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Federal Reserve Bank of Cleveland
Economic Review
ISSN 0013-0281
Spring 1981
Economic Review is published quarterly by the Research Department
of the Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,
OH 44101. Telephone: (216) 579-2000. Editor: Pat Wren.
Opinions stated in the 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 materials to the editor.
Spring 1981
Federal Reserve Bank of Cleveland
Economic Review
Contents___________________________________________________
The Monetary Base, the Economy, and Monetary Policy
2
In recent years the monetary base has received increasing attention as a
potentially useful variable for policy purposes. John B. Carlson examines the
theoretical underpinnings for such a role in two models of the aggregate
economy. He then reviews recent empirical studies of the usefulness of the
base in alternative policy roles.
Prices of Ohio’s Banks: The Multibank Holding Company Experience
14
Ohio’s banking structure is dominated by multibank holding companies.
Paul R. Watro examines the terms of bank acquisitions by multibank holding
companies in Ohio since 1970 and identifies factors that explain the pre
miums paid for these banks.
The High-Employment Budget: Recent Changes
and Persistent Shortcomings
23
The high-employment budget measures federal government receipts, ex
penditures, and the associated surplus or deficit that would result if the
economy always operated at its potential or full-employment level of output.
It is a tool that economists frequently employ to analyze federal fiscal policy.
Owen F. Humpage summarizes new methods of estimating the high-employ
ment budget and reviews the persistent problems that greatly restrict the
measure’s usefulness.
Working Paper Review
The Welfare Implications of Alternative Unemployment
Insurance Plans
32
In a working paper reviewed here, Mark S. Sniderman explores the relation
ship between public and private unemployment insurance systems and
individual welfare.
The Monetary Base,
the Economy,
and Monetary Policy
by John B. Carlson
Perhaps the most widespread interpretation of
the monetary base is that of a resource, i.e., the raw
material from which money is produced. This con
ception stems from analysis of money-supply deter
mination through a multiplier framework, in which
the level of monetary base—determined by the mone
tary authority— the basic constraint on money
is
creation. Consequently, this framework suggests
that it is a simple matter to control the money supply
by controlling the base. However, many discussions
of the money-base relationship abstract from the
actual institutional framework in which the Federal
Reserve (the supplier of the base) and depository in
stitutions (the suppliers of money) exist. When these
details are taken into consideration, issues concerning
the usefulness of the base in a monetary-control
procedure become more complicated.
Although the economic relevance of the base
usually is considered in terms of its relationship
to money, the base has its own theoretical role in
models of the aggregate economy. This role emerges
in an extension of the IS-LM framework by Tobin
(1969) establishing outside money (the nonbor
rowed base) as an essential determinant of income.
Nevertheless, the monetary base has not been given
the same status in policy formulation as traditional
measures of money.
This article reviews some of the fundamental
issues concerning the monetary base, its relationship
to economic activity, and its usefulness in the monetary-policy process. Part I describes briefly the role of
the base in the context o f the quantity theory and
post-Keynesian frameworks. Part II considers the
usefulness of the base in alternative policy roles and
reviews recent empirical studies on this matter.
I.
Role of the Base
in Macroeconomic Models
The analytical relevance of the monetary base can
be developed in either a quantity theory or a postKeynesian framework. In the quantity theory the
monetary base typically derives its importance by
being a “proximate” determinant of the money
stock, which occupies center stage in this analysis.
In the second approach, particularly in Tobin’s
extension of the standard IS-LM model, the basedefined as nonborrowed reserves plus currency— a
is
close counterpart to the framework’s conception
of “money” (see box 1, p. 4).
John B. Carlson is an economist with the Federal Reserve
Bank o f Cleveland.
2
Federal Reserve Bank of Cleveland
The Quantity Theory
The fundamental hypothesis that emerges from
the monetarist literature is that a change in “money”
leads to a change in expenditures that ultimately will
affect prices but with an initial and perhaps short
lived impact on real output. The most basic frame
work in which this hypothesis is represented is
Friedman’s (1956) restatement of the quantity
theory of money. In this reformulation, “the quan
tity theory is in the first instance a theory of the de
mand for money” (p. 4). When combined with other
relationships, the money-demand function plays a
key role in determining nominal income and prices.
In essence, quantity theorists view the moneydemand function as being relatively more stable than
alternative key relations, particularly expenditure
functions, giving money its special role.1 This as
sumption implies that changes in the public’s total
expenditures predominantly reflect adjustments in
asset portfolios in response to changes in the supply
of money rather than in the demand for money.
The money stock (M) typically is linked to the
unadjusted monetary base (.B) via the money mul
tiplier (m ):
(1) M = mB .
If Mis defined to be M-lB,ra will equal the expression
3
Fig. 1 The Simple Quantity Theory: The Linkages
O pen-m arket
o p eratio n s
' itilijili
TotaJ spending
(GNP)
''
T otal
m o n etary
base
M onetary
aggregates
E m ploym ent
The multiplier relationship is essentially a schedule
of market equilibrium money stock, not a true sup
ply function. The values of rand care not rigid ratios
but in fact respond to demand-side influences, among
other things.2 Nevertheless, this relationship provides
a framework for analyzing the influence of Federal
Reserve actions on the money supply. It is in this
operational sense (i.e., of controlling the money
stock) that the monetary base earns its status in a
quantity theory framework.
The relationships or linkages between policy
actions and economic activity frequently have been
represented along the lines of figure 1. While this
figure depicts an impact on real economic activity
(employment), it is temporary. The quantity theory
holds that a change in the money supply ultimately
must cause a proportionate change in the price level.
c+1
r +c
where c is the ratio of the currency to transactions
deposits in M-1B and r is the average reserve ratio,
i.e., the ratio of total reserves to transactions deposits.
1. The quantity theory, however, provides no definitive
theoretical basis for choosing among alternative definitions
of money. Monetarist writings have either invoked or implied
definitions corresponding to traditional money measures,
particularly monetary aggregates. Such measures have been
restricted to include only assets providing services generally
associated with “moneyness,” i.e., medium of exchange,
store of value, and unit of account. Without more definitive
theoretical guidance, the choice of the appropriate money
measure often is made on empirical grounds, adopting the
concept most closely related to economic activity in a
statistical sense or, in historical analysis, the definition for
which history provides data.
The Post-Keynesian Framework
In the post-Keynesian view, the influence of
changes in “money” is transmitted through changes
in market yields on financial assets and the market
value of real capital; these changes, in turn, affect
aggregate expenditures on goods and services. As
Tobin (1980) has emphasized, the essential dis2. Saving (1977) concludes that an industry moneysupply schedule (independent of demand-side influences)
cannot be derived. This follows from the uniqueness of
fractional reserve banking, where the demanders of the
product (demand deposits) also compete with producers
(banks) for a necessary factor of production (the mone
tary base). However, Saving argues that a monetary equi
libria schedule of the kind found in macroeconomic models
can be derived as long as one assumes that the demander’s de
sired and actual currency and time deposit ratios are equal
4
Economic Review □ Spring 1981
tinctions of money in this framework are that (1)
it is an “ outside” asset not generated by the private
sector and (2) its own nominal interest rate is fixed
and, hence, not determined in the marketplace. The
monetary base—defined as nonborrowed reserves
plus the currency component of M-1B—
has these
characteristics exclusively.
The importance of these distinctions is stated
clearly by Tobin (p. 319):
occur with other assets, outside or inside, with
market-determined yields, but by changes else
where in the economy. Adjustments to make the
public content to hold an enlarged supply of
outside money involve some combination of
reductions in nominal interest rates on other
assets, increases in real incomes, increases in
commodity prices, and possibly downward (!)
revisions of inflation expectations.3
The implication is that the nominal supply of
money is something to which the economy must
adapt, not a variable which adapts itself to the
economy—
unless the policy authorities want
it to. Furthermore, the private sector must be
induced to hold the “outside” supply, not by ad
justments in its own nominal yield as would
The linkages of the static post-Keynesian model
are illustrated in figure 2. This diagram highlights the
3. While Tobin considers the role of the base through
the financial market, many analysts also have emphasized
additional direct influence of outside money in the goods
market as part of the net wealth of the private sector.
Box 1 Monetary-Base Semantics
Like many other concepts in economics, the
monetary base (or base money) has been defined
several ways, reflecting the different contexts in
which it is found. In textbooks the monetary base
typically is defined as deposits at the Federal
Reserve and vault cash, both held as reserves, plus
currency held by the nonbank public. That is, the
base is defined by the uses it serves. According to
this criterion, anything accepted as reserves by the
monetary authority would be counted as part of the
monetary base. Because an additional dollar of base
can lead to a multiple increase in money, the base is
sometimes identified as high-powered money.
Alternatively, the monetary base can be defined
by the sum of its source components—
factors that
change the total amount of the base supplied to the
public. When defined this way, it is sometimes
called the source base or unadjusted monetary base.
In an accounting sense, of course, the sources of the
base will equal its uses. However, under the present
system of lagged-reserve accounting, vault cash held
two weeks earlier can be counted as reserves;hence,
the source base will differ slightly from the useoriented definition.
It is useful for both analytical and theoretical
reasons to make additional distinctions. In the first
regard, time series of the monetary base typically
are adjusted to reflect changes in reserve require
ments on deposits, which affect the relationship
between reserves and reservable deposits. This ad
justment is designed to incorporate the effects of reserve-requirement changes on the money stock. The
terms extended monetary base and monetary base
often are used to mean an adjusted monetary base.
Finally, for the theoretical reasons discussed in
Part I, the monetary base sometimes is defined as
nonborrowed reserves plus currency in the hands of
the nonbank public. This represents net government
demand debt generated “ outside” the private econ
omy by the monetary authority; hence, it is also re
ferred to as outside m oney.1 The nonborrowed
monetary base (or net monetary base) also can be
adjusted for changes in reserve requirements.
Because alternative definitions may have different
analytical and theoretical implications, it is impor
tant to be aware of what definition is being used.
1. Discount-window borrowings are excluded, be
cause they arise at the volition of depository institutions as
the counterpart of their (private) debt. While the nonbor
rowed base is “generated” solely by the Federal Reserve, its
level is not determined independently of economic activity
under the current operating procedure. Contemporaneous
demands for currency and non-targeted reservable deposits
are accommodated.
Federal Reserve Bank of Cleveland
result that the economy reacts to changes in outside
money (the nonborrowed base) and not the other
way around. The two unidirectional linkages from the
nonborrowed base to financial aggregates and yields
on these assets depict the initial impact of a change
in nonborrowed base on the economy through the
financial market, simultaneously affecting both price
and quantity of the financial assets. This impact is
assured by the fact that the nominal yield of the non
borrowed base is fixed legally (at zero), thereby
forcing other prices and quantities to adjust to changes
in the base. Because financial assets are gross sub
stitutes for real assets, changes that affect yields
(and prices) of financial assets also will affect the de
mand for real capital. The impact of policy actions
on economic activity depends on the influence of
such actions on the market value of real capital
relative to its replacement cost.
Assets such as demand and time deposits included
in traditional measures of money appear explicitly
in generalized versions of this framework (e.g.,
Tobin 1969 and Brunner and Meltzer 1972, 1976).
These assets arise on balance sheets of depository
institutions as the counterparts of private debt.
Hence, their equilibrium levels depend on the inter
action among borrowers, deposit holders, and fi
nancial intermediaries. In other words, levels of
these assets and aggregates including them are en
dogenous. But the endogeneity of money does not
preclude the type of relationship that some mone
tarists envision between the monetary aggregates
and nominal income (see Brunner and Meltzer 1972
and Brunner' 1973). Rather, if the demand function
for any particular monetary aggregate is stable over
time, that aggregate may be a useful indicator of
present and future levels of economic activity.
While the monetary sector of the Brunner-Meltzer model is consistent with Tobin’s general equi
librium approach, it is developed in the context of
a multiplier framework, highlighting the role of
the monetary aggregates in the model. That is, the
Brunner-Meltzer formulation of the monetary sector
allows for a special status of traditional money mea
sures. Regardless, the differences in the qualitative
results between the Tobin and the Brunner-Meltzer
models are not considered substantive. Because the
key aspect of economic response to monetary policy
in both models is the dependence on relative price
(yield) effects and stock effects, B. Friedman (1978)
argues that the “transmission mechanisms” are es
Fig. 2 The Post-Keynesian Model
Financial sector
5
Real sector
6
Economic Review □ Spring 1981
sentially identical. The basis for many monetarists’
propositions, particularly a constant money-supplygrowth rule, arises when time and uncertainty are in
troduced into the analysis. The issues that surface
when extending the framework in this direction are
largely empirical.
To summarize, in the post-Keynesian framework
it is outside money (the nonborrowed base) that
plays the essential role in affecting economic activity.
The monetary aggregates (including inside money)
are not necessarily of primary interest, although they
may be in monetarist extensions of this framework.
In the quantity theory the status of these variables
is reversed. The monetary base (however defined)
derives its importance from its relationship to money,
defined as an aggregate of transactions balances. In
the monetarist view this relationship may be im
portant on an operational level, where under appro
priate institutional arrangements it may serve to guide
policymakers in controlling the money supply. At
this level of generality, differences in the two models
are more a matter of focus and less of inconsistency.
While there seems to be widespread recognition
of the need to slow monetary growth to curb infla
tion, there is some divergence in view as to the ap
propriate means of achieving monetary deceleration.
Since 1978 the Federal Reserve has sought to reduce
its annual targets for the monetary aggregates by Vi
percentage point per year. This objective, however,
in principle could be pursued by establishing long
term targets for the monetary base or the nonbor
rowed base that would be consistent with a reduction
in “monetary” growth. Indeed, by virtue of being
exogenous in the economic models of Tobin and of
Brunner and Meltzer, the nonborrowed base would
seem a logical choice as “ the” monetary variable.
Even if one holds the quantity-theory view that the
behavior of transactions balances is the best signal
of monetary stimulus, the Brunner-Meltzer frame
work suggests a potential role for some form of the
base as an operating target to guide policy actions
in achieving long-term monetary targets.
II. Monetary Policy:
Considering the Usefulness of the Base
The choice of the appropriate intermediate tar
get ultimately involves (1) the closeness and stability
of the relationship between the target variable and
economic activity and (2) the Federal Reserve’s
ability to control the target variable.5 The issues that
arise then are largely empirical. The case for sup
planting long-term monetary aggregate targets with a
single monetary base target has been examined re
cently by Davis (1979-80) and Gambs (1980). Both
studies conclude that such a change does not appear
advisable, based largely on their empirical findings
that the monetary base is less closely related to the
economy than are money measures. This evidence,
The conduct of monetary policy has evolved
significantly during the past decade, away from an
emphasis on controlling interest rates (stabilizing
money-market conditions) toward controlling fi
nancial aggregates. The two most important indica
tions of this evolution are (1) the adoption of inter
mediate targets for monetary aggregates over both
the year and the near term and (2) the October 6,
1979, policy shift to reserves targeting in place of
day-to-day control of interest rates as the operating
procedure for monetary control. These changes may
be viewed as a response to the chronic inflation prob
lem. According to this view, the increasing role of fi
nancial aggregates, particularly as long-term inter
mediate targets, reflects a widespread belief in the
need to reduce the rate of monetary growth to re
duce inflation.4
4. This view does not rule out non-monetaxy sources
of “inflation” in the short run; hence, it does not suggest
a close short-run relationship between the time paths of
inflation and monetary aggregates.
The Monetary Base as an Intermediate Target
5. An intermediate target provides guidance for policy
action. It is useful because the transmission of monetary
policy to ultimate policy targets (e.g., output, employment,
and prices) is slow and uncertain. While not itself the ulti
mate concern of policymakers, the intermediate target can
be measured more quickly and frequently than measures
of policy objectives and, therefore, provide more timely
information about both the state of the economy and the
consistency of policy actions with objectives. Thus, inter
mediate targets should be closely related to ultimate goals,
so that policy actions seeking to achieve intermediate targets
will also accomplish ultimate targets.
Federal Reserve Bank of Cleveland
however, may reflect econometric problems as
sociated with the endogeneity of money.
To study the relationship between the economy
and various monetary variables, Davis and Gambs
estimate single-equation regression models relating
total spending, as measured by GNP, to various
monetary variables (see box 2, p. 8).6 Gambs also
includes a measure of fiscal stimulus. Because these
models were estimated using ordinary least-squares
techniques, no explanatory variable can be endoge
nous if the estimates (including goodness-of-fit) are to
be statistically meaningful (i.e., at least consistent).
However, the post-Keynesian framework (including
monetarist extensions) suggests that monetaryaggregate measures (even total-base measures) are
endogenously determined, specifically via the moneydemand function. In light of this, the explanatory
power of the money measures may reflect some
feedback from money demand. Hence, comparisons
involving such models are not very convincing.
It is difficult to assess the implications of the
econometric problems on the reliability of the
regression results. It is interesting to note, however,
that comparisons of the error statistics of these
models (average forecast errors four quarters out) do
not unambiguously suggest a superiority of the
monetary-aggregate measures over the base measures.
Although Davis finds that money measures better
forecast GNP, the differences are not statistically
significant. In a similar comparison, Andersen and
Karnosky (1977) find that the monetary base out
performs the monetary aggregates on the basis of
having a smaller mean absolute error.
The other criterion involved in selecting an inter
mediate target is the Federal Reserve’s ability to con
trol the target variable. Both Gambs and Davis argue
that the only substantial way that the base might be
superior to money as a long-term intermediate target
is that it is somewhat easier to control, especially over
short periods of time. Davis qualifies this advantage
with the comment that over periods as long as one
year, the problems of control for any of the money
6. Davis uses the adjusted monetary base published by the
Board of Governors, while Gambs uses the S t Louis measure;
neither examines a nonborrowed-base measure.
7
or base measures may not be technical. However, one
positive result of more reliable control within the
year is that it can enhance the credibility of the
policymakers, especially with regard to their commit
ment to its long-run objectives.7 It has been argued
that, by enhancing the credibility of its commitment
to a disinflationary strategy, policymakers can reduce
inflation expectations and thereby mitigate costly
real impacts generally associated with such a strategy.
Another related issue that has become more im
portant in recent years is the impact of financial
innovation, particularly in the use of deposits and
deposit substitutes.8 This innovation has tended to
reduce the level of demand deposits relative to pre
dicted levels based on estimated relationships with
interest rates and income. It is common to interpret
this impact as a shift in the money-demand function.
Because this impact is not readily predictable, esti
mated relationships relating money measures to
economic activity have become less reliable. It sub
sequently has been argued that the breakdown in
this relationship might make the base relatively more
attractive as an intermediate target.
But the relationship between the various base
measures and economic activity also is affected by
financial innovation. Shifts in the demand for de
mand deposits are translated into shifts in the de
mand for reserves backing those deposits and there
fore into shifts in the demand for base money. How
ever, the magnitude of this disturbance (shift) is
dampened by the required reserve ratio.9 As a result,
7. By maintaining growth of its intermediate variable
close to its midpoint target path, the Federal Reserve dem
onstrates that its targets are meaningful.
8. For an analysis and discussion of the implications of
financial innovation on the monetary aggregates, see Porter,
Simpson, and Mauskopf (1979) and Wenninger and Sivesind (1979).
9. For example, suppose this disturbance is characterized
by a permanent shift in the intercept of the demand for
checkable-deposits function. Other things equal, the demand
for reserves behind these deposits also will shift. But be
cause the average reserve requirement against these deposits
is less than 15 percent, the shift in the intercept of the de
mand for reserves (base money) will be less than 0.15 times
the shift in deposits.
8
Economic Review □ Spring 1981
Box 2 Alternative Measures of the Monetary Base
The two most widely available measures of the
total monetary base are published by the Board of
Governors (BOG) of the Federal Reserve System
and the Federal Reserve Bank of St. Louis. The
major difference between the two measures is the
method employed to adjust for changes in Regu
lations D and M (affecting reserve requirements).
The adjustment method used in computing the BOG
monetary base adjusts actual historical reserve levels
(use of base) as if current reserve requirements were
in effect for all past periods. This implies that any
time reserve requirements are changed, the entire
historical series of the adjusted monetary base must
be revised. For the period following the last change,
values of the adjusted monetary base will equal the
actual unadjusted balance sheet values of the uses of
the base as currency and reserves.
Specifically, the BOG has summarized the adjust
ment method as follows:1
1. For the week in which reserve requirements
against deposits (net demand or time and savings)
change due to a change in Regulation D, required
reserves are calculated on both the old and the
new reserve-requirement basis for the type of
deposits affected.
2. The ratio of “new” required reserves to “ old”
required reserves for the particular deposit type
is calculated, and this ratio is applied to actual
required reserves for that deposit type for all
weeks prior to the change in Regulation D.
3. As the ratio is applied back through time, it is
adjusted for earlier breaks in the series due to
changes in Regulation D by multiplying the cur
rent ratio by the ratio calculated at the time of
the previous change in Regulation D. (This pro
cedure is carried back, weekly, to January 1959;
monthly averages are derived from prorations
of the weekly data.)
4. Adjustments for breaks in the series due to changes
in Regulations D and M affecting other reservable
liabilities (i.e., commercial paper, finance bills,
Eurodollar borrowings) and marginal reserve re
quirements are made by subtracting the sum of
such required reserves from the actual series.
The monetary base published by the Federal Re
serve Bank of St. Louis, on the other hand, employs
an additive adjustment technique, allowing a source
(supply) rather than use (demand) orientation.
Whereas the BOG method sums up the various uses
of the base (adjusted separately), the St. Louis
method sums the sources of the base (e.g., Federal
Reserve credit, gold stock, Treasury deposits) and
then adds a reserve adjustment magnitude (RAM).
The RAM is obtained by subtracting the current
period’s required reserves (RR) from what would
have been required if some base period’s reserve
requirements were in effect instead.
Since December 1980 the latter magnitude has
been approximated by combining reservable de
posits into two categories—
member-bank trans
actions deposits (TD) and time and savings deposits
at such banks (TS).2 The base period requiredreserve ratios for these categories were chosen to
equal the average reserve ratios required (fTD and
rTS, respectively) for the period January 1976
through August 1980. Hence, under the current
practice of lagged-reserve accounting (where re
serve requirements are based on deposit levels
two weeks prior)
RAM f - ?TD TD t j +
^
t-2 ”
5
where rTD = 0.126640 and ?TS = 0.031964.
Prior to September 1968 required reserves were
based on deposit levels of the reserve settlement
week (i.e., contemporaneous). Prior to December
Federal Reserve Bank of Cleveland
1959 member banks were not permitted to count
vault cash as part of their balances held to satisfy
required reserves. The RAM thus is netted from
member-bank vault cash not counted as reserves
by the Federal Reserve (VCNR). Hence, prior to
September 1968
RAM t
=
f TD
T D t + f TS T S t ~ R R t ~ V C N R t
9
the relationship between base measures and nominal
income has been less affected. Over the last 20 years
the secular change in each of the velocities of al
ternative base measures has been significantly less
than that of M-1B. For long-run targeting, however,
adjustments can be made to target values once an
unanticipated shift becomes evident. Thus, there
appears to be no significant advantage to a long-term
base target in dealing with the problems of finan
cial innovation.
’
The Monetary Base as an Operating Target
where the last term equals 0 after December 1959.
The St. Louis and BOG measures of the mone
tary base also differ in respects other than reserve
adjustment techniques. The BOG monetary base is
seasonally adjusted at the components level. The St.
Louis measure, on the other hand, is seasonally
adjusted at the aggregate level. Because of reserve
accounting rules, the BOG monetary base includes
member-bank vault cash held two weeks earlier. The
St. Louis measure is computed from a balancesheet identity relating current sources and uses;
it thus includes current vault cash of member banks.
The effect of these differences on growth rates of
the two unadjusted series is small.3
1. Boaxd of Governors of the Federal Reserve System,
Member Bank Deposits and Reserves, March 1980.
2. For a more detailed description of the St. Louis ad
justment method, see R. Alton Gilbert, “Revision of the
S t Louis Federal Reserve’s Adjusted Monetary Base,”
Review, Federal Reserve Bank of S t Louis, vol. 62, no. 10
(December 1980), pp. 3-10. For comparisons between the
new St. Louis measure and alternative measures, in the
same issue see John A. Tatom, “Issues in Measuring an Ad
justed Monetary Base,” pp. 11-29.
3. See Albert E. Burger, “Alternative Measures of the
Monetary Base,” Review, Federal Reserve Bank of St.
Louis, vol. 61, no. 6 (June 1979), pp. 3-8.
Some monetarists have argued that the money
measures should be controlled more closely. Ad
vocates of tighter control have proposed that the
Federal Reserve supplant the present operating
procedures with some form of the base as an
operating guide for controlling the monetary ag
gregates. Because the total monetary base can
not be controlled closely by the Federal Reserve
under existing institutional arrangements, this vari
ant would not make an ideal day-to-day oper
ating target.10 The nonborrowed base, on the
other hand, could be substituted for nonbor
rowed reserves as the primary day-to-day guide for
policy actions.
The potential performance of base-type oper
ating targets has been investigated by Johannes
and Rasche (1979, 1981). They compare econo
metric forecasts of M-1B multipliers for four
reserve aggregates—
nonborrowed reserves, total
reserves, nonborrowed base, and total base. The
essential feature of their model is the use of
time-series analysis methods to forecast inde
pendently each of the components of the multi
pliers. The component forecasts then are substituted
10. Under the current practice of lagged-reserve accounting,
required reserves depend on deposit levels two weeks prior
and, hence, are predetermined. Because they cannot adjust to
the level of nonborrowed reserves supplied in the reserve
settlement week, any difference between required and
nonborrowed reserves not eligible for carryover must be
made available at the discount window. Thus, the Federal
Reserve has little control over the amount of total reserves
supplied in any given week.
10
Economic Review □ Spring 1981
into the multiplier formulae to obtain forecasts for
the various multipliers.1
1
To ascertain the potential usefulness of alternative
measures as operating targets, Johannes and Rasche
compare error dispersion statistics for forecasts of
the month-to-month percent changes of the cor
responding multipliers. They find that the relative
root mean square errors (RMSEs) of both the M-1B
total and nonborrowed base multipliers are less than
one-half of the relative RMSEs of their total and non
borrowed reserves counterparts.12 Thus, they con
clude that tighter short-run monetary control could
be obtained by employing the total or nonborrowed
11. To illustrate this technique, consider the M-1B net
monetary-base multiplier:
1+k
(/• + / - b)( 1 + t i + 12 +g + z) + k
where
k
ti
t2
g
z
b
r+1
and
=
=
=
=
=
=
=
C/D,
(M-2-M-1B )/D,
(M-3 - M-2)/A
G/D,
Z/D,
B K M -l-C + TLTD + TRPS + G + Z),
(SB + RAM - Q/(M-2 - C + TLTD + TRPS
+ G + Z),
C = currency component of M-1B,
D = total checkable deposits at banks and thrift
institutions,
TLTD = total large-denomination time deposits at
banks and thrift institutions,
G = government deposits at commercial banks
plus note balances at commercial banks and
thrift institutions,
Z = demand deposits at banks due to foreign
commercial banks and foreign official insti
tutions plus time and savings deposits due to
foreign commercial banks and official in
stitutions,
TRPS = term RPs,
B = member borrowing,
SB = source base,
RAM = reserve adjustment magnitude.
Each of the components (lower-case parameters) in the
multiplier is modeled using time-series methods (see Johannes
and Rasche 1979). Forecasts for each component are sub
stituted in the formula to obtain a forecast of the multiplier.
12. The relative RMSE equals RMSE divided by the mean
of the actual multiplier.
base as an operating target than by relying on total or
nonborrowed reserves. Johannes and Rasche ac
knowledge that they have assumed that the Federal
Reserve can achieve the level of the operating target
that is consistent with its money targets and that their
multiplier forecasting models would remain stable
under the alternative control regimes. By also ac
knowledging that nonborrowed reserves and nonbor
rowed base aggregates can be controlled more closely
than their total counterparts, the inference can be
drawn that the nonborrowed monetary base is the
appropriate control variable, i.e., operating target.
The Johannes-Rasche forecasting approach sub
sequently has been compared with the implicit mul
tiplier forecasts of the current procedure for alter
native operating targets in a Federal Reserve staff
study (Lindsey et al. 1981). The current procedure
differs from that implied by the Johannes-Rasche
approach in two respects: it does not involve ex
plicit estimation of the multiplier, and it employs
judgmental rather than strictly econometric pro
jection techniques.
While the Federal Reserve’s staff study finds that
its judgmental forecasts consistently outperform
the Johannes-Rasche forecasts for each of the four
reserve multipliers, the error dispersion statistics of
both approaches consistently decline as the reserve
aggregates considered are broadened. Thus, it seems
as though the Johannes-Rasche conclusion—
that
monetary control could be improved by employing
a broader reserve measure as an operating target—
also is supported by the staff study. But the staff
study argues that these error statistics do not provide
reliable evidence for choosing among alternative
concepts for use as an operating target. The reported
multiplier forecast errors contain endogenous move
ments of the alternative reserve aggregates away
from their predicted values. Thus, the staff study
concludes that these error statistics are not instructive
regarding the closeness of monetary control in a
regime where the alternative concepts are taken as
an invariant operating target.
To deal with the endogeneity problem, the staff
study employs a simulation technique designed to
exogenize the alternative variables. The simulations
are based on two monthly models of the money
market developed by the Board of Governors and
Federal Reserve Bank of Cleveland
the Federal Reserve Bank of San Francisco.13 (Un
fortunately, the Johannes-Rasche technique is not
amenable to such an experiment.) The simulation
results indicate that the endogeneity bias is sub
stantial. Error statistics of the simulation results
reveal a clear superiority of nonborrowed reserves
and nonborrowed base over their total counterparts.
On the other hand, the support for choosing nonbor
rowed reserves over the nonborrowed base is marginal.
The study concludes that, based on the 13-month ex
perience following October 1979, a change in opera
ting target from nonborrowed reserves to the nonbor
rowed base would not improve monetary control.
The Nonborrowed Base as a Supplemental Target
Empirical studies of the usefulness of the base in
alternative policy roles generally have not examined
its potential in a role that might supplement rather
than supplant current procedures. As an alternative
to supplanting monetary-aggregate targets with a
single-base target, policymakers could establish sup
plemental long-term growth ranges for the nonbor
rowed base. Such a strategy might be advanced on
a basis similar to Brunner’s (1980) restatement of
Friedman’s case for a nonactivist policy. He argues
that, because policymakers lack full and reliable
knowledge of the economy’s response structure
to changes in a monetary stimulus, attempts by
the monetary authority to stabilize economic activity
actually may destabilize it. Brunner offers a num
ber of reasons, both economic and political, sup
porting a constant money-supply-growth rule as the
safest strategy, given the risks involved.
By advocating a constant money-supply-growth
rule, Brunner presumes that policymakers have re
liable information of the response of money to
policy actions. Yet in his theoretical work with
Meltzer, money, like income, depends on the be
havior of the private sector. It is not apparent a priori
why policymakers should have more reliable infor
mation to forecast the public’s behavior with regard
13. For a description of this simulation technique, see
Lindsey et al. (1981, pp. 41-4).
11
to money than they do for income.14 On these grounds
it seems reasonable to argue that attempts to control
monetary aggregates too closely may destabilize them
and, hence, destabilize income. In practice, short
term movements in the monetary aggregates are
very difficult to interpret. They may result from
factors affecting money demand, such as changes
in interest rates and income, or from factors affecting
the supply of money, including the behavior of banks
and the public in financial markets. In addition,
short-run money movements may reflect disturbances
in demand and supply that are unexpected and per
haps unknown. Attempts to offset movements re
sulting from disturbances in money demand may in
fact destabilize income.15 A set of growth limits on
the nonborrowed base might be used to supplement
current procedures to hedge against such destabilizing
events. These bounds thereby would limit the extent
to which the monetary authority could vary the “ul
timate” monetary stimulus (outside money) to achieve
its monetary targets.
Such growth limits could be chosen to be con
sistent with the upper and lower growth path of
the primary target, which is currently M-1B. These
limits might be expressed in monthly average levels,
for example, based on the appropriate year-overyear growth rate. Weekly paths would be adjusted
seasonally. As long as the level of the nonborrowed
base would be within its target ranges, the current
operating procedure would remain in effect. If the
procedure would push the nonborrowed base outside
its long-term growth ranges, the boundary of the range
would supplant nonborrowed reserves as the short-run
14. Brunner acknowledges the potential information re
quirements currently imposed by the constant money-supplygrowth rule. As an alternative policy prescription, he pro
poses that the monetary authority concentrate on controlling
the monetary base and move its growth path to a noninflationary benchmark. He proposes this as an interim policy,
however, suggesting that the Federal Reserve continue its
efforts to improve monetary control.
15. For example, the disturbance may reflect an unex
pected change in the public’s preferences for holding other
assets relative to money. For an analysis of the implications
of this and other disturbances under monetary targeting,
see Sellon and Teigen (1981).
12
Economic Review □ Spring 1981
guide for open-market operations.16 The nonborrowed-base boundary would remain the short-run
guide until the nonborrowed-reserve path again would
be consistent with the nonborrowed-base objective.
Because the nonborrowed base can be controlled
closely, its growth could be contained within its
targeted boundaries with virtual certainty.
Alternatively, the target ranges of the nonbor
rowed base could be chosen independently of the
M-1B path. To reinforce the disinflation strategy,
an additional objective might be to seek annual de
celeration in the nonborrowed-base growth ranges,
regardless of what the money multiplier might be
expected to do. Such a strategy would hinge on the
view that the nonborrowed base is “the” appropriate
quantity fulcrum for disinflation.
would be achieved. Greater assurance of achieving
these objectives could serve to reduce inflation
expectations and thereby make the current disin
flation strategy less costly in terms of real impact.
The case against using monetary base measures in this
capacity hinges primarily on weak empirical evidence
that these measures are less closely related to income
than are money measures.
The case for supplanting nonborrowed reserves
with a base-type operating target is not definitive.
Evidence supporting such a change has been chal
lenged on the grounds of endogeneity bias. Further
more, it may be premature at this point to challenge
the efficacy of the new operating procedure after
fewer than two years of implementation.
IE. Conclusion
The monetary base has received increasing at
tention as a potentially useful variable for policy
purposes. It has been recently argued that the Federal
Reserve should de-emphasize the monetary aggregates
and rely on the monetary base as an intermediate
target. On the other hand, some monetarists have
argued that the monetary aggregates should be con
trolled more closely—
and could be, if the Federal Re
serve would use some form of the base as an operating
target. Perhaps the strongest argument for using a
monetary-base measure as an intermediate target is
that it can be more closely controlled, providing
greater assurance that its long-run targeted values
16. Growth outside these ranges would be considered po
tentially destabilizing. For example, policy actions that
would lead to nonborrowed-base growth above its target
range conceivably could lead to excessive money growth
at some time in the future, even if the current level of money
growth were below its long-term lower-boundary path. To
demonstrate this possibility, consider the experience of
1980, specifically from May to August, when M-1B was be
low its midpoint path. During May the nonborrowed base
grew at a 20 percent annual rate to a level above its longrun trend. It remained above trend for the rest of the year.
An effective constraint on nonborrowed-base growth could
have been chosen that still would have permitted an easing of
policy during this period but to a lesser extent than had
occurred; hence, the constraint could have reduced the
likelihood that M-1B would have grown to a level above its
long-term upper-boundary path by year-end.
References
1. Andersen, Leonall C., and Denis S. Kamosky.
“Some Considerations in the Use of Monetary Aggre
gates for the Implementation of Monetary Policy,”
Review, Federal Reserve Bank of St. Louis, vol. 59,
no. 9 (September 1977), pp. 2-7.
2. Board of Governors of the Federal Reserve Sys
tem, Member Bank Deposits and Reserves, March 1980.
3. Brunner, Karl. “A Diagrammatic Exposition of
the Money Supply Process,” Schweizerische Zietschrift fur Volkswirtschaft und Statistik, vol. 109
(December 1973), pp. 481-533.
4.
gates,” in
Proceedings
Conference
Boston, pp.
.“ The Control of Monetary Aggre
Controlling Monetary Aggregates III.
of a Conference Held in October 1980.
Series No. 23. Federal Reserve Bank of
1-65.
5. Brunner, Karl, and Allan H. Meltzer. “Money,
Debt, and Economic Activity,” Journal o f Political
Economy, vol. 80 (September/October 1972),
pp. 951-77.
6.
. “An Aggregate Theory for a Closed
Economy,” in Jerome L. Stein, E d Monetarism. Am
sterdam: North-Holland Publishing Company, 1976.
7. Burger, Albert E. “Alternative Measures of the
Monetary Base,” Review, Federal Reserve Bank of
St. Louis, vol. 61, no. 6 (June 1979), pp. 3-8.
Federal Reserve Bank of Cleveland
8. Davis, Richard G. “The Monetary Base as an
Intermediate Target for Monetary Policy,” Quar
terly Review, Federal Reserve Bank of New York,
vol. 4, no. 4 (Winter 1979-80), pp. 1-10.
9. Friedman, Benjamin M. “ The Theoretical Non
debate about Monetarism,” in Thomas Mayer, Ed.,
The Structure o f Monetarism. New York: W. W.
Norton & Company, 1978.
10. Friedman, Milton. “The Quantity Theory of
Money— Restatement,” in Milton Friedman, Ed.,
A
Studies in the Quantity Theory o f Money. Chicago:
University of Chicago, 1956, pp. 3-21.
13
17. Lindsey, David, et al. “Monetary Control Ex
perience under the New Operating Procedures,” in
New Monetary Control Procedures. Federal Reserve
Staff Study—
vol. II. Washington: Board of Governors
of the Federal Reserve System, February 1981.
18. Porter, Richard D., Thomas D. Simpson, and
Eileen Mauskopf. “Financial Innovation and the
Monetary Aggregates,” Brookings Papers on Eco
nomic Activity, vol. 1 (1979), pp. 213-29.
19. Saving, Thomas R. “A Theory of the Money
Supply with Competitive Banking,” Journal o f Mone
tary Economics, vol. 3 (July 1977), pp. 289-303.
11. Friedman, Milton, and Anna Jacobson Schwartz.
A Monetary History o f the United States 1867-1960.
National Bureau of Economic Research, Studies in
Business Cycles, no. 12. Princeton: Princeton Univer
sity Press, 1963.
20. Sellon, Gordon H., Jr., and Ronald L. Teigen.
“The Choice of Short-Run Targets for Monetary
Policy: Part 1,” Economic Review, Federal Reserve
Bank of Kansas City, vol. 66, no. 4 (April 1981),
pp. 3-16.
12. Gambs, Carl M. “Federal Reserve Intermediate
Targets: Money or Monetary Base,” Review, Federal
Reserve Bank of Kansas City, vol. 65, no. 1 (January
1980), pp. 3-15.
21. Tatom, John A. “Issues in Measuring an Ad
justed Monetary Base,” Review, Federal Reserve
Bank of St. Louis, vol. 62, no. 10 (December 1980),
pp. 11-29.
13. Gilbert, R. Alton. “Revision of the St. Louis
Federal Reserve’s Adjusted Monetary Base,” Review,
Federal Reserve Bank of St. Louis, vol. 62, no. 10
(December 1980), pp. 3-10.
22. Tobin, James. “A General Equilibrium Approach
to Monetary Theory,” Journal o f Money, Credit and
Banking, vol. 1, no. 1 (February 1969), pp. 15-29.
15.
. “Can the Reserves Approach to Mone
tary Control Really Work?” Manuscript, Michigan
State University, January 1981.
23.
. “Redefining the Aggregates: Com
ments on the Exercise,” in Measuring the Monetary
Aggregates. Compilation of Views Prepared for the
Subcommittee on Monetary Policy. House of Repre
sentatives. Committee on Banking, Finance, and Ur
ban Affairs. 96 Cong. 2 Sess. Washington: U.S. Gov
ernment Printing Office, 1980.
16. Klein, Lawrence R., et al. Controlling Money:
A Discussion. Original Paper 29. Los Angeles: Inter
national Institute for Economic Research, No
vember 1980.
24. Wenninger, John, and Charles M. Sivesind. “De
fining Money for a Changing Financial System,”
Quarterly Review, Federal Reserve Bank of New
York, vol. 4, no. 1 (Spring 1979), pp. 1-8.
14. Johannes, James M., and Robert H. Rasche. “Pre
dicting the Money Multiplier,” Journal o f Monetary
Economics, vol. 5 (July 1979), pp. 301-25.
Prices of Ohio’s Banks:
The Multibank Holding Company Experience
by Paul R. Watro
The growth of multibank holding companies has
been rapid during the past decade. Indeed, multibank
holding companies (MBHCs) are today the most im
portant type of banking organization in many states.
Ohio’s banking structure is dominated by MBHCs,
which today account for 64 percent of total banking
deposits, compared with only 17 percent in 1969.1
Geographical restrictions on bank branching prob
ably are an underlying factor behind the growth of
MBHCs. Until the liberalization of Ohio’s branching
law in 1979, a bank was prohibited from expanding
beyond its home-office county. MBHCs, however,
could acquire banks throughout the state.
The impact of MBHC affiliation on the perfor
mance of acquired banks has been widely documented.
It generally has been difficult to demonstrate that the
profitability of banks has been increased significantly
by MBHC affiliation, suggesting that the impetus for
formation of MBHCs lies elsewhere. Very few studies
have investigated the economic rationale behind the
MBHC-expansion strategies. Piper and Weiss (1971)
attributed “the failure of acquisitions, on average, to
improve earnings per share of the acquiring holding
company to excessively generous purchase premiums
paid to stockholders of the acquired bank” (pp. 3-4).
In this explanation, “competition among hoi ding com
panies to acquire additional banks drove up the price
of stocks of possible acquisitions” (p. 4). In contrast,
more recent studies by Varvel (1975) and Frieder and
Apilado (1980) indicate that bank acquisitions had a
positive impact on the organization’s earnings.
1. A few BHCs in Ohio recently have merged their banking
subsidiaries into one bank and by definition are no longer
MBHCs. However, these organizations are still considered
MBHCs for the purpose of this study.
In an approach that differs somewhat from that of
earlier research, this study examines the terms of bank
acquisitions by MBHCs in Ohio since 1970 and iden
tifies certain factors that are important in explaining
premiums paid for these banks.
I. Acquisitions and Premiums Paid
Measure o f Value
Determining the economic value of a bank is often
difficult.The most logical approach would be to con
sider the stock price of an institution as its true eco
nomic value. Except for the larger banks, however,
bank stocks are not traded on public markets. The
market price of bank stocks that are not sold over
the counter may be an unreliable indicator of value,
because the sale of only a few shares in a thin market
(i.e., relatively inactive) might produce substantial
price movements.
Another approach would be to determine the
actual economic value of an institution from its
selling price. One of the issues arising from the sale
of a bank is that the selling price may be above the
bank’s book value. In attempting to determine what
factors contribute to the selling price above the book
value, this study uses the ratio of purchase price to
book value as the measure of value.
A bank’s book value is its equity capital, including
common and preferred stock, surplus, undivided prof
its, and capital reserves. The book value is generally a
reliable yardstick for measuring value, because of the
relatively high turnover and liquidity of a bank’s assets
Paul R. Watro is an economist with the Federal Reserve Bank
o f Cleveland.
Federal Reserve Bank of Cleveland
and liabilities. Since a bank invests primarily in loans
and securities as opposed to plants, equipment, and
inventories, the book value of its assets more closely
reflects actual market value than would be the case
for manufacturing firms, for example, particularly
when interest rates are relatively stable.
The method of payment for an acquisition makes
a difference in calculating the premiums. When an
acquisition is for cash, the premium is derived simply
by dividing the purchase price by the equity capital
of the bank. When an acquisition involves an exchange
of stock, however, the purchase price is estimated
from the current value of the MBHC’s stock as listed
in the application. Such an estimate should reflect the
true value of the MBHC, since its stock is traded pub
licly. The estimated purchase price would be realized
if stockholders decided to sell after the acquisition,
provided the value of the MBHC’s stock remained con
stant between the time of the application and the
actual transaction.
15
Table 1 Premiums and Type of Acquisitions
Year3
Average
Range of
premium,
premium,
______________________ _
percent
percent
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
44
50
27
61
52
45
37
47
71
63
75
Total
Average
53b
Acquisitions
Total Cash c
Stock
- 9 - 82
3-173
- 1 - 57
5 -1 4 0
21 - 105
26- 69
10- 67
22- 62
47-126
40-116
-4 -110
16
10
9
8
5
8
4
10
8
10
11
1
1
2
4
4
8
4
8
7
10
10
15
9
7
4
1
0
0
2
1
0
1
- 9 -1 7 3
99
9
59
5.3
40
3.6
a. The year of acquisition refers to the application date
rather than the actual approval date.
b. This figure is an average of the individual premiums.
SOURCE: Data accumulated from applications received.
Acquisition Activity
The study examines MBHC acquisitions of 99 in
dividual banks in Ohio in the 1970-80 period.2 Share
holders of 95 of these banks received premiums ranging
from 3 percent to 173 percent, while MBHCs pur
chased four banks at prices ranging from 1 percent
to 9 percent below their book values (discounts).
MBHCs paid an average of 53 percent above book
value to acquire banks over the period (see table 1).
Premiums varied substantially within a given year as
well as over time. The average premium on a yearly
basis ranged from 27 percent in 1972 to 75 percent in
1980. There was a distinct tendency toward higher
premiums in the later years of the period, following
the liberalization of Ohio’s branching law.
The number of MBHC acquisitions varied widely
on a yearly basis. The year of greatest activity was
1970, when MBHCs acquired 16 banks. In contrast,
only four bank acquisitions occurred in 1976.
2. The year of acquisition refers to the application date
rather than the actual approval date. Acquisitions involving
formations of bank holding companies and ones in which two
or more banks were simultaneously acquired were omitted. In
addition, a few acquisitions were omitted because of in
complete information.
Acquisitions are made either through cash pay
ments or stock exchanges. Nearly all of the acquisi
tions in the early 1970s involved the exchange of
stock. In the 1970-72 period, for example, 31 of the
35 acquisitions were made in this manner. Since
1973, however, over 90 percent of the MBHC acqui
sitions involved cash payments, and all of the nonSMSA (or rural) bank acquisitions involved cash.3
The type of market area in which the acquired
bank operated did not dominate in the choice of
banks or premiums paid (see table 2). Forty-eight
acquired banks operated in SMSAs, while the other
51 operated in non-SMSA counties. The average
premium paid for the group of SMSA affiliates was
56 percent, compared with a 50 percent premium for
the average non-SMSA bank.
II.
Theoretical and
Operational Considerations
Many factors affect the premiums paid for bank
acquisitions. Assuming that MBHCs are profit-maxi-
3. SMSA stands for standard metropolitan statistical area,
and non-SMSA indicates a county located dutside metro
politan areas.
16
Economic Review □ Spring 1981
Table 2 Premiums and Acquisitions
by Type of Market
SMSA
Yeara
Average
premium,
percent
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
46
68
41
54
36
48
37
40
82
74
88
Total
Average
56b
Non-SMSA
Acqui
sitions
7
5
2
5
2
5
4
7
4
3
4
48
4.4
Average
premium,
percent
Acqui
sitions
42
31
22
73
63
40
9
5
7
3
3
3
-
-
64
59
58
68
3
4
7
7
50b
51
4.6
a. The year of acquisition refers to the application
date rather than the actual approval date.
b. This figure is an average of the individual premiums.
SOURCE: Data accumulated from applications received.
mizers, they should be concerned primarily with the
future earnings of their acquisition candidates. Future
earnings are likely to depend on an array of factors,
including the bank’s past earnings, caliber of manage
ment, deposit composition, competitive structure of
the market, and growth of the local area. The earnings
of the acquiring MBHC, size of the acquisition candi
date, type of market, and current branch law also
should affect the acquisition price relative to the
bank’s book value.
Acquisition strategies vary among MBHCs. Some
MBHCs are more likely to acquire well-managed and
highly profitable banks and make few changes in pol
icies and operations. Others have a tendency to acquire
less profitable banks and then make significant
changes to increase earning potential. In either case,
banks with higher earnings would be expected to
receive higher prices, presumably because a sale would
not be consummated unless the buyer offered the
seller at least the opportunity cost, or the present
value of the expected future-earnings stream of the
bank. If a MBHC objective were to maximize profits,
it would not pay a price beyond the expected-earnings
capacity of the bank. For these reasons, the futureearnings rate of acquired banks would be expected to
influence the premium offered by a MBHC. For empiri
cal work, a bank’s average rate of return on assets
during the past three years is used as one indication
of its future-income stream.
The earnings of MBHCs might affect the acquisi
tion price. During prosperous years, business organi
zations may have a greater propensity to expand
operations, because their cash flow is greater and be
cause expectations for the future may seem brighter.
Higher rates of return by MBHCs, therefore, should
increase the demand and the price for bank acquisi
tions. The rate of return on the average stockholders’
equity one year prior to the acquisition is used to
measure the MBHC’s earnings. (While earnings may
vary significantly from year to year, data limitations
for earlier acquisitions prohibit the use of additional
years in the measure.)
The cost of de novo market entry should be a
determinant of the premiums paid for banks. A
MBHC has two alternatives for entry into a market:
establishing a new bank or branch or acquiring an
existing institution. Experience suggests that it
usually takes three to five years for a new branch to
cover costs and probably longer for a new bank. The
“going-concern” value of such factors as location,
established customer relationships, and community
involvement should affect the value of a bank beyond
its book value, by an amount related to the cost of
expansion via de novo entry. Once a banking relation
ship is established, it is difficult to entice customers to
change banks. Recognizing the valuable market-entry
franchise, MBHCs have generally considered it to be
more advantageous to acquire established banks. As
suming that the going-concern value of an established
institution does not increase proportionately with
size, the acquisition premiums would diminish as
the size of the acquired bank increases.
The deposit composition of a bank often reflects
the costs incurred for funds and the type of bank
customers. Demand deposits have been a relatively in
expensive and stable source of funds for banks. Regu
lation Q prohibits the payment of interest on demand
deposits, and, prior to this year, banks basically held
a monopoly position on third-party payment accounts.
The Depository Institutions Deregulation and Mone
Federal Reserve Bank of Cleveland
tary Control Act of 1980, however, permits banks
and thrift institutions to offer negotiable order of
withdrawal (NOW) accounts. From a functional stand
point, NOWs are effectively interest-bearing checking
accounts. As customers substitute NOW accounts for
demand deposits, banks will incur higher costs. Never
theless, throughout the 1970s banks enjoyed this lowcost source of funds. A larger percentage of demand
deposits, moreover, indicates a larger proportion of
business customers, as banks often require commercialloan customers to maintain compensating balances in
demand accounts. Over 59 percent of the demand
deposits in the United States were owned by busi
nesses throughout the 1970s.4 A large base of busi
ness customers is generally advantageous for a banking
organization to become a leading competitor in a
given market. In proposed bank-acquisition appli
cations MBHCs often cite that the holding company
would enable the bank to offer improved services,
such as higher lending limits, trusts, international
banking, and industrial revenue financing. It is thus
presumed that MBHCs would prefer to acquire banks
with a larger proportion of demand deposits; such
acquisitions would provide relatively less expensive
funds and a relatively larger business customer base.
The type of market may affect the premiums paid
by MBHCs to acquire banks. If MBHCs perceive met
ropolitan areas to be more attractive than rural areas,
banks acquired in SMSAs would receive higher pre
miums. The fact that MBHCs did pay higher average
premiums to purchase SMSA banks was not statisti
cally significant. When considered with other variables,
the type of market may well affect the acquisition
premiums; thus, a variable for SMSA and non-SMSA
markets is included in the analysis.
As with other business organizations, banks are
more likely to gain additional business in high-growth
areas. MBHCs, which are legally empowered to ac
quire banks throughout Ohio, have an incentive to
make acquisitions in the rapidly expanding market
areas. In fact, MBHCs may forego short-run earnings
to augment their deposit base and long-run profits.
4. Board of Governors of the Federal Reserve System, “Gross
Demand Deposits of Individuals, Partnerships, and Corporations,” Annual Statistical Digest: 1970-79, p. 150.
17
The county growth factor is measured as the differ
ence between a county’s deposit growth and the
state’s deposit growth for the five-year period prior to
the acquisition. A priori, the growth factor is expected
to have a positive effect on the acquisition price.
While local economic conditions mainly determine
deposit growth for a market as a whole, bank manage
ment influences relative deposit growth.5 Some banks
consistently have grown faster than their competitors,
a fact that can be attributed to aggressive manage
ment. If MBHCs are concerned about growth, they
may well prefer to acquire banks with aggressive
management. Such a preference would bid up the
price of banks that have gained deposits at a faster
rate than their competitors. To capture this poten
tial influence, the analysis includes the bank’s deposit
growth for five years divided by the market’s deposit
growth for five years. It is presumed that fastergrowing banks in a given market would receive
higher premiums.
Business firms prefer to operate in less competi
tive market areas, since it is usually less difficult to
earn profits in such markets. To approximate the com
petitiveness of an area, researchers generally use the
three-firm concentration ratio (the percentage of de
posits held by the three largest organizations in a
given market). While this measure may not always re
flect the actual competitive conditions in a market, it
does provide a general view of the competitive en
vironment. It is assumed that the concentration ratio
would have a positive impact on the premiums paid
for banks.
It is theoretically unclear what effect a more lib
eral branching law would have on the premiums paid
for bank acquisitions, because a number of opposing
forces would seem to occur simultaneously. Ohio’s
new branching law, passed in April 1978 and effective
January 1, 1979, permits de novo branching by a
commercial bank within its home-office county and
5. For purposes of this study, banking markets are approxi
mated by SMSAs in urban areas and by counties in rural areas.
While it is recognized that individual market areas often do
not coincide with these political boundaries, data limitations
prohibit the use of more precise market delineations.
18
Economic Review □ Spring 1981
into all contiguous counties.6 A MBHC could open a
new branch through a bank affiliate instead of acquir
ing an existing bank in an adjacent county. This ex
pansion alternative may have reduced the demand to
acquire existing banks. On the other hand, the less re
strictive branching law enhances the flexibility of a
MBHC to enter and expand in new markets, which
tends to increase the demand for bank acquisitions. A
MBHC could acquire a bank and use its new branching
power to expand operations into contiguous counties.
In addition, the number of potential buyers increased
greatly when statewide bank mergers, acquisitions,
and consolidations became legal in 1979. MBHCs ob
viously were aware of many more potential bidders
when negotiating bank acquisitions after 1978. On
balance, the demand for bank acquisitions probably
increased because of the changed branching law.
Supply factors probably also were affected by the
liberalization of Ohio’s branching law. Stockholders
of banks may have become less willing to sell to a
MBHC, because one advantage of being a member of
a holding company has been eliminated with the
branching law change. Higher prices may have been
necessary to induce bank stockholders to sell. On the
other hand, the current branching law increases the
threat of entry by new competitors in a local mar
ket area, since banks in adjacent counties have become
potential entrants. De novo entry generally is associ
ated with increased competition and lower earnings.
This potential outcome may have encouraged stock
holders to sell at a lower price than otherwise would
have been the case. Given the uncertainty of demand
and supply factors, it is unclear what the effect of a
more liberal branching law would be on acqui
sition prices.
III. Test and Results
To explain the variance among the premiums paid
for bank acquisitions by MBHCs, the following rela
tionship is specified:7
6. For a discussion of the impact of the branching law change
in Ohio, see Whalen (1981).
7. Because the study entails a cross-sectional analysis over
an 11-year period, a time variable is included as a control. If
the time variable is not significant given the other variables
examined, it enhances the validity of using a cross-sectional
analysis over time.
P =f{ME, BE, BS, DC,MD, GBM, GCS, CONC, BL, T),
where P = premium = acquisition price/book value
of bank,
ME = MBHC’s earnings = net income/average
stockholders’ equity (one year),
BE = bank earnings = net income/average as
sets (three years),
BS = deposit size of bank (millions of dollars),
DC = deposit composition of bank = demand
deposits/total deposits,
MD = market dummy (SMSA = 1; nonSMSA = 0),
GBM = bank deposit growth/market deposit
growth (five years),
GCS = county deposit growth — state de
posit growth (five years),
CONC = three-bank concentration ratio,
BL = branching law dummy (1978, 1979,
and 1980 = 1; other years = 0),
T = time dummy (each year).
The Sample
Using a cross-sectional multivariate regression
analysis, the relationship explained 40 percent of the
variance in the premiums paid for 99 bank acquisitions
in Ohio between 1970 and 1980 (see table 3). Five of
the ten variables specified in the equation were statis
tically significant.
As expected, both earnings variables were signifi
cant. When MBHCs earned a higher average rate of re
turn on stockholders’ equity, they paid higher premi
ums for bank acquisitions, presumably because the
demand was greater. Similarly, banks earning a higher
average rate of return on assets required a higher price
to induce stockholders to sell. MBHCs paid signifi
cantly higher premiums for banks earning higher
average rates of return on assets three years prior to
the acquisitions.8
Banks located in SMSA markets received signifi
cantly higher premiums. In addition, MBHCs paid
higher premiums to acquire more rapidly growing
banks in a market area or banks that operated in more
rapidly growing areas. Acquired banks operating in
counties that experienced faster deposit growth than
8. Average rates of return on assets for one, two, and five years
prior to the acquisition also were tested and found significant.
Federal Reserve Bank of Cleveland
19
Table 3 Regression Results Explaining Premium Variability
All bank acquisitions
SMSA
bank acquisitions
Non-SMSA
bank acquisitions
Variable
Coefficient
t-value
Coefficient
t-value
Coefficient
t-value
MBHC earnings (1 year)
Bank earnings (3 years)
Bank deposit composition
Market dummy
Bank deposit growth/market
deposit growth (5 years)
County deposit growth - state
deposit growth (5 years)
Three-bank concentration ratio
Bank deposit size
Branching law change
Time dummy
Constant
0.02169
0.32002
0.42490
0.10598
2.90a
4.33a
1.45
1.73°
0.04188
0.19471
0.57539
2.34b
2.12b
1.68°
0.01706
0.35758
0.31471
1.50
3.23a
0.67
0.06935
2.86a
0.04413
1.82°
0.19170
1.55
0.00295
0.00225
-0.00078
0.13006
0.00005
0.43529
2.32°
1.25
1.45
1.29
0.00
0.00481
0.00432
-0.00146
0.29466
-0.00562
0.22978
3.15a
1.77c
2.83a
2.52
0.35
0.00207
0.00105
0.00458
-0.03151
0.00890
0.28868
0.97
0.43
2.45
0.20
0.42
F-value
Adjusted R2
7.45a
0.40
7.6 8a
0.57
4.4 2a
0.40
a. Denotes significance at 1 percent level.
b. Denotes significance at 5 percent level.
c. Denotes significance at 10 percent level.
SOURCES: Condition and income reports of banks and annual reports of MBHCs.
the state as a whole received significantly higher pre
miums. Banks that registered faster deposit growth
than the market area as a whole also reaped signifi
cantly higher premiums.
While other variables in the equation—
deposit
size, percentage of demand deposits, and market
concentration—
had the expected signs, none of them
was statistically significant in the pooled SMSA and
non-SMSA bank sample.
Type o f Market
Some observers of the MBHC movement suggest
that the type of market affects the factors that are
important when considering bank acquisitions. SMSA
markets usually are substantially larger than non-SMSA
(or rural) markets. MBHCs generally have entered
urban markets by acquiring larger banks with a rela
tively smaller share of market deposits. The average
acquired SMSA bank had deposits of $52 million,
with market deposits of less than 5 percent; the aver
age acquired non-SMSA bank had deposits of $33
million, with market deposits of 25 percent. Many of
the largest banks in urban areas already were affiliated
with MBHCs, including many lead banks acquired
with the formation of the holding companies. Be
cause of competitive factors, regulators traditionally
have discouraged acquisitions of banks with a large
proportion of market deposits, particularly in large
and rapidly growing market areas.
The substantial differences between SMSA and
non-SMSA conditions for acquisition suggest that the
explanatory factors of all other variables may be ob
scured when the two groups are pooled. Therefore,
the sample of 99 MBHC acquisitions was divided into
two groups: SMSA banks and non-SMSA banks. In
dependent variables are expected to have the same
relationship with the premiums paid for both groups
of banks. However, growth factors and the branching
law change should have a greater impact on the pre
miums paid for SMSA banks. MBHCs generally have
acquired banks in urban areas that are relatively small
compared with their competitors. Out-of-county
branching presumably would be more important for
banks in metropolitan areas, since these market areas
generally consist of more than one county.
The results indicate that the relationship explained
57 percent of the variance in the premiums paid for
SMSA banks and 40 percent for non-SMSA banks,
20
Economic Review □ Spring 1981
compared with 40 percent for all of the acquired
banks (see table 3). Eight of the nine variables, includ
ing bank size, percentage of demand deposits, market
concentration, and branching law change, were signif
icant when premiums paid for only the SMSA banks
were tested. In contrast, only two variables—
bank size
and bank earnings—
were significant for the non-SMSA
bank sample.
MBHCs paid significantly higher premiums for
smaller banks in SMSAs. Acquisitions of the
largest banks in SMSAs were discouraged, which
probably tended to increase the premiums paid
for smaller banks. Foothold entry into SMSAs is
relatively attractive, as expansion is presumably
easier in larger markets.
Market concentration, deposit composition, and
the branching law change had a significant impact on
the premiums paid for bank acquisitions in SMSAs.
Banks with a higher percentage of demand deposits
and operating in more concentrated markets received
significantly higher premiums. In addition, MBHCs
paid significantly higher premiums for SMSA banks
following the passage of the liberalized branching law
in April 1978. Banking markets in urban areas typi
cally extend beyond a single county, and much of the
growth in Ohio’s SMSAs in the past decade has been
outside the central-city counties. The new branching
law enables banks to branch throughout an entire mar
ket area, thereby better serving their customers and
enhancing their deposit base. Given a greater oppor
tunity for expansion, the demand for SMSA banks
probably has increased; at the same time, growth-ori
ented banks probably have become less willing to sell.
Earnings of the MBHCs and banks and deposit
growth variables were also significant in explaining the
premiums paid for SMSA banks. The time dummy was
the only variable that was statistically insignificant.
The specified relationship explains 40 percent of
the variance in the premiums paid for banks in nonSMSA counties. Only two of the nine variables—
bank
earnings and deposit size—
were statistically significant.
Larger rural banks with higher earnings received signif
icantly higher premiums. This differs with SMSA mar
ket acquisitions, in that bank size was inversely re
lated to the premiums paid for banks. Since banks
acquired in rural areas were generally much smaller
than banks acquired in urban areas, economies of
scale presumably outweighed the going-concem
aspect of an acquisition. While the other variables in
the equation (including growth measures) generally
had the expected signs, none of them significantly
affected the premiums. MBHCs apparently are con
cerned primarily with the earnings and market position
of the banks that they acquire in rural areas.
IV. Future Acquisition Premiums
Future premiums for bank acquisitions may be
predicted based on past experience and anticipated
changes in the significant explanatory variables in the
model. The premiums paid for both SMSA and nonSMSA banks were significantly affected by the earn
ings of the banks and their deposit size at the time of
acquisition. Several other variables, including MBHC
earnings, deposit growth, deposit composition, market
concentration, and branching law, also had a signifi
cant impact on the premium paid for the SMSA banks.
Premiums would change drastically if the values
of the explanatory variables changed by one standard
deviation from their means (see table 4). For example,
a SMSA bank would be expected to receive a price 2
percent below book value if the following conditions
were present:
1. the bank earned 0.39 percent on its average as
sets over the last five years;
2. the acquiring MBHC earned 11.12 percent on its
average stockholders’ equity in the past year;
3. demand deposits accounted for 23 percent of
the bank’s deposits;
4. the bank’s deposit growth was approximately equal
to the market’s deposit growth;
5. the deposit growth for all of the banks in the
county was only 2.1 percent above the deposit
growth for all of the banks in the state;
6. the three largest banking organizations in the mar
ket accounted for 50.1 percent of the total market
deposits;
7. the bank had total deposits of $119.8 million
prior to acquisition.
The ability of the specified relationship to predict
premiums for non-SMSA banks is lower given that only
two of the variables were significant in explaining past
premiums. Nevertheless, the model indicates that if a
non-SMSA bank had deposits and earnings one stan
Federal Reserve Bank of Cleveland
21
Table 4 Premiums Affected by Hypothetical Changes in Significant Variables*1
Variable
Mean value
Change of one
standard deviation
from mean value
Hypothetical
value
Reduction in premium,
percent of book value
SMSA banks
MBHC earnings (1 year)
Bank earnings (3 years)
Bank deposit composition
Bank deposit growth/market
deposit growth (5 years)
County deposit growth - state
deposit growth (5 years)
Three-bank concentration ratio
Bank deposit size (millions
of dollars)
13.29%
0.80%
33.87%
-2.17%
-0.41%
-11.20%
11.12%
0.39%
22.67%
9
8
6
1.64
-1.63
0.01
7
26.2%
64.2%
-24.1%
-14.1%
2.1%
50.1%
12
6
$51.7
$68.1
$119.8
10
Non-SMSA banks
Bank earnings (3 years)
Bank deposit size (millions
of dollars)
0.94%
$32.7
-0.37%
-$20.9
0.54%
$11.8
13
10
a. The branching dummy was not included, because it had only a one-time effect.
SOURCES: Condition and income reports of banks and annual reports of MBHCs.
dard deviation below the mean values of the other
acquired banks, it would be expected to receive a pre
mium of 27 percent (or 1.27 times book);this premium
compares with the average premium of 50 percent
paid by MBHCs to acquire non-SMSA banks in Ohio
since 1970.
Premiums paid for bank acquisitions in the near
future are likely to decline in light of recent develop
ments. Competition among banks and other financial
institutions has intensified in 1981. The introduction
of NOW accounts will probably have a negative impact
on bank earnings. Evidence suggests that the vast ma
jority of the NOW-account balances at banks was at
tributed to a shifting of demand deposits to these
interest-bearing third-party payment accounts. In ad
dition, banks are encountering increased competition
for consumer loans, as thrift institutions begin to use
the recently granted authority to offer credit cards
and extend installment loans. For the time being,
thrift institutions continue to maintain the authority
to pay 0.25 percent more than banks for most types
of time and savings deposits.
The impact of the Depository Institutions Dereg
ulation and Monetary Control Act of 1980 on indi
vidual banks will vary widely according to the compe
tition offered by thrift institutions in the market.9 A
greater amount of thrift competition increases the
probability of lower bank deposit growth. Individual
banks may find it more difficult to gain a large per
centage of deposits in these markets. Moreover,
aggressive thrift competition may well cause the con
centration of banking deposits in markets to fall.
These expected changes would tend to exert down
ward pressure on bank-acquisition premiums.
On the other hand, if interstate bank acquisitions
or branching is permitted, many more organizations
would wish to acquire banks in Ohio. The demand for
bank acquisitions probably would increase, thereby
exerting upward pressure on the price of banks. This
apparently was the case just a few years ago when lib
eralization of Ohio’s branching law was anticipated.
V. Conclusion
Many banks in Ohio have been acquired by MBHCs
since 1970, and nearly all of the acquired banks re
ceived a price that included a premium above book
9. For a discussion of competition among financial institu
tions, see Watro (1980b).
22
Economic Review □ Spring 1981
value. The premiums depended on the earnings of the
MBHC; the earnings of the bank and its deposit size,
composition, and growth; the deposit growth in the
local area; the market concentration; and the branch
ing law change. Each of these factors significantly af
fected the premiums paid for SMSA banks, but only
the bank’s earnings and its deposit size had a signif
icant impact on the premiums paid for non-SMSA
banks. The premiums paid for either type of bank
were not significantly affected over time, given the
other variables specified in the model.
Although caution must be exercised in predicting
future bank prices, it appears that premiums paid for
bank acquisitions could decline in the future. In
creased competition from thrift institutions generally
would tend to reduce bank earnings and deposit
growth. However, this negative impact on bank pre
miums could be offset by increased demand for bank
acquisitions if interstate banking were permitted.
References
1. Darnell, Jerome C. “What Is Your Bank Worth?”
Magazine o f Bank Administration, vol. 49, no. 6 (June
1973), pp. 25-31.
2. Frieder, Larry A., and Vincent P. Apilado. “The
Performance of Multibank Holding Companies in
Light of Valuation Theory and Financial Regulation,”
Proceedings o f a Conference on Bank Structure and
Competition, Federal Reserve Bank of Chicago, May
1980, pp. 122-55.
3. Piper, Thomas R. “The Economics of Bank Acqui
sitions by Registered Bank Holding Companies,”
Federal Reserve Bank of Boston, Research Report No.
48, March 1971.
4. Piper, Thomas R., and Stephen J. Weiss. “The Pro
fitability of Bank Acquisitions by Multibank Holding
Companies,” New England Economic Review, Federal
Reserve Bank of Boston, September/October 1971,
pp. 2-12.
5.
. “The Profitability of Multibank Hold
ing Company Acquisitions,” Journal o f Finance, vol.
29 (March 1974), pp. 163-74.
6. Varvel, Walter A. “A Valuation Approach to Bank
Holding Company Acquisitions,” Economic Review,
Federal Reserve Bank of Richmond, vol. 61 (July/
August 1975), pp. 9-15.
7. Watro, Paul R. “Market Share Gainers and Losers,”
Economic Commentary, Federal Reserve Bank of
Cleveland, May 19, 1980.
8.
. “Competition between Thrift Institu
tions and Banks in Ohio,” Economic Commentary,
Federal Reserve Bank of Cleveland, July 14,1980.
9. Whalen, Gary. “Bank Expansion in Ohio,” Eco
nomic Commentary, Federal Reserve Bank of Cleve
land, April 6, 1981.
The High-Employment Budget:
Recent Changes and
Persistent Shortcomings
by Owen F. Humpage
The high-employment budget measures federal
government receipts, expenditures, and the associated
surplus or deficit that would result if the economy
always operated at its potential or full-employment
level of output.1 Conceptually, the high-employment
budget enables one to distinguish discretionary fiscal
policies, which indicate changes in federal tax and
spending laws, from automatic (or induced) budget
developments, which reflect changes in economic
activity. Economists frequently have used the highemployment budget in setting and analyzing fiscal
policies. Unfortunately, many measurement and
conceptual problems plague the high-employment
budget and greatly circumscribe its ability to distin
guish between discretionary and automatic fiscalpolicy responses. In an effort to standardize and to
improve the high-employment budget, new estimates
have been prepared jointly by the Bureau of Economic
Analysis of the Department of Commerce, the Coun
cil of Economic Advisers, the Board of Governors of
the Federal Reserve System, the Office of Manage
ment and Budget, and the Department of the Treasury
(de Leeuw et al. 1980). The revisions, however, do
not address the fundamental shortcomings of the
high-employment budget. This article explains the
high-employment budget concept, summarizes the
1. This article uses the terms high employment and full
employment interchangeably. In recent years, government
publications have substituted high employment in places
where full employment previously appeared. This change
is meant to dramatize the uncertainty in calculating full
employment The problem is discussed in the Potential GNP
and Full Employment section.
new estimating procedure, and reviews the persistent
problems that greatly restrict the measure’s usefulness.
I. In Theory
Federal taxing and spending policies influence eco
nomic activity. A reduction in federal tax rates in the
absence of any offsetting change in federal spending
raises the budget deficit and, presumably, aggregate
demand.2 Simultaneously, however, a change in eco
nomic activity automatically alters the federal budget.
By reducing personal incomes and corporate profits,
an economic slowdown tends to lower federal incometax and payroll-tax receipts; at the same time, it
tends to raise spending for such programs as unem
ployment compensation and food stamps. An eco
nomic slowdown consequently increases the budget
deficit. Frequently, this interaction between the
budget and economic activity creates difficulties
in interpreting federal fiscal policy. An increase in
the federal budget deficit, as conventionally mea
sured, does not necessarily imply that fiscal author2. This apparently innocuous statement is the source of a
great deal of controversy, particularly among strict Keynes
ians, monetarists, and rational expectations’ advocates. In the
short run, if resources are not fully employed, and if policy
changes are not completely anticipated, a deficit-financed
change in fiscal policy would raise real output and employ
ment. In the long run, if resources are fully employed, or if
fiscal policy is fully anticipated, deficit-financed fiscal
policies may result only in a higher price level and a substi
tution of public for private spending.
Owen F. Humpage is an economist with the Federal Reserve
Bank o f Cleveland.
24
Economic Review □ Spring 1981
ities are actively undertaking stimulative fiscal policies.
In fact, if a decline in economic activity is sharp
enough, a rising budget deficit could mask a perverse
shift toward restrictive discretionary fiscal policy.
In 1974, for example, economic activity slumped,
and the deficit widened by $4.0 billion (national
income and product account basis). This shift toward
fiscal stimulus, however, was the automatic budget
response to the weakening economy. Discretionary
policy, as measured by the high-employment surplus
(HES), shifted $15.0 billion toward restraint. In
theory, therefore, by distinguishing between dis
cretionary and automatic budget changes, the HES
allows one to analyze the response, timing, and
strength of discretionary fiscal policy and to compare
the relative contributions of discretionary and auto
matic budget responses to stabilization over the
business cycle.3 One therefore can determine whether
discretionary fiscal policy is a stabilizing or destabi
lizing force over the business cycle.
In addition to distinguishing between discretionary
and automatic fiscal-policy changes, the HES con
ceptually provides an estimate of long-term creditmarket conditions associated with continuation
of current fiscal policies. The federal government
must borrow to finance its deficit, yet, in doing so,
it reduces the amount of savings available in the
economy to finance private investment. A highemployment deficit, therefore, indicates the amount
of private savings being diverted from private invest
ment at full employment. The consequences of
federal borrowing need not be serious, unless the
government borrows large sums for extended periods
of time. Then, the primary effect of deficit-financed
fiscal policies may be only to displace an equal
amount of private investment— phenomenon called
a
“crowding out.” Whereas a budget deficit, auto
matically induced by a decline in gross national
product (GNP) below its potential or full-employment level, will be self-correcting as the economy
moves back to full employment, a high-employment
deficit requires an offsetting change in fiscal policies
to avoid crowding out when the economy reaches
its potential level of output.
3. The actual deficit on a national income and product
account basis, less the HES, equals that portion of the
deficit attributable to automatic budget responses.
Although the HES concept traces back at least to
the Committee for Economic Development in the
1940s, it was used most widely in the early 1960s,
after its introduction in the 1962 Annual Report of
the Council of Economic Advisers. During the 1970s,
however, the HES largely disappeared from the anal
ysis of fiscal policy, because of fundamental problems
involving its measurement and interpretation. These
problems are reviewed below.
II. In Practice
Although the HES is a fairly simple theoretical
concept, it is very difficult to measure with the de
gree of precision necessary to render unquestionable
conclusions about fiscal policy. Since the initial pop
ularity of the HES measure in the early 1960s, econo
mists have developed increasingly more sophisticated
statistical procedures for estimating such things as
potential GNP growth and the associated components
of the high-employment budget. Besides incorporating
these developments, the new technique for estimating
the HES improves the measure in three other impor
tant ways: (1) it guarantees that the actual, and esti
mated, high-employment surplus or deficit is equal
when the economy is at full employment; (2) it re
moves the business-cycle influence on a wider range
of expenditures; and (3) it standardizes the official
government estimates of the HES (see appendix 1).
Nevertheless, many problems persist and greatly
restrict the usefulness of the HES for analyzing
fiscal policy.
Inflation
One reason for the HES’s wane is that it does not
achieve a complete dichotomy between discretionary
fiscal-policy actions and automatic budget responses.
Movements in nominal potential GNP produce changes
in the HES with the overall effect of making discre
tionary fiscal policy appear more restrictive than it
actually is. This problem is particularly severe during
periods of high and accelerating inflation; it stems,
in part, from the asymmetric impact of inflation on
budget receipts and expenditures. Although inflation
increases both receipts and expenditures, receipts
tend to rise faster than expenditures, because of the
general progressiveness of the federal tax structure
Federal Reserve Bank of Cleveland
and because of lags in adjusting most expenditures to
rising prices. The method of estimating the HES does
not yet correct for this difficulty. Actual prices are
used in the calculation of full-employment tax bases,
and full-employment expenditures are not deflated
for actual price-level changes. Consequently, infla
tion increases the HES and gives the appearance of
a shift in discretionary fiscal policy toward restraint.
In fact, however, discretionary policy is unchanged;
the budget is responding automatically to the in
flationary growth of nominal income.
Even if inflation were not a problem, the HES
would not completely distinguish discretionary
from automatic budget responses. Real economic
growth along the potential GNP trend line also will
increase the HES, falsely indicating discretionary
policy restraint. Normal economic growth raises
income levels and, under the progressive federal tax
structure, tends to raise effective tax rates. The bias
induced by real growth on the HES may be more
severe than that induced by inflation, because real
growth will not affect high-employment expenditures.
The asymmetric impacts of inflation and real
growth leave the level of the HES an unreliable indi
cator of discretionary policy and long-term crowding
out. Changes in the HES, however, remain useful
indicators of the direction and relative magnitude
of changes in discretionary fiscal policy, provided
that comparisons are restricted to relatively short
time periods.
Potential GNP and Full Employment
The accuracy of HES estimates depends on the ac
curacy of the potential GNP and the full-employment
unemployment rate estimates that underlie the HES
calculations. Potential GNP attempts to measure the
output capable of being produced when the economy
is using all resources at its full-employment level.
Basically, a potential GNP series is generated by first
calculating a full-employment level of the factors of
production, usually labor or labor plus capital, and
then multiplying this level by a long-term trend rate
of productivity growth. Full employment originally
meant the lowest unemployment rate attainable
under the existing institutional setting without accel
erating inflation. No simple, stable correlation,
however, exists between unemployment rates and
25
inflation rates. Moreover, the changing age-sex com
position of the labor force experienced during the
1970s further complicated interpretation of unem
ployment rates. Therefore, the full-employment
unemployment rate is now defined by assuming that
the 4.0 percent unemployment rate experienced in
1955 represented full employment and by adjusting
this figure for subsequent changes in the age-sex
composition of the work force. Similarly, full em
ployment of the capital stock is defined in terms of a
capacity utilization figure observed in previous years
when the economy seemed to be operating at po
tential GNP.
If the foregoing definitions of potential GNP
and full employment seem to be imprecise, it is
because the concepts themselves are rather vague.
Indicative of this fact is the continuing debate sur
rounding the proper methodology for calculating
potential GNP. The Council of Economic Advisers
(CEA), for example, originally calculated potential
GNP using labor as its only input. Similarly, the po
tential GNP estimates underlying the current HES
calculations assume that labor is the only input,
making adjustments for changes in the age-sex com
position of the labor force (de Leeuw et al. 1980).
In 1977, the CEA revised its estimating technique to
account for the growth of the capital stock and
changes in the age-sex composition of the labor force
(Clark 1977). Despite these revisions, the CEA’s
initial projections of potential GNP continuously
have over-estimated potential GNP, resulting in subse
quent downward revisions. These over-estimates
primarily reflect the inability of researchers to ex
plain the decline in the trend rate of productivity
growth and accurately to forecast future produc
tivity trends. Rasche and Tatom (1977) have argued
that the CEA’s estimates of potential GNP greatly
overstate the level of potential GNP, because they
do not include energy as a factor of production.
Rasche and Tatom contend that the sharp rise in
energy prices after 1973 greatly lowered productivity
growth and potential GNP. Penson and Webb (1981)
have criticized the conventional estimates of potential
GNP for focusing solely on highly aggregated supply
conditions. Penson and Webb estimate potential
GNP using a general equilibrium approach, which ac
counts for the inter-relationships among the produc
tion sectors and the demands for output and inputs.
26
Economic Review □ Spring 1981
other economists have argued that the rate may be as
high as 6 percent to 6.5 percent.
The calculation of the HES requires an estimate of
nominal potential GNP, but the CEA’s calculations
of potential GNP are in real terms. To adjust the data,
therefore, the CEA’s estimates of potential GNP are
multiplied by actual current prices as measured by
the GNP price deflator. The practice can be ques
tioned, however, because it implicitly assumes that
current price patterns are applicable at full employ
ment. In fact, current absolute price levels almost
certainly will be different, and relative price patterns
also may be significantly altered. As Penson and
Webb (1981) indicate, changing price patterns as
the economy moves toward full employment may
alter potential GNP.
The inability to measure precisely the level of
potential GNP discredits estimates of the HES,
whereas the inability to measure accurately the
4. The comparative estimates are found in Penson and
growth rate of potential GNP casts doubts on the
Webb (1981, p. 9). Because Penson and Webb have not
reliability of estimates of the change in the HES.
yet extended their estimates of potential GNP beyond 1971,
more recent comparative data were not used.
Frank de Leeuw et al. (1980) investigated the sensi
tivity of the HES to alternative
estimates of potential GNP by
Table 1 HES under Alternative Assumptions of the Full-Employment
constructing an alternative HES
Unemployment Rate
series based on a moving average
Billions of dollars, NIPA basis
of actual GNP. They found that
Levels of HES
Changes in HES
over short periods of time the
Calendar
assumptions about potential
year
At 5.1% At 6.1% Difference3 At 5.1% At 6.1% Difference3
GNP had little influence on
$-15.8
1977:IQ
$-9.7 $-25.5
$+0.9
$+12.6 $+11.7
changes in the HES; they cau
-15.8
-8 .4
-8.4
0
-33.9
HQ -18.1
tioned, however, that over
IIIQ -32.7
-48.8
-14.9
-0.3
-16.1
-14.6
longer periods the alternative
IVQ -31.6
-48.1
-16.5
+ 1.1
+0.4
+0.7
assumptions about potential out
1978:IQ
-45.5
-17.2
-28.3
+3.3
+2.6
+0.7
put could cause divergent pat
-14.2
+14.1
-17.7
+0.5
-31.9
+ 13.6
HQ
IIIQ -10.9
-29.4
-18.5
+3.3
+2.5
+0.8
terns in the changes of the
IVQ
-9.6
-28.7
-19.1
+ 1.3
+0.7
+0.6
resulting HES series. Table 1
1979:IQ
-4.6
-24.5
+4.2
+0.8
-19.9
+5.0
presents the HES series under
+5.1
-20.2
+9.4
-15.1
+0.3
+9.7
IIQ
alternative definitions of the
IIIQ
-23.4
-7 .4
-21.1
-2 .3
-8 .3
-0 .9
full-employment unemployment
IVQ
-7.1
-29.0
-21.9
-4.8
-5 .6
-0.8
rate. Although the HES levels
1980:IQ
-22.4
-17.1
-39.5
-10.5
-0.5
-10.0
are very different under the
-44.4
-4 .4
HQ -21.5
-22.9
-4 .9
-0.5
alternative full-employment as
IIIQ -21.2
-23.8
-45.0
+0.3
-0.6
+0.9
IVQ -13.4
sumptions, the changes in the
-37.8
-24.4
+7.2
+7.8
+0.6
respective series are similar. It
a. Level or change at 5.1 percent unemployment less level or change at 6.1 per
appears, therefore, that prob
cent unemployment rate.
lems in defining potential GNP
SOURCE: Board of Governors of the Federal Reserve System.
and full employment disrupt the
Under these alternative models, potential GNP esti
mates for 1970, for example, range from $1,124.9
billion according to the CEA’s original estimates
to $1,077.8 billion according to Penson and Webb’s
methodology.4 Moreover, the estimated rate of po
tential GNP growth for 1970 ranges from 4.0 percent
for the CEA to 1.0 percent under Penson and Webb.
A similar debate surrounds the numerical valuation
of the full-employment unemployment rate for labor.
The unemployment rate is important not only in the
calculations of potential GNP, but it also figures
directly into the cyclical adjustment of high-employment government expenditures (see appendix 1). The
Council of Economic Advisers recently defined full
employment as a 5.1 percent unemployment rate, but
Federal Reserve Bank of Cleveland
usefulness of the HES but do not greatly impair
interpretations of short-run changes in the HES,
especially if they are expressed as ratios to changes in
potential GNP.
Endogeneity
Richard Kopcke (1981) has raised a further
criticism of the HES and its interaction with poten
tial GNP. Kopcke correctly argues that the level
of potential output is not independent of fiscal
policy, and conventional measures of HES that
do not account for this endogeneity render false
readings of discretionary fiscal policy. To illustrate
his point, Kopcke considers the effects of infla
tion-induced increases in corporate taxes.5 Since the
mid-1960s, such taxes have raised the cost of capital
to firms, reduced investment in plant and equipment,
lowered productivity, and, consequently, trimmed
potential GNP. The effect has been to lower the HES,
i.e., to make discretionary fiscal policy seem more
stimulative than it actually is.
As supply-side economists are currently con
tending, the channels through which fiscal policy in
fluences potential GNP may be more extensive than
Kopcke chooses to illustrate. High marginal tax
rates, generous unemployment compensation, ex
tensive welfare payments, and liberal trade-adjustment assistance may cause individuals to work less.
Consequently, these factors may raise the highemployment unemployment rate and lower po
tential GNP. Similarly, high marginal tax rates also
may reduce savings relative to consumption and
cause large amounts of resources to be devoted to
tax avoidance, resulting in less investment and lower
potential output. Persistent federal deficits also may
lower potential GNP growth if they raise investors’
uncertainty about inflation and reduce investment.
These examples illustrate that the feedback be
tween the HES and potential GNP may be quite
extensive, suggesting that large distortions may
exist in the conventionally calculated HES. While
the distortions would certainly affect the HES,
changes in the measure could remain a useful shortrun indicator of the direction of fiscal policy despite
the feedback problem.
5. See also Kopcke (1980).
27
Dynamic Considerations
The HES is meant to be a summary measure of
discretionary fiscal policy, but the ultimate indication
of how fiscal policy affects the economy is the change
in a target variable, say real GNP or the unemploy
ment rate, induced by a change in fiscal policy. A
given fiscal policy, however, will have an initial
effect (the impact multiplier) and an associated
chain of induced (or multiplier) effects extending
over subsequent time periods. Moreover, different
fiscal policies may have different impact and multi
plier effects. The HES does not deal adequately with
these aspects of fiscal policy.
Much of the discussion about the HES as a sum
mary measure of discretionary fiscal policy centers
on its usefulness as a proxy for the impact multi
pliers associated with fiscal policy. Economists,
however, often argue that various fiscal policies
have different impact multipliers; for example,
a $ 10-billion government purchase probably has
a larger impact multiplier than a $ 10-billion grant
to state and local governments. Moreover, the simple
“balanced-budget theorem” argues that equal in
creases (or decreases) in expenditures and receipts
will have a net expansionary (or contractionary)
influence on the economy. The HES, however,
treats all dollars of fiscal stimulus as equal. It does
not distinguish between different initial effects of
alternative types of expenditures or taxes. Conse
quently, economists have argued that various fullemployment receipts and expenditure categories
should be weighted by their impact multipliers. One
serious problem with this approach is in determining
the weights to associate with specific fiscal policy.
The weights depend on one’s model of how the
economy reacts to discretionary fiscal policy, and
economists are not in total agreement on this score.
Moreover, the weights may change over time as other
economic variables change.
The second difficulty with this approach points
to a more general problem associated with using
the HES as a measure of fiscal policy. The HES is
a static concept, whereas the assessment of fiscal
policy involves important time-dimensional aspects.
Consider, for example, the hypothetical multipliers
presented in figure 1. Equal one-time expenditures
for government purchases and grants to state and
28
Economic Review □ Spring 1981
local governments may produce multipliers as de
picted by lines A and B, respectively. The total im
pact of these policies on real GNP equals the shaded
area under the lines. While the contours of the lines
are different, the areas associated with similar dollar
amounts of fiscal stimulus are the same. Moreover,
many economists believe that fiscal policy has no
long-run impact on real economic variables. A deficit
leads to real crowding out in the long run, so that
fiscal policy alters only the composition of real
output (smaller private sector, larger government
sector), not the level of real output. In figure 1,
accordingly, the multipliers turn negative. The con
tours of flscal-policy multipliers also depend on
many other factors, chiefly, the degree of restraint
or ease in monetary policy, the nation’s degree of
international “openness” and its exchange-rate re
gime, and the state of expectations.
Because the HES is a static concept, it is not
sensitive to these considerations. Is a temporary
decline in the HES stimulative in a long-term sense
when crowding out occurs? Can a string of fullemployment deficits, growing by a constant dollar
amount, be considered expansionary in the longer
term? Weighting the HES by impact multipliers
would seem to exacerbate the problem. In figure 1,
for example, weighting by impact multipliers would
imply that the policy associated with line A is more
stimulative than the policy associated with line B. Yet
it is not in a long-term sense.
Budget Shortcomings
One reason that the HES is limited as a satisfactory
Fig. 1 Fiscal-Policy Multipliers
Change in GNP
summary measure of discretionary fiscal policy is
that the federal budget itself is not a comprehensive
record of all government fiscal programs. Adrian
Throop (1981) has criticized the HES concept for
this reason. The HES excludes various on- and offbudget federal loans and loan guarantees. The average
interest rate of these government-sponsored loans is
less than the going market rate, thereby conferring
a subsidy on the borrowers. Throop correctly argues
that the value of this subsidy should be included in
the HES, because it influences economic activity.
The rapidly growing use of loans and loan guarantees
in recent years makes Throop’s criticisms all the
more relevant.
On the other hand, Throop argues that federal
interest payments on the national debt should not
be included in the HES, to the extent that they repre
sent the inflation premiums required by lenders to
hold government obligations. These payments offset
the reduced value of the debt held by the public
and therefore have no net influence on real economic
activity. Moreover, Throop argues that, because these
premiums are saved by lenders to maintain the real
value of their net worth, the funds are returned to
the capital market. Consequently, federal borrowing
to finance inflation premiums has no impact on
funds available to finance private credit demands.
Without this adjustment, the HES overstates the
degree of long-term crowding out associated with
fiscal policy.
III. In Conclusion
Although the revised high-employment budget
calculations provide some needed improvements,
they do not address the persistent fundamental
problems that have impaired the measure’s useful
ness. As indicated in the foregoing text, these prob
lems greatly distort the HES as a summary statistic
for discretionary fiscal policy and raise serious ques
tions about the ability of changes in the HES to
indicate anything but the general direction of the
initial thrust of discretionary fiscal policy over very
short time intervals.
On a more fundamental level, however, one may
question the basic usefulness of distinguishing between
discretionary and automatic fiscal policies, or even
the ability to do so. In an inflationary environment,
Federal Reserve Bank of Cleveland
29
for example, taxes automatically increase. Yet,
might not the decision of Congress not to offset
inflation-induced tax increases more correctly be
viewed as a discretionary decision to allow taxes
to rise? Similarly, many expenditure programs are
adjusted automatically to higher rates of inflation,
while others are routinely increased for the same
purpose by acts of Congress. Is distinguishing the
former as automatic, and the latter as discretionary,
meaningful or useful? In an inflationary environment
where such adjustments are frequent and pervasive,
distinctions between discretionary and automatic
budget changes become greatly blurred.
The analysis of fiscal policy is a complicated task,
not adequately captured in a single summary statistic.
One must consider not only the total dollar value,
and types, of major policy changes, but also the im
plied federal borrowing requirements against the
backdrop of current and future economic develop
ments. Over the last decade, there has been a rapid
increase in the use of large econometric models
capable of representing the basic relationships among
sectors of a complex economy. Resources probably
are more wisely spent in developing and analyzing
sensible fiscal policy simulations on large econo
metric models than in attempting to reduce the
multi-dimensional problem of assessing fiscal policy
to a single statistic, such as the HES.
rates next were calculated for the appropriate income
categories, and the corresponding full-employment
receipts equaled the tax rates times the bases. Total
full-employment receipts equaled the sum of the
components. Under the traditional methodology, all
spending categories were treated as discretionary
expenditures, except unemployment compensation,
which was adjusted to eliminate changes in benefit
payments associated with cyclical variations in the
unemployment rate. The HES equaled high-employ
ment receipts minus high-employment expenditures.
The new high-employment-budget calculations
depart from the traditional approach in three basic
ways.1 In one major change, a “grossing-up” proce
dure is used to calculate full-employment income
shares, tax bases, tax receipts, and expenditures.
Grossing-up ensures that the estimated full-employ
ment values of variables equal their observed actual
values at full employment. The traditional approach
cannot guarantee this result. In a second major
departure from the traditional approach, the new
method increases the number of expenditure cate
gories that are adjusted for their sensitivity to the
business cycle. In addition, more sophisticated
statistical methods are used under the new procedure.
To understand the new high-employment budget
estimation technique, consider the following process
for isolating the business-cycle influences on a vari
able. One might hypothesize that
Appendix 1 Calculating the High-Employment
Budget—Old and New Methods
(1)
Both the “ traditional” and the new methods of
calculating the high-employment budget rely on the
Council of Economic Advisers’ estimate of potential
GNP. Under the traditional method, potential GNP
was multiplied by the actual GNP deflator to arrive at
a nominal value. Next, to arrive at full-employment
receipts, potential GNP had to be allocated among
the various income-earning sectors of the econ
omy, since each can be taxed at a different rate.
Consequently, income shares at full employment for
the various national income components (e.g., cor
porate profits or wages and salaries) were assumed to
equal observed values in past years of full employ
ment. Multiplying current-dollar potential GNP by
the income shares yielded the corresponding fullemployment tax bases. Average full-employment tax
where X = the variable to be explained, such as in
come shares or federal expenditures,
a Q = a constant term,
T = a time trend,
G = a variable measuring the business cycle,
such as the GNP gap or the unemployment-rate gap,2
j3p $2 = hypothesized (unknown) measures of the
effect of a change in T or G, respectively,
on X,
e = the error term.
X = a0 +(31T + P 2G + e ,
1. The following is a summary of the methodology discussed
in de Leeuw et al. (1980).
2. The potential GNP gap equals potential GNP less actual
GNP; the unemployment-rate gap equals the full-employment
unemployment rate less the actual unemployment rate.
30
Economic Review □ Spring 1981
This equation can be estimated to obtain statistical
approximations of a Q, /Jp P2, and e, defined as a Q,
fi2, and e, respectively. The statistically estimated
equation 1 provides two values for the variable X.
First, it offers an estimate of actual X defined as
(2)
X = ^ 0 + ^ T + $2G .
Second, by setting G equal to zero, equation 2 pro
vides an estimate of full-employment X, defined as
(3)
x f
=
.
^T his is the traditional approach to estimating
XF. Notice that X F need not equal actual X when
the economy is at potential output. From equations 2
and 3 we obtain
(4) X F=
X - P 2G .
At full employment X F = X, but from the estimated
equations 1 and 2
(5)
X = X - e ,
so that
(6) X F = X - e
.
There is no guarantee that at full employment the
estimated value X F will equal the observed value X
because of the residual term e.
Under the new method of calculating HES, an
additional step (grossing-up) is introduced. Grossingup simply refers to adding the difference between^an
estimated preliminary fuU-employrnent value (XF)
and the estimated actual value (X) to an observed
actual value (X) to obtain the final full-employment
estimate of X. Therefore, define this final full-em
ployment value of X as
(8) X F = X F + e ,
it follows that grossing-up is important if the re
sidual term (e) equals a non-zero value for extended
periods of time. If e usually equals zero, grossing-up
is not necessary.
The statistical approach summarized by equation 1,
along with the grossing-up procedure indicated by
equation 7, is the general form used to calculate
full-employment income shares for the components
of national income. The components are wages and
salaries, other labor income plus employer contri
butions for social insurance, corporate profits, propri
etor’s income, interest and rental income, and a resid
ual component equal to GNP less national income.
The estimated income shares are used to gen
erate corresponding full-employment tax bases.
First, the full-employment income shares (analo
gous to X F in equation 7) are multiplied by
current-dollar potential GNP to provide preliminary
estimates of the respective tax bases (TBF). Next,
the estimated actual income shares (analogous to
X ) are multiplied by actual nominal GNP to yield
estimated actual tax bases (TB). As will be shown
below, the resulting difference between the esti
mated full-employment tax^ base jind the esti
mated actual tax base (TBF - TB) is used to
generate tax-revenue gross-ups for the respective
income categories.3
First, however, tax elasticities for the respective
tax categories are calculated. All elasticities are
specified as the percent changes in tax receipts
resulting from a 1 percent change in the respective
tax base. Because the base elasticity of any tax
depends on the source of the change in the tax base,
the elasticities used in the HES calculations often are
complex-weighted averages of many effects.4
The various tax elasticities can be multiplied by the
percentage change in the appropriate tax base to gen
erate a change in the respective tax receipts. That is,
(7) X F = ( X F - X ) + X .
At full ^employment, G = 0 in equation 2, and thus
XF = X and X F = X. Grossing-up ensures that the
observed actual values of X equal the final full-em
ployment estimates when the economy is at full
employment. Since equation 7 can be written as
3. The calculations are supplemented with separate estimates
for dividends, personal income less net interest, and cor
porate capital consumption adjustment.
4. For example, the elasticity of personal tax receipts with
respect to changes in the base (personal income) caused by
more workers is 1; it is greater than 1 when the base change
reflects additional income per worker.
Federal Reserve Bank of Cleveland
(9) In RFt - In R { = r?. (In TBF. - In TB.)
A
estimated actual expenditures (see equation 7). The
HES equals total high-employment receipts less total
high-employment expenditures.
,
A
where In RF. — In R i approximates the percentage
difference between full employment and actual taxes
for the income category /;
is the respective tax
A In R .
elasticity equal t o -------- -—
y 4
A In TB.
i
-a
^
; In TBF. — In TB.
1
1
approximates the percentage deviation between the
actual and full-employment tax base.5
The estimated changes in tax receipts for the various
income categories are used to gross up actual tax
revenues to the full-employment level. Total highemployment receipts equal the sum of the components.
The new technique for estimating HES also adjusts
a broader range of expenditure categories for business-cycle fluctuations than the traditional method.
Now the cyclical components are removed from a
wide range of benefit payments—
unemployment
compensation, old age and survivors’ insurance,
disability, food stamps, aid to families with depen
dent children, medicaid, and veterans’ education. In
most cases, the cyclical adjustments rely on previ
ously completed studies done by various government
agencies, and usually they rely on the gap between
the observed unemployment rate and a full-employment unemployment rate (5.1 percent in 1980) to
make the business-cycle adjustments. The grossing-up
procedure described above is applied to expenditures;
full-employment expenditures equal actual observed
expenditures plus the difference between the prelimi
nary estimate of full-employment expenditures and
5. Changes in the natural logarithm can be used to approxi
mate small percentage changes.
31
References
1. Clark, Peter K. “Potential GNP in the United
States, 1948-80,” U.S. Productive Capacity: Esti
mating the Utilization Gap. St. Louis: Center for
the Study of American Business, Washington Uni
versity, December 1977, pp. 21-67.
2. de Leeuw, Frank, et al. “The High-Employment
Budget: New Estimates, 1.955-80,” Survey o f Cur
rent Business, vol. 60, no. 11 (November 1980),
pp. 13-43.
3. Kopcke, Richard W. “Potential Growth, Produc
tivity, and Capital Accumulation,” New England
Economic Review, Federal Reserve Bank of Boston,
May/June 1980, pp. 2241.
4.
. “Is the Federal Budget Out of Control?”
New England Economic Review, Federal Reserve
Bank of Boston, forthcoming.
5. Penson, John B., Jr.,
National Product at Full
Review, Federal Reserve
66, no. 6 (June 1981), pp.
and Kerry Webb. “Gross
Employment,” Economic
Bank of Kansas City, vol.
3-15.
6. Rasche, Robert H., and John A. Tatom. “Energy
Resources and Potential GNP,” Review, Federal Re
serve Bank of St. Louis, vol. 59, no. 6 (June 1977),
pp. 10-24.
7. Throop, Adrian W. “Gauging Fiscal Policy: I,”
Weekly Letter, Federal Reserve Bank of San Fran
cisco, January 9, 1981.
8 .
. “Gauging Fiscal Policy: II,” Weekly
Letter, Federal Reserve Bank of San Francisco,
January 16, 1981.
32
Economic Review □ Spring 1981
Mark S. Sniderman, “The Welfare Implications
of Alternative Unemployment Insurance
Plans,” Working Paper 8101, April 1981,
20 pp. Bibliography.
Following is an abstract o f a working paper recently released by the Federal
Reserve Bank o f Geveland.
A penumbral issue in the unemployment insurance
by government for the benefit of high-risk firms
financing literature is the relationship between experi
and employees. Incomplete experience rating is
ence rating, public and private unemployment insur
controversial where UI is concerned, in part be
ance (UI) systems, and individual welfare. A public
cause of the adverse incentives it provides firms
insurance system can never be perfectly experience
and employees. A great deal more is known about the
rated if the government desires people with different
distribution of the turnover risk ex ante than is
layoff probabilities to hold identical insurance
the case in many other insurance markets.
policies. A corollary proposition is that a private in
A proper concern of state governments is the
surance system, if information is perfect, would
solvency of UI plans operating within state juris
always feature fully rated plans, but the character
dictions. Perfectly experience-rated private UI plans
istics of these plans may frustrate other public policy
are likely to structure premiums and indemnities
goals (e.g., income transfer or maintenance).
differently than public UI plans, partly because
Though virtually all previous research points out
public plans are less concerned about solvency.
the moral hazard aspects of the UI system, little
Public plans in principle can be perfectly experience
attention has been paid to the efficiency-equity
rated, but such plans would entail different costs
trade-off introduced by government control of the
per dollar of insurance for high- and low-risk indi
insurance contract. This paper introduces this issue
viduals. Though economically justifiable, these dif
explicitly. Full experience rating for each firm is
ferences may be difficult to defend politically. Yet,
tantamount to complete exposure for the firm to
once governments attempt to provide “adequate”
the vagaries of the business cycle. Firms may be
benefits, or “proportional” benefits, perfect ex
willing to bear this exposure when UI is part of an
perience rating must be replaced by some pooled-
implicit labor contract with its employees, and em
equilibria-contracting
ployees likewise may be willing to pay for the risk
system based on pooling (imperfect experience
shifting through wage adjustments. For some firms,
rating) forces some people to purchase less than
however, the degree of exposure necessary to insure
optimal insurance coverage, while others may pur
all workers legally may contribute to insolvency.
chase more than is optimal.
pattern.
A
monopoly
UI
Incomplete experience rating is one method of
achieving risk pooling among firms and limits the
Copies o f the paper are available on request to the
exposure of high-turnover firms. Incomplete ex
Federal Reserve Bank o f Cleveland, Research De
perience rating is a form of market intervention
partment, P.O. Box 6387, Cleveland, OH 44101.
@FedFRASER