Full text of Economic Review (Federal Reserve Bank of Cleveland) : 1992 Quarter 1, Vol. 28, No. 1

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

Vol. 28, No. 1

ECONOMIC REVIEW
1992 Quarter 1

Recent Behavior of Velocity:
Alternative Measures of Money

2

by John B. Carlson and
Susan M. Byrne

Commodity Prices and P-Star

11

by Jeffrey J. Hallman and
Edward J. Bryden

The Causes and Consequences
of Structural Changes in U.S.
Labor Markets: A Review
by Randall W. Eberts and
Erica L. Groshen




FEDERAL RESERVE BANK
OF CLEVELAND

18

ECONOMI C

REVI EW

1992 Quarterl
Vol. 28, No. 1
Recent Behavior of
Velocity: Alternative
Measures of Money

2

by John B. Carlson and
Susan M. Byrne
Changes in the structure of the U.S. financial industry over the last dec­
ade have raised questions about the reliability of M2 as the primary
guide for monetary policy. Although the simple ratio of economic activ­
ity to M2 — that is, M2 velocity — indicates nothing unusual, the rela­
tionship between velocity and interest rates has been disrupted in recent
years. This appears to be related to a breakdown in money demand in
1988, which could in turn be linked to the restructuring of depositories.
The authors examine the velocities of two alternative monetary aggre­
gates, but find that, like M2, these measures are not impervious to finan­
cial change.

Commodity Prices and P-Star

11

by Jeffrey J. Hallman and
Edward J. Bryden
The P-Star (P*) model forecasts inflation by exploiting the stability of
M2 velocity and the tendency of the real economy to operate near its
potential. For a given stock of M2, P* is the price level that would pre­
vail if velocity were at its mean and real income equaled potential out­
put. The ratio of the actual price level (P) to P* can be considered an
indicator of how the current money stock will affect inflation over the
next several years. Over shorter horizons, other factors may be ex­
pected to influence the inflation rate. This paper shows how the P*
model can be modified to include information about the recent behav­
ior of commodity prices. This modified model yields more accurate
short-run inflation forecasts while still retaining the property that, over
longer horizons, only money matters.

The Causes and
Consequences of
Structural Changes
in U.S. Labor Markets:
A Review

18

by Randall W. Eberts and
Erica L. Groshen
During the initial stages of the expansion of the 1980s, wage growth
remained relatively subdued. Even as the economy picked up steam
later in the decade, tight labor markets did not drive up wages to the
extent that past experience would have suggested. In an effort to find
out what was behind this unusual wage restraint, the Federal Reserve
Bank of Cleveland held a two-day conference in October 1989 on the
causes and consequences of structural changes in U.S. labor markets.
This article provides an overview of those proceedings.



Economic Review is published
quarterly by the Research Depart­
ment of the Federal Reserve Bank
of Cleveland. Copies of the Review
are available through our Public
Affairs and Bank Relations Depart­
ment, 1-800-543-3489.

Coordinating Economist:
James B. Thomson
Advisory Board:
David Altig
Erica L. Groshen
William P. Osterberg

Editors: Tess Ferg
Robin Ratliff
Design: Michael Galka
Typography: Liz Hanna

Opinions stated in Economic
Review are those of the authors
and not necessarily those of the
Federal 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 material to the editors.

ISSN 0013-0281

Recent Behavior of Velocity:
Alternative Measures of Money
by John B. Carlson and Susan M. Byrne

Introduction
The unusual weakness of the M2 monetary aggre­
gate over the past year or so has raised concerns
about implications for the economy and has
brought into question the reliability of this meas­
ure as a guide for policy. These concerns height­
ened last summer as initial reports indicated
that M2 declined in the third quarter, leaving it
around the lower bound of its target range. His­
torically, such sharp slowdowns in money growth
have been associated with subsequent weakness
in economic activity.1
By contrast, growth in the narrower M l meas­
ure has been robust, having increased almost 9
percent in 1991. Growth in the monetary base
has also been strong, driven to some extent by
the transitory foreign demand for U .S . currency
during the Gulf War. Moreover, Poole (1991)
and Motley (1988) have proposed alternative
measures of money that suggest monetary
policy is not as stringent as it might appear.

1 Although revisions to the data revealed that initial reports under­
stated M2 growth during the summer and for the year, the revised figures
were still inexplicably sluggish. We recognize, however, that the associa­
 tion between money growth and economic activity does not imply causal­
http://fraser.stlouisfed.org/
ity. For a discussion of this issue, see Carlstrom and Gamber (1990).

John B. Carlson is an economist
and Susan M. Byrne is a senior
research assistant at the Federal
Reserve Bank of Cleveland. The
authors gratefully acknowledge
helpful discussions with David
Altig, W illiam Gavin, William
Poole, and James Thomson.

From time to time, policymakers reexamine
the potential usefulness of alternative measures
of money as policy guides. Indeed, in the mid1980s, the Federal Open Market Committee
(FOMC) abandoned M l as its primary policy tar­
get in favor of M2. One basis for forsaking M l is
most clearly evident in the marked change in
the historical pattern of its velocity, defined as
the ratio of nominal income to M l (see figure 1).
Over much of the postwar period, M l velocity
increased steadily along a trend rate of 3 percent.
In the early 1980s, however, this measure became
substantially more variable with no clear trend.
The dismption in the historical pattern was attrib­
uted largely to financial innovation in conjunction
with deregulation and disinflation.2
M2 velocity, on the other hand, appeared to be
unaffected by these events. Although the measure
has always varied systematically with interest
rates, it is essentially trendless both before and
after the early 1980s (see figure 1). In fact, since
the founding of the Federal Reserve in 1913, M2

■

Federal Reserve Bank of St. Louis

■

2 For a discussion of the breakdown of M1 velocity and its implica­
tions for monetary targeting, see Poole (1988). For a brief summary of
the effects of financial innovation, deregulation, and disinflation on M1
and its velocity, see Judd and Scadding (1982) and Carlson (1989).

3

FI GURE

1

been trending up while its opportunity cost has
been falling. Yet, history suggests that velocity
should be declining, at least in the short mn. Un­
derstanding this anomaly is, of course, important
for interpreting the aggregate’s recent weakness.
This article examines the factors that some
analysts believe account for the unusual behav­
ior of M2 and its velocity. We also discuss alter­
native measures of money recently proposed by
Poole, and estimate a demand function for an
expanded measure of M2. The analysis suggests
that part of the anomalous behavior of M2 veloc­
ity is related to the ongoing restmcturing of the
savings and loan (thrift) industry. Although the
implications for the long m n are unclear, M2
velocity is likely to remain higher over the near
term than one might otherwise expect given the
level of its opportunity cost.

M1 and M2 Velocity
Ratio

SOURCE: Board of Governors of the Federal Reserve System.

F I G U R E

2

M2 Velocity and Opportunity Cost
Ratio

I. Velocity and the
Demand for Money
Percent

SOI JRCE: Board of Governors of the Federal Reserve System.

and nominal income have grown at approxi­
mately the same rate, suggesting the existence
of a relatively simple and enduring relationship
between the two.
On the surface, there is little basis for believ­
ing that M2 velocity has behaved unusually
over the past few years; after all, it is currently
close to its trendless long-run average. What is
unusual, however, is that around 1989, an appar­
ent break occurred in the relationship between
M2 velocity and the opportunity cost of the aggre­
gate, defined as the difference between the mar­
ket interest rate and the rates paid on M2 instru­
ments (see figure 2).3 Since then, M2 velocity has
■ 3 More precisely, the interest rate paid on M2 instruments is the
weighted average of the component rates, where the weights are relative
shares. The market rate is the weighted average of yields on the threemonth Treasury bill and the three-year Treasury note, with weights being
shares of both the non-tim e deposit (zero-maturity) and small time de­
posit components of M2. For further discussion of this opportunity cost

measure, see Carlson and Parrott (1991).
http://fraser.stlouisfed.org/

Federal Reserve Bank of St. Louis

The concept of velocity is central to discussions of
monetary policy7, largely because it affords the
Federal Reserve a straightforward and relatively
nontechnical language that Congress and the pub­
lic can easily understand.4 The fact that M2 veloc­
ity has been trendless makes it easy to convey to the
public why the M2 aggregate might te viewed as a
reliable guide over the long term. As the simple
ratio of income to money, however, velocity em­
bodies some complex structural relationships.
Economic explanations for the behavior of
velocity have generally focused on the existence
of a “stable” money demand function. The notion
of stability typically implies that this function
should have relatively few arguments, and that it
should include some measure of spending or
economic activity (see Friedman [1956] ).5 If the
function were to require knowledge about a large
number of variables in order to pin it down, the
simple relationship between money and eco­
nomic activity would be less predictable.
For many years, economists were confident
that reasonably stable money demand specifica­
tions could be estimated for narrow definitions
of money. Many specifications were based on
the inventory-theoretic models of Baumol (1952)

■

4 Since 1978, the FOMC has been required by law to report to
Congress on its annual monetary objectives. The Committee's progress
is reviewed at midyear and again at the beginning of the following year,
when the next set of objectives is reported.
■

5 For a recent comprehensive survey of the empirical literature
spawned by Friedman’s restatement, see Judd and Scadding (1982).

and Tobin (1956). One theoretical result of such
models was that the income elasticity of cash bal­
ances is less than one, implying that the velocity
of money would rise secularly.
This seemed to square with estimates of in­
come elasticity associated with conventional
specifications of M l demand. Estimates of inter­
est elasticity, however, were much lower than
the theoretical models predicted.6 Although
Hoffman and Rasche (1989) recently obtained
more substantial estimates of the long-run inter­
est elasticity of M l, it is doubtful that stable
short-run specifications for M l demand exist.
The evidence suggests that changes in the struc­
ture of the financial industry have affected M l
demand in too many ways to pin down.
Because M2 velocity appeared to be imper­
vious to the financial changes of the 1970s and
early 1980s, attention turned toward finding
stable short-mn specifications for M2 demand.
One of the most promising was developed by
Moore, Porter, and Small (1990), hereafter
referred to as MPS. They applied econometric
techniques that enabled them to take account of
the stationarity of M2 velocity and found that a
reasonably stable M2 demand specification
could be estimated, at least through 1988. Since
then, however, their model has overpredicted
M2 growth, raising questions about whether M2
velocity has drifted upward.
MPS specified M2 demand in an errorcorrection framework, noting two advantages to
this approach.s First, error-correction regressors
— entered as first differences in the levels — are
more likely to be stationary and are much less colinear than they would be as undifferenced regres­
sors. Second, the long- and short-run money
demand relationships are clearly distinguished.
The long-run money demand function is
specified as

cost.9 Since one might expect M2 opportunity
cost to be essentially trendless in the long run, M2
velocity would also be trendless. Thus, although
equation (1) may specify a partial equilibrium for
the level of M2, the implied long-ain general equi­
librium for its velocity is essentially a constant.
The second component of the MPS model is a
dynamic equation based on an error-correction
adjustment specification:
u
= a + bet_ j +

w

V

+ 1 di As,~i + X / A y ,
i=0
/= 0
q

n

+ X X g ijA x i,t-j+en
i= 17=0
where et_ j is the deviation of money from its
long-run equilibrium value (derived from equa­
tion [1]) and £t is white noise. Adjustment speed
is determined by changes in the lagged values of
M2 and in the current and lagged values of the
opportunity cost and scale variable. The general
form of the model allows other variables to affect
adjustment speed (both current and lagged val­
ues). These variables, which need not affect longRin equilibrium money balances, include any
factors that influence the adjustment process.10
Equation (2) essentially specifies the short-run
convergence process of M2 to its equilibrium val­
ue. When the coefficient on the error-correction
terni is negative, convergence is ensured. Substi­
tuting (1) into (2) yields
(3)

A mt = a - b a - b $st_ x+ b (m t_ l - yt_ j)
11

+E
(1)

V

ci Am t~i

i= 16

mt - a + yt + ps, + et ,

+ X
i= 1

+ S di Ast~i
/=0

w
where mt - log (M2), yt - log (n o m in al G N P),
and 6'= log (opportunity cost). Note that the
unitary' coefficient on nominal GNP ensures that
equation (1) also specifies a relationship in which
long-Rin velocity varies only with opportunity7

■

c; Amt_
i= 1

q
fi

,+ X

n
X

g i j A x i t _ j + e,

i= 1 j =o

■

6 For a possible explanation of this discrepancy, see Poole (1988).

7 Although Hendry and Ericsson (1990) have found “stable” speci­
fications, these generally include many explanatory variables and hence
are not convincingly useful for predicting changes in the simple link be­
tween M1 and economic activity.

9 MPS include a time index as a regressor to estimate any drift in
M2 velocity directly. Although they find the coefficient to be significant,
the drift is negligible (around 0.03 percent per year).

■

■

8 Earlier advocates of this framework include Baba, Hendry, and

Starr (1988).


■ 10 MPS also specify a set of error-correction models for determin­
ing interest rates paid on the components of M2. They find that many
bank deposit rates adjust relatively slowly to changes in money market in­
terest rates. However, because their specifications are not very durable,
we w ill focus only on the demand for M2 given the opportunity cost, not
on how the opportunity cost is determined.

hmqqh

II. The MPS
Specification and
Thrift Restructuring

CP Specification
The CP specification and estimated coefficients are
A mt= -.053 - .0095,_ j - .138 ( mt_ , - y ,_ x)
(4.44)

(4.60)

(5.13)

+ ,245Aw/_ j - .007As, - .007As,_ j
(3.08)

(3.32)

(3.39)

+ .186Ac,+ .241A xt_ ! + .031REGDUM + e,
(2.87)

(3.30)

(7.38)

Adj. R 2 = .74; SEE = .0040; est. period = 1964:IQ to 1986:IVQ,
where .s' is a measure of opportunity cost, c is personal con­
sumption expenditures, x is thrift deposits (including other
checkables, money market deposit accounts [MMDAs], savings
deposits, small and large time deposits, and term repurchase
agreements [RPs]), and REGDUM is a qualitative variable that
equals zero in all quarters except 1983:IQ, when it equals one.a
Because thrift restructuring has been ongoing since 1988, and
because we seek to avoid high influence points given the sub­
stantial changes in the industry since that time, equation (4) is
estimated before the thrift crisis (1964:IQ to 1986:IVQ) and
simulated through 1990. All parameters are significant at the 5
percent level or better.
a. Following MPS, we present results that approximate log(s) using a firstorder Taylor series expansion w hen the opportunity cost is less than 0.5. W e
also estimate the model using the simple log o f opportunity cost. Although
the simple measure improves the in-sample fit, out-of-sample simulations are
less favorable. Nevertheless, the usefulness of the Taylog transformation
remains an open issue, though beyond the scope o f this study.

MPS estimate a version of equation (3) over the
1964:IQ to 1986:IIQ period. They find that their
specification is relatively stable, despite the advent
of both deregulation and, perhaps more signifi­
cantly, disinflation. Beginning in 1988, however, it
begins to overpredict M2 growth.
The implications of this overprediction for
velocity depend on what parameters of the M2
demand function may be changing. If any of
those in the long-run specification (equation [1])
have changed, then M2 velocity will likely
fluctuate around a new, higher equilibrium
level. If, on the other hand, the error-correction
process is misspecified, the divergence between
interest rates and velocity could be temporary.




Carlson and Parrott (1991), hereafter CP, pro­
pose a specification of equation (3) that includes
the change in thrift deposits as a determinant in
the error-correction equation (see box l) .11 They
argue that this change is a proxy for depositpricing effects that, though related to the thrift
restructuring, are not adequately captured in the
measure of opportunity cost. This implicitly as­
sumes that the effects of restructuring influence
the adjustment of M2 to its equilibrium level,
but do not affect the equilibrium level itself.
These effects may arise when failing thrifts
are liquidated and time deposit contracts are
abrogated. Because many of these deposits
were contracted at rates substantially higher
than those paid in recent years, holders of these
deposits realize a sharp drop in their returns
when contracts are nullified. Since the historical
series on time-deposit yields records only the
rate paid on new contracts, it understates this
recent decline. Thus, the measure of opportu­
nity cost is inadequate. For holders of abrogated
contracts, opportunity cost has increased; in
contrast, measured opportunity cost has fallen
in recent years.
The CP specification is estimated before 1988
to avoid high influence points given the collapse
in thrift deposits thereafter. (Out-of-sample sim­
ulations after 1988 account for most of the short­
fall evident in the MPS model. ) The results are
consistent both with the hypothesis that thrift
restructuring has played a major role in the recent
M2 weakness, and with the belief that this realign­
ment will not significantly alter long-mn velocity.
It is important to note that the CP specification
does not examine the potential for effects on the
equilibrium level of velocity. Unfortunately, the
data are not of sufficient duration to discriminate
convincingly between long- and short-run effects.
Nevertheless, the depository restructuring hypoth­
esis is consistent with previous anomalies in the
relationship between interest rates and velocity.
For example, M2 velocity appeared to be un­
usually low in the mid-1980s, given the level of
its opportunity cost (see figure 2). Soon after the
advent of deregulation, many analysts specu­
lated that M2 velocity would shift downward.12
It was believed that deregulation left the deposi­
tories in a better position to compete for funds to

■

11 For an alternative approach, see Duca (1991).

■

12 See Hallman, Porter, and Small (1989).

H
F I G U R E

3

MZM and M2E
Billions of dollars (ratio scale)

NOTE: M2E equals M2 plus institution-only MMMFs. MZM equals M2E minus small time deposits. Shaded areas represent recessions. Estimated
trough date for 1990-91 recession is 1991 :IIQ.
SOURCE: Board of Governors o f the Federal Reserve System.

expand their market share of credit; hence, many
argued that deposits included in M2 would in­
crease as a share of the nation’s portfolio. This in
aim implied that M2 velocity would fall.

III. Alternative
Measures of Money
Historically, when money demand specifica­
tions have broken down, analysts have found
that the problem is often reflective of the partic­
ular definition of money being used. Over time,
financial innovations occur, resulting in new in­
struments that have properties similar to more
than one asset. For example, money market
mutual funds (MMMFs), first offered in the early
1970s, have characteristics of both transactions
deposits and mutual funds. Moreover, when
regulations change, such as the elimination of
Regulation Q, the range of assets for which
deposits are substitutable can be substantially
affected. Hence, financial innovation and dereg­
ulation can blur the functional distinctions be­
tween the monetary aggregates.
Poole ( 1991) recently identified three func­
tional components of M2: 1) traditional trans­
actions balances (currency plus checkable
deposits) that are defined as M l, 2) savings bal­
ances that can be converted without notice into
transactions balances (such as MMMFs and state­
 ment savings accounts at banks), and 3) small
time deposits (defined as certificates of deposit


denominated in amounts of less than $100,000)
that can be converted into transactions balances
(without penalty) only upon maturity.
Although M2 has served well until recently,
Poole questions its longer-term durability as the
appropriate measure of money. He proposes
two alternative aggregates. The first, based on a
principle advanced by Friedman and Schwartz
(1970), views money as a “temporary abode of
purchasing power.” To satisfy this principle,
Poole advocates including all instruments avail­
able with zero maturity. Thus, he would broaden
M l to include all savings balances that can be
immediately converted into transactions balances
(hereafter called MZM).13
Poole also advocates expanding the M2 meas­
ure (M2E hereafter) to include MMMFs available
to institutions only. He notes that these instal­
ments allow institutions to earn interest on check­
able accounts in the face of the long-standing and
still-effective prohibition of interest payments on
demand deposits. The time series of the two meas­
ures are illustrated in figure 3Prior to 1980, MZM velocity seemed to be
trending up, although at a slower rate than that
of M l. Since 1983, however, MZM’s velocity has
appeared to be the more stable of the two series

■

13 Although Motley (1988) proposed a measure of zero-maturity

instruments, the logical antecedent to this measure is Friedman and
Schwartz's M2 aggregate, which consists of all commercial bank deposits
(demand plus time and savings).

FI GURE

4

M1 and MZM Velocity
Ratio

SOURCE: Board of Governors o f the Federal Reserve System.

FI GURE

5

M2E Velocity and Opportunity Cost
Ratio
1.80

1964

1969

1974

1979

1984

1989

SOURCE: Board of Governors o f the Federal Reserve System.

(see figure 4).14 Poole recognizes that the stabil­
ity of MZM velocity (manifest only since dereg­
ulation) does not provide a sufficient empirical
basis for choosing this aggregate over the
broader alternatives. Nevertheless, he prefers it
because, as a comprehensive measure of assets
that serve as a temporary abode of purchasing
power, MZM should be durably linked to spend­
ing. Moreover, he essentially argues that the
trend in MZM velocity prior to 1980 was largely
a consequence of Regulation Q, which distorted
the competition between time deposits and non­
regulated depository assets.
Without Regulation Q, banks have much less
incentive for developing regulatory avoidance
schemes, such as automatic transfer accounts, that
distort the relationship between measured transac­
tions deposits and spending.1’ Also, it seems rea­
■ 14 Because there is no empirical basis for assuming that MZM
velocity has been stable, we do not estimate a demand function below.


sonable to assume that without interest-rate
regulation, banks will treat small time deposits
much more like managed liabilities, enabling them
to compete more directly in capital markets. Thus,
the volume of small CDs will be more indicative of
changes in the competitive positions of depositories
than of monetary conditions.
It also seems less likely that nondepository
competitors w ill have the same incentives to in­
vest in financial innovations that seek to compete
directly with depository savings instruments. For
example, the explosive growth of MMMFs was
due in large part to the inability of depositories
to compete for funds on the same footing with
liquid instmments offering market rates of
return. In the absence of binding constraints, it
is unlikely that we will see the same burst of
financial innovation as occurred under Regula­
tion Q; hence, one might expect a more stable
link between zero-maturity instruments and
economic activity. Since it remains to be seen
whether the principle guiding the choice of
MZM will lead to an empirically more robust
measure of money, however, Poole recom­
mends that M2 and MZM be given equal weight
in policy deliberations.
The velocity of M2F appears to have charac­
teristics that suggest its relationship to the econ­
omy is less disrupted by regulatory change than
that of M2 (see figure 5). Indeed, M2E velocity
has been falling in recent years roughly com­
mensurate with the decline in opportunity cost.
This more consistent pattern suggests that over
the whole sample period, the demand for M2E
has been relatively more stable than the
demand for M2.
Nevertheless, before it returned to a more
consistent relationship with interest rates, M2E
velocity was still unusually low over most of the
1980s. As suggested above, this could reflect the
unsustainable attempt by depositories to in­
crease their market share once they were freed
from the regulatory constraints that limited the
types of loans they could make. Perhaps the
best example of this was in the thrift industry.
By the early 1980s, the rising cost of funds,
reflecting accelerating inflation, had left many
thrifts that were holding relatively low-yielding
mortgages insolvent. Kane (1989, p. 4) argues
that, with nothing to lose, these “zombie” institu­
tions attempted "to grow out of their problems by
undertaking long-shot lending and funding
activities” that essentially renewed and ex-

■

15 Although the existence of reserve requirements on transactions

deposits leaves some incentive intact, the effects of most potential avoidance schemes would probably be internalized in zero-maturity assets.

FI GURE

6

first step in resolving the insurance crisis, and to
close zombie thrifts. The weakness in deposit
growth since 1988 is to some extent an unw ind­
ing of the unsustainable depository share of
credit markets.

Nontransactions Deposits
Billions of dollars
3,000

IV. The Demand
for M2E

2,000

1,000

1986

1987

1988

1989

1990

1991

1992

SOURCE: Board o f Governors of the Federal Reserve System.

FI GURE

7

Simulated and Actual M2E:
Based on Equation (4)
Billions of dollars
4,000
Simulated^’
"

3,600

We estimate two variations of the velocity speci­
fication (equation [31) using the M2E measure.17
The first regression includes a temporary inter­
cept shift variable embodying the hypothesis
that the unsustainable expansion of depositories
affected equilibrium velocity in the 1980s. It pre­
sumes that the overextension of depository
intermediation was financed largely by time
deposits, which are closer substitutes for capital
market instalments than are money market se­
curities. This hypothesis would explain why a
large part of the ainoff of nontransactions de­
posits at thrifts did not find its way back to other
depositories, but was instead transferred to non­
depository investment vehicles (see figure 6).
The first specification does not include the
thrift-change variable proposed by CP. The esti­
mated coefficients are

^^^^Actual

(4)

3,200 -

A mt= -.076 - .012s(_ j - . 1
(5.13)

(5.25)

8

9

yt_ j)

(5.62)

2,800
+ ,421Aw/_ 1 - .008As,- ,005As/_ 1
2,400
1985

1 1 1 » -* 1 » 1 « 1 -i-l ■.l i i i 1 i i » 1 i i i_

1986

1987

1988

1989

1990

1991

SOURCE: Authors’ calculations.

panded the lost bets of the past. To finance this
expansion, thrifts offered a premium on depos­
its, leading to a sharp increase in the depository
component of M2E (and M2) relative to income,
thereby decreasing velocity.16 With the under­
standing that such instruments were federally
guaranteed, depositors were all too willing to
provide the funds. As the decade unfolded,
however, it became clear that this strategy was
not sustainable.
Beginning in 1989, Congress and the Bush
administration officially recognized the insolvency
of both a large portion of the savings and loan
industry and the thrift deposit insurance fund. In
August of that year, they allocated funds as the

■ 16 As CP note, such a premium is not adequately incorporated in
measured yields. Thus, measured M2E opportunity cost probably over­
 states true opportunity cost. This would explain why M2 velocity appears
to be low relative to its measured opportunity cost.
http://fraser.stlouisfed.org/

Federal Reserve Bank of St. Louis

(6.91)

(4.27)

(1.92)

1992
+ ,292Ac/+ .005DBUDUMt_1
(4.27)

(2.81)

+ .02AREGDUM + e,
( 5 -6 1 )

Adj. R 2 = .72; SEE = .0043; est. period = 1964:IQ
to 1989:IVQ,
where 5 is a measure of M2E opportunity cost, c
Ls personal consumption expenditures, DBUDUM
is the temporary intercept shift variable, and
REGDUM is a qualitative variable accounting

■ 17 Although Hoffman and Rasche (1989) find a stable long-run
relationship between real M 1, interest rates, and real income, they ques­
tion the existence of a stable short-run specification for M1 demand.
Hendry and Ericsson (1990) do find stable short-run specifications for
the narrow measure, but raise a number of issues that are beyond the
scope of this paper. We focus on the short-run demand for M2E, which
has the virtue of a trendless velocity over the past 30 years.

9

F I G U R E

where x denotes thrift institution deposits (includ­
ing other checkables, MMDAs, savings deposits,
small and large time deposits, and term RPs). The
coefficient on the thrift proxy is statistically signifi­
cant, but somewhat smaller than in the CP specifi­
cation. This suggests that depository restructuring
is an important and continuing factor, at least in
the short tun. Out-of-sample simulations of M2E
demand tend to underpredict M2E over most of
the past three years, but the bias has been small
(see figure 8). Thus, although not immune to the
structural change, the measure would seem to
warrant a closer look.

8

Simulated and Actual M2E:
Based on Equation (5)
Billions of dollars

V. Conclusion
SOURCE: Authors' calculations.

for the introduction of nationwide N OW
accounts. DBUDUM and REGDUM equal zero
in all periods except 1981 :IVQ- 1988:IIQ and
1983:IQ, respectively, when they equal one.
The estimated coefficient on DBUDUM is
positive and statistically significant. This is con­
sistent with the hypothesis that equilibrium ve­
locity was temporarily low in the 1980s. Though
the model has reasonably good in-sample prop­
erties, out-of-sample simulations indicate that it
overpredicts M2E growth in 1991 (see figure 7).
The 1991:HIQ drop in M2E (and the sharp rise
in its velocity) is greater than two standard
deviations of its predicted value based on insample experience.18
One explanation for the shortfall in M2 is
that the savings and loan restructuring peaked
in the summer months of 1991- Thus, the sec­
ond regression extends equation (4) to include
the change in thrift deposits as a regressor in the
error-correction specification:
(5)

Am, = -.079 - .O lls ,^ - ■
194(mt_ i -yt_ l)
(5.64)

(5.07)

(6.10)

+ ,271Am,_1 - .008As, - .OOôAs,^
(3.77)

(4.05)

(2.56)

+ .240Ac, + .004DBUDUM t_ l
(3.62)

(3.18)

Changes in the structure of the U.S. financial in­
dustry have justifiably brought into question the
reliability of M2 as a guide for monetary policy.
The aggregate’s appeal as an intermediate pol­
icy guide has been largely due to its relatively
stable and simple relationship with income and
interest rates. Over most of the past 30 years,
this stability was manifest in the behavior of M2
velocity, which, though influenced by interest
rates, ultimately reverted to a trendless mean.
Although M2 velocity, by itself, indicates noth­
ing unusual, its relationship with interest rates has
been disrupted in the last few years. This appears
to be related to a breakdown in M2 demand after
1988, which probably reflects to some extent the
restructuring of depositories.
We examine the velocities of two alternative
measures of money: MZM and M2E. O f these,
M2E holds the most promise, because its veloc­
ity appears to be least affected by the events of
recent years. Moreover, velocity specifications
of money demand seem to be more durable for
the M2E measure than for M2.
Nonetheless, we must stress the tentative nature
of any conclusions based on the analysis above.
Unfortunately, money demand theory has not ad­
vanced to a state in which empirical hypotheses
are sharply defined and testable. This perhaps re­
flects the tension arising from the idea that if
money demand is to be useful for policy, it should
have relatively few detenuinants.
O n the other hand, as Judd and Scadding
(1982) note, the fundamental source of the insta­
bility of money demand has been the excessive
growth in money. They argue that the failure of

+ .027REGDUM + •180A *,_•, + £,
(6.37)
(3.31)
Adj. R 2 = .75; SEE = .0041; est. period = 1964:IQ

http://fraser.stlouisfed.org/
to 1989:IVQ,
Federal Reserve Bank of St. Louis

■

18 We recognize that statistical tests comparing M2 and M2E may
not be very meaningful. However, from a monetary targeting point of view, it
is much more persuasive if one can demonstrate an empirical basis for
believing that the velocity of the targeted aggregate is relatively stationary.

monetary policy to restrain inflation led to the
high market interest rates that, in combination
with regulatory restraints, induced much of the
financial innovation disrupting the relationship
between M l and the economy. Similarly, one
might argue that rising inflation was the funda­
mental source of the unsustainable expansion
— and ultimate collapse — of the thrift industry.

References
Baba, Yoshihisa, David F. Hendry, and Ross M.
Starr. “U.S. Money Demand, 1960-1984,” Dis­
cussion Papers in Economics, No. 27, Nuffield
College, Oxford, England, January 1988.
Baumol, William J. "The Transactions Demand
for Cash: An Inventory Theoretic Approach,”
Quarterly Jo u rn a l o f Economics, vol. 66
(November 1952), pp. 545 - 56.
Carlson, John B. “The Stability of Money Demand,
Its Interest Sensitivity, and Some Implications
for Money as a Policy Guide,” Federal Reserve
Bank of Cleveland, Economic Revieu', vol. 25,
no. 3 (1989 Quarter 3), pp. 2 -13_______ , and Sharon E. Parrott. “The Demand
for M2, Opportunity Cost, and Financial
Change,” Federal Reserve Bank of Cleveland,
Economic Review, vol. 27, no. 2 (1991 Quar­
ter 2), pp. 2-11.
Carlstrom, Charles T., and Edward N. Gamber.
“Does the Fed Cause Christmas?” Federal
Reserve Bank of Cleveland, Economic Com­
mentary, January 1, 1990.
Duca, John V. “The Case of the ‘Missing M2’,”
Federal Reserve Bank of Dallas, mimeo,
December 1991.
Friedman, Milton. “The Quantity Theory of
Money — A Restatement,” in Milton Friedman,
ed., Studies in the Quantity Theory’ o f Money.
Chicago: University of Chicago Press, 1956,
pp. 3-21.
______ , and Anna Schwartz. Monetary Statistics
o f the United States: Estimates, Sources,
Methods. New York: National Bureau of
Economic Research, 1970.




Hallman, Jeffrey J., Richard D. Porter, and David
H. Small. “M2 per Unit of Potential GNP as an
Anchor for the Price Level,” Board of Gover­
nors of the Federal Reserve System, Staff
Studies 157, April 1989Hendry, David F., and Neil R. Ericsson. “Model­
ing the Demand for Narrow Money in the
United Kingdom and the United States,”
Board of Governors of the Federal Reserve
System, International Finance Discussion
Papers No. 383, July 1990.
Hoffman, Dennis, and Robert H. Rasche. “LongRun Income and Interest Elasticities of Money
Demand in the United States,” National Bureau
of Economic Research, Working Paper No.
2949, April 1989.
Judd, John P., and John L. Scadding. “The Search
for a Stable Money Demand Function: A Sur­
vey of the Post-1973 Literature,”Journal o f
Economic Literature, vol. 20, no. 3 (Septem­
ber 1982), pp. 993-1023.
Kane, Edward J. The S&L Insurance Mess: How
D id It Happen? Washington, D.C.: The
Urban Institute, 1989.
Moore, George R., Richard D. Porter, and David H.
Small. “Modeling the Disaggregated Demands
for M2 and Ml: The U.S. Experience in the
1980s,” in Peter Hooper et al., eds., Financial
Sectors in Open Economies: Empirical Analysis
an d Policy Issues. Washington, D.C.: Board of
Governors of the Federal Reserve System, 1990,
pp. 21-105.
Motley, Brian. “Should M2 Be Redefined?” Federal
Reserve Bank of San Francisco, Economic Re­
view, Winter 1988, pp. 33 - 51.
Poole, William. “Monetary Policy Lessons of
Recent Inflation and Disinflation,” Jo u rn a l o f
Economic Perspectives, vol. 2 (Summer
1988), pp. 73-100.
______ . Statement before the Subcommittee on
Domestic Monetary Policy of the Committee
on Banking, Finance, and Urban Affairs, U.S.
House of Representatives, November 6, 1991.
Tobin, James. “The Interest-Elasticity of Transac­
tions Demand for Cash,” Review o f Economics
a n d Statistics, vol. 38, no. 3 (August 1956),
pp. 241-47.

Commodity Prices and P-Star
by Jeffrey J. Hallman and Edward J. Bryden

Introduction
A recent article by Hallman, Porter, and Small
(1991), henceforth referred to as HPS, presented
the P-Star (P*) indicator of future inflation. The
HPS models exploit the stability of two long-run
relationships: that between M2 and nominal out­
put, and that between actual and potential real
output. Despite paying no attention to other
possible influences on inflation, such as com­
modity prices or interest rates, the HPS models
produced better forecasts of the GNP implicit
price deflator over the 1970s and 1980s than did
a number of alternatives, including both univar­
iate ARIMA models and the published forecasts
of several econometric consulting firms.
Most economists believe the quantity theory
relationship that underlies the P* model holds
only in the long mn, if at all. In the short run,
standard economic theory predicts that any fac­
tors affecting aggregate supply or aggregate
demand may also affect the price level. Com­
modity prices may give early indications of shifts
in either supply or demand; if so, augmenting the
P* models to include information about the recent
behavior of commodity prices may be expected

to improve both fit and forecasting perfomiance,


Jeffrey J. Hallman Is an
economist and Edward J. Bryden
is a research assistant at the
Federal Reserve Bank of
Cleveland.

particularly over short horizons. This paper
shows that these results can indeed occur.
After briefly reviewing the P* idea, we show
how the P* approach can be extended to incor­
porate commodity price data. Two notable
results are obtained: First, the resulting models
outperform the HPS models in fit and forecast­
ing ability, although the improvement is not
large. Second, the relative significance of the P*
and commodity price terms depends on the
sampling frequency of the data. The two terms
are equally significant in explaining inflation at
quarterly and annual frequencies, but inflation
in the biennial version of the model depends
exclusively on the monetary (P*) term. This ac­
cords well with the orthodox view that, while
commodity market developments may signifi­
cantly influence inflation in the short run, in the
long run only money matters.

I. The P* Model
The HPS work was motivated by the observa­
tion that, rather than trending up or dow n over
the past 35 years, V (the velocity of M2, defined
as GNP divided by M2) has simply fluctuated
around its average value of 1.65 (V*). During

Ej
FI GURE

1

M2 Velocity, Real GNP,
and Potential Output
Ratio

the same period, real GNP (Q ) has usually been
within 5 or 6 percent of potential output (Q*).
Both of these regularities can be seen in figure 1.
Using lower-case letters to denote natural loga­
rithms, HPS found that they could not reject the
hypothesis that the velocity gap (v- v *) and
output gap (q * - q) are covariance stationary.1
A stationary series has a mean to which it tends
to return infinitely often. More important, as the
forecasting horizon lengthens, the optimal fore­
cast of a stationary series tends to approach the
series mean.2
The relation between real output, the price
level as measured by the implicit price deflator
(P), money, and velocity is given by the quan­
tity equation:

Billions of dollars
(1)

SOURCE: Board o f Governors o f the Federal Reserve System.

F I G U R E

2

p + q - m2 + v.

As the velocity and output gaps are stationary,
so too is the price gap (p - p *), where P* is
defined as M2* X V* / Q*. The reason is that the
price gap is simply the sum of the velocity and
output gaps. Since V* is constant, the economic
interpretation of stationarity of the price gap is
that, given M2 and potential output, the price
level that can be supported in the long a m is P*.
Historically, inflation has usually accelerated
when P* has exceeded P, and slowed when the
reverse was true. Letting rc denote the rate of
change of the implicit price deflator, HPS used a
quarterly model of the form

Long-Run Aggregate
Supply and Demand

4

(2 )

A n t= a ( p [_ 1- p * _ l) + Y J P /A tc,_ y
7=1

Price level

to exploit this regularity in forecasting inflation.
The lagged Arc terms in equation (2) reflect the
fact that quarterly changes in the inflation rate
are often partly reversed in subsequent quarters,
perhaps due to measurement error. Lagged Arc
terms are unnecessary when the model is esti­
mated using annual data. The model then be­
comes
(3)

Ant = a ( p l_ 1-p*_1),

where the subscript t is now an annual index
(measured in every fourth quarter) rather than a
quarterly index as in equation (2). Estimates of
the models in equations (2) and (3), and a bien­
nial version (one observation from the fourth
Output
SOURCE: Authors’ calculations.




■ 1 A series yt is covariance stationary if, for all k and j, E{yl+ k ) =
m, and cov( yw ,y ,) = c o v (y t+ k , jt y t+ k ) .

■

2 Optimal here means the forecast that minimizes the expected
variance of the forecast error.

13

TABLE

1

Estimates of the Models
Coefficients

«1

a2

Annual'1
Biennial0

ß4

R2

Standard
Error

Durbin Watson

-.12
(-1.3)

.32

1.56

1.96

.38

1.19

2.36

.70

.97

1.50

.36

1.51

1.97

.56

1.00

2.34

.84

.77

2.25

Price Gap Models
-.64
(-7.4)

-.145
(-4.2)
-.214
(-4.2)

-.47
(-4.7)

-.27
(-2.7)

-.31
(-5.6)

Price Gap Models with Commodity Price Inflation

Frequency
Quarterlya

-.107
(-3.0)

Annualb

-.171
(-3.5)
-.37
(-7.4)

Biennial0

ß3

Pi

Frequency
Quarterly3

Regression Statistics

-.039
(-2.9)
-.061
(-3.5)
-.015
(-1.8)

-.70
(-8.1)
-.30

-.55
(-5.5)

-.34
(-3.5)

-.15
(-1.8)

(-2.3)

a. Estimated from 1960:IIQ to 1990:IIQ; 121 observations.
b. Estimated from 1961 to 1990; 30 observations.
c. Estimated from 1962 to 1990; 15 observations.
NOTE: T-statistics are indicated in parentheses.
SOURCE: Authors’ calculations.

quarter of every other year) of equation (3) are
given in table 1.
The economic intuition underlying the P*
model can be illustrated using the long-run ag­
gregate supply and long-run aggregate demand
diagram in figure 2. Stationarity of the velocity
and output gaps indicates the shape of the curves.
The stationarity of velocity means that V is con­
stant at V* along the long-run aggregate demand
curve. But because money is also held fixed along
the curve, long-mn aggregate demand is repre­
sented as the hyperbola fonned by the locus of
points where P X Q = M X V*. The stationarity of
the output gap means that the long-mn aggregate
supply curve is vertical at Q*.
Changes in the money stock shift the longm n aggregate demand curve by proportionate
amounts. A 4.5 percent increase in M2, for ex­
ample, shifts the demand curve up (or equiva­
lently, to the right) by 4.5 percent. That is, the
shifted curve is the locus of (P, Q) pairs whose
product is now 4.5 percent greater than before
the shift. Changes in potential output are drawn
as shifts in aggregate supply to the left or right.
A
 2.5 percent increase in Q* shifts the vertical


line 2.5 percent to the right. In the example
shown, the result of both shifts taken together is
a 2 percent rise in prices accompanied by a 2.5
percent increase in real output.
Although the above analysis shows how
money and potential output determine prices in

the long run, it may have less application in the
short run. The velocity and output gaps are sta­
tionary, but they are not identically zero at all
times. Short-mn aggregate demand may not be a
hyperbola, and short-mn aggregate supply may
not be vertical. Furthermore, in constructing a
measure of potential output, it is customary to
restrict it to grow smoothly over time. The best
that can be hoped for such a measure is that it will
correctly capture the trend in potential output.
This catalog of short-run omissions and in­
adequacies is reason to hope that the P* model
can be enhanced. The inclusion of variables
that reflect information about the location or
movements of the short-run aggregate supply
and demand curves may improve the model’s
performance. One such candidate for inclusion
is a measure of commodity prices.

FI GURE

3

Implicit Price Deflator, P*,
and the Commodity Price Index
Index

SOURCES: Board of Governors o f the Federal Reserve System, and the
Commodity Research Bureau.

FI GURE

4

Inflation Rates for the Implicit
Price Deflator and the
Commodity Price Index

SOURCES: Board o f Governors o f the Federal Reserve System, and the
Commodity Research Bureau.




II. Commodity
Prices and the
Deflator
Figure 3 plots the logarithms of P, P*, and the
Commodity Research Bureau’s (CRB) spot
market price index for 22 commodities, labeled
p c in the figure. While both p and p c have in­
creased over the years, a simple long-run rela­
tionship between their levels is not apparent.
Rather, there has been a decline in (pc - p), the
log of real commodities prices.
There is no reason to expect a simple relation­
ship to hold between the levels of a commodity
price index and the implicit price deflator. The
deflator is meant to measure the price of all of the
economy’s outputs, while most of the 22 CRB
commodities are primarily used as inputs to vari­
ous production processes. Even if firms price on a
pure markup basis, output prices can diverge from
commodity prices if the relative prices of other,
noncommodity inputs change. One can easily
imagine that continuing technological progress in
agriculture, for example, will result in a downward
trend in the price of wheat relative to the price of
labor. Trends in the real prices of commodities are
simply trends in the prices of commodities relative
to the prices of other goods, so we should not be
surprised to find them in the data.
While it is easy to see how a trend in (p c- p)
might arise from such forces as technological
progress, it is much harder to imagine a scenario
in which the inflation rates n and nc would trend
apart indefinitely. Not only would this imply a
trend in the real price of commodities, but it
would require a trend in the trend, resulting in
explosive real commodity prices. That kind of
relative behavior is not evident in the data, so
there is an implied long-run relationship be­
tween the inflation rates of prices in general and
commodity prices.
The top panel of figure 4 plots quarterly infla­
tion rates for the GNP deflator and the com­
modity price index. The commodity inflation
index is divided by three to put it on the same
scale in the plot. The relationship between the
two indices is clearer in the lower panel, where
inflation rates are calculated over four quarters,
resulting in a smoother plot. Notice that in keep­
ing with the downward trend in real commodity
prices evident in figure 3, the arithmetic mean
of the commodity inflation index is lower than
the arithmetic mean of GNP inflation. Finally,
figure 5 shows that both (p - p *) and
(the
change in / / over four quarters) foreshadow
subsequent changes in the inflation rate.

FI GURE

5

III. P* with
Commodity Prices

Inflation Predictions by
the Price Gap and by
Commodity Price Changes

The figures argue for a specification of the
dynamic relationship between p and p c that
preserves a long-run relationship in which the
commodity inflation rate is less than GNP de­
flator inflation. Just as the term (pt_ x—p*_ j) in
equations (2) and (3) enforces a long-run rela­
tionship between p and p*, the introduction of a
term
rn) with a negative coeffi­
cient will enforce a similar relationship between
the inflation rates for P and Pc. Here, m denotes
the mean difference of the two inflation rates, so
that the real commodity inflation rate (tu4 - n4 )
enters as a deviation about its mean. The result­
ing equation for the quarterly model is

Percent change

(4)

A n l= a l(pt_ x- p * _ l)
+ a 2(7iu _ 1 -71

- rn)

4

+ X

P /A ic ,_ y ,

7=1

SOURCES: Board of Governors o f the Federal Reserve System, and the
Commodity Research Bureau.

and the implied equilibrium has both p = p* and
a trend of -rn in the real price of commodities.
The annual and biennial versions of this model
take the form
(5)

A n t= a 1(pt_ ]- p * _ 1)
+ a 2(A4p t_ l- A 4p ct_ l- rn)
+ p, An,_v

T A B L E

2

Significance of the
Error-Correction Terms
T-statistics
Frequency

(P ~P*)

(n - if )

Quarterly

-3.0

-2.9

Annual

-3.5

-3.5

Biennial

-7.4

-1.8

SOURCE: Authors’ calculations.




The biennial version does not require the lagged
An term. Estimates for all three versions may be
found in table 1.
In all of the estimated models, both a coeffi­
cients are significantly less than zero, and the
equations using the price gap model with com­
modity price inflation fit better than those that
do not use the commodity price term.
Table 2 shows an interesting comparison of the
error-correction t-statistics taken from table 1. The
quarterly model predicts inflation over the coming
quarter, the annual model over the coming year,
and the biennial model over two years. At the low­
est frequency, the explanatory power of the com­
modity inflation term is minor; nearly all of the
explanatory power of the model comes from the
price gap tenn. This result confirms that w hile
supply shocks reflected in ( n - if ) affect inflation
in the short run, over longer horizons money
(reflected in [p - p*}) is more important. If both
velocity and real output eventually return to their
long-mn values, supply shocks not accommodated

Ea
TABLE

3

Year-yithead Forecasting Performance
Quarterly ( p -P*)
Actual

Predicted

Error

1970

5.17

1971
1972

6.09
4.42

5.41
4.94

1973
1974

8.25
9.96

1975
1976

1985
1986
1987
1988

8.35
5.74
6.82
7.98
8.87
9.88
8.76
5.06
3.64
3.42
2.94
2.58
2.96
4.14

1989
1990

3.73
3.98

Year

1977
1978
1979
1980
1981
1982
1983
1984

1991
Mean forecast error
Mean absolute forecast error
Root mean squared forecast error

6.39
5.42
8.88
9.69
7.97

Error

Predicted

Error

-0.24

5.52
4.99
6.38

-0.35
1.10
-1.96

7.14

1.15
-1.97
2.82

-1.97
0.70
-2.08

5.05
8.94

3.19
1.02

9.25
7.75
6.08
7.47
7.95
7.90
8.17

-0.91
-2.01

1.09
-1.34

7.49
8.49
6.92
3.70
3.29
3-31
3.44

0.13
-0.38
-0.86

3.79
3.46

-0.83
0.68
- 0.66
0.25

4.39
3.74

Annual (p - P *)
and (7t - 7 t C)

Predicted

-2.23
0.09
0.69
1.05
2.39
0.27
-1.85
-0.06

6.73
7.30
7.82

Annual ( p -P*)

3.03

6.73
3.02
2.94
3.12
3.26
3.75
3.76
4.59
3.80
3.80

0.01
1.001
1.28

0.75
0.51
0.92
1.98
0.59
-1.67
0.62
0.48
-0.18
-0.68
-0.80
0.37
-0.86
0.19

0.11
1.006
1.24

5.39
6.49
7.45
8.10
9.14
7.81
7.52
6.98
8.57
8.10
8.00
6.27
4.28
5.13
3.11
2.60
3.69
4.44
4.68
3.57
3.57

0.79
-1.86
-0.80
-2.07
-0.70
1.00
0.30
1.78
0.76
-1.20
-0.64
-1.71
-0.17
-0.02
-0.74
-0.30
-0.96
0.41

-0.27
0.999
1.15

NOTE: Entries represent the annual growth rate o f the GNP implicit price deflator over fourth-quarter to fourth-quarter periods ending in the
indicated year.
SOURCE: Authors’ calculations.

by the monetary authority will have no long-run
effect on the overall price level. In the short run,
they can influence the rate at which P converges
to P*, but the fit of the biennial equation indi­
cates that the effect dissipates within two years.
Table 3 compares the out-of-sample forecast­
ing performance of some of these models. The
first three columns showr the performance of the
model in equation (1), while the remaining
columns are for the annual models in equations
(3) and (5). The forecasts reported in the table are
not truly out of sample for two reasons. First, the
estimates of v* and q* used in constructing the p*
series are actually based on the full sample of ob­
servations. However, all of the models use this p*
series, so none of them has an unfair advantage.
This
“cheating” would be important if we were

http://fraser.stlouisfed.org/
comparing the perfonnance of P* models with
Federal Reserve Bank of St. Louis

other models, as was done in HPS.3 Second, the
year-ahead forecasts made from the quarterly
model cheat in the sense that we assume the values
taken by p* over the intervening three quarters
were known. This is not true of the year-ahead fore­
casts for the annual models making up the rest of
the table, since all of their right-hand-side variables
are lagged at least once.
The root mean squared forecast error for the
annual price gap model (equation [3]) is slightly
smaller than for the quarterly version, showing
that the short-run dynamics modeled by the
lagged Attterms in the quarterly model are not

■

3 In their paper, HPS did try estimates of q* and v* based only on
information that would have been available to a forecaster operating in
real time and found that it made little difference to the forecasting per­
formance of their models.

WÈÈÊÊÊÈM T A B L E 4

f§

Encompassing Tests
Independent
Variable
(right-hand side)

Dependent
Variable
(left-hand side)

e (i —eP*

e ci
eP'
eq

e ci —e CP

e cP

e?
e cP

e p* —e cp

T-statistic

_

1.08
0.01
2.23
1.18
2.24
1.63

For 1991, the quarterly and annual price gap
models predict inflation rates of 3-1 and 3.8 per­
cent, respectively. Augmenting the annual model
with the commodity price tenn yields a somewhat
lower prediction of 3.6 percent. The low predic­
tion of the quarterly model reflects the unusually
slow money growth in the first three quarters of
this year. If we assume that P, P*, and Pc all grew
at a 2 percent annual rate for the fourth quarter of
1991, the inflation rate for all of 1991 would be 3.2
percent. Both annual models (equations 131 and [51)
would then forecast 1992 inflation at 2.1 percent.

SOURCE: Authors’ calculations.

IV. Conclusion
important for forecasting a year ahead. The
results for the annual models (equations [3] and
[51) show that adding the commodity price tenn
yields smaller forecast errors. Another way to
compare competing forecasts is to ask whether
the forecast error from a given model can be ex­
plained (encompassed) by the forecast of
another model, as elucidated in Chong and
Hendiy (1986). To make this comparison, let e '
and e 2 represent the forecast errors made by
models 1 and 2. Then examine the t-statistics for
the coefficients a 1and or in the regressions
e) = v}(e ) - ef),

e f = a 2( e f - e j) .

If a 1is significantly different from zero, model
2 encompasses model 1, as it contains useful in­
formation (for forecasting purposes) that is not
in model 1. If a 1is significant but a 2 is not, the
encompassing is one-way; that is, model 1 is en­
compassed (by model 2) but is not encompassing.
Mcxlel 2 is then clearly better on statistical grounds.
The statistics in table 4 show that the annual model
(equation [5]) with commodity prices holds just
such a relationship with the quarterly and annual
price gap models, while neither of the latter en­
compasses the other.
Although the comparisons in tables 3 and 4
show that commodity price information can im­
prove the forecasting performance of the price
gap model, the t-statistic comparison in table 2
indicates that the improvement will be less at
longer horizons. Commodity prices themselves
are notoriously difficult to forecast (as implied by
efficient markets theory), so it is probably im­
practical to make multistep forecasts from mod­
els like equations (4) and (5) to predict at
longer horizons.



The P* approach to forecasting inflation exploits
the long-ain tendencies of output to return to
potential and velocity to return to its mean.
However, other factors may also influence the
inflation rate over shorter horizons. Incorporat­
ing such influences into the HPS model can be
accomplished simply by including additional
terms that measure the lagged discrepancy be­
tween the actual inflation rate and the rate that
would be predicted based on the relationship
between inflation and the new factor.
The commodity inflation data used here are
only one of many possible augmentations. Infla­
tion as measured by a wholesale price index, for
example, would be one reasonable addition;
another might be an expectations measure de­
rived from the yield curve. So long as these addi­
tional factors are related to the inflation rate, rather
than to the price level, the latter will continue to
be determined only by money and potential out­
put. If potential output is taken to be exogenous,
then ultimately, only money matters.

References
Chong, Yock Y., and David F. Hendry. “Econo­
metric Evaluation of Linear Macro-Economic
Models,” Review o f Economic Studies, vol.
53, no. 4 (August 1986), pp. 671-90.
Hallman, Jeffrey J., Richard D. Porter, and David
H. Small. “Is the Price Level Tied to the M2
Monetary Aggregate in the Long Run?” Ameri­
can Economic Review, vol. 81, no. 4 (Septem­
ber 1991), pp. 841-58.

The Causes and Consequences
of Structural Changes in U.S.
Labor Markets: A Review
by Randall W. Eberts and Erica L. Groshen

Introduction
Despite apparently tight labor markets, wage infla­
tion in the late 1980s was much lower than most
observers anticipated. The W all StreetJournal
quoted one noted economist as saying, “The most
interesting phenomenon in the United States to­
day is the existence of enormous labor shortages
in some areas accompanied by no upward pres­
sure on wages.”1The article went on to state that
the reasons for this phenomenon challenge the
assumptions about the relationship between wage
changes and general price changes that we formed
during the 1960s and 1970s.
Several explanations were offered at that time
for the slow nominal wage growth seen during
the second half of the decade. Chief among the
factors cited by labor-market analysts and the
media was a reversal in labor-management psy­
chology about wage increases, brought on in
part by slow productivity growth, a severe eco­
nomic downturn, and increased foreign compe­
tition. The common perception was that during
the 1970s, workers, with the consent of manage­
ment, felt entitled to automatic wage increases
that were at least in line with inflation. The

http://fraser.stlouisfed.org/
■ 1 See Uchitelle (1987).
Federal Reserve Bank of St. Louis

Randan w. Eberts is an assistant
vice president and economist and
Erica L. Groshen is an economist at
the Federal Reserve Bank of Cleve­
land. The authors would like to
thank William Osterberg and James
Thomson for helpful suggestions.

demand for “3 percent plus cost of living” was a
common refrain around many negotiating tables.
This mind-set evaporated as workers suffered
massive job losses during the twin recessions of
the early 1980s, and as managers faced mounting
foreign competition that eroded U.S. firms’ market
share and placed downward pressure on domes­
tic prices. Instead of focusing on wage increases,
negotiations became centered on wage conces­
sions in exchange for job security.
In addition to a change in the psychology of
wage-setting behavior, institutional changes
were also cited as possible causes of sluggish
wage growth. Mitchell (1989), in comparing the
wage pressures of the 1980s with those of the
1960s, concludes that recent changes in labormarket institutions have pushed wage-setting in
a more competitive direction. With the declines
in the proportion of workers in the union sector
and in big firms, jobs are less likely to be
cushioned from labor-market forces by union
contracts and bureaucratic personnel practices.
Changes in demographics, particularly the
greater participation of women in the labor
force, were also said to figure into the moderate
wage growth witnessed during the 1980s. To
the extent that women are less attached to the
labor force than are men, they may provide a

19

TABLE

1

Economic Conditions
in Previous Decades
1960s
Expansion
Quarters3

Condition
Average annual percentage change in
Average hourly earnings,
private business sector
Compensation per hour index
Consumer Price Index
Output per hour, private
business sector
Real GNP, 1982 dollars
Average level of:
Unemployment rate
Unemployment rate, male,
age 25 and up
Capacity utilization

1970s
Recession
Quarters15

____________ 1980s__________

Expansion
Quarters

Recession
Quarters0

Expansion
Quarters

6.93

7.38

7.66

3.39

6.36

9.01
8.45
-0.38

8.35
6.94
1.82

9.10
10.04
0.18

4.26

3.41
2.41
4.21

0.18

3.47

-0.25

3.65

4.06

5.37
2.99

6.42
3.78

8.17
5.81

7.02

2.31
87.80

80.99

80.78

75.93

79.99

5.21

3.68
1.70

5.39

a. 19 6 l:IQ to 1969:IVQ.
h. 1970:IQ to 1970:IVQ and 1973:IVQ to 1975:IQ.
c. 1980:IQ to 1980:IIQ and 1981:IIQ to 1982:IVQ.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis; U.S. Department o f Labor, Bureau of Labor Statistics; and Board of
Governors of the Federal Reserve System.

buffer by filling vacancies during tight labor
markets and by leaving the labor force during
slack periods.
The questions facing policymakers and
analysts during this period were twofold: What
was really behind the apparent change in wage
behavior, and was the shift permanent or tempo­
rary? In October 1989, the Federal Reserve Bank
of Cleveland sponsored a conference on the
causes and consequences of structural changes
in U.S. labor markets. Several prominent labor
economists were asked to provide a careful and
comprehensive analysis of some of the important
developments that took place during the 1980s.
The research focuses on a range of labor-market
behaviors and industrial relations practices that
could explain the macroeconomic relationship
between unemployment and wages, and also on
the effects of this relationship on output and
employment stability. Four of the six papers deal
with alternative compensation practices (fringe
benefits and lump-sum and profit-sharing pay­
ments) and the structure of union contracts. The
remaining studies examine how changing laborforce demographics and increased pressure from
international competition have affected wages.



I. Comparisons
across the Last
Three Decades
Was wage behavior different during the 1980s
than in the preceding two decades? This brief sec­
tion argues that this may indeed have been the
case. Many analysts have noted that nominal wage
growth during the expansions of the 1980s fell far
short of that experienced during the upturns of
the 1970s and even of the 1960s (table 1). And the
same relatively low growth rates are also evident
for the broader measure of compensation per
hour, which includes fringe benefits, a growing
component of employee compensation.
This sluggish response alone might tempt
one to conclude that fundamental changes in
the structure of wage determination and worker
compensation during the 1980s dampened the
upward pressure on wages. However, leaping
to that conclusion ignores differences in eco­
nomic conditions across the past three decades.
Although observers in the 1980s generally per­
ceived labor markets to be extremely tight (par­
ticularly during 1988 and early 1989), typical
measures of labor-market tightness do not sup­
port this view. In fact, the minimum unemploy­
ment rate during the expansions of the 1980s

TABLE

2

Explaining Annual Percentage
Changes in Nominal Average
Hourly Earnings
1960s

1970s

1980s

0.465
(0.63)

6.022
(7.43)

0.473
(2.11)

Consumer Price Indexa

0.887
(2.07)

0.082
(1.18)

0.325
(5.70)

Unemployment rateb

-0.018
(-1.74)

0.027
(1.84)

Capacity utilization rateb

0.045
(0.63)

0.150
(2.66)

0.051
(6.09)
0.142

Labor productivity11

0.286
(2.07)

-0.221
(-2.70)

GNP implicit price deflator*1

0.271
(0.77)

0.138
(1.12)

(0.03)
0.498
(5.60)

-0.387
(-1.10)

-0.674
(-1.80)

-0.138
(-0.43)

0.89

0.52

0.99

Intercept

Recession0
R2

(6.19)
0.002

a. Year-over-year change, lagged one quarter.
b. Year-over-year change.
c. Variable equals one for quarters marked by recession.
NOTE: Observations are quarterly, and percentage changes are year over year.
Separate regressions were run for each decade. T-statistics are in parentheses.
SOURCE: Authors’ calculations.

(5.2 percent) was higher than that of the up ­
turns of the previous two decades (3.4 percent
during the 1960s and 4.8 percent during the
1970s). Moreover, the maximum rate of capacity
utilization was lower in the 1980s expansions
(84.4 percent) than during those of the 1960s
and 1970s (91-6 percent and 87.3 percent, respec­
tively). Thus, it is not clear whether the slow
wage growth of the 1980s stemmed from struc­
tural changes in wage-setting practices or simply
from differences in business conditions.
One way to partially disentangle these effects
is to ask the conceptual question, What would
have happened to wages if the expansions of all
three decades had shared the same economic
conditions and differed only in the relationship
between wages and changes in the economic en­
vironment? We use a simple econometric tech­
nique to estimate the wage behavior separately
for each of the last three decades. These estimates,
which summarize the link between wages and
economic conditions in each decade, are then
used to simulate the net nominal wage change



that would have taken place if wages had re­
sponded to similar conditions.
We follow a variant of the wage-change
model used recently by Wachter and Carter
(1989) and earlier by Gordon (1982).2 Annual
changes in average hourly nominal earnings are
explained econometrically by annual changes in
the unemployment rate, capacity utilization, labor
productivity (measured by output per hour), the
GNP implicit price deflator, and the Consumer
Price Index (CPI, all items for urban workers).
Other specifications of the wage-change model
are possible, and many have been posited. Our
simple five-variable specification is based on
the premise that wages reflect both pressures in
the labor market and inflation expectations. We
use the CPI to measure expected price inflation.
Changes in the unemployment and capacity
utilization rates are assumed to proxy for shifts
in the tightness of labor and product markets.
Labor productivity changes measure workers’
contribution to production and, consequently,
employers’ ability to grant higher wages. And
finally, the GNP implicit price deflator captures
shifts in producer prices, which also reflect
employers’ ability to pay higher wages.
We estimate these relationships separately for
each decade using quarterly observations. We
also include a variable that takes the value of one
during quarters marked by national recessions to
account for business-cycle effects.
Because our main purpose is to demonstrate
wage behavior under similar economic condi­
tions, we do not dwell on the estimates of in­
dividual coefficients. Nevertheless, we note that
most of the variables in table 2 appear to have
the expected effect on nominal wage changes:
Higher nominal wage increases are generally
associated with stepped-up inflation expecta­
tions, increased capacity utilization, labor pro­
ductivity gains, and higher producer prices.
Although the positive relationship between
changes in nominal wages and unemployment
rates in the 1970s and 1980s is perhaps surpris­
ing, it is consistent both with periods of stagfla­
tion during the earlier decade and with the
long, gradual recovery of the 1980s, when wage
and price increases moderated and unemploy­
ment fell.
The net effects of these differences in the
relationship between nominal wage changes
and changes in economic conditions are shown

■ 2 We present this specification simply as an illustration of the changes
sensed by analysts and practitioners during the 1980s. Individual coefficient
estimates from this exercise should be interpreted cautiously because of the
short time periods involved.

21

T A B L E

II. Why the Slow
Wage Growth in
the 1980s?

3

Simulations of Annual
Nominal Hourly
Earnings Changes

Explanatory variables
(economic conditions)

Structure (relationship between
conditions and wages)
--------------------------1960s
1970s
1980s

1960s

5.41

6.17

3.65

1970s

9.52

7.51

6.97

1980s

6.43

6.65

4.24

NOTE: The values are the average annual percentage changes in nom inal
hourly earnings during the decade. Simulations were performed by multiply­
ing the explanatory variables for a given decade by the coefficients for the
appropriate decade. The values on the diagonal (that is, for the same decade)
are identical to the actual annual wage changes.
SOURCE: Authors’ calculations using estimates from table 2.

in table 3. The bottom row is of primary interest.
The first entry in that row is the average annual
nominal wage change that would have taken
place in the 1980s if labor had had the same
relationship to economic conditions then as in
the 1960s. In this hypothetical case, wages would
have increased an average of 6.43 percent
annually in the 1980s. Subjecting the wage be­
havior that prevailed during the 1970s expan­
sions to 1980s economic conditions yields a
slightly higher annual growth rate of 6.65 per­
cent. Both of these figures substantially exceed
the 4.24 percent average annual increase that
actually took place during the 1980s.
It is also interesting to note that if wages had
had the same relationship to economic conditions
during the 1960s as they did in the 1980s, wage
growth would have been considerably lower in
the earlier decade than it actually was (3.65 per­
cent versus 5.41 percent). The same holds true for
the 1970s. The actual annual wage increase was
7.51 percent, compared with 6.97 percent when
the 1980 wage structure is used.
This simple analysis suggests that something
dampened the relationship between wages and
economic conditions during the 1980s, such as
changes in unemployment rates and in price
levels. The papers summarized below explore the
various shifts that have taken place and consider
their implications for both wage behavior and the
performance of the U.S. economy.




The explanations explored at this conference for
the slow wage growth of the 1980s can be
grouped around three phenomena: increased
international competition, changes in wage-setting
practices, and demographic shifts.

Increased
International
Competition
The first category considers increased competition
within product markets, particularly that resulting
from greater penetration of foreign imports into
U.S. domestic markets. Under this scenario, pres­
sures to keep prices in line with those of foreign
competitors would moderate wage increases.
Susan Vroman and Wayne Vroman address this
issue in “International Trade and Money Wage
Growth in the 1980s.” Their focus on international
trade as a significant contributor to sluggish wage
growth is well supported by the events of the
1980s. The U.S. economy has become increasingly
open to foreign trade with respect to both imports
and exports. As imports further penetrate our
product markets, one would also expect labor
markets to become more competitive, constraining
domestic nominal wage growth.
The authors present two sets of estimates to
test this hypothesis. The first is based on a timeseries analysis of a modified Phillips curve,
which shows the trade-off between nominal
wage growth and unemployment. The second
is based on a longitudinal study of more than
2,000 collective bargaining agreements in the man­
ufacturing sector between 1959 and 1984. Both
sets of estimates show that developments in inter­
national trade in the 1980s contributed to the slow­
down in money-wage inflation, with nonpetroleum
import prices and real nonpetroleum import share
registering the most significant effects. The authors
are quick to point out, however, that international
trade accounted for only a small part of the slow­
down, at most 18 percent in selected years. This
contribution would have been even less significant
for the private business sector as a whole, since in­
ternational trade should have the largest impact on
manufacturing, a sector that directly involves only
one-fifth of U.S. workers.
Vroman and Vroman place the estimated
trade effect into perspective by exploring other
possible explanations for the modest wage
growth of the 1980s. Most important among these

are inflationary expectations and the composi­
tion of unemployment. The authors conclude
that, of the factors considered, the reduction in
inflationary' expectations during the latter half of
the decade was the primary factor in the slower
nominal wage growth. The unusually high rate of
unemployment among prime-age males was also
found to exert a restraining effect on money-wage
growth, equaling the impact of international trade.

Changes in
Wage-Setting
Practices
The second class of explanations relates to institu­
tional changes in wage-setting practices. These in­
clude alternative forms of compensation, such as
lump-sum payments, profit sharing, and fringe
benefits. Also covered are changes in the structure
of labor union contracts, such as contract dura­
tion, cost-of-living indexation, and the emphasis
on job security over wage growth.
As documented below, workers have increas­
ingly received compensation in forms other than
cash wages. For instance, the percentage of
workers receiving lump-sum or profit-sharing
payments has risen over the last decade. Fringe
benefits as a share of total compensation has
also increased, although a slightly smaller pro­
portion of workers are now covered by pen­
sions and health care benefits— the two largest
components of this fomi of payment. Moreover,
the prevalence of cost-of-living indexation fell dur­
ing the 1980s, while contract length grew. A theme
shared by all four papers summarized in this sec­
tion is that developments in wage-setting pro­
cesses may have reduced the trade-off between
wage inflation and unemployment.
Lump-Sum Payments. In “Lump-Sum Payments
and Wage Moderation in the Union Sector,” Linda
Bell and David Neumark examine the growth of
lump-sum payments in union firms in an effort to de­
termine whether the spread of this alternative com­
pensation arrangement contributed to the decline in
wage growth during the past decade. Lump-sum
payments can reduce wage inflation in at least three
ways. First, they may signal a change in the labormanagement environment toward either a strength­
ened management stance or a worker preference
for that form of payment. Second, they may simply
reflect an accounting change as certain labor costs
are shifted out of wages and salaries and into other
forms of compensation. Third, they may increase
labor-market flexibility by tying compensation
more directly to worker productivity and to firm
 profits. Profit sharing provides employers with a


method for responding to shocks in the product
market beyond simply adjusting employment.
Since profit-sharing payments are not counted as
part of an employee’s base salary, adjustments in
either direction can be made quickly in response
to changing business conditions. This increased
flexibility has led some economists, including
Weitzman (1986), to advocate profit sharing as a
means of stabilizing employment and output.
To analyze these effects, Bell and Neumark ex­
amine more than 5,000 contracts negotiated in
1,200 private-sector establishments between 1975
and 1988. Within this sample, they find a dramatic
jump in the number of contracts with lump-sum
payment provisions. Indeed, between 1983 and
1984, the proportion of workers signing such con­
tracts skyrocketed from 5.9 percent to 69-5 per­
cent! The authors present evidence that this surge
resulted from unions’ preference for this alterna­
tive form of compensation.
Applying the Phillips-curve framework to the
trade-off between nominal wage increases and un­
employment, Bell and Neumark find that the prev­
alence of lump-sum payments is associated with
reduced wage growth. They estimate that a 10percentage-point rise in the share of workers cov­
ered by lump-sum contracts pushes the annual
rate of wage inflation down 0.3 to 0.4 percentage
point. The authors then reject all but one of the
aforementioned explanations for this dampening
effect. They dismiss the accounting explanation of
a shift from base wages by showing that lump­
sum payments also reduce the percentage in­
crease in firms' total labor costs. Likewise, they
find little support for the flexibility explanation. In
fact, their estimates are inconsistent with the
hypothesis: Firms offering lump-sum payments ex­
hibit less labor-cost flexibility in response to
changes in demand for their products. The authors
conclude that the labor-management environment
must have changed during the 1980s.
Profit Sharing. Douglas Kruse explores the
effect of a second form of nonwage payment—
profit sharing— on wage growth. In “Profit Sharing
in the 1980s: Disguised Wages or a Fundamentally
Different Form of Compensation?” he points out
that even this somewhat narrow type of com­
pensation takes several different fomis, includ­
ing profit-related bonuses, deferred pension
plans, or some combination of the two. Results
of his study show a steady growth in deferred
profit sharing, as the percentage of the private
wage and salary work force with such coverage
rose from 13-3 percent in 1980 to 18.4 percent in
1986. Although this still represents a relatively
small share of the total labor force, the covered
workers appear to be concentrated in industries

that have historically demonstrated downwardly
rigid wage behavior, such as manufacturing.
Kruse concentrates on increased labor flexibil­
ity to explain the negative relationship between
profit sharing and wage growth— a relationship
that is similar to the one between lump sums and
wages described by Bell and Neumark. He re­
views the empirical literature on the connection
between profit sharing and employment stability
and finds little agreement among the studies.
Kruse also pursues his own empirical test using
deferred pension plans as a measure of profit shar­
ing. His analysis yields some support for the posi­
tion that firms do not view profit-sharing payments
as part of the short-mn cost of labor, but rather as
a distribution of profits to labor after other costs
(including base labor costs) have been taken into
account. In this way, a company’s employment
decisions are not influenced by profit-sharing pay­
ments, since these are not considered part of base
wages. For 586 publicly traded U.S. companies,
Kruse notes little trade-off between higher profitsharing payments and employment. On the other
hand, he does find the expected trade-off be­
tween base wages and employment. The author
concludes that profit sharing is not simply “dis­
guised wages,” but a more flexible form of
employee compensation.
Fringe Benefit Coverage. In "The Decline of
Fringe-Benefit Coverage in the 1980s,” Stephen
Woodbury and Douglas Bettinger suggest that
compensation became more flexible during the
last decade because a lower percentage of
workers received employer-based health in­
surance coverage and pension plans. The share
of workers included in employer-provided pen­
sion plans dropped from 60 percent in 1979 to 55
percent in 1988. During the same period, the per­
centage of workers covered by employer-provided
group health insurance plans shrank slightly, from
74 percent to 72 percent. As a result, the ratio of
employer costs for these two fringe benefit pack­
ages to wages and salaries edged down. These
statistics suggest that the moderate wage growth
in the 1980s was not necessarily due to large off­
setting increases in benefit coverage. However,
the reduced coverage may have led to more flex­
ible compensation.
Woodbury and Bettinger’s primary purpose
is to provide a detailed analysis of the determi­
nants of fringe benefit coverage. They conclude
that the decline in coverage during the 1980s
resulted both from the decrease in marginal tax
rates on personal income during the middle of
the decade and from the steady drop in union rep­
resentation throughout the decade. Dwindling

manufacturing employment, shifts in occupa­


tional mix, and aging of the work force had little
to do with the decrease in coverage, according to
the authors.
The most significant detenninant was the low­
ering of marginal tax rates in 1986, which induced
workers to trade fringe benefits for increased
wages. However, their willingness to substitute
wages for fringes was not uniform across all types
of voluntary benefits. Woodbury and Bettinger
estimate that workers were more willing to trade
wages for employer-provided pensions than for
employer-provided health coverage. The authors
interpret the decline in benefit coverage as a ten­
dency for a reduction in the fixed component of
worker compensation, which can be seen as a
move toward a more “spot market” type of pay.
Union Contracts. Wage moderation in the
1980s was disproportionately concentrated in the
union sector, which experienced lower wage
growth in the latter half of the decade (14.2 per­
cent) than did the nonunion sector (23-9 percent).
In contrast, in every year between 1976 (when
data first became available) and 1982, union wage
hikes outpaced nonunion wage changes. After
1982, when the economy began to recover from
the high unemployment brought on by the twin
recessions that inaugurated the decade, many
unions placed job security above wage growth as
the top priority in their bargaining rounds. This
reordering is certainly evident in unions’ nominal
wage increases.
In “Indexation and Contract Length in Union­
ized U.S. Manufacturing,” Mark Bils examines two
changes in the stmcture of labor contracts that
could have led to slower wage growth in the
union sector: reductions in indexation and shorter
contract length. For all union contracts settled in
the private sector, the proportion of workers with
inflation escalator clauses fell from an average of
55.2 percent between 1980 and 1983 to 36.8 per­
cent between 1984 and 1988. However, the length
of contracts remained the same over the decade,
averaging slightly more than 31 months.
An extensive body of theoretical literature
supports the view that the length of contracts
and the inclusion of indexation reflect the de­
gree of uncertainty facing workers and employ­
ers. To explore this proposition, Bils examines a
detailed longitudinal set of major collective bar­
gaining agreements reached between 1955 and
1985 in the manufacturing sector. His results con­
tradict the generally accepted prediction that
increased uncertainty will shorten contracts. Rather,
he finds that contracts are longer in industries that
face more uncertainty (durable goods, for example).
Bils suggests that these results are consistent with

the notion that longer contracts are written in
order to reduce strikes.
With respect to indexing, he finds that the per­
centage of contracts with cost-of-living escalator
clauses is positively related to increases in both in­
flation and inflation uncertainty. This is consistent
with the generally accepted view that escalator
clauses protect workers from unanticipated pricelevel changes. Consequently, consumers’ lower
inflation expectations during the latter half of the
1980s could explain the lower nominal wage
growth at that time. This finding is in accord with
Vroman and Vroman’s results.

Demographic Shifts
In “Gender Differences in Cyclical Unemploy­
ment,” Sanders Korenman and Barbara Okun con­
sider the effect of female participation in the work
force on cyclical unemployment. It may be that
women provide a pool of workers who move
freely into and out of the labor force (depending
on the stage of the business cycle), since they are
historically less attached to it than are men. Such a
procyclical participation pattern of a large group
of workers would weaken the effectiveness of un­
employment rates as a measure of labor-market
tightness. Consequently, fluctuations in wages and
in standard measures of unemployment rates asso­
ciated with business cycles wrould be dampened.
The major issue that Korenman and Okun ex­
plore, therefore, is whether women are indeed
less attached to the labor force than are men.
Their analysis shows that although women are
still less attached, their connection grew during
the 1980s.
These results might suggest that cyclical
unemployment should rise in response to in­
creased labor-force attachment among women,
but further analysis shows no association be­
tween these two factors. The authors attribute
this to the disparate distribution of the sexes
across industries and occupations. W om en’s
employment is disproportionately concentrated
in growth industries that demonstrate little cycli­
cal fluctuation, while men are concentrated in
industries with the opposite characteristic. Thus,
although Korenman and Okun do not rule out
the possibility that the increase in female labor
supply during the 1980s reduced wage growth
by lowering labor-market tightness, their find­
ings suggest little, if any, change in the long-run
cyclical behavior of the economy as a result of
this phenomenon.



III. Implications for
Macroeconomics
Two prominent macroeconomists, Olivier
Blanchard and Finn Kydland, were invited to
the conference to comment on whether the find­
ings of the papers summarized above alter the
way in which labor markets figure into their
view of the workings of the macroeconomy. In
particular, we were interested in whether the
trend toward more flexibility and risk sharing in
wage-setting practices would alter their theories
and policy recommendations.
Blanchard’s remarks focus primarily on the
macroeconomic implications of lump-sum
bonuses and profit sharing. He sees both
schemes as ways of lowering the risk of bank­
ruptcy among firms, and notes an interesting
tension between the implications of increased
risk sharing in labor contracts and of recently
introduced financial arrangements, such as highyield junk bonds. The former generally provides
greater stability by reducing the likelihood of
bankmptcy, while the latter raises the chances
of a firm going under.
Blanchard argues that the reduction in bankmptcy risks has had three macroeconomic effects:
1) stabilization of employment in the short run, 2)
alteration of the factors determining labor mobil­
ity, and 3) modification of the Phillips-curve speci­
fication. The first effect results from the simple fact
that firms will not be as likely to close their doors
during downturns and, through wage adjustments,
will be able to retain workers longer. This should
reduce employment swings during business
cycles. The second effect is related to labor adjust­
ments that follow sectoral shocks. If wages are
rigid, then declining employment is the only sig­
nal that leads workers to leave hard-hit sectors.
However, if wages vary, then both they and job
security enter into a worker’s decision. Finally, an
increase in wage flexibility breaks the link be­
tween tightness in the labor markets (as measured
by unemployment rates) and price inflation.
Kydland frames his remarks in terms of im ­
plications for business-cycle theory. He notes
that many researchers interested in this line of
inquiry have changed their methodology from
the system-of-equations approach popular in
the 1960s to one based on the neoclassical
growth model. Under the former framework,
models are constmcted around equations that
describe aggregate economic behavior, such as
wage rates, unemployment rates, household con­
sumption, and business investment. In contrast,
the approach based on the neoclassical growth
model stresses the use of empirical knowledge to

obtain parameter estimates for technology, pref­
erences, and institutional arrangements. These
parameter estimates provide realistic calibra­
tions for simulation models intended to mimic,
and thus explain, macroeconomic phenomena.
Consequently, this transition to the use of the
neoclassical growth model as the basis of macroeconomic analysis is important in detemrining how
questions are posed and data are organized.
Kydland finds that research presented in this
volume is, for the most part, organized around the
fonner methodology— that is, based on estimates
of aggregate behavioral equations. He stresses that
in order to bridge the gap, questions posed in the
business-cycle framework will have to be translated
into the behavioral-equation framework, and vice
versa. Therefore, business-cycle researchers may
have to ask slightly different questions or else organ­
ize the information presented at this conference in a
different way if they are to incorporate these find­
ings into their research.

IV. Conclusion
The research presented at this conference under­
scores the thinking of many observers and market
analysts who, during the latter half of the 1980s,
perceived that developments were taking place in
labor markets that altered certain basic relation­
ships between wage behavior and economic perfonnance. These essays suggest that the increased
adoption of more-flexible pay schemes during the
latter half of the decade led to lower labor costs,
perhaps to more flexibility for firms in their em­
ployment decisions, and, in general, to more sta­
bility in employment (at least in the short run).
Thus, evidence indicates that these more flexible
pay schemes might be able to accommodate rela­
tively lower unemployment rates without igniting
serious wage inflation.
Although some observers argue that this in­
creased flexibility, which stemmed from the adop­
tion of lump-sum payments and profit-sharing
arrangements, is simply a way to obscure wage
concessions, the research presented here finds
little support for this view. The fairly widespread
acceptance of these alternative compensation
practices by both workers and managers suggests
that the shift in the relationship between labor
markets, unemployment, and price inflation
observed in the 1980s may extend well into the
1990s. This structural change, along with other
changes noted at the conference, may be wel­
comed by policymakers attempting to contain in­
flation while simultaneously stabilizing output.



References
Bell, Linda, and David Neumark. “Lump-Sum
Payments and Wage Moderation in the
Union Sector,” in Randall W. Eberts and Erica
L. Groshen, eds., Structural Changes in U.S.
Labor Markets. Aunonk, N.Y.: M.E. Sharpe,
Inc., 1991. pp. 45-62.
Bils, Mark. “Indexation and Contract Length in
Unionized U.S. Manufacturing,” in Randall W.
Eberts and Erica L. Groshen, eds., Structural
Changes in U.S. Labor Markets. Armonk:
N.Y.: M.E. Sharpe, Inc., 1991, pp. 145-71.
Blanchard, Olivier Jean. “Macroeconomic Impli­
cations,” in Randall W. Eberts and Erica L.
Groshen, eds., Structural Changes in U.S.
Labor Markets. Armonk: N.Y.: M.E. Sharpe,
Inc., 1991, pp. 201 -05.
Gordon, Robert J. “Inflation, Flexible Exchange
Rates, and the Natural Rate of Unemploy­
ment,” in Martin N. Baily, ed., Workers, Jobs,
a n d Inflation. Washington, D.C.: The Brook­
ings Institution, 1982, pp. 89- 155.
Korenman, Sanders, and Barbara Okun. “Gender
Differences in Cyclical Unemployment,” in Ran­
dall W. Eberts and Erica L. Groshen, eds., Struc­
tural Changes in U.S. Labor Markets. Armonk:
N.Y.: M.E. Sharpe, Inc., 1991, pp. 177-95.
Kruse, Douglas. “Profit Sharing in the 1980s:
Disguised Wages or a Fundamentally Dif­
ferent Fonn of Compensation?” in Randall W.
Eberts and Erica L. Groshen, eds., Structural
Changes in U.S. I.abor Markets. Armonk:
N.Y.: M.E. Sharpe, Inc., 1991, pp. 67-99.
Kydland, Finn E. “Macroeonomic Implications,”
in Randall W. Eberts and Erica L. Groshen.
eds., Structural Changes in U.S. Labor M ar­
kets. Armonk: N.Y.: M.E. Sharpe, Inc., 1991,
pp. 207-13.
Mitchell, Daniel J.B. “Wage Pressures and Labor
Shortages: The 1960s and the 1980s,” Brook­
ings Paper's on Economic Activity, vol. 2
(1989), pp. 191-231.
Uchitelle, Louis. “Wage Increases Are Sluggish
despite a Scarcity of Workers,” The W all
StreetJournal, September 1, 1987, p. Al.

Vroman, Susan, and Wayne Vroman. “Interna­
tional Trade and Money Wage Growth in
the 1980s," in Randall W. Eberts and Erica L.
Groshen, eds., Structural Changes in U.S.
Lahor Markets. Armonk: N.Y.: M.E. Sharpe,
Inc., 1991, pp. 13-40.
Wächter, Michael L., and William Carter. “Norm
Shifts in Union Wages: Will 1989 Be a Replay
of 1969?” Brookings Papers on Economic Ac­
tivity, vol. 2 (1989), pp. 233-64.
Weitzman, Martin L. “Macroeconomic Implica­
tions of Profit-Sharing,” in Stanley Fischer,
ed., NBERMacroeconomics A n n u a l 1986.
Cambridge, Mass.: MIT Press, 1986.
Woodbury, Stephen A., and Douglas R. Bettinger.
“The Decline of Fringe-Benefit Coverage in
the 1980s,” in Randall W. Eberts and Erica L.
Groshen, eds., Structural Changes in U.S.
Labor Markets. Armonk: N.Y.: M.E. Sharpe,
Inc., 1991, pp. 105-38.




First Quarter
Working Papers

■ 9119
Estimating a Firm's AgeProductivity Profile Using
the Present Value of
Workers’ Earnings

Current Working Papers of the
Cleveland Federal Reserve Bank
are listed in each quarterly issue
of the Economic Review. Copies
of specific papers may be re­
quested by completing and mail­
ing the attached form below.

Single copies of individual
papers will be sent free of charge
to those who request them. A
mailing list service for personal
subscribers, however, is not
available.

Institutional subscribers, such
as libraries and other organiza­
tions, will be placed on a mail­
ing list upon request and will
automatically receive Working
Papers as they are published.

■ 9121
Rising Inequality in a
Salary Survey: Another
Piece of the Puzzle

■ 9201
Binomial Approximation
in Financial Models:
Computational Simplicity
and Convergence

■ 9203
Post-Louvre Interven­
tion: Did Target Zones
Stabilize the Dollar?

by Erica L. Groshen

by Anlong Li

by Laurence J. Kotlikoff and
Jagadeesh Gokhale

■ 9120
A Dynamic Analysis of
Recent Changes in the
Rate of Part-time
Employment
by Donald R. Williams

■ 9122
A Different Kind of Money
Illusion: The Case of
Long and Variable Lags
by Michael F. Bryan and
William T. Gavin

■ 9202
Wagner’s Hypothesis:
A Local Perspective
by Randall W. Eberts and
Timothy J. Gronberg

by Richard T. Baillie and
Owen F. Humpage

■ 9204
Bank Performance and
Regional Economic
Growth: Evidence of a
Regional Credit Channel
by Katherine A. Samolyk

■ 9205
The Gold Standard
as a Rule
by Michael D. Bordo and
Finn E. Kydland

Please complete and detach the form below and mail to:
Research Department
Federal Reserve Bank of Cleveland
P.O. Box 6387
Cleveland, Ohio 44101




Check item(s)
requested

Send to:

Please send the following Working Paper(s):

□ 9119

□ 9122

□ 9203

□ 9120

□ 9201

□ 9204

□ 9121

□ 9202

□ 9205

Please print

Name

Address

City

State

Zip

E9

Structural Changes in U.S. Labor Markets




Conference Proceedings Now Available
The papers in this book, “Struc­
tural Changes in U.S. Labor Mar­
kets: Causes and Consequences,"
edited by Randall W. Eberts and
Erica L. Groshen, were presented
and discussed at a conference
held at the Federal Reserve Bank
of Cleveland in October 1989. The
purpose of the conference was to

identify and analyze recent de­
velopments in personnel policy
and worker compensation prac­
tices, which may have led to less
wage inflation during the 1980s
and may continue to affect wage
behavior in the 1990s. Also con­
sidered were possible conse­
quences that these changes

might have on the formulation
of macroeconomic policy. The
contributors— academic and
research economists in labor eco­
nomics— provide a comprehen­
sive assessment of the current
state of the wage-setting process
in the U.S. labor market.

■ Profit Sharing in the
1980s: Disguised Wages
or a Fundamentally
Different Form of
Compensation?

■ Indexation and Contract
Length in Unionized
U.S. Manufacturing

Contents:
■

Overview

by Randall W. Eberts and
Erica L. Groshen

■ International Trade
and Money Wage
Growth in the 1980s
by Susan Vroman and
Wayne Vroman
Comments: Louis Jacobson

■ Lump-Sum Payments
and Wage Moderation in
the Union Sector

by Mark Bils
Comments: Michael L. Wächter

by Douglas Kruse
Comments: Sharon P. Smith

■ Gender Differences in
Cyclical Unemployment
■ The Decline of
Fringe-Benefit Coverage
in the 1980s

by Sanders Korenman and
Barbara Okun
Comments: Katherine G. Abraham

by Stephen A. Woodbury and
Douglas R. Bettinger
Comments: David Lewin

by Linda Bell and
David Neumark

■ Macroeconomic
Implications
by Olivier Jean Blanchard
and by Finn E. Kydland

Comments: Ken Ross

Ordering Information
Structural Changes in U.S. Labor Markets: Causes and Consequences
Randall W. Eberts and Erica L. Groshen, editors
1991 352 pages: tables, figures, index
ISBN 0-87332-825-6
Hardcover, $39.95
For orders and inquiries, please contact:
M.E. Sharpe, Inc.
80 Business Park Drive
Armonk, NY 10504
Credit card orders accepted.
Call toll-free 1-800-541-6563
FAX: 914-273-2106