan portfolio for the high-earning
and residual groups are, respectively,
8.26 percent
and S.33 percent.
In a number
of other respects,
the income
sources
for the two groups are similar.
Both
derive a fairly large share of income from Federal

NOVEMBER/DECEMBER

1976

iunds
banks

sales, something
characteristic
of smaller
generally.
Likewise,
their service charge

income is fairly high: although it is more so for
Trust
department
income
the residual
group.
makes a very minor contribution
to total income.
Interest

and dividends

earned

on investments

represents
30.0 percent of total operating
income
ior the high-earning
group and 28.4 percent for
These proportions
are close
the residual group.
but, as in the case of loans, disguise important
differences
of portfolio composition.
The residual
is relatively
heavily
invested
in U. S.
group
Treasury
securities
and relatively
under invested
in municipal securities,
while the converse is true
Thus, the residual
for the high-earning
group.
group derives 80.2 percent of its investment
income from the taxable yields off U. S. Treasury
and U. S. Government
agency securities,
and only
12.8 percent off nontaxable
municipal securities.
group derives 67.7 percent of
The high-earning
its investment
income from U. S. Treasury
and
Zr. S. Government
agency
securities,
and 23.0
percent from municipal
securities.
The importance
between
sized.

the
The

tax position

of tax management

two

groups

high-earning

cannot
group

differences

be overemphahas managed

in such a way as to minimize

cable

corporate

cable

income

income
taxes

taxes;

as a percent

indeed,

its

appli-

its appli-

of gross

income

equals only 20.5 percent.
For the residual group..
an unusual result is obtained.
It will be recalled
that this group has sustained an income loss over
the four-year
consolidation
; nonetheless,
the
group has still paid corporate income taxes equal
to 30.4 percent of its losses.
This contradictory
situation is explained by the fact that the members of the group have had different
tax and
earning experiences,
some earning no income and
paying no tas and some paying tax on earned
income.
Also, the tax and earnings data are consolidated over a four-year period, allowing yearly
income period fluctuations
to show up in the
final figures.
The high-earning
group, incidentally,
has been
able to achieve its status without paying out an
excessive
proportion
of net income in dividends.
Cash dividends paid by the high-earning
group
amounts
to a conservative
28.4 percent
of net
income.
This means that a significant
portion of
earnings has been retained and added to reserve
accounts.
The residual group has paid cash dividends equal to 35.1 percent
of its losses;
thi$
anomalous
situation
is explained by the consoliFEDERAL RESERVE BANK

dation process
tax payments.

described

Summary

Conclusions

and

nority-owned
comparison

groups

dated

return

better

constitute

the

on

ren:air:ing

dated
cent

return
are

performance

four years

to

with

on investment
into

of

10

group,

of the high-earning

or

while
consoli-

of less than

pared with that of the residual

per-

consoli-

percent

a four-year

a residual

anal>-.;rc; oi key operating

mi-

earnings

high-earning

banks

combined

with

with a four-year

investment
the

study,

are divided into two

according

banks

of

this

banks

experience

Those

in the context

In

commercial

or more operating
formance.

above

10 per-

group.
group

The

is

COIII-

group through

an

ratios.

Tht: findings
indicate
that the high-earning
group is somewhat more adept at generating
income t*::ar.: is the residual group; total operating
income to total assets is 7.0 for the high-earning
group and 6.8 for the residual group.
On the
other hand, the high-earning
group is much more
effective at controlling
expenses than the residual
ratios of total operating
group, the respective
expense to total assets being 6.2 and 6.9. Consequerlrix. she high-earning
group has an excess of
operaring income over operating expense equal to
0.8 l>crceilt of total assets, compared to an excess
of operating
expense over operating
income of
0.1 percent for the residual group.
Both groups
invest a fairly low propoition
of funds, about 43
percent, in loans. The types of loans made, however, are quite different
between
groups;
real
estate loans dominate the portfolio of the highearning
group, and commercial
and industrial
loans
dominate
the portfolio
of the residual
With respect
to securities,
the high:
group.
earning group favors tax-free
municipals
while
the residual group favors U. S. Treasury
securiEmployee
remuneration
accounts
for 27
ties.
percent

of toral expenses

est paid on deposits
the high-earning
extent

group,

which

on time and savings

residual
and loa::

This

proup.

high-ea:-:;ing
ating

for both groups.

is a much higher

group

higher

esperises.

four-year

The

consolidated

12.6 percent,

compared

for iIkt: J-csidual
OF RICHMOND

to a greater
item for the

by lower

occupancy

and by lower general
management

lowed aiiow the high-earning
return

group

for

than does the

expense

is offset

ions charges

relies

deposits

Inter-

expense

oper-

practices

fol-

to achieve

on investment

a
of

with a loss of 2.3 percent

group.
11

These
findings
basic conclusions

can be synthesized
into two
about minority
banks.
First,

there exist a variety
of circumstances
under
which minority
banks can successfully
operate;
this is suggested by the heterogeneous
nature of
the high-earning
group.
Although
such factors
as size, location, type of charter,
etc. may, and
probably do influence bank operation, they do not
dictate success or failure.
Rather, quality of financial
management
appears to be the critical
determinant
of minority
Second, there appears

bank performance.
to be a direct conflict

be-

tween market exigencies
faced by minority banks
generally,
for example the need to correctly
assess and balance

risk and return

on loans, and the

idealized
set of community
service goals under
which minority banks are often conceived.
This
conflict is most evident in the differences
between
the loan policies of the high-earning
and residual
groups.
The high-earning
group has clearly
chosen to forego some lending opportunities,
particularly in the business and consumer loan areas,
due to what is evidently viewed as excessive risk.
The residual group has been much more active in
making business and consumer
loans in the minority community
but has suffered from unusuIt is largely the relative success
ally large losses.
in limiting the expense of losses associated
with
bad loans that provides
the high-earning
group
with its margin of performance
over the residual
group.
While many minority
banks choose to
follow the typical
path of success
laid out by
nonminority
banks, particularly
in making high
proportions
of business
loans, the loan portfolio
of the high-earning
group definitely
reflects
a
concern with the special risk that might be connected with this type of lending in the minority
community.
It would seem, therefore,
that successful banking
in the minority
community
requires very careful attention
to asset quality and
may not be wholly compatable
with the capital
demands of minority business.
The high-earning
group is, in a number of important
ways,
more
like majority-owned
and
operated commercial
banks than like the residual
group.
For example,
the high-earning
group is
more competitive
and market oriented than the
residual group, as evidenced by its deposit structure. It is more conscious of operating efficiency,
as shown through key expense ratios.
And, not
least important,
the high-earning
group seems
more adept at practicing
the subtleties
of financial management
than the residual
group:
evidence of this is provided by the tax management
12

ECONOMIC

REVIEW,

practices
of the two groups.
More interesting,
though, is the fact that the high-earning
group
does more than simply copy the portfolio
behavior of successful
nonminority
banks.
Rather,
it applies the practice
of accepted
management
patterns to fit the special environment
in which it
operates, thus achieving financial success.
References
1. Ang, James and Richard Willhour. “The Consumer
Loan Supply Function of a Minority Bank: Art
Empirical Note.” Jour?zal of Money, Credit and
Banking, (May 1976), pp. 255-9.
2. Boorman, John T. New Minority-Owned
Commercial Banks: A Comparative Analysis.
Washington,
D. C. : Federal Deposit Insurance Corporation, 1973.
3.
“The Prospects for Minority-Owned
Commercial Banks : A Comparative Performance
Analysis.”
Journal of Bank Research,
(Winter
1974), pp. 263-79.
4.
and Myron L. Kwast. “The Start-U:p
Experience of Minority-Owned Commercial Banks :
A Comparative Analysis.”
Journal of Finance,
(September 1974), pp. 1123-41.
5. J330mF;;,,Andrew F. “The Negro in the National
The American Negro Reference Book.
Edited by John P. Davis. Englewood Cliffs, New
Jersey: Prentice Hall, Inc., 1966.
6.
“The Banking System and Urba.n
Economic Development.”
Paper presented before
a joint session of the 1968 Annual Meetings of the
American Real Estate and Urban Economics Association and the American Finance Association,
Chicago, Illinois, December 28, 1968.
7.
“The Black Banks: An Assessment of
Performance and Prosnects.” Journal of Finance,
(May 1971)) pp. 379435.
8.
“Recent Developments in Black Bankinn: 1970-i971.” Washington. D. C., July 31, 19’72.
-’ (Mimeographed.)
9. Corwin, R. D. Racial Minorities in Banking: Aiew
Workers in the Banking Industry.
New Haven:
College & University Press, 1971.
10. Emeka, Mauris Lee Porter. Black Banks, Past and
Present.
Kansas City: Mauris L. P. Emeka, 1971.
11. Irons, Edward D. “Black. Banking-Problems
and
z;r;Fts.”
Journal of Fanance, (May 1971), pp.
- .
12. Knight, Kenneth E. and Terry Dorsey. “Capital
Problems in Minority Business Development: A
Critical Analysis.”
American Economic Review,
(May 19761, pp. 328-31.
13. Kohn, Donald L.
“Minority
Owned Banks.”
Monthly Review, Federal Reserve Bank of Kansas
City, (February 1972)) pp. 11-20.
14. Leavitt, Brentin C. “Black Banks: A Review of
Earnings Performance.” Address before the Fi.rst
Annual Director-Senior Management Seminar of
the National Bankers Association, Inc., Atlanta,
Georgia, July 21, 1972.
15. Marsh, James. “Viewing the Loss Experience on
Minority Enternrise Loans.” Bankers Magazilze,
(Winter 1971) ,-pp. 84-7.
16. Thieblot, Armond J., Jr. The Negro in the Banking
Industry.
Philadelphia : Industrial Research Unit,
Wharton School of Finance and Commerce, University of Pennsylvania, 1970.
17. Walker, Charles E. Address before the 43rd Annual Convention of the National Bankers Association, St. Louis, Missouri, October 16, 1970.
Reprinted in the Department of the Treasury
News, Washington, D. C.

NOVEMBER/DECEMBER

1976

A MONETARIST

MODEL OF WORLD

INFLATION

AND THE BALANCE OF PAYMENTS
Thomas

M. Humphrey

The inflation of the past ten years has been a
lvorldwide
phenomenon.
Accordingly,
analysts
have become increasingly
aware that any satisfactory

explanation

of price

level

behavior

must

account for its international
character. These analysts fall into three main schools.
First are the
eclectics, who attribute world inflation to a complex
and ever-changing
mixture
of causes, e.g., the
exercise of monopoly power by oil-producing
nations ; the international
conjuncture
of cyclical
booms; and the occurrence
of bad harvests, poor
fish catches, and other autonomous
reductions
in
the supplies of key commodities.
Second are the
members of the cost-push school, who blame inflation
on worldwide labor militancy.
Third are the global
uYtonetarists, who, in sharp contrast with the other
schools, focus largely or exclusively
on the monetary factor.
The

theoretical

the monetary
As usually

basis

theory

of this third

approach

of the balance

presented,

this

is

of payments.

theory

assumes

that

the countries

of the world are linked together

they actually

were until

rates

between

sum

total

common
tutes

unit
with

price

individual

convertible

at the fixed

operation

level,

currencies.

which

converted

exchange

stock.

the demand

countries

by fixed eschange

currencies

the world money

junction
world

freely

of these

1973)

This

rate
stock,

Finally,

is then

money

in eschange

nation

uses

payments

the

to bring

importing

constithe
to

arbitrage,
prices
or

the
in all

exporting

for goods and securities,
mechanism
its domestic

of

a

in con-

transmitted

by commodity
by

The
into

for it, determines

of which tends to equalize

markets.

(as

the

balance

money

stock

each
of
into

line with the exact quantity required to support
the price level.
\Vhen applied to the interpretation of recent inflationary
experience-at
least up
to 1973 when fixed rates were widely abandoned
for flexible ones-this
theory implies that excessive world monetary expansion generated the infIation, that commodity
arbitrage
propagated
it,
and that the balance
of payments
mechanism
distributed
the world money supply as requirecl
to accommodate
or validate it in each natioll.
FEDERAL RESERVE BANK

This articie
seeks to explain
the foregoing
theory and i:s public policy implications
with the
aid of a simple expository
model of the international monetary mechanism.
Although originally
constructed
ior the specific purpose of analyzing
the economic
effects of a currency
devaluation,
the model is easily adaptable
to the monetarist
esplanation
of world inf1ation.l
In fact, it constitutes an almost ideal framework
within which
to articulate
the global monetarist
view because
it embodies most of the elements essential to that
view. These elements are outlined in the following section, which serves as a necessary
preliminary to the description
of the model and its components.
Monetarist
Propositions
Any analytical
model
that conveys the essence of the global monetarist
explanation
of world inflation must contain certain key ingredients
that characterize
that approach.
These elements include the following:
1. THE VIEW OF THE WORLD AS THE
RELEVANT
CLOSED ECONOMY.
The global
monetarist views the world as a closed system of
interdependent open national economies connected
by fixed or imperfectly floating exchange rates. In
this view, nations are interpreted as regions of the
closed world economy, and problems of inflation in
any particular nation are treated as purely regional phenomena, as are questions relating to an
individual nation’s distributive share of the world
money stock.
2. THE QUANTITY THEORY OF MONEY. The
quantity theory constitutes the second key component of the global monetarist view. The quantity
theory states that the path of world prices in longrun equilibrium is completely determined by the
path of the world money stock. This conclusion
follows from the theory of the interaction between
the demand for real (price-deflated) money balances and the nominal stock of money. The demand
for real balances is interpreted as a stable mathematical function of a few macroeconomic variables,
the most important being real income and an inter’ The model is presented by Dornbuseh in [31.
See Mundell [4.
Chapter S: 5, Chapters 9, 10, 11, 12. 151 for an earlier and 6omewhat different trezrment of the main elements of the model.
The
most complete
description
of the Dornbusch
model appears
in
Whitman [il. who uses it to explain the global monetarist approach
to the balance of payments.
Swoboda [61 and Claassen [21 emplov
the Dornbusch
model to analvze world inflation
under fixed and
flexible exchange rates, respectively.
Also see Branson
Cl] for a
similar approach.
The present article follows Whitman and Swoboda
ClOSdY.

OF RICHMOND

13

est rate variable representing the opportunity cost
of holding money. Given the values of these independent variables, the theory states that the price
level will adjust to bring the real volume of any
nominal stock of money into equality with the
amount demanded. From this it follows that if the
income and interest rate determinants of the demand for money are given. an exogenously given
nominal stock of money completely determines the
price level. Xore generally, in terms of a growing
world economy, the long-run rate of world monetary expansion determines the steady-state rate of
world inflation, given the trend growth rate of
world output. Two important implications of the
quantity theory should be noted at this point. The
first is that money has no influence on real economic variables in the long run. The second is
that in long-run equilibrium the price level will
vary in exactly the same proportion as the money
stock. Known as the neutrality and equiproportionality postulates, respectively, these two propositions must be embodied in any mathematical model
that purports to represent the logical structure of
the global monetarist view.
3. LAW OF ONE PRICE. From the universally
accepted pxoposition that commodity arbitrage
tends to equalize prices of identical traded goods
across countries-due
allowance of course being
made for tariffs and transportation costs-monetarists move directly to the proposition that general
price levels also tend to be equalized. Monetarists
note that in a world of rigidly fixed exchange rates
between freely convertible currencies money itself
becomes a homogeneous traded good whose price,
like that of any other traded good, will be equalized
But since the domestic price of
internationalIy.
money in terms of goods is simply the inverse of
the general price level, it follows that equalization
of the price of money implies equalization of national price levels. This point, incidentally, distinguishes modern global monetarists from their classical counterparts of the 18th and 19th centuries,
notably David Hume and David Ricardo. The latter
group argued that the volume of imports and
exports depends on domestic prices reIative to
foreign prices and that changes in these relative
prices constitute a key link in the automatic specieflow mechanism that operates to correct payments
imbalances and to maintain the equilibrium international distribution of the precious metals. Xodern monetarists deemphasize such relative price
effects on the grounds (1) that efficient arbitrage
prevents price disparities from developing except
for the briefest of intervals and (2) that the automatic adjustment process operates mainly through
divergences between income and expenditure rather
than through the classical relative price mechanism.
4. MONETARY IXTERPRETATIOK
OF THE
BALANCE OF PAYMENTS.
The fourth key
component of the monetarist approach is the concept of the balance of payments as the means by
which open economies adjust their existing stocks
of money to the stocks they desire to hold. Suppose
a country’s actual money stock is smaller than the
14

ECONOMIC

REVIEW,

stock its residents desire to hold. Endeavoring to
replenish their cash balances, these residents wiIl
cut their expenditure thereby releasing resources
for the export trade. The country will run a trade
balance surplus, exporting goods and importing
money until the gap between actual and desired
money stocks is eliminated.
Conversely, if the
existing stock of money is greater than that desired, national expenditure will exceed national
output and the country will run a trade balance
deficit, importing goods and exporting money until
the excess money balances are worked off. In this
manner, each nation will use its balance of payments to attain monetary equilibrium, and for the
world as a whole, the balance of payments mechanism will distribute the world money stock across
nations consistent with monetary equilibrium in
each nation. The key assumption underlying the
foregoing view is that, in the long run at least,
national central banks do not use open market
operations and other policy weapons to offset or
neutralize (“sterilize”)
the impact of external
money flows on the behavior of the domestic money
stock. One justification for this assumption is that
the effect of sterilization operations wouId be to
create international interest rate differentials that
would induce capital flows sufficient to undermine
the sterilization policy. Finally, it should be noted
that the nonsterilization assumption means that
from the point of view of an individual country the
money supply is an endogenous variable completely
determined by the public’s decisions to acquire or
get rid of cash through the balance of payments.
Here the traditional monetarist assumption of an
exogenous money stock applies only to the closed
world economy and not to individual open nationa
economies.
Constituting
the essential
ingredients
of the
monetarist
theory of world inflation,
these four
elements are incorporated
in the analytical
model
presented
below.
The Model and Its Components
The model itself
consists
of a hypothetical
two-country
world
economy represented
by a set of equations
containing the following
variables.
Let D be the
desired stock of national nominal money balances
and M the actual stock composed of a domestic
credit component
C and an international
reserve
component
R. Furthermore,
let &f and R be the
rates of change (time derivatives)
of the national
money stock and its foreign
exchange
reserve
component,
respectively,
and A be an adjustment
coefficient
representing
the speed of adjustment
-41~0, let IX
of actual to desired money stocks.
be the desired ratio of nominal cash balances to
nominal income, U the level of real output, P the
price level, and X the exchange
rate (domestic
currency
price of a unit of foreign
currency).
The cash balance ratio I< is treated as a numeriNOVEMBER/DECEMBER

1976

cal constant,
and the output and exchange
rate
variables
are taken as exogenously-determined
givens.
Finally,
let E be nominal national
expenditure
and B the trade balance measured
in
domestic
currency.
For simplicity,
the trade
balance is identified
with the overall balance of
payments,
i.e., the capital account
and international capital flows are ignored.
Unstarred
variables refer to the home country,
starred
variables to the foreign
country
(i.e., rest of the
world), and the subscript
w to the closed world
economy.
Percentage
rates of change of variables are represented
by lower-case
letters-for
example, p is the percentage
rate of change of the
price level P.
Purchasing
Power Parity
Equation
equation of the model is the goods
purchasing
power parity equation
(1)

P =

The first
arbitrage
or

xp*,

which embodies the “law of one price” proposition that international
arbitrage tends to equalize
the money price of goods in terms of either currency. The equation states that the price level in
the home country is equal to the product of the
exchange
rate and the price level in the foreign
country, implying that the price levels in the two
countries
are the same when converted
into a
common unit at the fixed exchange
rate.
Note
corresponds
to the global
that this equation
monetarist view that national commodity markets
are merely parts of a single unified world commodity market.
Money

Demand

Equations

The

second

part

of

the model consists
of demand for money equations, one for each country.
These
equations
express the stock of nominal money balances that
the public desires to hold in the aggregate
as a
constant
fraction
K of the level of nominal national income (the product of the price level and
the exogenously
given level of real output).
The
equations are written as follows:
(2)

D =

KPY

and D* =

K*P*Y*.

As written,
these demand
functions
comply
with the quantity
theory of money in at least
First, the exogeneity
of the real
three respects.
output variable
squares
with the quantity
theory’s assumption
that output is determined
independently
of the behavior of money in the long
run.
Second,
the demand functions
exhibit
a
one-to-one
relationship
between the quantity
of
FEDERAL RESERVE BANK

money demanded
and the price level.
In the
technical
jargon of monetary
theory,
the functions are said to be homogeneous
of degree one
This homogeneity
property
implies
in prices.
both (1) absence of money illusion (the inability
of economic agents to distinguish
between
real
and nominal economic magnitudes)
and (2) longrun neutrality
of money as postulated
by the
quantity theory.
It also ensures that the theory’s
equiproportionality
postulate
will be satisfied,
i.e., that the price level will vary in exactly the
same proportion
as the money supply.
Third,
the demand functions
exhibit
the stability
required by the theory, this stability being assured
by the assumed constancy
of the desired money/
income ratios.
Money Supply Equations
The foregoing demand
equations represent
only one side of the money
market and must be matched by supply equations
representing
the other.
These equations
are derived from the consolidated
balance sheet of the
commercial
banks and the central bank of each
country.
By a simple accounting
identity,
the
monetary liabilities of those sectors can be shown
to be backed by an equivalent
amount of assets
as indicated by the equations
(3)

M = C + R and M* =

C* + R*.

Here M is the narrowly
defined money supply
(currency
plus demand deposits),
C is domestic
credit defined as the banking system’s holdings
of net domestic assets, and R is the banking system’s holdings
of international
reserves.
The
foregoing
equations
merely
express
national
money stocks
as the sum of their respective
source components,
domestic
and foreign.
Of
these two components
only the first is under the
control of the monetary authority.
By contrast,
the foreign source component-and
therefore the
money stock itself-is
determined by the public’s
demand for cash. If the public is just satisfied to
hold the existing
stock of money, any policyengineered change in the domestic credit component will induce an equal but opposite change in
the foreign source component,
leaving the nation’s money stock unchanged.
Corresponding
to the
equations is the equation
(4)

M,

=

M +

national

money

supply

XM*

that defines the world money stock M, as the
sum of the national money stocks expressed
in a
common currency unit.
The world money stock
OF RICHMOND

15

This folis treated as an exogenous
variable.
lows from the assumption
that the quantity
of
world reserves is given.
Given the latter, all the
components
of the world money stock, namely
the domestic
source component
of the national
money stocks plus world reserves, are exogenous
and therefore
so is the world money stock itself.
Note, however,
that while total world reserves
can be treated as a given, a single nation’s reserve
holdings cannot be so treated, which is the reason
national money supplies are endogenous variables
from the viewpoint
of the national
authorities.
Despite
their simplicity,
equations
3 and 4 are
taken as constituting
an accurate specification
of
the supply side of the money market.
Money market equilibrium,
of course, requires
that money demand equal money supply in each
nation,
implying
a zero
excess
demand
for
money. Although this condition must be satisfied
in the long run, it may well be violated in the
short run, in which case national money markets
will exhibit
temporary
disequihbrium
as manifested
by excess
demands
for or supplies
of
money.
When monetary
disequilibrium
occurs,
however, an automatic
self-corrective
mechanism
starts to function as people begin to adjust their
cash holdings to bring actual liquidity back into
line with desired liquidity.
Money Stock Adjustment
Equations
The adjustment mechanism
mentioned
in the preceding
paragraph
is represented
by the model’s fifth set
of equations,
which state that the rate at which
each country augments
or depletes its cash holdings is proportional
to the excess demand for
money-. These money stock adjustment
equations
are written as follows:
(5)

$1 =

A(D--M)

and $I* =

A*(D*-$I*),

where S$ is the change in money holdings
per
unit of time, D-M
is escess demand for money
between
desired
and
actual
(the
difference
stocks),
and A is an adjustment
coefficient
expressing
the speed at which money stocks are
The
adjusted
in response
to excess
demand.
cfoser the coefficient
is to unity the faster the
adjustment,
and the closer it is to zero the slower
In the extreme case where the
the adjustment.
coefficient
has a numerical value of unity, adjustment is sufficiently
rapid to eliminate
excess
stock demand within the same period it occurs.
In the opposite case, i.e., a zero coefficient,
adjustment
never occurs and excess demand persists indefinitely.
The model assumes that the
16

ECONOMIC

REVIEW,

coefficient
is large enough to
stock adjustment
is eventually

insure that
achieved.

full

The
channel or mechanism
through which monetary
adjustment
is accomplished
is, of course, the balance of payments.
Balance of Payments
Equation
The sixth component of the model is the balance of payments
equation,
which performs
two important
functions.
First, it specifies the role of the external
trade balance
in the money stock adjustment
process.
Specifically,
the equation states that the
trade balance surplus (the excess of money re-,
ceipts from sales abroad over monetary
expenditures on purchases
from abroad) is by definition
equal to the country’s net change in international
reserves and therefore,
given domestic credit, in
the stock of money itself, i.e., B = R = 1%. This
expression corresponds
to the monetary theory of
the balance
of payments
according
to which a
nation adds to its stock of money by running :a
trade balance
surplus,
exporting
goods in exchange for money, and reduces its money stock
by running a trade deficit, importing
goods in
exchange
for exports of money.
The expression
also embodies the key monetarist
assumption
that
the policy authorities
do not offset or nullify
(“sterilize”)
the impact of payments disequilibria
and reserve flows on the domestic money supply.
The second purpose of the equation is to insure
that the two-country
model is internally
consistent by imposing the condition that, for the world
as a whole, the sum of the individual trade balances when measured
in terms of a common
monetary unit is identically
equal to zero.
This
condition means that if the home country is running a trade balance surplus, the foreign country
(rest of world) must be running a trade defilcit
of the same amount when measured in terms of
home country currency.
Symbolically,
the balance of payments
identity is B = -XB*,
where
B is the home country’s
trade balance
surplus
and -XB*
is the foreign country’s
trade deficit
(a negative
surplus)
expressed
in units of domestic currency at the fised exchange rate. This
expression,
showing how the individual countries
are unified via the balance of payments identity,
constitutes
a mathematical
statement
of the
global monetarist
view of the world as a closed
system of interdependent
open economies.
To summarize,
the complete
balance
of payments equation,
expressing
both the zero world
trade balance identity and the monetary view oi
the external accounts,
is written as follows:

NOVEMBER/DECEMBER

1976

(6)

sulting in a trade surplus.
Only if expenditure
just equals production
will the trade balance be
zero.

B=-XB*=~~;IR=--XM*=
-xR*.

Note that since by definition
the foreign country’s trade deficit measured in terms of domestic
currency must equal the home country’s surplus,
it follows that the money outflow from the for-

The Equations Summarized

Taken together,
the
foregoing equations embody the main elements of
the monetarist
view of the world economy.
The
equations link the levels of prices, expenditures,
and desired and actual money stocks in the two
countries
as well as the flows of money and
goods between them.
To summarize,
the equations are written as follows:

mer country must also equal the money inflow
into the latter.
Here is the global monetarist
view of the balance of payments as the allocation
mechanism that distributes
money across nations.

Expenditure

a given total

of world

(1)

are the expenditure

(7)

E =

PY -

ti and E*

=

P*Y*

-

M,

(5)

ti = A(D-M)

(6)

B=-XB*=M=l&---X&l*=

M*,
(7)

R

M +

K*P*Y*

M* =

C* +

R*

XM

&I* = A*(D*-M*)

E = PY -

M

E* =

P*Y*

-

M*.

Equations
i-4 help determine
the equilibrium
(steady-state)
values of the price and monetary
variables, while equations S-7 describe the adjustment mechanism by which equilibrium
is restored
following a monetary
disturbance.
Specifically,
the equilibrium world price level is determined by
equating the n-or-Id money supply shown in equation 4 with the aggregate
world real demand for
money implicit in equation 2. Once determined,
the world price level is then transmitted
to the
two countries
via commodity
arbitrage
as de-

i?if.
According
to the equations,
spending
equals
income only when cash balances
are not being
augmented
or depleted, i.e., when the public is
just satisfied to hold the existing stock of money.
An excess supply or demand for money, however,
causes expenditure
to deviate from income.
For
example, an excess demand for cash means that
commodity
expenditure
falls short of income as
the public endeavors to build up its cash balance.
Conversely,
an excess supply of money implies
that expenditure
exceeds income as the community tries to get rid of its excess cash holdings.
Note also that the equations imply a relationship
between spending, income, and the trade balance.
This corresponds
to the monetarist
view that the
international
adjustment
p.rocess operates
primarily through divergences
between expenditure
and income rather than through changes in the
relative prices of exports and imports.
The equations imply that when domestic
spending
for
goods exceeds domestic income (production),
net
commodity imports will fill the gap and the trade
balance will be in deficit.
Similarly,
when domestic expenditure
falls short of production,
the
unabsorbed
output will be exported,
thereby reRESERVE

=

D* =

-xl%*

the equations express a relationship
between domestic expenditure
E (i.e., spending by domestic
residents
on both home- and foreign-produced
goods),
nominal
income
PY, and the rate of
accumulation
or decumulation
of cash balances

FEDERAL

M = C +

(4)

connection
between
the money market and the
commodity
market.
These
equations
indicate
that in a world in which the public can hold only
money and/or goods, an excess demand for one
implies
a corresponding
excess
supply of the
other and vice versa.
Written
as follows:

D = KPY

(3)

Completing
the model
equations
that describe the

p = xp*

(2)

Equations

scribed in equation
1.
The resulting
country
price levels enter equation 2 to determine nominal
national demands for money. If these latter variables differ from the existing
national
money
stocks
shown in equation
3, the discrepancy
enters equation 5 to determine the rate of money
stock adjustment,
which enters equations 6 and 7
to determine
national
expenditures,
trade balances, and the corresponding
international
redistribution
of the world money stock.
Less formaliy, the model implies the following
causal chain :
1. The world stock of money determines the world
price level.

2. International arbitrage brings national
into equality with world prices.

prices

3. National price levels determine national nominal
demands for money.
BANK

OF RICHMOND

17

4. National money demands in conjunction with
national money supplies determine the rate of
money stock adjustment.
5. Xoney stock adjustment determines spending,
trade balances, and the direction and volume of
international money flows.
6. This process continues until the equilibrium
international distribution of money is achieved,
and money market equilibrium is restored in each
country. At this point the system is said to be in
steady-state equilibrium.
Long-Run

Steady-State

Solution

of the System

In anq’ economic
system,
the long-run
steadystate is characterized
by full stock equilibrium,
i.e., a situation in which existing asset stocks just
equal desired asset stocks.
In the hypothetical
system described by the model, steady-state
equilibrium occurs when the existing stock of money
(the sole asset) equals the desired stock. -4s can
been seen from equations
5 through
7, this in
turn implies that money stock adjustment,
trade
balances,
and the gap between expenditure
and
In long-run
equilibrium,
income are all zero.
therefore,
equations
5 through 7 are irrelevant,
and one can analyze the determination
of world
prices and their rate of inflation
from the first
four equations
alone.
World Price Level and Inflation Rate A central
is that, under a
proposition
of global monetarism
regime of fixed exchange rates, the steady-state
path of world prices is determined
by the path of
the world money stock. A version of the quantity
theory of money, this proposition
can be demonstrated with the aid of the four equations relevant
to the analysis of long-run equilibrium.
The demonstration
requires several steps. First,
impose the condition of stock equilibrium
and set
the supplies
of money equal to demands,
e.g.,
Second, use the fised exchange rate
M z KPY.
to express the money stock and price variables
as world-level
magnitudes.
As defined in equation 4: the world money stock is the sum of the
national
money stocks measured
in terms of a
single currency, i.e., M, = 31 +X&l*.
Similarly,
by virtue of the purchasing
power parity assumption, each nation’s price level espressed
in terms
of a common unit is equal to the world price
Note that the assumplevel, i.e., P, = P = XP*.
tion of a fixed exchange
rate is absolutely
indispensable
here since it provides
the invariable
common unit required
to convert national variables
into a single
homogeneous
world-level
measure that has analytical
significance.”
The
third step is to recognize
that by choice of an
18

ECONOMIC

REVIEW,

appropriate
unit of measurement
for either currency the exchange rate can be set equal to unity,
thus permitting
the relationship
between
the
world money stock and the world price level to
be written simply as 3ijI, = M + M* = (KY -+
In long-run
equilibrium,
the variK”Y*) P,.
ables enclosed
by parentheses
are regarded
as
exogenously
determined
by tastes,
technolo,T,
and resource endowments,
and consequently
are
It follows, therefore,
that, in
taken as given.
terms of the model, the world price level is fully
determined
in the long run by the world money
stock, with changes in the latter variable
equiproportionate
changes in the former.

causing

Corresponding
to the preceding
equilibrium
money-price
relationship
is the equilibrium
distribution
of the world money stock.
The home
country’s
natural proportional
share or fraction
S of world money can be espressed
as S =
M/&
= KY/(KY
+ K*Y*),
and similarly
for
the other country (rest of world), whose share, of
course, is 1-S.
This important result states that,
in steady-state
equilibrium,
the fraction of world
money distributed
to each nation depends upon
the relative
importance
of the nation’s
demand
for real cash balances as compared with the demands of the entire world.
The demand for real
balances,
of course, is expressed
as the product
of the desired money/income
ratio and real income.
Assuming
both countries
have identical
money/income
ratios,
the country
with
the
greater real income will command the lion’s share
of the world money stock.
As shown below, the
distributive
share parameters
S and 1-S
appear
in the expression
for the world rate of inflation,
the derivation of which constitutes
the final stlep
of the demonstration.
The expression
for the world rate of inflation
is derived by taking the time derivative
of the
logarithm
of the world money-price
level relationship and is written as pW = m, [Sy +
Here pm is the percentage
rate of
(l-s>yq.3
.*
.
tvorld mZiatlon, m, is the percentage
rate of
growth of the world money stock, y and y* are
the exogenously
given trend growth rates of real
output in the two countries,
and S and 1-S
are
the shares of each country in the world money
2 A flexible exchange rare implies two distinct national money stocks
and price levels separated by a variable exchange rate relationship
between them, and therefore precludes any meaninaful concept of a
single world money stock and world price Ievel.
3 Note that the derivation of this formula requires that the model be
reinterpreted to allow for steady-state growth of the relevant variables. Accordin&,
the equilibrium mannitudes of the variable3 are
expressed not as absoiute dollar levels but rather as constant percentage rates of change.

NOVEMBER/DECEMBER

1976

stock. This equation states that the rate of world
inflation
is equal to the difference
between
the
world rate of monetary expansion and the growth
rate of world output as measured by the sum of
the weighted
national
output growth rates, the
weights being the countries’
shares in the world
money supply.
In short, the equation is an exact
statement of the monetarist
conclusion that inflation results when world monetary expansion outpaces
The

world
Dynamic

output

growth.

Adjustment

the determination

Process

of the path

So much

of world

steady-state
equilibrium.
The next
analysis deals with the international

prices

for
in

stage of the
adjustment

mechanism as described in equations 5 through 7.
Regarding
the adjustment
process,
three questions are especially
pertinent.
First,
what responses are provoked by an autonomous
increase
in the domestic money supply of a single open
economy?
Second, how do these responses raise
the world price level. ? Third, how do individual
countries subsequently
adjust to the higher world
price level ?
To answer these questions,
start from a hypothetical situation of worldwide monetary equilibrium, and let this equilibrium
be disturbed by a
Acmonetary
expansion
in the home country.
cording to the model, this disturbance
generates
an excess supply of money leading to a trade balance deficit and an excess
home demand
for
goods in the world commodity
market, putting
upward pressure on world prices.
The resulting
world price increase, disseminated
abroad via the
international
arbitrage mechanism,
induces corresponding changes of opposite sign in the demandfor-money,
stock-adjustment,
expenditure,
and
trade-balance
equations
of the foreign country.*
Adjustment
continues
until both monetary
redundancy in the one country and monetary
deficiency in the other are eliminated.
When equilibrium is restored, world and national price levels
will have risen in proportion
to the rise in the
world money supply.
The preceding corresponds
closely to the monetarist interpretation
of the worldwide inflation of
the late 1960’s and early 1970’s.
According
to
this view, excessive
monetary
expansion
in the

U. S. generated
a persistent
excess demand for
goods and consequently
a series of balance
of
payments
deficits that pumped dollars into the
international
monetary system in sufficient quantities to contribute
significantly
to global inflation.
This view departs from the model only in
one key respect.
It contends that, because the
dollar itself constituted
the primary international
reserve asset, the U. S. was able to engage in
domestic
credit expansion
that led to the inflationary rise in world liquidity without suffering a
loss of its own reserves.
Lacking
an external
reserve constraint,
the U. S., in this view, became
a potentially
potent source of world inflation.
Policy
Implications
of the Model
The model
described
in the preceding
paragraphs
contains
some radical implications
for economic stabilization policy.
These implications
can be classified
according
to whether they pertain to small or to
large open economies.
Small economies are those
whose domestic policy actions can be treated as
having a negligible
impact on the rest of the
world.
Large economies,
by contrast,
are those
whose policies have a significant
global influence.
In some cases-e.g.,
the United States-an
economy may be so large as to warrant interpretation
as a closed economy.
In what follows it is also
well to remember
that the often unconventional
conclusions
derived from the model reflect the
particular
assumptions
underlying
it, and that
many of these assumptions
are open to serious
criticism.
This is especially true of the assumptions of (1) full employment,
(2) perfect international arbitrage,
(3) exogeneity
of real income,
(4) nonsterilization
of international
money flows,
and (5) the existence of an inherently stable self:
regulating
world economy.
While these assump;
tions may hold in long-run equilibrium,
empirical
evidence suggests
that they may not hold over
any realistic
current policy-making
horizon nor
over the transitional
adjustment
period following
monetary shocks.
Recognition
of this fact would
certainly
modify-perhaps
drastically-any
pohcy prescriptions
based on the model.
Subject to
these caveats,
the policy
implications
of the
model are summarized
below.

*The rise in world prices also affects the home country. reducing
but not eliminating the excess supply of money
there.
This latter
result follows from the fact that world prices rise in proportion to
the world, not the national, money stock. Since the home country’s
stock is but a fraction of the world stock, a given percentage change
in the former corresponds
to a smaller percentage
change in the
latter. and therefore in the world price level. In short, world prices
will not rise sufficiently
to eliminate the initial excess supply of
money in the home country.
The redundant money must be gotten
rid of through the balance of payment&

FEDERAL RESERVE BANK

Small Country Implications
The first and most
radical implication
stemming
from the model is
that, in the case of small open economies operating with fixed exchange
rates, traditional
macroeconomic monetary and balance of payments policies are both unnecessary
and useless.
They are
OF RICHMONO

19

unnecessary
mechanism

because the international
adjustment
works automatically
to correct
eco-

nomic disequilibria
and to provide each country
with sufficient
money to accommodate
full capacity levels of output.
They are useless because
the domestic
authorities
cannot
control
the
money supply or the balance of payments, both of
which are endogenous
variables
determined
by
the public’s demand for money.
Suppose,
for example,
the authorities
try to
improve the country’s
balance
of payments
by
devaluing
the currency,
i.e., engineering
a onetime increase in the pegged exchange
rate.
This
devaluation
has no permanent
impact
on the
trade balance.
There is, to be sure, a favorable
&or&rzin impact, but this impact is inherently transient as can be seen by tracing the sequence
of
events triggered
by the policy action.
First, the
devaluation
causes
a step increase
in the exchange rate.
Given the foreign price level, however, the home price level must immediately
rise
in the same proportion
as the exchange
rate to
preserve purchasing
power parity.
The domestic
price increase
raises the stock of cash ,balances
demanded by the public.
This generates
an excess demand for money, leading to a reduction in
expenditure
and to a trade balance surplus.
The
surplus, however, is short-lived,
since it is accompanied by an inflow of money that eventually
eliminates
the discrepancy
between
actual and
desired cash balances.
When this happens, the
adjustment
process
ceases,
domestic
spending
again equals production,
and the trade baIance
surplus vanishes.
The sole long-run effect of the
devaluation
is on the price level which, according
to the demand for money equation, rises in exact
proportion
to the increase.in
the domestic money
supply.
Within the context of the example, the
authorities
are powerless
to exercise
permanent
control over the balance of payments.
The only thing the monetary
authorities
can
controI in a small open economy is the cowposition
of the money .supply, i.e., the mix between
domestic credit and international
reserves.
They
cannot, however, govern the size or total quantity
of the money supply.
For according to the monetary theory of the balance of payments, an expansion in the controllable
domestic
credit component of the money stock will result in a balance of
payments
deficit and an outflow of the uncontrollable
international
reserve
component
until
the money stock returns to its initial level. When
equilibrium
is restored,
the mix of the. money
stock will be changed-domestic
credit having
20

ECONOMIC

REVIEW,

displaced international
reserves dollar for dollar
-but
the total will be unaltered.
This conclusion
follows directly from the model as can be seen
by setting the money supply equation equal to the
money demand equation to yield C + R = KPY.
Given the long-run
equilibrium
values of the
variables on the right-hand
side of this equation,
it follows that any change in the domestic credit
component C must be offset by a change identical
in size but opposite in sign in the international
reserve
component
R to keep the total money
stock equal to the unchanged
steady-state
demand for it. In short, the total ‘stock of money is
no more a controllable
variable than is the balance of payments
in a small open economy.
A second policy implication
is that, assuming
the absence
of monetary
contraction
abroad, a
nation’s monetary authorities
are solely to blame
for ‘its balance of payments
deficits, since there
can be no deficits unless there is an excess supply
of money. It should be noted, however, that such.
deficits are inherently
transitory
phenomena.
For
the model predicts that they will vanish as soon
as the redundant
money is diffused throughour
the world economy by the operation of the international adjustment
mechanism.
A third policy implication
is that, in a world of
fixed exchange
rates, a small open economy can
control neither its price level nor its rate of inila.tion, since both are determined in world markets.
This means that an individua1 country will find it
impossible to avoid inflating at the world rate. It
also means that in a fixed exchange
rate system
all national inflation
rates must eventually
converge.
This latter
conclusion
can be demonstrated by taking the time derivative of the logarithm of the purchasing
power parity equation.
This operation
yields the result p = s + p*
?+here p an’d p* are the percentage
rates of price
iniIation
in the ‘home and foreign
countryt
respectively,
and x is the percentage
rate of change
of the exchange rate. This result states that rates
of inflation in the home country and the rest of
the world can differ only by the proportional
rate
In a system of
of change of the exchange
rate.
fixed exchange rates, however, the latter variable
is zero and therefore
the two inflation
rates
must .converge.
In short, with fixed exchange
rates, countries cannot continually
infiate at diiferent rates.
A fourth policy implication,
therefore,
is that
if a country wishes to choose its own inflation
rate independent
of the rest of the world it
must operate with a flexible exchange
rate.
By

NOVEMBER/DECEMBER

1974

letting its currency float, a country can gain control over its money supply and hence its rate of

bank.

inflation.
The logic behind this conclusion
is
straightforward.
Floating exchange rates operate
to maintain continuous equilibrium
in a country’s

Laidler,
while agreeing
that volatile
exchange
rates introduce risk and inefficiency into the international economy, do not believe that a regime of
institutionally
fixed exchange rates is necessarily
the best solution. According to these latter mone-

external accounts, thereby obviating the need for
international
money flows.
It follows, therefore,
that increases
in the domestic
money stock, instead of being diffused abroad through the balance of payments,
will remain at home to induce
equiproportional
rises in the domestic price level.
Note that the adjustment
mechanism in the floating rate case differs markedly from that of a fixed
rate regime.
In the latter, money market equilibrium is restored by quantity
adjustments,
namely,
international flows of money.
In the former case.
however, stock equilibrium is restored by price adjustments,
namely, changes in the domestic price
levels.
To summarize,
with the exchange
rate
floating so as to equilibrate
the balance of payments, a nation’s money stock becomes an exogenous variable which the authorities
can control
to achieve any rate of inflation they desire.
If a floating exchange
rate permits a country
to determine its own rate of inflation, then it also
insulates
that country from inflation originating
abroad.
Thus when a foreign nation inflates its
money supply while the home country holds its
currency
constant,
the resulting
rise in the foreign price level will be offset by an equiproportional fall in the exchange rate, leaving domestic
prices unchanged.
Xote, however, that this conclusion has an important
corollary,
namely, that
under a flexible
exchange
rate a country must
suffer the full consequences
of its inflationary
policies since it cannot export its inflation abroad.
It would be wrong to conclude from the above
arguments
that monetarists
believe that flexible
exchange
rates are inherently
superior to fixed
rates.
On the contrary,
many monetarists
are
opposed to floatin, m rates for at least two reasons.
First,
floating
rates eliminate
the risk-pooling
and efficiency
advantages
of international
money
associated
with fixed rates.
Second, volatile exchange rates between
currencies
would tend to
reduce the effectiveness
of money as a social
institution
for economizing
on the use of scarce
resources
in the production
and dissemination
of
economic information.
It is on the basis of such arguments
that some
monetarists-e.g.,
Robert A. Mundell and Arthur
Laffer-urge
the restoration
of a system of fixed
exchange
rates, with the rate of world monetary
expansion
being regulated
by a world central
FEDERAL RESERVE BANK

5lilton

By contrast,
other monetarists
such as
Friedman,
Harry G. Johnson,
and David

tarists,
floating
rate volatility
stems from domestic monerary policies that are erratic, variable,
and divergent as between countries.
This volatility, it is claimed,
countries abandoned
monetary management
The adoption of rules

would be eliminated
if all
discretionary
countercyclical
for fixed monetary
rules.
calling for a constant rate

of domestic
monetary
expansion
equal to the
trend growth
rate of real output
supposedly
would make the flexible rate virtually
as stable
as a rigidly fixed rate.
Moreover,
flexible rates
have the added advantage of being determined by
market forces, thus freeing governments
to use
their policy instruments
in pursuit
of purely
domestic objectives.
It is apparent from the above that while monetarists agree that exchange rate stability is necessary for an efficiently
operating
international
economy, they disagree
on the question
of the
most appropriate
exchange
rate regime.
This
disagreement
is not as important
as it appears,
however, since all monetarists
acknowledge
that
the key to exchange rate stability lies less in the
way the foreign exchange
market is organized
than in finding a means of coordinating
national
monetary policies.
True, the policy coordination
problem
has not been solved, although
many
solutions
have been proposed
(including
the
above-mentioned
proposals of rules and a world
central bankj.
But if and when it is solved, the
exchange
rate-whether
fixed or floating-will
be stable.
And once the exchange
rate is stabilized, inflation
will again be an international
rather than a national problem.
This is because a
stable rate oi exchange between national currencies makes the sum of those currencies
an economically
relevant
aggregate
and also implies
that national inflation
rates will converge
on a
common (world) level.
Large Country Implications
The policy implications discussed in the preceding paragraphs
refer
to small open economies.
As pointed out earlier,
however, the implications
are substantially
different when the individual country is large relative
to the rest of <he world. The main difference concerns the ability of a country to control its own
OF RICHMOND

21

inflation
rate under a system of fixed exchange
rates. As noted earlier, in a fixed rate regime an
individual

country’s

domestic

monetary

expan-

sion will affect its price level only indirectly
by
influencing
the world money supply
and the
world price level. The strength of this influence
is in direct

proportion

to the

relative

economic

size of the country as measured by its share of
the world money supply. For an individual small
country this share is negligible
and therefore
so
is the country’s ability to influence its own price
level.

In sharp contrast,

a large country’s

money

stock forms a substantial
proportion of the world
money stock such that an expansion in the former
stock will result in a significant
expansion
in the
latter and, therefore,
in the world and national
price levels. Because of its size, the large country
is able to indirectly regulate its own money stock
and price level even in a world of fixed exchange
In this sense, a large country’s
money
rates.
stock becomes an exogenous variable and its price
level an endogenous one, which is just the reverse
of the case for small countries.
Apart from sheer size, there is a second reason
why a large country may be able to control its
money supply even in a fixed rate regime.
The
country may be a reserve curresc_v country, i.e., one
whose currency
is held by other countries
as a
form of international
reserves.
As previously
mentioned,
in a fixed rate world with no reserve
currency country, nations can control the composition but not the quantity
of their individual
money stocks.
According to the monetary theory
of the balance of payments,
an expansion
in the
controllable
domestic credit component
of a nation’s money stock will result in a balance
of
payments
deficit and an outflow of the uncontrollable
international
reserve
component
until
the money stock returns to its initial level.
In the case of a reserve
currency
country,
however,
an expansion
in the domestic
credit
portion of the money supply need not lead to an
offsetting
contraction
in the international
reserve
component
if the rest of the world holds its increased reserves
in the form of government
securities issued by the reserve currency
country.
Although the country runs a balance of payments
deficit as a result of its domestic monetary expansion, its status as a reserve
currency
country
enables it to effectively
neutralize
the impact of
the payments deficit on its money supply.
Thus
despite the deficit, the authority is able to achieve
-4pparentlJ
an expansion
of the money supply.
such was the case in the late 1960’s and early
22

ECONOMIC

REVIEW,

1970’s

when

dollar

enabled

the

reserve

the

currency

U.

status

S. to expand

of the

its

money

stock in the face of large external deficits.
latter experience
indicates
that the reserve

This
cur-

rency case constitutes
an important
exception to
the monetarist
prediction
that payments
deficits
tend to be accompanied
tion’s money stock.
Summary

This

article

by reductions

in the na-

has expounded

the global

monetarist

explanation

of

inflation

within

the

framework

of a simple

two-country

model

that

links national price levels,
flows, spending,
and the

money

stocks,

money

balance
of payments.
The model can account
for the generation
of
world inflation
under fixed exchange
rates, for
the transmission
of that inflation
to individual
national
economies,
and for the distribution
of
world money necessary
to support
it in each
nation.
Typically
monetarist,
the model stresses
the role of the demand for money in determining
both the steady-state
path of world prices and
the dynamic adjustment
to that path. The model
also yields the standard predictions
of the quantity theory, namely equiproportionality
of money
and prices, long-run neutrality
of money, and the
equilibrium
international
distribution
of money.
Moreover, it embodies the global monetarist
conception of the international
economy as a stable
self-regulating
mechanism
in which
monetary
and payments
disequilibria
are inherently
transitory phenomena.
Finally,
the model provides a
iramework
for stating cleariy the macroeconomic
policy problems confronting small open economies.
References
1. Branson, William

H. “Monetarist and Keynesian
Models of the Transmission of Inflation.” Ametican
Economic Review, 65 (May 1975)) li5-19.

2. Claassen, Emil M. “World Inflation Under Flexible
Exchange Rates.”
Scctndinavian Journal oj Economics, 78, No. 2 (1976)) 346-65.
3. Dornbusch,

Rudiger.
“Devaluation, Money, and
Nontraded Goods.” American Economic Review, 63
(December 1973), 871-80.

4.

Mundell, Robert A. International
York : Macmillan, 1968.

5.

. Monetary Theory: Inflation, Interest,
und Growth in the World Economy.
Pacific Palisades : Goodyear, 1971.

Economics.

New

6. Swoboda, Alexander K.

“Monetary Approaches to
the Transmission and Generation of Worldwide Inflation.” Geneva : Graduate Institute of International Studies, 1975. (Mimeographed.)

5 Whitman, Marina v.li.
1.

“Global Monetarism and the
Monetary Approach to the Balance of Payments.”
Brookings

papers

(1975)) 491-536.

NOVEMBER/DECEMBER

1976

on Economic

Activity,

6, No. 3

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