Full text of Economic Review (Federal Reserve Bank of Cleveland) : 1985 Quarter 1

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IC REVIEW
FEDERAL RESERVE BANK
of CLEVELAND

QUARTER I

Economic Review
Federal Reserve Bank
of Cleveland
Quarter I 1985

Beauty and the Bulls:
The Investment
Characteristics of Paintings ................. 2
The rate of increase in fine paintings prices
was large when compared with many other
investments during the 1970s and was extra­
ordinarily large from 1977 to 1980. One prom­
inent explanation for the behavior of fine
painting prices over this period is the abil­
ity of this asset to hedge against uncertain
inflation. This article models the market
return for fine paintings from an investment
perspective and investigates the influence
of uncertain inflation on painting returns.
The Reserve Market and
the Information Content
of M l Announcements .........................

11

Recent changes in Federal Reserve operating
procedures and reserve accounting rules have
led to major changes in the market for bank
reserves. Economists William T. Gavin and
Nicholas V. Karamouzis describe changes
made by the Federal Reserve over the last
seven years. The authors show how market
participants have used information in the
weekly Ml announcements to predict reserve
market conditions under alternative rules
and procedures. They also present evidence
on the efficiency with which market partici­
pants forecast the weekly Ml data.
Economic Review is published quarterly by the
Research Department of the Federal Reserve Bank
of Cleveland, PO. Box 6387, Cleveland, OH 44101.
Telephone: 216/579-2000.
Editor: William G. Murmann. Assistant editor:
Meredith Holmes. Design: Jamie Feldman. Type­
setting: Lucy Balazek.
Opinions stated in Economic Review are those of
the authors and not necessarily those of the Fed­
eral Reserve Bank of Cleveland or of the Board of
Governors of the Federal Reserve System.
Material may be reprinted provided that the source
is credited. Please send copies of reprinted materi­
als to the editor.
ISSN 0013-0281

Michael F Bryan is
an economist with
the Federal Reserve
bank o f Cleveland.
The author would
like to acknowledge,
without implicat­
ing, John Carlson,
William Gavin,
Laurence Kantor,
andK.J. Kowalewski
fo r their comments
on an earlier draft
o f this article. The
research assistance o f
Diane Mogren and
Michael Pakko is
greatly appreciated.

1. The original
application o f this
model to paintings
prices was done by
Stein (1977) fo r the
period 1946-1968.
2. For a more thor­
ough analysis o f the
influence o f infla­
tion on asset returns,
see Kantor (1983).

Beauty and the Bulls:
The Investment
Characteristics
of Paintings
by Michael F. Bryan

This article examines the investment and
consumption characteristics of the paintings
market between 1971 and 1984, using the
capital asset pricing model.1
There are two principal motivations behind
this research. Owners of paintings may be
regarded both as consumers of aesthetics and
as investors possessing a claim on future con­
sumption. Since fine art prices increased in
value by 11 percent per year on average be­
tween 1971 and 1984, and by 19 percent per
year between 1977 and 1980, the investment
character of the art market appears prominent
and worth investigation.
Paintings and other “ collectibles” belong
to the durable goods class of commodities
because they provide current consumption
and claims on future consumption. In this
sense, they differ little from automobiles or
real estate. Insofar as durable goods yield a ser­
vice flow to the owner over time, as opposed
to the nominal income flow associated with
financial assets, owners of durable assets are
in some measure protected from unexpected
inflation because the value of the service flow
increases along with the general price level.
The nominal return on the durable asset,
from the investment perspective, is inflation
“ hedged” in a way that returns from other
investments (for example, stocks and bonds)
are not.2 The analysis of the paintings mar­
ket in this paper may provide additional in­
sights to the performance of other durable
goods markets during periods of inflation.

I. Measuring Fine Art Prices:
The Sotheby’s Index
The market for fine art operates in a capri­
cious environment. Over short periods of
time, auctioned art prices are subject to ex­
treme market fluctuations. Art is often sold
in groups, or “ collections.” The composition
of a collection can vary considerably from one
auction to the next, in terms of object types

3. A nother art
market price index
is constructed by
Christie’s Limited,
also o f London.

(paintings, ceramics, furniture, etc.), in period
(Renaissance, Impressionist, Modern, etc.),
in reputation of the artist, and in condition of
the object.
Reputation of the seller, rumors, “ taste”
swings, and auction location (London, New
York, Hong Kong, Monaco, etc.) can also tempo­
rarily influence individual auction activity,
further contributing to short-term price
instability.
From the perspective of the art consumer,
distinguishing temporary price movements
from underlying appreciation is generally
important only as a curiosity.
The pleasure received from the object over
its life relative to its discounted purchase price
need only be greater than that of other goods.
Indeed, the product turnover in the art mar­
ket has historically been quite low, and many
art collections are sold only following the
death of the owner.
This suggests that, from a historical perspec­
tive, the art market has been dominated by
the art lover and not by the investor. To the
investor, however, the distinction between a
temporary price fluctuation and asset appreci­
ation in the marketplace is crucial. As inves­
tor interest in the art market intensified in
the 1960s, financial analysts pressured art
experts to measure underlying price appreci-

Table 1 Asset Return
Correlations 1 9 71-1984
Paintings
Paintings

Gold

Housing

Gold

Housing

Stocks

AAA
bonds

1.000
0.6663

1.000

0.321

0.477b

ation in the fine art market. Like most price
statistics, this information takes the form
of an index.
One of the most popular art market price
indexes is produced by Sotheby’s auction house
in London.3 Essentially, the index does for fine
art objects what the Consumer Price Index
does for consumer goods and services.
The index represents a fixed basket of about
500 art objects categorized into 12 major com­
ponents: Old Master paintings, Nineteenth
Century European paintings, Impressionist
and Post-Impressionist paintings, Ameri­
can paintings (1800 to pre-World War II),
Modern paintings (1900-1950), English fur­
niture, American furniture, Continental fur­
niture, English silver, Continental silver,
Chinese ceramics, and Continental ceramics.
A Sotheby’s expert on each of the 12 compo­
nents tracks auction prices. The expert then
reappraises Sotheby’s market basket objects
on the basis of the recent price information.
These valuation judgments, although highly
subjective, attempt to filter out special or
temporary influences from price data.
The major commodity components are
weighted with respect to each component’s
share of combined sales by major New York
and London auction houses during 1975, aggre­
gated into a total art market index, and stan­
dardized at 1975 = 100.
For this analysis, an all-paintings index was
constructed from four major paintings com­
ponents in the Sotheby’s index: Old Masters,
Impressionist and Post-Impressionists, Nine­
teenth Century European paintings and draw­
ings, and Modern Paintings (see appendix).

II. Recent Behavior of
Paintings Appreciation
1.000

Stocks

0.003

-0.213

0.204

1.000

AAA
bonds

0.336

0.243

0.307

-0.162

a. Significant at the 5 percent level of confidence.
b. Significant at the 10 percent level of confidence.

1.000

We begin by comparing the investment return
on paintings with the return on alternative
assets, including gold, housing, stocks, and
bonds (table 1).
Over the period of analysis (1971-1984), inter­
asset correlations reveal a strong positive

relationship between the rate of increase in
the price of paintings and in the price of gold.
The only other significant correlation was
found between housing and gold price changes.
That the rate of return in the market for
paintings correlates more closely with the
market return on gold than with returns on
financial assets (which are high in investment
characteristics relative to consumption char­
acteristics) or with returns on housing (which
offers much greater consumption returns rel­
ative to financial assets) implies a rather
mixed personality.
Our first impression of the art market,
therefore, seems to be one of an asset that
fits neatly neither into the world of consum­
ers nor the world of investors.
Since the investor interest in the fine paint­
ings market is at least partially a function
of the rate of inflation, we can test the sensi­
tivity of paintings prices to changes in the
general price level and to real growth in the
U.S. economy (see appendix for results). The
elasticity of paintings prices, with respect
to real economic growth and the general price
level, was significantly positive over the test
period. The sensitivity of paintings prices

Fig. 1 The Rate of Return on
Paintings Relative to Inflation
Percent

to the general price level was near, but less
than unity (elasticity = 0.96), while the real
economic growth elasticity was stronger
(elasticity = 1.35).
Despite the statistical strength of the esti­
mates, the presence of serial correlation gives
us reason to suspect that this simplistic speci­
fication obscures the underlying investment
nature of the paintings market.
Figure 1 shows the behavior of the all-paint­
ings index relative to the Consumer Price Index
since 1970. Over the 15-year period, the rate
of appreciation in paintings typically outpaced
the rate of increase in the general price index.
However, within short intervals (1973-1977
and 1980-1982), paintings price appreciation
did not keep pace with inflation. During one
year of inflationary pressure (1980-1981) paint­
ings actually depreciated in value.
In short, while the rate of appreciation in
paintings is positively related to the general
price level, and moreover has outpaced infla­
tion over the full period of analysis, its yearto-year performance has been considerably
volatile.
In the language of the financial analyst,
returns on paintings involve a degree of risk.
One cursory measure of investment risk is the
standard deviation of the investment return.
Table 2 compares the average annual rate
of return and standard deviation in the paint­
ings market between 1971 and 1984 against
a sample of alternative investments. The rate
of return in paintings was high over the sam­
ple period, relative to four major investment
alternatives: gold, stocks, bonds, and hous­
ing. This contrasts with the finding of Ander­
son (1972) and Stein (1977) that demonstrated
a rather weak return to paintings relative to
other financial assets over earlier time hori­
zons. Indeed, only investment in gold out­
performed paintings over the sample period
chosen here. The volatility of the art mar­
ket return, however, also was above average,
exceeded only by the volatility of gold and
stock returns.

Within the paintings market basket, the
investment return and volatility among major
components was quite mixed. For example,
Nineteenth Century European paintings fared
much better during the period of analysis
than Old Master paintings (average return of
15.5 percent vs. 8.7 percent), and the former
appeared to be only somewhat more risky (stan­
dard deviation of 15.6 percent vs. 12.7 per­
cent). Moreover, the return on Impressionist
and Post-Impressionist paintings was 10.3 per­
cent, despite a comparatively low return stan­
dard deviation of only 7.1 percent.

III. Capital Asset Pricing Model
The casual analysis above merely places fine
paintings price increases in perspective. Stan­
dard deviation estimates of return volatility
are not very adequate measures of invest­
ment return risk, because they lack any theo­
retical underpinning.
To characterize nominal asset return behav­
ior more formally, it is necessary to formu-

Table 2 Pre-Tax Returns and Standard
Deviations of Alternative Household
Investments, 1 9 7 0 -1 9 8 4 (annual rates)
Rate of
return

Standard
deviation

Gold
Paintings index
Stocks
One-year Treasury bonds
Market portfolio
Inflation
Housing
AAA corporate bonds

16.2
10.7
8.4
7.9
7.1
7.0
6.4
6.1

31.4
8.2
19.4
2.3
4.8
3.1
4.3
2.5

19th century
European paintings
Chinese ceramics
Modern paintings
All paintings
Impressionist paintings
English silver
Old Master paintings

15.5

15.6

14.3
11.9
10.7
10.3
9.1
8.7

37.7
11.8
8.2
7.1
13.7
12.7

Investment

late an economic model of returns. Because
paintings have dual personalities—being at
once investment goods and consumer goods—
their price behavior can be modeled from the
consumer perspective, adjusting for invest­
ment characteristics (Anderson 1982 and
Singer 1974), or modeled from the investment
perspective, adjusting for consumption char­
acteristics (Stein 1977).
The primary interest in this analysis is the
investment side of paintings; consequently,
the modeling approach chosen here takes the
investment perspective and uses the capital
asset pricing model (CAPM) represented
by equation (1).
(1 )

(R a
e, t - R f t ) = P ( R m
e ,t- Rft).

This time series application of a rather pop­
ular investment model, originally postulated
by Black, Jensen, and Scholes (1972) and esti­
mated by Stein (1977) for paintings prices over
the period 1946-1968, relates the expected nom­
inal one-year rate of return on the relevant
asset in time period t (Ra t) in excess of a risk­
free rate of return (Rft) as a function of the
expected rate of return on a market portfolio
(Rm,t) in excess of a risk-free rate of return.
The estimated coefficient, (3, represents the
paintings market risk relative to the market
portfolio risk—called relative systematic risk.
For example, (3 estimates greater than 1
imply the relevant asset has proportionately
greater risk than the market portfolio, and
estimates less than 1 imply proportionately
less risk than the market portfolio.
One may further visualize the expected
return on paintings (Rea,t) as having two com­
ponents: the expected return in consumption
(viewing pleasure), R h, and the expected
investment return (Rf t). More formally:
(2)

ReaJ = Recj + Rlt.

4. Stein (1977
p. 1,029) has argued
earlier that any pos­
itive annualized pre­
miums to account
fo r the tax advan­
tages o f art and neg­
ative prem ium s to
account fo r illiquid­
ity should be small
because o f the rela­
tively long holding
period o f paintings.
Further, these two
influences will tend
to cancel one another.
5. See Lawler
(1978). Since data
on expected nom i­
nal return rates are
unobserved, the
standard C A P M
is estimable using
the assumption that
expected rates o f
return deviate from
actual rates o f return
by a random, nor­
mally distributed
error with a mean
et o f zero, or:

Rt = R, + ttDuring periods o f
uncertain inflation,
when hedging char­
acteristics vary across
assets, this assump­
tion is violated, as
errors in expectations
may not be random.
For a good discus­
sion o f the standard
assumptions used in
deriving and apply­
ing the standard
CAPM, see Niagorniak (1972).
6. See Kantor
(1983, p. 28).
7. The expected
inflation values
were obtained from
the University o f
M ichigan’s Survey
of Consum er A tti­
tudes (1984).

If we assume that the rate of return on paint­
ings from viewing pleasure is nearly constant
over time, equation (2) can be combined with
equation (1) and rewritten as:
(3)

(.R l t - R f t ) = (So + ft (R em ,t-R /t).

The intuition behind equation (3) is the
same as equation (1), except for the constant
term, /?o, which represents any superior return
(or systematic deviation) from what would be
predicted by the asset’s relative systematic
risk, less the expected return in art viewing
pleasure, Rec. For goods that yield no con­
sumption services and that operate in an effi­
cient market with no transactions costs or
taxes, (3o, will be near zero.4
Unfortunately, this simple CAPM model is
mis-specified under conditions of uncertain
inflation where the inflation hedging charac­
teristics of the asset in question deviates
from that of the market basket.5
It can easily be shown that under conditions
of price uncertainty, differences between the
nominal rate of return of an asset and what
was expected (Rt - RT) are equal to the differ­
ence between that asset’s real rate of return
from what was expected (rt - r\) and errors in
inflation expectations (Pt - Pf), or:
(4)

(Rt - R te) = ( n - r f ) + ( P t - P f ) .

Notice that when nominal rates of return
are fixed, errors in inflation expectations gen­
erate errors in expected real asset returns.6
Alternatively, where assets are hedged against
inflation—that is, where errors in inflation
are incorporated completely into nominal asset
premiums—the real rate of return for the
asset is fixed.
To adjust for uncertain inflation in the
CAPM, this study employs the specification:
(5)

Rt - Ret = b(Pt - P f ) + Vt-

where b represents the degree to which asset
returns are hedged against inflation, and vt
is a normally distributed error term with

a mean zero and a constant variance. A b = 1
implies that the real return on the asset is
unaffected by inflation forecasting errors (that
is, the asset is a perfect hedge against infla­
tion). A b = 0 implies the rate of return on the
asset is completely exposed to inflation fore­
casting errors, or the asset is “ unhedged.”
Combining equation (3) with (5) gives a
CAPM under conditions of price uncertainty
(CAPMUI) in the form of equation (6):
(6)

Riit - Rft = £o + PxiRmj - R ft)

+ ft, (Pt-Pf) + e/f
where
= bi - (b j((3 i),
and
Ru - Rfj = b,(Pt - Pf),
Rfn, t ~ Rfn, t = bm(Pt - Pf).
Using the actual consumer price performance
over the year less expected consumer price
increases, equation (6) was estimated annually
over the 1971-1984 period.7 The return on the
market portfolio reflects a weighted average
of the return from stocks, bonds, and real
estate.8 The risk-free rate of return is repre­
sented by the one-year yield on U.S. Treasury
securities held until maturity. A dummy var­
iable was included to capture special influ­
ences that occurred in the art market, namely
proposed changes in British taxation rules
involving art and the U.S. legalization of pri­
vate gold ownership, which jointly severely
depressed fine art prices in 1975. The esti­
mation results are reproduced in table 3.
Under this CAPMUI specification, paintings
were found to be a moderately risky invest­
ment when compared against the yield on a
diversified market portfolio (although not sig­
nificantly so), since the relative systematic
risk of paintings was found to be slightly
greater than 1 (0i = 1.15).
Within the paintings market basket, indi­
vidual painting periods generated different
results. The return on Old Masters paint-

8. Ideally, the mar­
ket portfolio should
include all assets
available fo r private
ownership. Because
o f weighting diffi­
culties, some assets
that may be consid­
ered components o f
household wealth,
such as gold and farm
land, were excluded
from the market
return calculations.
9. Other assump­
tions regarding bm
would yield different
interpretations o f
the inflation-hedging
strength o f the paint­
ings market. Some
studies—Nelson
(1976), Bodie (1976),
and Jaffe and Mandelker (1976)—sug­
gest that bmmay actu ally be negative. A l­
though a negative
bmwould imply a
smaller value fo r bit
even these extreme
estimates were not
large enough to reject
the hypothesis that
bj= 1.00.
10. It must be noted
that a significant
intercept term may
also reflect the influ­
ence o f market fa c­
tors, which are not
adequately intro­
duced into this sim ­
ple specification.
11. Conversations
with art curators
tend to support this
result. Investor inter­
est in the art market
may be relatively lim ­
ited to moderately
priced objects.

ings was found to have a relatively large risk
factor (0i = 1.34), compared against the more
conservative return on Impressionist and
Post-Impressionist paintings (/3i = 0.97). Of
all the components tested, Modern art regis­
tered the least systematic risk (fii = 0.92),
while Nineteenth Century European draw­
ings and paintings showed the greatest risk
factor (Pi = 1.54).
The price expectation error coefficients,
02, give an indication of the impact of uncer­
tain inflation on the asset. The inflationhedging ability of paintings, relative to the
market basket, depends on the sizes of bt and
bm. Knowledge of /?i and
enables inferences
about b{ and bmto be drawn.
In all cases, the results strongly suggest
that the inflation-hedging ability of paintings
was superior to that of the market basket
tested. However, the pure inflation-hedging
ability of the asset (bt) is not econometrically
identified. If we assume that bm- 0; that is,
the total portfolio is unhedged against infla­
tion, the point estimate of the inflationhedging strength of the paintings market,
bi, is greater than 1 (bt - 1.76). This result
implies that paintings returns are completely
hedged against uncertain inflation.9 The con­
stant terms, which include any superior return
over the 1971-1984 period, less the return in
art viewing services, were all positive and
generally significantly different than zero.
From this result, we can infer that over
the period of analysis, the returns in the art
market were lucrative for the pure art spec­
ulator.10 The largest superior returns were
found in the market for Nineteenth Century
European drawings and paintings, with a nonsystematic return coefficient of 7.2 percent.
Of the individual art categories tested using
this CAPMUI specification, the capital asset
pricing model fit best for Modern paintings

(R 2 = 0.80), an indication that this particular
market most closely resembles a standard
investment market over the sample period,
while a market such as Nineteenth Century
and Old Masters paintings was only weakly
approximated by this investment behavior
specification.11
It should be noted that as the art market
becomes more disaggregated, the ability to
model its behavior accurately becomes more
difficult, because the actions of a small circle
of investors can influence price patterns.
For example, the rather dramatic volatility
in Nineteenth Century paintings prices may, in
part, be explained by a few investors driving
up the prices of particular artists or even
specific works and may not be an accurate
appraisal of the market for other Nineteenth
Century types.
Conversely, the conservative nature of the
Impressionist and Post-Impressionist paintings
market may reflect greater product homoge­
neity, which is to say that this market may
have a relatively wide appeal. Consequently,
individual buyers are probably less influen­
tial in the marketplace for Impressionist and
Post-Impressionist paintings.
The results found in this analysis are largely
consistent with the earlier studies, with one
notable exception: fine paintings prices yielded
superior returns for the pure art speculator.
Over the extended horizon of 1780 to 1970,
the risk-adjusted return on paintings was
estimated by Anderson (1972) to be superior
only for the art lover. The art investment
return over this 190-year period was only
50 percent of that earned on common stock.
Stein, on whose original work this project is
based, found that over the period 1946-1968
the investment return on paintings provided
only about 73 percent of the return earned
on common stock. In our current analysis, the
rate of return on a paintings basket exceeded
that earned by stocks by approximately
30 percent.

12. This analysis
is done with apology
to the art connois­
seur, who may be­
lieve that the appre­
ciation o f fin e art
transcends economic
valuation.

IV. A Word on the
Consumption Value of Art

13. A check on art
insurance costs un­
covered a range o f
estimates, from a low
o f 0.14 percent o f
the object’s appraised
value to a high o f
almost 2 percent.
For the individual
investor with a total
art value o f over
$1,000, insurance
was generally under
0.5 percent o f the
object’s appraised
value per year.

An important issue, which is only implied
in the CAPM model is the “ value” that art pro­
vides in viewing pleasure.12 A check on the
value of viewing services can be made through
the rental art market, where the art consumer
enjoys only the art, and the investment re­
turns accrue to the owner.
Many museums have partially developed ren­
tal markets. A few have fully developed mar­
kets that lend objects of fine art to corpora­
tions, universities, public offices, and indi­
viduals. Unfortunately, the rental market is
almost exclusively within the contemporary
art market, to which this analysis may not
directly apply.
Further, the cost of art rental is determined
by many factors, such as whether the owner
or the renter bears the cost of insurance.13
Moreover, the renter frequently has the option
to buy the object, which may distort the true

Table 3

rental return implied by the rents earned in
these markets.
For these reasons, the actual rental price
of the type of art found in the Sotheby’s art
basket is unknown. In 1977, Stein set the ren­
tal price of paintings at no more than 11 per­
cent of the object’s appraised value. More
recent estimates of rental costs in the con­
temporary fine art market, which included
the option to buy, ranged from 17.8 percent
to 19.7 percent.14 Compared with the 11.9 per­
cent investment return in the Modern paint­
ings component of Sotheby’s art index (its
closest relative) it yielded an approximate
service return in the contemporary art mar­
ket of 6 percent to 8 percent a year between
1971 and 1984.
In one case, a corporate rental program for
certain “ traditional” Nineteenth and Twen­
tieth Century art works, also with an option
to purchase, found an average return of about
29 percent (a.r.). Compared with the 15.5 per­
cent investment return by its closest coun-

Capital Asset Pricing Model Regression Results, 1 9 7 1 -1 9 8 4
(RP- Rf ) - 0o + P i ( K - R f ) + f c i P - P * ) + /33Dum75 + e
Po

02

03

Paintings

0.041
(1.91)b

+1.15
(3.00)a

+1.76
(1.84)b

-0.17
(2.04)b

R 2= 0.56

DW= 1.40

F = 4.31

Old Masters

0.028
(0.70)

+1.34
(1.89)b

+1.20
(0.67)

-0.20
(1.32)

J?2= 0.31

DW= 1.52

F= 1.45

Impressionists

0.036
(2.27)a

+0.97
(3.38)a

+1.34
(1.87)b

-0.16
(2.50)a

Z?2= 0.62

DW= 1.54

F= 5.48

19th century

0.072
(1.46)

+1.53
(1.75)

+2.84
(1.30)

+0.04
(0.22)

/?2= 0.31

DW= 1.22

F= 1.51

Modern

0.061
(3.10)a

+0.92
(2.64)a

+2.70
(3.11)a

-0.37
(4.87)a

R 2= 0.80

DW= 1.45

F= 13.02

NOTE: All equations were estimated using ordinary least squares (t-statistics in parentheses).
a. Significant at 5 percent.
b. Significant at 10 percent.

Original Stein Regression (Rm = stock returns), 1 9 4 6 -1 9 6 8
Paintings

-0.016
(-0.45)

+0.82
(2.30)

R2= 0.24

DW= 2.18

14. The contem­
porary art market
was defined as art
produced by living
artists, and tradi­
tional art was de­
fin ed as that pro­
duced by artists
no longer alive.
15. For corporate
borrowers, the range
o f those exercising
the buying option
was between 2 5 and
33 percent, given a
sample o f five rental
programs. The pro­
grams considered
were the Philadel­
phia Museum o f A rt
(Philadelphia, PA),
Chicago A rt Insti­
tute (Chicago, IL),
Kansas City A rt
Museum (Kansas
City, MO), the
Newport Harbour
Museum o f A rt
(Newport Harbour,
CA), and the Fogg
A rt Museum (Cam­
bridge, M A).

terpart in Sotheby’s Art Index (Nineteenth
Century European paintings), it yielded a tra­
ditional art service return of approximately
13 percent.15
Given these rental cost estimates, it appears
safe to conclude that during the past 14 years,
the art market was a superior investment for
those who also enjoy the beauty of paintings.

V. Conclusion
This analysis is not intended to serve as a
basis for individual investment decisions.
The actual investment performance of any
art object depends on events that cannot be
accurately reproduced by the simple financial
model and short sample period presented here.
Even in the aggregate, the CAPMUI equa­
tion for all paintings showed an R 2 of 0.56,
which is to say that this specification only
“ explains” a little more than 50 percent
of the variation in paintings prices over the
1971-1984 period.
However, the results of this analysis suggest
that, on average, the total paintings index
was not measurably more risky than a market
portfolio containing stocks, bonds, and real
estate. Moreover, even for the pure art spec­
ulator, paintings were generally superior
investments (that is, they generated returns
in excess of comparable risk) over the test
period when compared against the market
portfolio proxy.
Of the individual art components studied
here, Nineteenth Century drawings and
paintings were found to have the greatest
systematic risk, and Modern paintings were
the most conservative performers. Most impor­
tantly, these results demonstrate that nomi­
nal paintings returns were relatively more
inflation-hedged than the representative mar­
ket portfolio, especially Modern paintings.
The degree to which the paintings market is
hedged against uncertain inflation is unde­
fined in this model. Yet, if the market basket
used here is a good approximation of the com­

plete market portfolio, and if this portfolio’s
hedging ability is near zero, then these results
suggest that paintings are virtually completely
inflation-hedged.
Finally, given only limited information on
returns in the rental art market, this analysis
was also unable to determine conclusively the
magnitude of the consumption returns from
art. However, we can conservatively guess
that art lovers enjoyed very sizable returns
from owning paintings due to the additional
consumption service they provided.

Data Appendix
Annual rates of return were calculated on
a third-quarter to third-quarter basis, because
the Sotheby’s index was computed only dur­
ing September between 1967 and 1981. After
1981, the Sotheby’s index is available monthly.
Compounded rates of return were estimated
by using natural logarithms.
The data used in this analysis were:
Bonds
AAA Corporate Yield from Moody’s.
Stocks
The stock return estimates were approximated
using price changes and dividends from 500
stocks as calculated by Standard and Poors.
Gold
Gold prices were found using the CPI retail price
per troy ounce.
Housing
Housing prices were estimated using the
CPI-W home purchase price component.
P
The rate of inflation estimate used in this study
was the Consumer Price Index for all urban
consumers (CPIU).
pe

The price expectations data used in this anal­
ysis are average consumer price increase ex­
pectations over the next 12 months, obtained
from the University of Michigan Institute
for Social Research, Surveys of Consumer Atti­
tudes, September 1984.

Rf
The risk-free rate of return is represented by
the one-year rate of return on new-issue U.S.
Treasury bonds held until maturity.
Rm
The return on the market portfolio was cal­
culated using a weighted average of housing,
bonds, and stock market returns. The weights
applied came from the asset’s share of out­
standing household net worth normalized to 1.
Ri
The Sotheby’s Index is available monthly in
Barron’s. For a complete explanation of the
construction of the index, see “ Unveiling
Sotheby’s Art Index,” Barron’s, November 4,
1981; and “ The Sotheby’s Index: What’s In
It?” Barron’s, February 15, 1982.
Elasticity estimates
The constant elasticity estimates for paintings
prices (Pp) were estimated annually over the
1970-1984 period using the log-transformed
regression:
In

= -9.85 + 0.96 In P
(4.19)
+ 1.35 In Real GNP + OAORHO
(2.22)
(1.70)

R 2 = 0.96, DW= 1.58
(t-statistics in parentheses)

References
Anderson, Robert C. “ Paintings as an Invest­
ment,” Economic Inquiry, vol. 12, no. 1
(March 1974), pp. 13-26.
Ang, James S., Jess H. Chua, and Walter J. Rein­
hart. “ Monetary Appreciation and InflationHedging Characteristics of Comic Books,”
The Financial Review, 1983, pp. 196-205.

Black, Fischer, Michael C. Jensen, and Myron
Scholes. “ The Capital Asset Pricing Model:
Some Empirical Tests,” in Michael C. Jen­
son, ed., Studies in the Theory of Capital
Markets. New York: Praeger Publishers,
1972, pp. 79-121.
Bodie, Zvi. “ Common Stocks as a Hedge
Against Inflation,” The Journal of Finance,
vol. 31, no. 2 (May 1976), pp. 459-70.
Jaffe, Jeffrey F, and Gershon Mandelker. “ The
Fisher Effect for Risky Assets: An Empiri­
cal Investigation,” The Journal of Finance,
vol. 31, no. 2 (May 1976), pp. 447-58.
Kantor, Laurence G. “ Inflation Uncertainty
and Inflation Hedging,” Economic Review,
Federal Reserve Bank of Kansas City (September-October 1983), pp. 24-37.
Lawler, Thomas A. “ Uncertain Inflation,
Systematic Risk, and the Capital Asset
Pricing Model,” Working Paper Series 78-2,
Federal Reserve Bank of Richmond (Feb­
ruary 1978), pp. 1-5.
Nagorniak, John J. “ The Application of the
Capital Asset Pricing Model to Debt and
Equity Markets,” in Giorgio P. Szego and
Karl Shell, eds., Mathematical Methods
in Investment and Finance. Amsterdam:
North Holland Publishing Company, 1972,
pp. 344-66.
Nelson, Charles R. “ Inflation and Rates of
Return on Common Stocks,” The Journal
of Finance, vol. 31, no. 2 (May 1976),
pp. 471-83.
Singer, Leslie. “ Microeconomics of the Art
Market,” Journal of Cultural Economics,
1974, pp. 21-40.
Stein, John Picard. “ The Monetary Apprecia­
tion of Paintings,’'Journal of Political Econ­
omy, vol. 85, no. 5 (1977), pp. 1,021-35.
University of Michigan, Survey Research Cen­
ter. Surveys of Consumer Attitudes, Insti­
tute for Social Research, September 1984.

William T. Gavin is
an economist at the
Federal Reserve
Bank o f Cleveland.
Nicholas V. Karamouzis is an Assistant
Professor in the
Department o f E co­
nomics at Case West­
ern Reserve Univer­
sity and Visiting
Scholar at the Fed­
eral Reserve Bank
o f Cleveland. We
thank John B. Carl­
son, James Hoehn,
Raymond Lombra,
Donald Mullineaux,
Mack Ott, David
Small, and Edward
Stevens fo r helpful
comments. We thank
Michael Pakko fo r
his assistance in
gathering data and
computing statistics.

The Reserve Market
and the Information
Content of M l
Announcements
By William T. Gavin
and Nicholas V. Karamouzis

I. Introduction
In the last five years, there have been many
changes in the institutional arrangements
of monetary control. Understanding these
arrangements is an important factor in gaug­
ing the short-term effects of monetary policy.
Participants in the money market monitor
information about short-run changes in the
tools of monetary policy, because correctly pre­
dicting Federal Reserve behavior is a major
factor in correctly predicting changes in the
cost of very short-term funds. People outside
the money market monitor such information in
an attempt to predict shifts in the longer-run
stance of monetary policy.
This Economic Review article describes the
changes that have taken place both in the
process generating the federal funds rate and
in the procedures used by the Federal Reserve
to guide policy on a day-to-day basis. The
authors show how institutional changes affect
the market for bank reserves and explain how
weekly money stock announcements have
been used by reserve market participants to
predict future events in the reserve market.
The authors conclude that the two most
recent changes by the Federal Reserve—the
switch to a borrowed reserve operating pro­
cedure in October 1982, and the switch to
contemporaneous reserve accounting rules
in February 1984—have led to reductions in
the information about the reserve market
that one can extract from money stock
announcements.
The money stock announcements have
become relatively unimportant for predicting
events in the contemporaneous reserve mar­
ket, both because the Federal Reserve is target­
ing borrowed reserves, which tends to smooth
interest rates on a weekly or biweekly basis,
and because much of the reserve-market infor­
mation previously associated with the money
stock announcement is now outdated. Under
the new contemporaneous reserve require­
ments, the reserve market clears before the
Ml data are released.

1. See Tinsley, von
zur Muehlen, and
Fries (1982); M cC ol­
lum and Hoehn
(1983); and Walsh
(1982) fo r the deri­
vation o f analytical
expressions show­
ing the unplanned
change in the federal
funds rate expected
under different oper­
ating procedures and
different reserve
accounting regimes.
2. See Niehans
(1978), Chapter 9,
fo r a theoretical anal­
ysis o f the demand
fo r bank reserves.
The term bank is
used to include all
depository insti­
tutions.
3. See Friedman
and Roberts (1983)
fo r a discussion o f
the carryover provi­
sion. This clear and
concise discussion
explains why excess
reserves might appear
to be perfectly inelas­
tic with respect to
interest rates.

II. The Reserve Market

Reserve Demand

In this paper, we are concerned with the use of
the information in the Ml announcement for
predicting events in the reserve market. To
keep the analysis simple, we use a partial
equilibrium model of the reserve market.
Contemporaneous activity in other markets
is important for the reserve market, but the
importance lies mainly in the future. The
inability of the banking system to arbitrage
reserves intertemporally (between reserve set­
tlement periods) tends to isolate the reserve
market so that the federal funds rate depends
mainly on current or past money growth and
on the supply of reserves provided by the
Federal Reserve in any given reserve settle­
ment period.
The federal funds rate is the interest rate in
the market for inter-bank reserve loans. The
demand for reserves is a function of banks’
demand for funds to meet legal reserve require­
ments and demand for clearing balances. The
supply of bank reserves comes from the Fed­
eral Reserve, either through open-market
operations or lending through the discount
window.
Throughout this paper, we assume that
market forces operate to keep the federal
funds rate equal to the rate that is expected
on the final day of the reserve settlement
period. Any change in the rate is the result of
a change in expectations about reserve supply
or reserve demand for the current reserve
settlement period.
In order to explain the reaction of the fed­
eral funds rate to the money stock announce­
ment, we have to look at three factors: the
reserve accounting rules underlying demand
for reserves, the operating procedures under­
lying supply of reserves, and the timing of
the release of aggregate information about
demand and supply.1(See appendix for detailed
description of the change in reserve account­
ing rules.)

The demand for reserves is largely determined
by the level of bank deposits and by the struc­
ture of reserve requirements against bank
deposits. In the absence of reserve require­
ments, banks would still need reserves as
clearing balances to hedge against the uncer­
tainty associated with fluctuations in deposit
and loan activity.2 However, reserve ratios
have been high enough in the past so that
required reserves have been greater than re­
serves demanded for clearing purposes. As a
result, the market has been able to reduce
excess reserves to very low levels. The use
of the carryover provision and active trading
in federal funds has also helped reduce excess
reserves associated with uncertain reserve
flows on the last day of the reserve settle­
ment period.3
Required reserves were calculated against
deposit levels of two weeks earlier during the
period of lagged reserve requirements (LRR)
from September 1968 to February 1984. Thus,
under LRR, the demand schedule was very
inelastic with respect to interest rates, because
reserves were calculated against predetermined
levels of deposits. Changes in interest rates
could not affect the past deposit levels. This
inelasticity is illustrated by the steepness
of the demand curves in figure 1. Under the
current form of contemporaneous reserve
requirements (CRR), required reserves are
predetermined on the last two days of the re­
serve settlement period. Therefore, we have
not made a distinction between LRR and CRR
in figure 1.
Reserve Supply
The shape and location of the reserve sup­
ply schedule are determined by the Federal
Reserve’s operating targets and procedures.

In the planning stage, this policy can be char­
acterized by the intended growth rate for Ml

Fig. 1

The Reserve Market

over a suitable time horizon. For this study,
we consider that horizon to be the two- or
three-month interval for which the Federal
Reserve Open Market Committee (FOMC)
set short-run paths for Ml.
The same planned growth rate for Ml can
be achieved using very different operating
procedures. The operating procedure can be
defined by an instrument and a feedback rule.
The Federal Reserve’s instruments include
the discount rate and one of the following: the
federal funds rate, the level of nonborrowed
reserves, or the level of borrowed reserves. In
general, we define the instrument as the var­
iable that is chosen by the FOMC and main­
tained by the Federal Reserve staff at the
same level until new instructions are received
from the FOMC. Feedback is defined as the
discretionary adjustments to the instrument
made by the FOMC.
The form of the operating procedure is
important because some operating procedures
may be more effective than others in achiev­
ing a smaller discrepancy between planned
and actual Ml growth. Since the monetary
targets are merely intermediate targets, one
cannot necessarily conclude that the optimal
operating procedure is the one that gives the
smallest discrepancy between planned and
actual Ml growth in the short run.
Feedback can be used with any of the instru­
ments to control Ml over a longer horizon.
The major reason the operating procedure is
important is that the form of the procedure
(including the administrative procedures used
at the discount window) determines the slope
of the short-run reserve supply curve. This
slope, in turn, determines whether shocks to
the reserve market are absorbed by changes
in interest rates or by changes in reserves.
A relatively elastic (flat) supply curve implies
that shocks will be met by changes in the quan­
tity of reserves. A relatively inelastic (steep)
supply curve implies that shocks will be met
by changes in the interest rate.

4. Our period o f
analysis begins in
September 1977 with
the availability o f
survey data on expec­
tations o f the M l
announcement. Some
may argue that
the Federal Reserve
began to operate
more flexibly under
the nonborrowed
reserve procedure
as early as July 1982.
We chose October,
because the decision
was made to set aside
the M l target at
the October FO M C
meeting.
5. See Lombra and
Moran (1980) f o r a
detailed description
o f the policy process
under the federal
funds rate proce­
dure. Also, see Wallich and K eir (1979)
f o r a general discus­
sion o f interest-rate
sm oothing under
the federal funds
operating procedure.

Whether a given shock should or should
not be accommodated depends, in part, on the
long-run objectives of the Federal Reserve
and the nature of the shock. If the Federal
Reserve is attempting to maintain a stable
price level, then real shocks, such as fluctua­
tions in investment or government spending,
should be met by changes in the nominal inter­
est rate. Financial shocks, such as fluctua­
tions in money demand, should be absorbed
by changes in reserves.
The most common of these financial shocks,
the seasonal fluctuations in money demand,
arise because of the regular weekly, monthly,
and quarterly variations that arise from in­
stitutional details such as the average length
of the payment period in the labor market,
differences in cash management practices be­
tween households and firms, tax payment
dates, holidays, etc. The seasonal adjustment
procedure may be thought of as an attempt
to supply reserves in a way that fully accom­
modates these transitory shocks to money
demand. However, the errors in the estimated
seasonal factors are quite large. Therefore, one
reason to have an elastic short-run reserve
supply schedule is to accommodate these hardto-predict seasonal fluctuations in money
demand.
The reason not to accommodate short-run
shocks to the reserve market is to prevent
accelerating inflation from becoming embedded
in the economy, as it did during the inflation­
ary period of the 1960s and 1970s, when the
Federal Reserve did maintain a flat short-run
reserve supply curve. In principle, the Fed­
eral Reserve could make discretionary shifts
in a very flat short-run reserve supply curve
and maintain long-run price stablity. In prac­
tice, this procedure has led to a great deal
of uncertainty about future inflation.
In order to eliminate this uncertainty, cen­
tral banks have adopted formal rules (such as
monetary growth targets, exchange rate pegs,
a commodity standard, etc.) that instill con­
fidence in their behavior over the long run.

Given a long-run anchor for price stability, one
can use the framework developed by Poole
(1970) to show that an optimal short-run pro­
cedure would partially accommodate shocks
of unknown origin, allowing both the fed­
eral funds rate and the quantity of reserves
to adjust.
The period of our analysis includes three
different operating procedures. Each of those
procedures is described in detail below. We
begin in 1977 with the federal funds proce­
dure that was replaced in October 1979 by the
nonborrowed reserve procedure. This proce­
dure was replaced by the borrowed reserve
procedure in October 1982.4
The Federal Funds Rate Procedure
Following each regular meeting, the FOMC
sent an operational directive to the manager
of the open market desk at the New York Fed­
eral Reserve Bank (hereafter referred to as
the trading desk). The directive included shortrun paths for Ml and M2 and a narrow range
for the federal funds rate. The thrust of the
policy intention under this, or any other, pro­
cedure can be described by the planned growth
path for the monetary aggregates.
The FOMC used econometric and judgmen­
tal models of money demand to estimate the
relationship between the monetary paths and
the level of the federal funds rate. If the FOMC
had been mechanically trying to achieve the
monetary paths, it would have manipulated the
federal funds rate target in response to new
information about the money demand relation­
ship. However, the FOMC did not mechanic­
ally react in this way. While changes in the fed­
eral funds target were made in the direction
implied by mechanical application of the pro­
cedure, the changes were smaller than required
to effectively control monetary growth. The
FOMC showed a preference for smoothing
changes in the federal funds rate.5
A typical directive for this period included
a federal funds range 25 to 50 basis points
wide. Growth within the range was usually
conditioned on growth of the monetary aggre­

6. However, we might
expect medium- and
long-term interest
rates to rise i f the
market participants
expect this increase
in supply to intensify
inflation, or i f they
expect the Federal
Reserve to raise the
interest-rate operat­
ing range in fu tu re
weeks. See Cornell
(1983) and Hardouvelis (1984) fo r
an examination o f
the information con­
tent o f money stock
announcements in
other markets and
fo r a survey o f the
literature. Gavin
and Karamouzis
(1984) extend the
evidence to include
the experience under
the borrowed reserve
operating procedure
and CRR.

gates relative to two month paths that were
chosen at the meeting. The range in the last
week of September 1977 was 6 percent to
6.5 percent. The target was raised 16 times
in the next 2 years, usually in response to mon­
etary growth above the short-run provisional
paths. The average change was 33 basis points
so that the federal funds range was 11.25 per­
cent to 11.75 percent in the last week before
the change to the nonborrowed reserve oper­
ating procedure.
To comply with the directive, the trading
desk would sell securities (thus draining re­
serves) whenever the federal funds rate was
expected to trade consistently below the lower
limit and buy securities (thus supplying re­
serves) whenever the federal funds rate was
expected to trade consistently above the upper
limit. Market participants used the level of
the federal funds rate at the time of trading
desk market intervention to estimate the
limits on the operating range for the federal
funds rate.
While the narrow federal funds rate range
was subject to a proviso about short-run
growth in Ml and M2, changes in the limits
for the federal funds rate range were small
(25 to 50 basis points) and infrequent (on aver­
age less than once a month). As a result of this
procedure, the market not only knew the cur­
rent target, but also could forecast the federal
funds rate several weeks in advance with rel­
atively small errors.
While market participants were wellinformed about the location of the reserve
supply function, they had little information
about aggregate reserve demand. Individual
banks could observe their own reserve require­
ments because requirements were calculated
against deposits of two weeks earlier. How­
ever, market participants had little informa­
tion with which to estimate aggregate reserve
demand until the aggregate monetary data
were released. Thus, while the weekly money
stock announcement was important in pre­
dicting aggregate reserve demand, it was use­
ful in predicting the reserve supply function
only in so far as the federal funds rate limits

were expected to be changed in response to
a deviation of the money stock from the
desired path.
The reserve market under the federal funds
rate operating procedure is shown in panel a
of figure 1. The reserve supply function Rg
represents the end-of-period position of the
reserve supply curve expected by market par­
ticipants before the money stock announce­
ment. The reserve supply function is infinitely
elastic, representing the expectation that the
Federal Reserve would maintain the federal
funds rate in the target range, thus accom­
modating all short-run changes in the de­
mand for reserves.
Likewise, Rb represents the reserve de­
mand function expected by market partici­
pants before the money stock announcement.
The reserve demand curve is inelastic with
respect to the money stock and the federal
funds rate because of LRR. The perceived fed­
eral funds rate target before the announce­
ment is illustrated in panel a of figure 1 by a
point estimate, FF*. This is the rate that is
expected to prevail through the end of the
reserve maintenance period.
Suppose that a large unexpected increase
in Ml was announced. The expected end-ofperiod reserve demand curve would shift to
the right. Because the public expected the
Federal Reserve to accommodate unexpected
shifts in the short-run demand for reserves,
the cost of obtaining reserves through the
end of the settlement period was expected to
be relatively unchanged. We have portrayed
the short-run reserve supply curve as perfectly
horizontal on the assumption that there was
no feedback to the change in Ml by the Fed­
eral Reserve. If there were a systematic revi­
sion of the target between the announcement
and the end of the reserve settlement period,
then the reserve supply function would have a
positive slope. The feedback procedure used
by the Federal Reserve to adjust the interestrate target determined the information content
of the unexpected part of the M l announce­
ment for the contemporaneous reserve market.6

7. Goodfriend (1983)
develops an aggre­
gate borrowing de­
mand function from
a theory o f the bank­
ing firm . He shows
that the expected
spread between the
federal funds rate
and discount rate is
a non-linear function
o f past and expected
futu re borrowing.
This provides a chan­
nel fo r the expected
futu re federal funds
rate to influence the
contemporaneous
federal funds rate.
8. See Stevens (1981)
fo r a detailed descrip­
tion o f policy during
the first two years
o f the nonborrowed
reserve targeting pro­
cedure. See McCallum (1985) fo r f u r ­
ther discussion o f
this point.

The Nonborrowed Reserve Procedure
When the FOMC announced a change in oper­
ating procedure on October 6, 1979, there was
a dramatic change in the information flow
to the market about the relative position of
the reserve supply functions for the period
between FOMC meetings. The Federal Reserve
constructed paths for reserves based on the
short-run path for desired growth in the mon­
etary aggregates. This procedure was made
quite complicated by lagged reserve require­
ments. Since the level of required reserves
was based on past Ml, the FOMC was essen­
tially forced to supply reserves to accommo­
date past Ml growth. However, it could affect
future money growth by changing the price
banks paid for reserves.
At the planning stage, this is the same analyt­
ical framework used in policy decisions before
October 6, 1979. However, there were impor­
tant differences. First, there was a change
in the public discussion surrounding FOMC
decisions. When the FOMC was choosing
an explicit target for the federal funds rate,
many observers attributed changes in the gen­
eral level of all market interest rates to Fed­
eral Reserve policy. While the Federal Reserve
could not control market interest rates, there
may have been a perceived political constraint
preventing large, discretionary changes in
the federal funds rate target.
Second, and perhaps more important,
neither the FOMC, nor anyone else, could
predict the short-run changes in the interest
rate that were necessary to achieve the Fed­
eral Reserve’s monetary targets. By choosing
a nonborrowed reserve target, the Federal
Reserve allowed the market a greater hand in
determining the level of the federal funds rate.
In the planning stage, the decision about
the expected federal funds rate was made
implicitly by the FOMC through the decision
on the mix of nonborrowed versus borrowed
reserves. Given the discount rate and total

reserve demand (based on past money growth),
the federal funds rate was positively related
to changes in the ratio of borrowed to total
reserves. The initial level of total reserves
was calculated using the short-run monetary
paths and estimates of the components of
the money multiplier.
Using its money demand framework, the
Federal Reserve staff estimated a federal funds
rate that was consistent with the monetary
path. Suppose this rate was FFB shown in
panel b of figure 1. The FOMC also used econ­
ometric and judgmental models to estimate
the borrowing function. This is the upwardsloping portion of the reserve supply curve ( R s
in panel b). Because Federal Reserve admin­
istrative guidelines discouraged banks from
borrowing at the discount window, a greater
spread between the federal funds rate and the
discount rate was required to induce banks
to borrow more at the discount window.7
In theory, the intersection of the horizontal
line through FFB with the borrowing portion
of the reserve supply function suggested an
appropriate initial borrowing assumption.
The target for nonborrowed reserves (NBR*)
could be calculated by subtracting this borrow­
ing assumption from expected total reserves.
In practice, the FOMC often chose the most
recent level of borrowing as the initial bor­
rowing assumption.8
In summary, under the nonborrowed reserve
procedure, targets for nonborrowed reserves
were based on a short-run target path for Ml
and an initial borrowing assumption. The
procedure was to maintain that path for non­
borrowed reserves and to allow unexpected
changes in money and total reserve demand to
spill over into the discount window. The non­
borrowed reserve path was adjusted by the
Federal Reserve staff in response to currently
known, but previously unexpected, changes
in the multiplier. There was a proviso during
this period stated as a wide band for the fed­
eral funds rate. Initially set to be four percen­
tage points wide, it was at times as large as
six percentage points.

Also, the FOMC sometimes chose to deviate
from the short-run Ml path for other policy
reasons. This could be done by changing the
discount rate, which would lead to a vertical
shift in the borrowing function. It could also be
done by changing the nonborrowed reserve
target which would lead to a horizontal shift
in the reserve supply function.
Market participants calculated the expected
nonborrowed reserve targets (NBR*) using
information about the annual monetary tar­
gets, minutes from past FOMC meetings, and
the latest information about M l. An unex­
pectedly large change in the weekly money
announcement induced a corresponding shift in
the expected aggregate-reserve demand curve,
causing market participants to revise their
expectations about the cost of federal funds.
Market participants scrambled for reserves
immediately after the announcement of an
unexpectedly large increase in the money
stock, causing upward pressure on the fed­
eral funds rate. In panel b of figure 1, a sur­
prise increase in the demand for reserves,
from Rg to Ra would cause the federal funds
rate to rise from FFg to FF&.
An important aspect of the nonborrowed
reserve operating procedure was the automaticity in the response of interest rates to a devi­
ation of Ml from the short-run policy path.
Under this procedure, deviations of M2 and
M3 were automatically accommodated by the
weekly multiplier adjustments to the nonbor­
rowed reserve path. For the short run at least,
Ml was clearly the primary target.
In the second half of 1982, the FOMC decided
that it did not wish to automatically react to
deviations of Ml from the policy path, making
the nonborrowed reserve procedure inappro­
priate. This decision was based on the uncer­
tainty surrounding financial innovations,
changing regulations, and the unusual behav­
ior of Ml velocity.

The Borrowed Reserve Procedure
In October 1982, the FOMC set aside the Ml
target and the nonborrowed reserve procedure.
The directive to the trading desk called for a
degree of restraint in the provision of reserves,
often phrased in relative terms, such as some­
what less, the same, or somewhat more restraint.
The FOMC made this directive operational
for the trading desk by translating the degree
of restraint into a target for borrowed reserves.
The trading desk set nonborrowed reserve
paths for one week at a time based on staff
projections of reserve demand and on the bor­
rowed reserve target chosen by the FOMC.
On a day-to-day basis, therefore, nonborrowed
reserves continued to be the instrument.
Under LRR, the Federal Reserve had good
information about reserve demand. Each week
(usually on Friday) the trading desk adjusted
the nonborrowed reserve path to accommo­
date the shift in reserve demand. The proce­
dure is portrayed in panel c of figure 1. The
announcement of an unexpectedly large
increase in Ml and in reserve demand was
accompanied by a compensating dollar-fordollar shift in the nonborrowed reserve path
so that the borrowing target was maintained.
On a weekly average basis, this procedure
looked much like the federal funds operat­
ing procedure in effect before October 1979.
The nonborrowed reserve paths were adjusted
each week to accommodate changes in reserve
demand. Within the week, variations in the
reserve market were along a given supply
schedule.
From one week to the next, the supply
schedule was shifted to match the expected
change in reserve demand and, thus, main­
tain a given level for borrowed reserves. This
borrowed reserve procedure was similar to
the federal funds procedure on an interweek
basis, as it led to expectations of a horizontal
supply curve for total reserves from one week
to the next.
One difference was that any shift in the
borrowing demand curve after October 1982 led

to a different federal funds rate. Another dif­
ference was in the daily operating procedure.
During the federal funds rate targeting
period, the trading desk entered the market
whenever the federal funds rate deviated from
the operating target. During both the nonbor­
rowed reserve and the borrowed reserve pro­
cedures, the Federal Reserve entered the mar­
ket, if at all, only once a day, usually between
11:30 a.m. and noon. The operation was pri­
marily defensive; that is, it was a response to
offset movements in the uncontrollable sources
of reserve supply, such as float, the Treasury
balance at the Federal Reserve, and other fac­
tors. Also, the FOMC continued to set a pro­
viso in terms of a wide band for the federal
funds rate as it had done during the nonbor­
rowed reserve procedure.
Market participants did not know the exact
amount of the borrowing target. Neither they
nor the Federal Reserve knew the exact loca­
tion of the borrowing function. Consequently,
market participants could not narrow down
a small range for the federal funds rate as they
had done prior to October 1979. The weekly
averages were very stable, but since the trigger
for trading desk intervention was primarily
reserve quantities rather than the federal funds
rate, the daily noise in the rate made it more
difficult for the market to perceive changes in
the stance of policy than had been the case
when the federal funds rate was the operating
target. Nevertheless, on an interweekly basis,
the borrowing target could be described as
an interest-rate smoothing procedure.
Due to lagged reserve accounting, the money
stock announcement still contained informa­
tion about the aggregate demand for reserves.
However, under a borrowed reserve proce­
dure, as under a federal funds procedure, the
slope of the expected reserve supply function
depends on the feedback procedure used by
the Federal Reserve to adjust the borrowed
reserve target. In panel c of figure 1, we have
portrayed the case where there is no feedback.
However, in this case, expectations of higher
interest rates in coming weeks may cause

an upward shift in the borrowing demand
function, and the reserve supply would have
a positive slope.
Contemporaneous Reserve Requirements
Finally, the recent change to contemporaneous
reserve settlement rules has important impli­
cations for the effect of money stock announce­
ments on the federal funds rate. Before Feb­
ruary 2,1984, the deviation of the money stock
announcement from the expected level gave
the market two types of information: the first
was information about the aggregate quan­
tity of reserves that would be demanded be­
tween the day of the announcement and the
next Wednesday; the second was information
about the position of the money stock relative
to the perceived policy target.
Under CRR, the money stock announce­
ments no longer include new information about
aggregate reserve demand. The reserve data
are released with a one day lag at the end
of each two week reserve settlement period.
The Ml data are released with a 10 day lag.
The reserve market will have cleared before
the money stock data for both weeks of the
reserve settlement period have been released.
While the Ml announcement may contain
new information about the level of Ml relative
to the perceived policy target, the market now
has better information than it had before the
change in rules. To some extent, the level
of M l will be inferred from the information
in aggregate reserves. Before CRR, the levels of
deposits and required reserves against depos­
its were reported in the same week. Under
CRR, the reserve data are available to be used
in conjunction with multiplier projections to
forecast Ml. Whether this would be a useful
procedure depends on the quality of the multi­
plier projections.
Furthermore, banks have installed new
information-gathering systems to meet reserve

9. We thank Mark
Porter and Money
Market Services fo r
generously provid­
ing the survey data.
10. Hafer (1984)
shows that the mar­
ket does not try to pre­
dict seasonal and
benchmark revisions
o f M l. Therefore,
we have excluded
those weeks from
this study.

requirements on a contemporaneous basis. In­
dividual banks are learning more quickly
about their own deposit levels, and they are
pooling this information to make forecasts of
Ml. These factors suggest market expecta­
tions of Ml should have become more accurate
after February 2,1984.

III. Empirical Results
The objective in this section is to summarize
empirical findings about how the pattern of
federal funds rate response to unexpected
money stock announcements has been influ­
enced by the Federal Reserve’s operating pro­
cedures and reserve accounting rules. We also
look at the quality of the Ml forecasts.
The Data
Ml is the figure first published by the Fed­
eral Reserve in the H.6 press release. The
expected change in Ml is calculated using the
median of a survey taken by Money Market
Services.9 The expected changes (MMSP) are
in billions of dollars. The expected change
in Ml is calculated as:
EMt = log (M2m + MMSPt)
- log (MZm ),
where t refers to the week of the announce­
ment rather than the statement week for
which Ml was calculated. The unexpected
change in Ml is calculated as:
UMt = log(MZ,) - log(MZM + MMSP,).
The actual change in Ml is calculated as:
AM t - log (M i/) - log (M l t_i).
We have used first-published numbers rather
than revised numbers in making these cal­
culations. This amounts to treating the revi­
sion as an unexpected change. Weeks that
included seasonal or benchmark revisions
were omitted from the sample.10

We used the Ml series that was published in
the H.6 release. When the definition of Ml
changed, our measure changed. Overlapping
data were used to splice the series in early
1980, when the Federal Reserve changed the
definition of M l to include other checkable
deposits.
The change in the federal funds rate (DFF)
is calculated from the trade-weighted averages
published in the H.15 release. Since the H.6
release (money announcement) was made avail­
able to the public on various days of the week
throughout the sample period, we collected
daily data on the federal funds rate. A “ before­
announcement” rate was taken as the last
available value before the announcement. The
“ after-announcement” rate was taken as the
first available value after the announcement.
DFF, measured in basis points, is calculated
as the difference between these rates.
Figure 2 depicts the time series for DFF.
The stochastic process generating the change
in the federal funds rate subsequent to the
announcement of a money stock surprise has
apparently undergone change over this sam­
ple period. Changes in the response of the
federal funds rate following money stock
announcements are much larger during the
nonborrowed reserve subperiod than in the
rest of the sample period.
Casual inspection reveals another change
between July and October of 1982. The vari­
ation in the series fell in the summer, but a
systematic persistence or regularity is not
evident until after October 1982. Variation in
DFF has been reduced since the summer of
1982, but not to the low levels seen before
October 1979. While the process generating
DFF shows apparent change with changes in
the operating procedures, there is no appar­
ent change in the process generating the inter­
est rate series with the switch to CRR.
The variance of UM (the median survey
forecast error) was higher during the nonbor­
rowed reserve operating procedure than it
was during the other periods. There was also
a tendency for the variance of the forecast

11. See, fo r exam­
ple, Grossman
(1981), Hafer (1983),
Roley (1983), and
Urich and Wachtel
(1984). A forecast is
defined as rational
i f the mean forecast
is equal to the actual
mean (it is unbiased),
and i f the error is
not systematically
related to past infor­
mation (it is effi­
cient).

error to fall, over time, after October 1979.
This can be seen in table 1, which includes
statistics measuring the accuracy of the Ml
forecast.
We have regressed the change in the loga­
rithm of first announced changes in Ml on a
constant and on the median survey forecast.
The constant was estimated to be different
from zero in the period of federal funds rate
targeting and in the last period under CRR.
The coefficient on the expected change was not
significantly different from 1, except in the

Fig. 2
Percent

last period. The explanatory power of the equa­
tion was lowest during the period of nonbor­
rowed reserve targeting. It rose from 51 per­
cent under the borrowed reserves targeting
procedure and LRR to 75 percent with the
switch to CRR.
Many authors have presented evidence on
the rationality of the median of the survey
forecast.11 In general, they find that the
median survey forecast is unbiased and effi­
cient, except during the early part of the
nonborrowed reserve operating procedure.

The Change in the Federal Funds Rate Following a Money Stock Announcement

Hafer (1983) finds that median survey fore­
cast errors are correlated with past informa­
tion during this period. He attributes this
apparent inefficiency to a learning process
associated with the new procedure.
We have also found that the median sur­
vey forecast errors are correlated with past
interest rates and actual Ml changes during
this period. In a regression of UM on past
announced changes in Ml and past weekly
changes in the federal funds rate, we cannot
reject the hypothesis that 13-week lags in both
variables help significantly in predicting UM.
Webb (1984) points out that these in-sample
tests are inadequate tests of rationality. As
Webb predicts, we find that using the esti­
mated systematic variation from the first half
of the nonborrowed reserve period does not
help predict Ml in the second half of the period.
These results are available upon request
from the authors.
We find a more serious problem with the
forecast in the last period. While the forecast
is unbiased in the first three subperiods, we
cannot reject the hypothesis that it has been

Table 1

badly biased since the introduction of CRR
(see table 1). Once again, the market may be
going through a learning period. We saw above
that the standard error of the forecast fell
with the introduction of CRR. In table 1, we
see that the explanatory power of the equa­
tion is highest in the last period even though
the forecast is biased. There are two cases
in which this estimated bias would not be a
sign of irrationality.
The first is the case in which past estimated
bias does not help predict Ml in the future.
We followed the procedure suggested by Webb
(1984) to construct a more powerful test of
the rationality of the survey forecast in this
period. We estimated the equation shown
in table 2 over the first 31 weeks of CRR
(deleting the February 16, 1984, observation
due to seasonal and benchmark revisions) and
used the estimated equation, AMt = -0.113
+ 1.36 EMt to forecast the remaining 16 weeks
of the sample period. The root mean squared
error (RMSE) of the adjusted forecast was
22 percent lower than the RMSE of the median
survey forecast, suggesting that the median

Accuracy of the Median Survey Forecast

*0

+

Sample period

CT
+
o

AM, =

Cl

SEE

R2

DW

9/29/77 to 10/4/79
(103 observations)

-0.13
(-2.64)

1.16
(9.91)

0.42

0.49

1.81

10/11/79 to 10/1/82
(150 observations)

0.05
(1.06)

1.14
(8.12)

0.54

0.30

1.85

10/8/82 to 1/27/84
(68 observations)

0.05
(1.04)

1.12
(8.44)

0.37

0.51

2.23

2/3/84 to 12/20/84
(46 observations)

-0.14
(-3.07)

1.48
(11.69)

0.28

0.75

2.30

NOTE: The expected change in Ml is calculated as:
EM, = log ( A / i , + MMSPt) - log ( M l M ),
where MMSP is the median survey forecast of the Ml change, and t refers to the week of the announcement rather than the statement week for
which Ml was calculated. The actual change in Ml is calculated as:
AM, = log (M l,) - log (Ml,_\).
SEE is the standard error of the regression, R 2 is the coefficient of determination adjusted for degrees of freedom, and D W is the Durbin-Watson
statistic. We have excluded observations in which the announced level of M l included an expected benchmark or seasonal factor revision. The
t-statistics are shown in parentheses.

12. See Gavin
and Karamouzis
(1984) fo r evidence
that prior knowledge
o f the unexpected
change in M l would
not have helped pre­
dict asset prices in
the first months
under CRR.

where

survey (M M SP) was not a rational forecast of
the actual Ml change during this short period.
The second is the case in which predicting
Ml more accurately does not help predict
changes in asset prices more accurately. In
this case the market may have little incentive
to correct the systematic bias in predictions
of Ml.12

DFFt = change in the federal funds rate
from before the announcement
to after the announcement,
UMt = unexpected change in the money
stock announcement at time t,
EMt = expected change in the money
stock at time t, and
e = error term.

The Model
The empirical model used to examine the
behavior of the federal funds rate following
a money stock announcement is based on the
efficient market hypothesis, which implies
that the current asset price will reflect all
publicly available information. Therefore, sub­
sequent changes in the asset price should
reflect only new information coming into the
market. The empirical model takes the fol­
lowing form:
(1)

Table 2

DFFt = «o + a\UMt + d2 EMt + et,

Under the efficient market hypothesis, if
expectations are rational, then «o and «2 will
be zero, and the error term will be random.
If the money stock is an important factor in
determining the federal funds rate, a\ will
be significant. In other words, under the effi­
cient market hypothesis, only the unantic­
ipated component of the Ml announcement
should influence DFF because the federal
funds rate level before the announcement
should already reflect all relevant publicly
available information.
The sample period, September 15, 1977, to

Impact of Money Stock Announcements on the Federal Funds Rate
Contemporaneous
reserve accounting

Lagged reserve accounting
Federal
funds
targeting

Nonborrowed
reserve
targeting

Borrowed
reserve
targeting

Borrowed
reserve
targeting

9/29/77
to 10/4/79

10/11/79
to 10/1/82

10/8/82
to 1/27/84

2/3/84
to 12/20/84

Constant

0.009
(0.79)

0.064
(1.17)

0.047
(1.77)

-0.070
(-1.14)

Surprise in Ml

0.020
(0.92)

0.408
(4.11)

0.098
(1.49)

0.210
(1.64)

-0.023
(-0.89)

-0.161
(-0.94)

-0.035
(-0.49)

-0.337
(-2.76)

Estimation period

Expected change in Ml
Autocorrelation coefficient

—

—

—

0.342

Standard error of the regression

0.092

0.651

0.203

0.265

Durbin-Watson

1.891

2.235

1.733

2.040

-0.005

0.093

0.005

0.114

0.724

8.645

1.161

3.907

R2
F statistics
NOTE: The t-statistics are shown in parentheses.

December 20, 1984, is divided into the four
subperiods that correspond to different oper­
ating procedures or different reserve account­
ing regimes. The first subperiod began with
the availability of survey data about expected
changes in Ml and covers the pre-October 1979
period of federal funds rate targeting. In this
period, we do not expect the federal funds rate
to respond to unexpected changes in Ml.
The second subperiod covers the October 11,
1979, to October 1, 1982, period of nonbor­
rowed reserve targeting and lagged reserve
accounting. In this period, we expect a strong
positive correlation between unexpected
changes in Ml and subsequent changes in
the federal funds rate.
The third subperiod covers the October 8,
1982, to January 27, 1984, period of borrowed
reserve targeting and lagged reserve account­
ing. Since the trading desk is expected to fully
accommodate unexpected shifts in reserve
demand, we do not expect the federal funds
rate to respond to unexpected changes in Ml
under the borrowed reserve targeting pro­
cedure.
The last subperiod, February 3, 1984,
to December 20, 1984, is a period of borrowed
reserve targeting and contemporaneous re­
serve accounting. Since a borrowed reserve
operating procedure is in effect, estimates of
a\ are expected to be insignificant unless
there is a systematic shift in the borrowing
demand function following a money stock
announcement.
Reaction to Surprises in M l
The results from estimating equation 3 for
four different subperiods are reported in
table 2. The coefficient of the unexpected
change in the Ml, a\, is positive in all cases,
but statistically significant at the 5 percent
level only in the nonborrowed reserve target­
ing period. A 1 percent surprise in the money
stock in that period resulted in a 40-basispoint increase in the federal funds rate. No

statistically significant relationship was un­
covered in the other three subperiods. These
empirical results are consistent with the
simple illustrations of the reserve market
shown in figure 1. They indicate that the
money stock announcement was not a signif­
icant factor in the current reserve market
except during the period of nonborrowed re­
serve targeting.
Tests for Structural Change
We have assumed that either a change in the
operating procedure or in the reserve account­
ing rules would cause a change in our esti­
mates of the coefficients in the efficient mar­
ket model. We calculated the Wald Statistic
to test whether or not the estimated coeffi­
cients are equal for any two adjacent subperi­
ods (see table 3). The hypothesis that the esti­
mated coefficient vectors are equal is rejected
at a 1 percent level of significance when the
estimates from the federal funds targeting
period are compared to the estimates from the
nonborrowed reserve targeting period. The
same hypothesis is also rejected at the 1 per­
cent level of significance when estimates from
the borrowed reserve targeting period under
lagged reserve requirements are compared to
estimates from the borrowed reserve tar­
geting period under contemporaneous reserve
requirements. However, we can only weakly
reject (at a 10 percent level) the hypothesis
that the vector of coefficients from the non­
borrowed reserve period is equal to the vector
of coefficients estimated for the period of bor­
rowed reserve targeting.
The hypothesis that the estimated a\ coeffi­
cients are equal is rejected at a 1 percent level
of significance when the estimate from the
federal funds targeting period as compared to
the estimate from the nonborrowed reserve
targeting period. This hypothesis is also re­
jected at a 1 percent level of significance when
the estimate from the nonborrowed reserve
targeting period is compared to the estimate
from the borrowed reserve targeting period.

The same hypothesis cannot be rejected when
the borrowed reserve targeting period under
lagged reserve requirements is compared to
borrowed reserve targeting period under con­
temporaneous reserve requirements. While
the overall model changed with the introduc­
tion of CRR, there was no significant reaction
to Ml in either period.
The Efficient Market Hypothesis
In no case is the constant term statistically
significant. In addition, the estimates of a2, the
coefficient of the expected changes in Ml, are
not statistically different from zero in the first

Table 3 Large Sample Tests
for Structural Change
Wald Statistic for the
null hypothesis

Periods compared

Vector a
equal
across
periods

a l equal
across
periods

X(3)

X(2l>

Federal funds
targeting vs.
Non borrowed reserve
targeting

16.253

14.57a

Non borrowed reserve
targeting vs.
Borrowed reserve
targeting (LRR)

7.17b

6.77a

Borrowed reserve
targeting (LRR) vs.
Borrowed reserve
targeting (CRR)

three subperiods. However, in the last sub­
period of contemporaneous reserve account­
ing, the coefficient has a negative sign and
the null hypothesis is not rejected at the 5 per­
cent level. This finding, in conjunction with
the presence of serial correlation in the resid­
uals, raises concern about the efficiency of
the market and/or the rationality of the fore­
cast. We saw above that the median survey
forecast was biased in this last period.
Roley (1983) finds a similar problem in the
Treasury bill market during the period of non­
borrowed reserve targeting. He constructed
a revised expectation series by allowing for
bias in the forecast, and by modifying the
median of the Tuesday survey to include the
new information (the change in the interest
rate) from the time of the survey to just before
the money announcement. Using this revised
forecast, Roley finds that the estimated coef­
ficient of the revised expected change in M l is
not statistically different from zero.
Hein (1985) shows that if one does not cor­
rect for bias in the forecast, then the estimated
coefficient of the revised expected change in
Ml in Roley’s model is again significant at the
5 percent level. We have found similar results
for the federal funds rate under CRR. How­
ever, even when we constructed a revised fore­
cast as in Roley, we could not eliminate the
significance of a2 or the serial correlation in
the residual of the D F F equation.

IV. Conclusions
12.10"

0.61

NOTE: These tests are based on the Wald Statistic (W)\
W = ( P 1 - M l o U x [ X i ) - ' * ct|(A 2*2)-»]U 8i - 02),
where /3, is the vector of regression coefficients and o j ( X i X i ) ' 1 is the
variance-covariance matrix of the coefficients in the «th period. Unlike
the Chow F test, this test does not require equal sample size or equal
covariance matrixes across regimes. Watt (1979) presents Monte Carlo
evidence to show that, in the presence of heteroskedasticity, this test is
at least as powerful as the Jayatissa (1977) modification of the Chow test
when the sample size is as large as 50. See Silvey (1975, pp. 115-116) for
a description of the Wald Statistic.
a. Reject the hypothesis that the estimated coefficients are the same
for the two sample periods with a critical region of 1 percent.
b. Reject the hypothesis that the estimated coefficients are the same
for the two sample periods with a critical region of 10 percent.

The role and formation of expectations have
received considerable attention in the last
decade. Studies have emphasized the impor­
tance of the market’s perception of and reac­
tion to new information about economic policy.
This article examines the effect that monetary
control arrangements have on the informa­
tion content of the money stock announce­

a. This description
o f CRR applies only
to banks that report
deposits and reserves
weekly and not to the
small, quarterly re­
porters that are still
subject to lagged re­
serve requirements
and one week main­
tenance periods.

ments in the market for reserves. Specifically,
we show that there was very little informa­
tion in the announcement for the reserve
market except during the period when the
Federal Reserve used a nonborrowed reserve
operating procedure. We show that the pres­
ent operating procedure may be characterized
as an interest-rate smoothing procedure.
Since the introduction of contemporaneous
reserve requirements, we show that, while
the error in the Ml forecast has been reduced,
the forecast has been biased and the stochastic
process generating the federal funds rate has
not been consistent with statistical assump­
tions of the efficient market model. While we
have rejected the statistical implications of
the efficient market model for this short
sample period, we have not rejected the eco­
nomic implications; that is, we have not shown
that one could profit by using our model to
trade in the reserve market.

Appendix: Contemporaneous
Reserve Requirements and
the Timing of the Weekly
M l Announcement
Between September 1968 and February 1984,
banks were required to hold reserves against
deposits on a lagged basis; that is, average
daily reserves held in any given week were
used to meet reserve requirements calculated
from deposit levels of two weeks earlier. This
lag was instituted in 1968 to give individual
banks precise knowledge about the level of
their reserve requirements. The lag also gave
the Federal Reserve time to collect informa­
tion about aggregate reserve demand.
In February 1984, the Federal Reserve
implemented a return to almost contempo­
raneous reserve requirements (CRR).a The
banking system had objected to this switch
on the grounds that it would be costly to set
up the information systems necessary to
monitor deposit levels on an instantaneous
basis. As a concession to this issue, the Fed­
eral Reserve chose a form of CRR that was

not truly contemporaneous. Instead, the lag
was reduced from 14 days to 2 days.
The new rules included other changes.
One change is a lengthening of the reserve
accounting period from one week to two weeks.
Banks now post reserves, averaged over two
weeks ending on a Wednesday, against depos­
its averaged over two weeks ending on a
Monday, giving them two days to collect data
on transactions deposits and to adjust their
reserve positions accordingly.
Another change is that the lag on reserve
requirements against other reservable depos­
its (nonpersonal time deposits and Eurocur­
rency liabilities) has increased from 14 days
to 30 days. For example, reserve requirements
held in a two week period ending Wednesday,
March 13, 1985, were held against transaction
deposits held in the two week period ending
Monday, March 11, and against other reserv­
able deposits held in the two week period end­
ing Monday, February 11. Vault cash eligible
to be counted as reserves in the period Feb­
ruary 28 to March 13 was equal to vault cash
held during the period January 29 to Febru­
ary 11—also a 30-day difference.
Under lagged reserve requirement rules
(LRR), banks had been permitted to carry
forward any excess or deficiency up to 2 per­
cent of their required reserves. Any carry­
over not offset during the next period could
not be carried forward into additional peri­
ods. There was a temporary change under the
new rules. The new rules stated that the per­
centage of required reserves that an institu­
tion may carry forward would be 3 percent
until August 1, 1984, and 2.5 percent until
January 30, 1985. Thereafter, the percentage
would be 2 percent or $25,000, whichever was
greater. Since the 2 percent is based on reserves
cumulated, not daily averages, the absolute
amount of carryover is now double the amount
allowed under LRR, because the reserve settle­
ment period has been increased to two weeks.
There was also a change in the timing of
the weekly money stock announcement. The

announcement was moved up one day to
Thursday, 4:30 Eastern standard time. Even
though the Federal Reserve required banks
to speed up the collection and reporting of
deposit data, the actual data released on
Thursday are slightly “ older” than data that
had been released on Friday. Under the LRR
regime, the weekly money stock data released
on Friday referred to the average daily level
of Ml for the week ending on Wednesday,
nine days earlier. Under the new arrange­
ment, the data released on Thursday refer to
the average daily level of Ml for the week
ending Monday, 10 days earlier.
On the last day (Wednesday) of the reserve
maintenance period, all banks have to meet
their reserve requirements. This is an unusual
market; we can think of no other where all
firms are required to adjust inventories to
specified levels at the same time. During the
reserve accounting period, before the money

stock announcement, each bank can monitor
its own deposits to estimate its individual
reserve requirement, but it has no informa­
tion about aggregate reserve demand. Under
lagged reserve accounting rules, the announce­
ment of Ml was made nine days after the end
of the deposit computation period, but five
days before the end of the reserve mainte­
nance period. Consequently, the money stock
announcement contained information about
the aggregate demand for reserves in the settle­
ment period that would end five days hence
(see figure 3, panel a). Under CRR, the weekly
announcements on Thursday apply to only
half of a deposit computation period. The an­
nouncement of Ml for the first half of the
deposit computation period is made one day
after the reserve market clears. The announce­
ment of Ml for the second half of the deposit
computation period is made eight days after
the reserve market clears (see figure 3, panel b).

Fig. 3 The Timing of Reserve Requirements
and M l Announcements
a. Lagged Reserve Requirements
Reserve maintenance period

i— i— i— i— r

i

M T W T F

M T W T F

i

i

i

i — i— i— i— i— r

r

M T W T F

1/11

1/4/85

I-------------------------- 1
"1----1----1----1--- 1
n— i— i— i— i— r
M T W T

1/18

M T W T

F

F

2/1

1/25

I___
Computation period for
transaction deposits
included in Ml

Fed announces
M l for the week
ending 1/18/85

b. Contemporaneous Reserve Requirements
Reserve maintenance period

I---- 1--- 1--- 1----1----T 1--- 1----1----1--- 1----1
M T W T F

M T W T

2 / 18/85

2/25

F

1----1----1----1----1---- 1--- T i — i— i— i— i— r
M T W T F

M T W T F

3/4

3/11

Computation period for transaction
deposits included in M l

3/13 3/14

Fed announces
Ml for the week
ending 2/4/85

T

I

I

I I I

M T W T F
3/21

Fed announces
Ml for the week
ending 3/11/85

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