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Economic
Review
Federal Reserve Bank
of San Francisco
1993

Number 3

John P. Judd and
Brian Motley

Using a Nominal GDP Rule to Uuide
Discretionary Monetary Policy

Ramon Moreno and
Sun Bae Kim

Money, Interest Rates and Economic Activity:
Stylized Facts for Japan

John P. Judd and
Jack H. Beebe

The Output-Inflation Trade-off in the United
States: Has It Changed Since the Late 1970s?

Timothy Cogley

Ronald H. Schmidt and
Steven E. Plaut

Adapting to Instability in Money Demand:
Forecasting Money Growth with a Time-¥arying
Parameter Model
Water Policy in California and Israel

Table o f Contents

Using a Nominal GDP Rule to Guide Discretionary Monetary Policy........................ 3
John P. Judd and Brian Motley

Money, Interest Rates and Economic Activity:
Stylized Facts for Japan ....................................... .......................... ......................... 12
Ramon Moreno and Sun Bae Kim

The Output-Inflation Trade-off in the United States:
Has It Changed Since the Late 1970s? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
John P. Judd and Jack H. Beebe

Adapting to Instability in Money Demand:
Forecasting Money Growth with a Time-Varying Parameter Model ........................... 35
Timothy Cogley

Water Policy in California and Israel .................................................
Ronald H. Schmidt and Steven E. Plaut

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Using a Nominal GDP Rule to Guide
Discretionary Monetary Policy

John P. Judd and Brian Motley
The authors are Vice President and Associate Director of
Research and Senior Economist, respectively, at the Federal Reserve Bank of San Francisco. They would like
to thank Jack Beebe, Chan Huh, Bennett McCallum,
Ann-Marie Meulendyke, Glenn Rudebusch, John Taylor,
Bharat'Trehan, and Carl Walsh for helpful suggestions,
and Andrew Biehl. for excellent research assistance. Any
remaining errors are the sole responsibility of the authors.

Given doubts about the reliability of the monetary aggregates as intermediate targets of monetary policy, the
Federal Reserve attempts to meet its dual goals-gradual
reduction ofinflation and mitigation ofcyclical downturns
in output-through purely discretionary adjustments ofan
interest rate instrument in response to myriad incoming
data. A procedure in which the Fed would consult a
nominal GDP feedback rule, while retaining the flexibility
to use discretion in its monetary policy decisions, might
contribute to achieving its long-run inflation goal without
significantly interfering with its ability to pursue its shortrun cyclical goal. This paper describes such a policy
regime, and presents some empirical evidence pertinent to
an assessment of how it might work.

In recent years, the Federal Reserve has become more
explicit about its desire to reduce and ultimately eliminate
inflation, citing the beneficial effects of stable prices on
long-term economic growth.! At the same time, it has
retained the goal of mitigating cyclical downturns in
employment and output. Dual goals inevitably raise the
issue of which should take precedence when they have
conflicting implications for policy. The Fed resolves these
conflicts on a case-by-case basis, using its discretion to set
policy after analyzing a wide array of real and financial
indicators. Like most of its counterparts in otherindustrial
countries, it uses a short-term nominal interest rate (the
federal funds rate) as its policy instrument (Kasman 1993).
In pursuing gradual disinflation over the last fifteen
years, the Fed has attempted to use the monetary aggregates (mainly M2 since 1982) as a "noIT'J1nal anchor" to
help prevent short-term discretionary decisions from inadvertently allowing inflation to stray from the long-term
goal. Annual target ranges have been established for various measures of money, and these have been lowered
gradually over time to be consistent with declining inflation'The idea underlying this approach is that if the funds
rate were adjusted so that money fell within these declining
ranges over time, inflation would be slowed correspondingly. At the same time, the ranges are wide enough to
permit flexibility to respond to cyclical downturns.
However, the Fed has de-emphasized the monetary aggregates because their relationships with prices and output
have deteriorated, apparently in response to financial deregulation and innovation (Judd and Trehan 1992). As a
consequence, policy has been left without much guidance
from a nominal quantity variable that is closely linked to
inflation in the long-run.
This void makes it difficult to tell if short-run decisions
about the funds rate are consistent with the long-run
objective of lowering inflation. Moreover, since there is no
single variable that provides an automatic signal to policymakers that an interest rate change should be seriously
contemplated, each change in the funds rate must be made
on a judgmental, case-by-case basis. Perhaps inevitably,
there is a temptation for policymakers to respond more

1. See Judd and Beebe, this issue. For a discussion of the possible
benefits of low inflation, see Howitt (1990).

FRBSF ECONOMIC REVIEW 1993,

NUMBER

strongly and quickly to shocks that threaten a recession
than to those that are stimulative, and this can test policymakers' resolve to control inflation (Barro 1986).
Use of an interest rate instrument without the guidance
of a nominal anchor also tends to foster the questionable
view that the stance of policy can be characterized by the
level of the funds rate. As a result, tightening or easing
policy becomes defined as raising or lowering the funds
rate, while a decision to leave the funds rate unchanged is
seen as no change in policy. However, these characterizations can be misleading. For example, a constant interest
rate can be consistent with either tighter or easier policy,
depending upon what is happening to the other determinants of aggregate demand. Thus a sudden rise in consumer confidence that leads to less saving could render a
constant interest rate more expansionary. The same problem also arises for long-run inflation policy. To maintain a
constant policy with respect to the inflation rate, interest
rates would need to change frequently to offset the effects
of shocks and assure that aggregate demand grew in line
with the economy's productive potential.
The purpose of this paper is to describe a monetary
policy regime in which discretionary changes in a shortterm interest rate would be oriented around a baseline
interest rate path that would be designed to be consistent
with a disinflation or low-inflation goa1. Specifically, under
this approach, the baseline (or no-change-in-policy) option
would be defined by a policy rule that would link changes
in a short-term interest rate to a nominal GDP target
designed to be consistent with the inflation goal in the long
run. Thus, the rule would provide information to policymakers in formulating short-term discretionary actions that
might help them avoid inadvertently allowing inflation to
drift away from its desired level over time. The nominal
GDP target either could be made public or used for internal
purposes only.
The remainder of this paper is organized as follows.
Section I discusses the relationship between monetary and
nominal GDP targets, and argues that the latter have
intrinsic appeal when unstable velocity makes monetary
targets unreliable. In Section II, simulations of a specific
nominal GDP rule are presented as an example to illustrate
some properties of such rules. Section III discusses how a
nominal GDP rule could be used to inform a discretionary
monetary policy, and concludes by briefly noting some
practical problems that would need to be solved in actually
implementing such an approach.

NOMINAL

GDP TARGETS

In this section, we discuss why nominal GDP may have
some appeal as an intermediate target of monetary policy,

especially as an alternative to the monetary aggregates
when their velocities become unstable.
The channel of influence from nominal GDP growth to
inflation can be seen from the following definition, which
states that inflation is equal to the difference between
growth in nominal and real GDP:
(1)

~p=~x

~y,

where li.p, ax, and ay represent the annualized growth
rates of the implicit GDP deflator, nominal GDP, and real
GDP, respectively. In the long-run, real GDP growth can
be approximated by a trend rate that is determined by real
factors including the growth in labor, capital, and productivity, and thus is largely independent of nominal GDP
growth. 2 As a consequence, any given growth rate of
nominal GDP can be translated into a corresponding
inflation rate in a straightforward way. 3 For example, trend
(or potential) real GDP growth commonly is estimated
at around 2 percent, so that a 5 percent growth rate
of nominal GDP would fix long..,run inflation at around
3 percent.
Since the growth rate of nominal GDP is· equal to the
growth rate of money (~m) plus the growth rate of velocity
(~v), targeting money can be seen as an indirect method of
targeting nominal GDP. Thus,

(2)

~x=~m

+ ~v,

Putting these definitions together yields,4
(3)

~p=~m

+ ~v

- ~y.

So long as trend velocity growth is stable, any given longrun growth rate of money can be translated into a long-run
inflation rate in a straightforward manner. When the velocity of M2 was stable, the relationship between M2· and
inflation was particularly simple, since historically the

2. This statement abstracts from possible effects of trend inflation on
trend real GDP growth. Thus lower (higher) nominal GDP growth will
result in lower (higher) inflation, which for various reasons may be
associated with higher (lower) trend growth of real GDP (Motley 1993).
However, these effects are likely to be small when compared with the
range of nominal GDP growth rates and inflation observed in the past.
3. We have specified the nominal GDP identity in terms of growth rates
rather than levels. Research suggests that the steady-state growth rate of
real GDP is stationary, so that fixing the growth rate of nominal GDP
will result in a stationary inflation rate. The situation is more complex
when the equation is specified in levels. It is uncertain whether the level
of real GDP is stationary or not, so that it is difficult to tell if the price
level would be stationary under a nominal GDP level target.
4. The relationships discussed in this paragraph are growth-rate versions of the ones behind the p* model (Hallman, Porter and Small,
1991).

JUDD AND MOTLEY / NOMINAL GDP RULE TO GUIDE DISCRETIONARY MONETARY POLICY

GDP

trend growth rate of M2 velocity was zero. Thus, for
example, a 5 percent growth rate of M2 would produce
5 percent nominal GDP growth and 3 percent inflation in
the long run. However, when velocity is unstable, direct
nominal GDP targeting has the advantage that it is not
adversely affected by unpredictable swings in velocity. In
effect, nominal GDP targeting is a way to circumvent
problems with the velocity of money in conducting monetat-y policy. 5
The principal drawback to using nominal GDP as an intermediate target is that it does not respond as promptly as
money does to the Fed's policy instruments, and henceis
not very controllable, even over periods as long as several
quarters. Thus it would. be difficult for the. Fed, or the
public, to know if day-to-day policy actions were consistent with achieving the nominal GDP target over time. One
way of dealing with this control problem is to compare
discretionary policy changes to those called for by a
feedback rule, which specifies responses of the policy
instrument to incoming data on nominal GDP. 6
A feedback rule of the type suggested by McCallum
(1990); for example, would specify that the policy instrument would be adjusted in each period by a predetermined
proportion of the difference between actual and targeted
nominal GDP in the prior period. Ifthe instrument were set
strictly according to a properly specified rule of this type,
the nominal GDP target would be achieved to a reasonable
approximation over the long run,even though it might be
missed over shorter time periods. Hence, a practice of
orienting discretionary changes in the policy instrument
around such a baseline would provide policymakers with
information they could use to help them achieve their nominal GDP target over the long haul. And, achieving the
nominal GDP target in the long run would hold average
inflation to within a reasonable range around its target.

II. EXAMPLE: A NOMINAL
GROWTH RATE RULE

5. Given that the ultimate objective of long-run monetary policy is to
control inflation, it might make sense to target the rate of inflation
directly. However, as shown in Judd and Motley (1991), the lags from
monetary policy to the rate of inflation appear to be sufficiently long in
Keynesian-type (stiCky-price) models that attempts at direct inflation
targeting might result in extreme volatility in the interest rate and real
GDP. Since it is desirable to select a rule that is robust across alternative
types of models, we have not focused On direct inflation targeting in this
paper.
6. The feedback rule discussed later in this paper is specified along the
lines of rules originally proposed and analyzed by McCallum (e.g., see
his 1990 paper). Feedback rules also have been examined by a number of
other researchers, including Hess, Small and Brayton (1993), Judd and
Motley (1991, 1992), Meltzer (1987), and Taylor (1985, 1992).

8.. Specifying a rule in terms of the change, rather than the level, of the
interest rate has the advantage that it is not necessary to know in advance
the equilibrium level of the real interest rate. Under a properly specified
rule for the change in the nominal interest rate, the economy automatically would tend to adjust such that the real interest rate would move
toward its equilibrium level over time, whateverthat level happened to be.

A number of different nominal GDP feedback rules have
been explored in the literature. These differ as to whether
the policy instrument is a reserves aggregate or a shortterm interest rate, and whether nominal GDP and/or the
policy instrument are specified in levels or growth rates. A
common feature of these feedback rules is that the Fed
responds to actual data on nominal GDP rather than to
forecasts.7 This feature has an advantage when decisions
are being made by a committee of individuals who may
disagree· about the implications of incoming data for the
future path of nominal GDP.
Below we briefly review research on a policy regime
in which the Fed changes the short-term interest rate in
response to divergences between actual and targeted nominal GDP growth rates (Judd and Motley 1992). 8 A shortterm interest rate is specified as the instrument because it is
controllable in the short run and because the FOMC has
shown a preference over the years for operating through
such an instrument rather than a reserves aggregate. 9 Our
purpose in presenting this example is neither to advocat.e
this particular form of feedback rule, nor to advocate strict
adherence to any rule. Rather our purpose is to show how
this class of rules might work as a baseline for discretionary policy decisions. The rule we have examined is specified as follows:
(4)

JiR t = X,(Jix t _

1 -

Jixt-l)' X,

> O.

In this equation, JiR t is the quarterly percentage point
change in a short-term interest rate (we used the threemonth Treasury bill rate), and Jixt - 1 and JiXt-l are the
7. This feature of the rule could be modified to incorporate more up-todate information by replacing last quarter's nominal GDP growth rate
with a projection of the current quarter's data. Such short-term forecasts
would be purely a matter of interpreting monthly indicator variables
and would not depend very much upon views of the structure of the
economy. As such they would not violate the spirit of the feedback rule.

9. As shown in Judd-Motley (1992), in principle, a reserves aggregate
offers the possibility of much tighter control over inflation than appears
likely under an interest rate instrument. The main difficulty with these
aggregates as instruments of policy is that financial innovation and
deregulation have made the velocities of reserves and the monetary base
highly unstable. Moreover, increased international (paper) currency
movements have added to problems with the velocity and controllability
of the monetary base.

FRBSF ECONOMIC REVIEW 1993,

NUMBER

actual and targeted annualized growth rates of nominal
GDP in the preceding quarter. lO
The nominal GDP growth rate target would be chosen to
be cons'istent with the target for inflation. For example, a
goal of reducing inflation gradually to zero and holding it
there would imply that the nominal GDP growth target
would be lowered gradually toward 2 percent and held at
about that pace.
The strength of the interest rate response to a given
target deviation is defined by 'A, and would be chosen by
the central bank. As discussed below, simulations suggest
that a value of 'A of 0.2 would be sufficient to achieve
reasonable control of inflation, without raising the volatility of output or interest rates compared with actual
experience in the past three decades. This value of 'A
implies that the interest rate would be raised (lowered) by
20 basis points during each quarter in which the annualized
nominal GDP growth rate exceeded (fell short of) the target by 1 percentage point. Although this may seem a rather
weak response, it is important to recognize that under the
rule the interest rate would continue to be raised (lowered)
each quarter so long as growth remained above (below)
target. According to the simulations, the consistent application of this modest response is sufficient to hold
nominal GDP growth near its target over the long haul.

Simulation Results
In order to obtain a rough idea about how implementation
of this rule might affect the economy, we employed simulations of two simple macroeconomic models under the
assumption that the rule was in place and the economy was
hit by shocks like those that actually occurred. We did large
numbers of stochastic simulations so that we could construct confidence intervals for the outcomes for inflation,

10. As an alternative, the rule could specify a target for average nominal
GDP growth over more than one prior quarter. For example, the nominal GDP target could be specified each quarter in terms of growth over
the prior half year or full year. This approach would have the advantage
of smoothing out quarter-to-quarter volatility in nominal GDP growth
(whether due to "noise" in preliminary data, inventory cycles, or other
factors) that might otherwise induce unnecessary interest rate responses. The disadvantage of using averages of several past quarters of
nominal GDP growth would be that it introduces additional lags into the
interest rate responses under the rule. Simulation experiments with
the models referred to in this paper suggest that these longer lags tend to
increase the size of cycles in real GDP and inflation that might occur
under a mechanical application of the rule. In effect, using an average
of several prior quarters of nominal GDP growth delays the response of
interest rates to deviations of nominal GDP from the target, and thus
tends to set off cycles of overshooting followed by undershooting of that
target.

real GDP, and the short-term interest rate. In constructing
these simulations, we had to assume that the rule was
followed precisely. If the rule were used as a baseline for
discretionary policy, the policymakers could attempt to
improve on these results in whatever ways they deemed
appropriate.
As with any counterfactual simulations, these exercises
are subject to some valid criticisms, which mean that such
results should be interpreted with caution. First,. the simulation results will depend upon the particular model(s)
used. Since individuals will differ as to what they think
characterizes a reasonable model, simulation results may
be suspect. In an attempt to deal with this problem, the
simulations were run with two alternative models, a small
Keynesian model, and a (largely) atheoretical vector errorcorrection model.
Second, counterfactual simulations are subject to the
Lucas critique that the structure of the economy would have
been different from history if the rule actually had been
used. To attempt to deal with this concern, we varied the
key coefficients in the models and re-ran the simulations to .

test for robustness. As discussed in

Judd-~Aotley

(1992),

based upon these exercises, we concluded that the results
were not particularly sensitive to the alternatives considered, although there were some instances in which coefficient changes did significantly affect the simulation
results. We do not consider our study, or any other single
study, to be definitive, and it would be useful to test this and
other rules further in the context of other models.
The simulations suggest that following such a rule
would have provided for improved control of inflation
compared with actual experience over the past three decades. As measured by the GDP deflator, actual inflation
averaged 5Y2 percent over the 30-year sample. The simulation results suggest that average annual inflation over
1960-1989 would have been held to between about zero
and about 2Y2 percent (depending on the model) with a
probability of two-thirds (see the box.) Moreover, it appears that this result could have been achieved without
significantly increasing the volatility of real GDP and with
a reduction in the volatility of interest rates compared to
historical experience. 11 The lessened interest rate swings
11. According to our simulations, a rule that focuses on the growth rate,
rather than the level, of nominal GDP has the advantage of producing
less volatility in real GDP and interest rates. However, the growth rate
rule has the disadvantage that the price level could drift over time in the
event of a prolonged series of positive or negative shocks. One way of
attempting to deal with this problem would be to provide for occasional
adjustments to the nominal GDP growth target when it permitted
unacceptably large price-level (or nominal GDP) drift. This method
might help to preserve the price level in the long run, while retaining the
benefits of less volatility most of the time.

JUDD AND MOTLEY / NOMINAL GDP RULE TO GUIDE DISCRETIONARY MONETARY POLICY

SIMULATIONS OF THE NOMINAL

GDP GROWTH RATE RULE

Below we present results of simulations that assess how
the macroeconomy might have evolved over the past
three decades if the nominal GDP growth rate rule had
been in use, and the structure of the economy had remained unchanged. In these "counterfactual simulations," the targeted values of nominal GDP growth were
set to be consistent with zero inflation over 1960-1989.
We used a value for A of 0.20. For each of two models
(a small Keynesian and a VECM, described in Judd and
Motley 1992, pp. 14~16), we calculated 500 stochastic
simulations, where the random shocks in each model

equation were drawn from distributions that had the
same means and variances as the estimated error terms.
We measure inflation performance in terms of average annual inflation over the simulation period. The
volatility of output is measured in terms of the fourquarter growth rate of real GDP. Finally, the volatility of
interest rates is measured as quarter-to-quarter changes
in the three-month Treasury bill rate. The results of the
simulations are shown below in the form of one standard
deviation confidence .bands (thus, two-thirds of the
stochastic simulations fell within the bands.)

STOCHASTIC SIMULATIONS WITH NOMINAL GDP GROWTH RULE
ONE-STANDARD DEVIATION CONFIDENCE INTERVALS

1960-1989

. ACTUAL
RULE
Keynesian Model
VECM

AVERAGE ANNUAL
INFLATION RATE

4-QUARTER REAL GDP
GROWTH RATE

QUARTER-m-QUARTER
CHANGE IN INTEREST RATE

5.4%

0.5% to 5.5%

- 1.0% to 1.0%

-0.2% to 2.7%

1.2% to 5.8%
2.5% to 7.5%a

-0.6% to 0.9%
- 0.6% to 0.8%

0.4% to 2.1%

aTaken literally, the results of the VECM simulations suggest that achieving lower inflation would produce an average rate ofgrowth of real GDP
that is above the experience in the U.S. in the post World War II period. This result reflects the well-known negative correlation observed in the
U.S. data between inflation and real GDP growth, which is embedded in the VECM coefficients. This correlation could reflect the effects of
inflation on growth, and/or the effects of supply shocks (e.g., oil shocks) on both variables. Since the VECM is not designed to distinguish
between these two effects, our results should be interpreted as agnostic concerning the extent to which low inflation might boost long-term
growth. In this paper, we take as given the Fed's stated goal of gradually moving toward price stability, and do not attempt to assess the possible
effects of such a policy on average real GDP growth.

apparently arise because a consistent application of the
rule keeps the inflation rate under control in the simulations, and thus highly aggressive policy responses are not
likely to be needed. Thus, for example, use of the rule
prevents simulated inflation from rising as sharply in the
mid 1970s and early 1980s, and thus moderates the size of
any policy tightening that might have been necessary to
return inflation to lower levels.
One potential problem with these simulations is that they
do not take into account the effects of measurement errors
in nominal GDP. Even though the rule involves policy
reactions to "actual" data on nominal GDP lagged one
quarter, these data are revised a number· of times before
they are considered final. Measurement errors in the early
releases of nominal GDP data, which policymakers would
observe as they used the rule, would induce movements in

interest rates and thus also affect outcomes for real GDP
and inflation. In order to estimate the size of any such
effects, we re-ran the above simulations with measurement
errors (equal in size to those observed over 1978-1989)
added to the "observations" of nominal GDP in the rule. 12
12. The measurement errors were introduced as white-noise shocks
with a standard deviation of 1.5 percent (annual rate), which is equal to
the standard deviation of the differences between the "advance" nominal GDP growth rates and the "latest revised" nominal GDP growth
rates over 1978-1989 (Bureau of Economic Analysis). Following the
approach of Gagnon and Tryon (1993), the model was estimated with
final revised data, but we added shocks representing measurement errors
to the nominal GDP growth rates that enter the rule. Thus, the rule used
in these simulations was: I1R, = >.. (I1X'_l + E'-l ~ I1X7-1)' where
E, -1 represents measurement error. We also investigated the possibility
that the revisions are autocorrelated by estimating first and second order

FRBSF ECONOMIC REVIEW 1993,

NUMBER

This exercise yielded confidence intervals for inflation,
real GDP and interest rates very close to those shown in the
box-in fact, no confidence interval was increased in
width by more than 0.1 percentage point. 13

Comparison of the Rule with Actual Policy
How would the nominal GDP growth rate rule have performed in recent years in comparison with actual policy?
To shed some light on this issue, we conducted counterfactual simulations over 1988-1993 in which we assumed that
the economy was hit by the same set of shocks that actually
occurred during this period. Consistent with the Fed's
objective to lower the inflation rate gradually over time, we
(somewhat arbitrarily) assumed targets for nominal GDP
growth that declined by Y4 percent per year from 7 percent
in 1988 to 5% percent in 1993, so that they roughly
matched the overall decline of nominal GDP growth rates
over the period.
As shown in Figure 1, the simulated path of the interest
rate generated by this combination of targetpath and rule is
fairly close to the path that actually occurred. 14 These
simulations were computed using the latest revised data,
rather than the data the FOMC actually observed at the
time. When the measurement errors in these data are
accounted for in the simulations, the short-term interest
rate is about 50 basis points lower (in both models) over
mid-1990 to mid-1993 than the simulation shown in Figure 1. In the final four quarters shown in Figure 1, the
simulated interest rates with and without measurement
errors bracket the actual level of the interest rate (for both
models).
autocorrelation coefficients of nominal GDP revisions over 1976-1983,
as shown in Walsh (1985). Autocorrelation was rejected at very high
marginal significance levels. Despite this result, we experimented with
first-order autocorrelated revision errors (with standard error of 1.5 percent) in the simulations, and found that their effect was virtually the
same as the white-noise errors as long as the autocorrelation coefficient
was less than 1.
13; The small effect of measurement errors in the simulations results
from several factors. First, the size of the typical revision to nominal
GDP in recent years is sufficient to have only very modest effects on the
short-term interest rate in the nominal GDP rule. For example, a onestandard deviation revision (1.5 percent, annual rate) induces a change
in the interest rate of 30 basis points. Second, as is typical of macroeconomic models, the coefficients linking changes in interest rates
to changes in real GDP and inflation in the models used in this paper
are relatively small. Third, interest rates affect real GDP and inflation
with relatively long distributed lags. Thus measurement errors of
opposite signs will tend to have offsetting effects on real GDP and
inflation.
14. Similar results were obtained when the simulation was begun in
later years.

These simulations suggest that, even though the Fed was
not following a nominal GDP rule during this period,
actual policy was not inconsistent with that indicated by the
rule in combination with a disinflationary path for nominal
GDP.15 It should be noted, however, that the level (but not
the pattern) of the simulated interest rate is sensitive to the
exact level of the assumed nominal GDP growth rate targets. Thus, for example, an equally plausible set of targets
that consistently were Yz percentage point lower than the
ones assumed would produce a simulated interest rate path
that was parallel and uniformly higher than the one in the
figure.
Figure 2 shows simulations of the interest rate paths that
would be produced by adopting alternative targets for
nominalGDP growth, and compares them with the path
produced by the nominal GDP target assumed in Figure 1.
The line marked "easy" corresponds to a nominal GDP
growth rate target that remains unchanged at 7 percent in
1988 through mid 1993. The line marked "tight" simulates
what might have happened if the nominal GDP growth rate
target had been reduced by Y2 percent per year from 7 percent in 1988 to 4Yz percent in 1993. As can be seen, the
constant nominal GDP growth rate target is projected to
involve a lower interest rate by 1993 than projected under
the gradual disinflation targets of Figure 1 (labeled "moderate"), while the more rapid Y2-percent-per-year decline in
the nominal GDP growth target under the "tight" policy
would have involved a higher interest rate. Under all three
target paths for nominal GDP growth, the interest rate
would have fallen noticeably in the 1990-1991 recession.

INFORMING DISCRETIONARY POLICY
DECISIONS WITH A RULE

The above discussion of the nominal GDP growth rate rule
was not designed to advocate that particular feedback
rule as a baseline for a discretionary policy, but rather to
provide a specific illustration of the properties of this class
of rules. Given the demise of the monetary aggregates as
reliable intermediate targets, the FOMC attempts to meet
its dual goals (control of inflation and the mitigation of
cyclical downturns in output) through purely discretionary
adjustments of an interest rate instrument in response to
myriad incoming data. A procedure in which the FOMC
would consult a nominal GDP feedback rule, while retaining the flexibility to use discretion in its short-run decisions, might contribute to achieving its inflation goal
without significantly interfering with its ability to pursue

15. Taylor (1992) has obtained a similar result with a different nominal
GDP rule, using data prior to the most recent re-benchmarking.

JUDD AND MOTLEY / NOMINAL GDP RULE TO GUIDE DISCRETIONARY MONETARY POLICY

FIGURE 1
SIMULATIONS OF A POLICY RULE
KEYNESIAN MODEL

VECTOR ERROR CORRECTION MODEL

Nominal GDP Growth

Percent

o-I---'--r----T--"=T=----r----,...----.

o-f---r-""""""T"--"""~'--~-.,._----,

Actual

Simulated

3-Month T-Bill Rate

Percent

'.
..'
6

4
Actual

Actual
2+-----,r-----r----:~~---.--_r_-___,

FRBSF ECONOMIC REVIEW 1993,

NUMBER

FIGURE 2
ALTERNATIVE POLICY SIMULATIONS: 3-MoNTH T-BILL RATE
KEYNESIAN MODEL

VECTOR ERROR CORRECTION MODEL

Percent

10 1
8

".
4

Moderate
~

....

O+---....----,.---=~"""'----r---.........----..

4
,.

- - - .. Easy

, ". Tight

,•.• Tight

its cyclical goal. Such a rule could be announced to the
public or used for internal information only.
Consultation with a rule could take several forms. For
example, Taylor (1992) has suggested that the FOMC
simply include the interest-rate "recommendations" of a
nominal GDP feedback rule with any other monetary
policy indicators they wish to consult.
While this idea seems reasonable, the decision-making
process might benefit by having a feedback rule playa more
central role. Specifically, the interest rate path indicated by
a rule could be defined explicitly as representing an
unchanged policy stance, in the sense of a consistent policy
regime designed to achieve the Fed's inflation goal in the
long run~ IIi this way, the rule-based interest rate path
would provide a benchmark around which discretionary
decisions could be made. 16 In any specific situation, more
or less expansionary policies than indicated by a rule could
be adopted, During a recession the FOMC might want to
lean toward a lower short-term interest rate than was called
for by a rule. For example, if the growth rates of real and
nominal GDP were to increase-and thus to signal an

16. Following such an approach might enhance the credibility of the
disinflation goal (Judd and Beebe, this issue.)

.
_,
I

Moderate

\. Easy

interest rate increase-the Fed might choose to override
this signal if the level of real GDP were considered to be far
below its potential level. By the same token, ifthe economy
seemed to be "overheating," as a result, say, of a surge in
demand for our exports, policy could lean in the direction
of tightness for a time. So long as such discretionary
deviations from a rule-based policy averaged out to zero
over time, the long-run benefits of a feedback rule for
inflation would be realized. Of course, if it were deemed
advisable to change the inflation objective, the policy
regime could be modified by changing the nominal GDP
target itself.
In this paper we have focused on the general issue of
whether using a nominal GDP feedback rule as a baseline
for discretionary decisions might help the FOMC achieve
its goals by rationalizing and simplifying the decisionmaking process, Of course, a number of practical issues would
need to be addressed before such an approach could be
adopted in practice. The biggest one would be to choose a
specific nominal GDP feedback rule. As noted above, our
earlier research suggests that a rule defined in terms of an
interest rate instrument, a nominal GDP growth rate target, and a relatively mild reaction coefficient seems promising. However, since other .researchers have supported
other types of feedback rules, this issue is by no means

JUDD AND MOTLEY / NOMINAL GDP RULE TO GUIDE DISCRETIONARY MONETARY POLICY

settled. Actual use of a feedback rule would require more
research within the context of other models in order to
narrow the range of appropriate choices of rules.
A number of more detailed issues also would arise. For
example, the FOMC meets eight times per year, whereas
the rules discussed above give a "recommendation" for the
average level of the short-term interest rate over a quarterly
period (given last quarter's level). Thus a method would
need to be devised to link the decision period between
FOMC meetings (which averages 6Yz weeks) with the
quarterly period of time used to define the rule.

Finally, as with any new approach to policy, there is no
way to anticipate all of the problems that might be encountered if it actually were implemented. The process of implementation most likely would involve a good deal of
learning and modification. The approach discussed in this
paper does not require mechanically following a rule.
Instead, it represents a discretionary approach that would
be informed by a rule. As such, policymakers would continue to be in a position to use their judgment to react to
circumstances as they arose, but with the benefit of the
additional information provided by the rule.

REFERENCES

_ _ _~, and Brian Motley. 1991. "Nominal Feedback Rules for
Monetary Policy," Federal Reserve BaIlk of San Francisco economic Review (Summer) pp. 3-17.
________ , and
. 1992. "Controlling Inflation with an
Interest Rate Instrument." Federal Reserve BaIlk of San Francisco
Economic Review 3, pp. 3-22.

Barro, Robert 1. 1986. "Recent Developments in the Theory of
Rules Versus Discretion." The Economic Journal (Supplement)
pp.23-37.
Bureau of Economic Analysis, U.S. Department of Commerce. 1993.
"Gross Domestic Product: Second Quarter 1993 (Advance),"
News Release (July 29).
Gagnon, Joseph E., and Ralph W. Tryon. 1993. "Price and Output
Stability Under Alternative Monetary Policy Rules." Board of
Governors of the Federal Reserve System, Finance and Economic
Discussion Series, Working Studies 1: Part 2.
Hallman, Jeffrey 1., Richard D. Porter, and David Small. 1991. "Is the
Price Level Tied to the M2 Monetary Aggregate in the Long Run?"
American Economic Review (September) pp. 841-858.
Hess, Gregory D., David H. Small, and Flint Brayton. 1993. "Nominal
Income Targeting with the Monetary Base as Instrument: An
Evaluation of the McCallum Rule." Board of Governors of the
Federal Reserve System, Finance and Economics Discussion
Series, Working Studies 1: Part 2.
Howitt, Peter. 1990. "Zero Inflation as a Long-Term Target for Monetary Policy." In Zero Inflation: The Goal ofPrice Stability (Policy
Study 8),ed. Richard G. Lipsey, pp. 67-108. Ottawa, Ontario:
C.D. Howe Institute.
Judd; John P., and Jack H. Beebe. 1993. "The Output-Inflation Tradeoff in the United States: Has It Chariged Since the Late 1970s?"
.Federal Reserve BaIlk of San Francisco Economic Review, this
issue.

_ _ _~, and Bharat Trehan. 1992. "Money, Credit and M2."
Federal Reserve BaIlk of San Francisco Weekly Letter (September 4).
Kasman, Bruce: 1993. "A Comparison of Monetary Policy Operating
Procedures in Six Industrial Countries." Finance and Economics
Discussion Series, Working Studies 1: Part 1, March.
McCallum, Bennett T. 1990. "Targets, Indicators, and Instruments of
Monetary Policy." NBER Reprint No. 1550.
Meltzer, Allan H. 1987. "The Limits of Short-Run Stabilization Policy." Economic Inquiry (January) pp.1-14.
Motley, Brian. 1993. "Growth and Inflation: A Cross-Country Study."
Working Paper 93-11. Federal Reserve BaIlk of San Francisco.
Taylor, John B. 1985. "What Would Nominal GDP Targeting Do to the
Business Cycle?" Carnegie-Rochester Series on Public Policy 22,
pp.61-84.
_ _ _ _ . 1992. "Discretion Versus Policy Rules in Practice."
CEPR Publication No. 327. Center for Economic Policy Research,
Stanford University.
Walsh, Carl E. 1985. "Revisions in the 'Flash' Estimates of GNP
Growth: Measurement Error or Forecast Error?" Federal Reserve
BaIlk of San Francisco Economic Review (Fall) pp. 5-13.

Money, Interest Rates and Economic Activity:
Stylized Facts for Japan

Ramon Moreno and Sun Bae Kim
Economists, Federal Reserve Bank of San Francisco. The
authors thank the Editorial Committee, comprising Chan
Huh, Elizabeth Laderman, and Bharat Trehan, for many
helpful comments. We also thank Greg Holmes and Jacob
Pozharny for research assistance.

This paper examines how financial market changes affect
the usefulness of two alternative indicators of monetary
policy in Japan, a monetary aggregate and an interest
rate. The paper tests whether these variables are good
predictors of output, and whether responses to shocks to
these variables broadly conform to the implications ofthe
monetary transmission model, over two periods between
1960 and 1992. In the earlier period when Japan's financial markets were less developed, a monetary aggregate
(M2+CDs) is a relatively useful indicator of monetary
policy whereas an interest rate variable is not. In particular, we find some evidence of a "liquidity effect" in
response to innovations in money. Neither variable is an
entirely satisfactory indicator of monetary policy in the
second sample. The results suggest that financial market
development may have contributed to reducing the usefulness of money as an indicator of monetary policy.

Are monetary. policy innovations better represented by
shocks to money or to interest rates? In order to resolve
this question, researchers have used vector autoregression
(VAR) models to attempt to ascertain whether responses to
innovations in either variable satisfY two criteria. First,
changes or innovations in monetary policy should be good
predictors of real economic activity. Second, the qualitative effects of monetary policy innovations should conform
to those predicted by the traditional monetary transmission
model; namely, in the short run, an expansionary policy
leads to an excess supply of money because of output and
price rigidities. In response to this excess supply, nominal
and real interest rates fall. This "liquidity effect" is a key
element in the monetary transmission mechanism which
ultimately leads to an increase in real output.
The empirical evidence is ambiguous. Research applying VAR models to U.S. data generally concludes that
interest rates are better predictors of real output than are
monetary aggregates. 1 However, responses to shocks to
either money or interest rates are not entirely consistent
with the monetary transmission model. For example, some
impulse response analyses reveal that while a positive
monetary aggregate shock is associated with increases
in the price level, it is also associated with an increase in
interest rates, or no liquidity effect (Sims 1986, Leeper and
Gordon 1992), and a contraction in output (Sims 1986).
The last two responses do not correspond to the monetary
transmission model. 2 Furthermore, while an interest rate
innovation is associated with declines in money and output, as would be expected, it is also associated with an
increase in the price level, a result that contradicts the
monetary transmission model (Sims 1986).
1. See, for example, Sims (1980) and Bemanke and Blinder (1992). An
exception is Strongin (1992) which focuses on a special representation
of a very narrow monetary aggregate.

2. However, recent research indicates that a liquidity effect can be found
in U.S. data if a narrower monetary aggregate is used that takes some of
the subtleties of Fed operating procedure into account (Eichenbaum
1992, Christiano and Eichenbaum 1992, and Strongin 1992). While
Eichenbaum (1992) finds a liquidity effect using a nonborrowed reserves
aggregate, this measure is not entirely successful because real output
declines in response to innovations in nonborrowed reserves. Strongin
(1992) uses the ratio of nonborrowed reserves to total reserves as an
indicator of policy innovations, and a recursive ordering that appears to
successfully reflect Fed operating procedure. His indicator satisfies the
two criteria outlined in the text.

MORENO AND

KIM / MONEY,

Research applying VAR models to Japanese data also
has yielded ambiguous results. For example, Suzuki, Kuroda, and Shirakawa (1988) find that a broad monetary
aggregate, M2 + CDs, is a good predictor of Japanese real
GNP. 3 However, the dynamic responses to money shocks
presented in Sims (1992) do not conform to the transmission model. As in the U. S., the response to a money shock
reveals the absence of the "liquidity" effect in Japan, as
well as a contraction in output. Japanese data also yield the
"price puzzle" of an interest rate innovation leading to a
price increase.
Two explanations may be offered for why VAR models
have failed to identify an unambiguous indicator of monetary policy in the U. S. or in Japan. FIrst, the studies cited
in this paper generally rely on a recursive identification
procedure to distinguish between innovations in money
or interest rates. Under certain conditions, innovations
identified using such a procedure will not successfully
distinguish monetary policy shocks from real shocks to
aggregate supply or shocks to money demand. Difficulties
in isolating shocks are particularly likely if monetary
authorities do not consistently target a monetary aggregate
or an interest rate. Second, developments in financial
markets .may influence the ability to identify a policy
indicator. For example, even if the authorities consistently
target a monetary aggregate, demand shocks may still
cause short-term fluctuations in monetary aggregates if
deregulation and innovations in financial markets weaken
the central bank's effectiveness incontrolling the monetary
aggregate target. In fact, the choice of target itself may
shift as a result of significant changes in financial markets.
Japan provides a potentially illuminating case study to
ascertain the plausibility of the second explanation. Up to
the early 1980s, securities markets were undeveloped and
commercial banks were heavily dependent on the Bank of
Japan (BOJ), which used both market and nonmarket instruments to achieve a credit target. Subsequent deregulation and innovations in financial markets have reduced the
dependence of commercial banks on the BOJ. As a result,
the BOJ has relied more heavily on market instruments for
monetary control, and has paid attention to both monetary
aggregates and interest rates.
The primary aim of this paper is to explore the implications of financial market changes for the identification 6f
monetary policy innovations in Japan. We do this by
3. The authors base this conclusion on exclusion restrictions or
"Granger causality." Ito (1982) finds that the narrower monetary
aggregate Ml is not a good predictor of Japanese output in a VAR
model, according to variance decompositions. Other studies focus on
the ability of money to predict nominal GNP. See the survey by Okina
(1985).

INTEREST RATES AND EcONOMIC ACTIVITY: JAPAN

estimating a four-variable VAR model of the Japanese
economy similar to the models estimated by Sims (1980,
1992) over two sample periods: the first, 1960-1980, when
securities markets were undeveloped and the BOJ wielded
much greater direct influence on commercial banks in
implementing monetary policy, and the second, 19811992, when Japan's financial markets became more developed, the dependence of banks on the BOJ declined,

and the BOJ begfu~ to rely more heavily on market=based
mechanisms for monetary control.
OUf main findings may be summarized as follows. A
monetary aggregate (M2 + CDs) is a relatively useful
indicator of monetary policy in the first sample period.
Money is a good predictor of output according to one
measure used, and responses to money shocks also conform broadly to the implications of the monetary transmission model. In particular, we find some evidence of a
"liquidity effect." In this sample, an interest rate indicator
has about the same predictive power as money, but responses to interest rate shocks do not entirely conform to
the monetary transmission model.
In contrast to the first sample, no entirely successful
indicator of monetary policy is identified in the second
sample. Although money continues to be a good predictor
of output in this sample (much better than interest rates),
the responses to innovations in either variable cannot be
interpreted as reflecting innovations in monetary policy.
The rest of the paper is organized as follows. Section
I describes how financial markets and the approach to
monetary policy have changed over time in Japan. Section II describes the macroeconomic models to be estimated, discusses the approach to identification, motivates
the selection of variables included in the two alternative
models, and summarizes the estimation procedure. Section
III reports the results while Section IV provides some
conclusions.

JAPANESE MONETARY POLICY:
INSTRUMENTS AND TARGETS

The monetary transmission model implies a certain relationship among variables that can be influenced by policy-monetary aggregates and interest rates-and the
ultimate objectives of policy, such as real economic activity. One issue confronting policymakers is whether to
target a monetary aggregate or an interest rate. 4 This policy
choice determines whether, in empirical analysis, a monetary aggregate or an interest rate will be a suitable measure
of changes in monetary policy. An interest rate (e.g., the

4. For a survey of this issue see Friedman (1990).

FRBSF EcONOMIC REVIEW 1993,

NUMBER

interbank rate) may be considered a useful indicator of
monetary policy if policymakers supply reserves perfectly
elastically to target a given interest rate. In this case,
shocks to money demand will not affect the targeted rate. A
monetary aggregate will be the appropriate indicator of
monetary policy if monetary authorities target the aggregate and do not accommodate shocks to demand. 5 Thus the
use of either an interest rate or a monetary aggregate as an
indicator of monetary policy involves fairly stringent assumptions about the behavior of monetary authorities. In
practice, the targets and instruments used by monetary
authorities, and the commitment to any given target, vary
over time. Financial market development may also affect
the ability to control monetary aggregates with precision.
These various considerations make empirical analysis
difficult. However, such difficulties may be mitigated by
examining the institutional setting and the operating procedure employed by the BOJ, as well as the financial
market environment. Such an examination may facilitate
the choice of an indicator of monetary policy and the
interpretation of any empirical results. 6 In this section we
perform suchan institutional review, focusing on the
following questions. First, has monetary policy in Japan
primarily targeted a monetary aggregate or interest rate(s)?
Second, given a choice of a particular target (or set of
targets), what operational procedure has been used to
implement it? Third, how has financial liberalization affected monetary control and the choice of operational
procedure and target? To begin, we provide some background on the postwar Japanese financial system.

rate,ensuring a relatively tight link between government
interest rate policy and the cost of funds faced by nonbank
borrowers, Selective and aggregate credit targeting ensured direct government input in the allocation and growth
in credit, as did the heavy reliance of banks on borrowing
from the BOJ's discount window. Controls over the nonbank financial sector ensured that market forces would not
erode the effectiveness of banking sector controls. For
example, the government controlled which firms could
issue bonds as well as the corporate bond rate. Finally,
exchange and capital controls prevented financial market
participants from circumventing regulation via overseas
transactions.
Japan's regulated financial system gradually gave way to
market forces beginning in the mid-1970s. The main factor
appears to have been the slowdown in economic growth in
the early 1970s, which sharply reduced government revenues and prompted large increases in government borrowing. Initially, government bonds were allocated to banks at
below-market interest rates, but as the volume of borrowing increased, there was strong pressure for the develop-

ment of an active seconda.ry market in government bonds at
a market-determined rate. By arbitrage, this stimulated
the development ofshort-term money markets such as the
gensaki (repurchase) and CD markets. However, a shortterm government debt market did not develop until very
recently. The liberalization of financial markets extended
to international capital transactions, restrictions on which
were progressively dismantled in the course of the 1980s. 7

Monetary Control Prior to Deregulation
Japan's Financial System
Throughout most of the postwar period, the task of mobilizing funds from net savers to investors in Japan has fallen
primarily on the banking sector. Up to the 1980s, the
government intervened actively in this process of intermediation, initially in an effort to promote investment and
growth, and later to meet the financing needs of the
government. Deposit rates were strictly controlled, while
the bank lending rate was anchored to the official discount
5. There may be ambiguities in interpreting the stance of monetary
policy when using an interest rate target. Since shocks to demand are
fully accommodated, an unchanged interest rate may be consistent with
stimulus or contraction in output.· Similar difficulties in interpretation
may arise when focusing on a money aggregate if money demand is
unstable. Such instability became a concern in Japan in the second
half of the 1980s, when money growth accelerated with less-thanproportionate increases in nominal income.
6. For example, Strongin (1992) motivates a recursive identification
procedure from knowledge of the Federal Reserve's operational procedures. However, his reasoning is not applicable to Japan.

In an environment in which banks dominated as financial
intermediaries and the heavily indebted private business
sector had virtually no alternative to bank loans for external financing, the BOJ's traditional approach to monetary
control consisted of controlling the amount of bank lending
to the nonfinancial corporate sector. We can think of this as
similar to monetary targeting because, with corporate
loans dominating the asset side of banks' balance sheets,
bank credit and broad monetary aggregates tended to move
very closely for much of the postwar period. While it is
clear from accounts of BOJ practices that the BOJ attached
a great deal of importance to achieving its credit targets,
these credit targets have not been disclosed, so it is unclear
whether they were truly exogenous, or whether the BOJ
from time to time accommodated shocks to credit demand.
Also,. the weight the BOJ attached to curbing inflation
7. For overviews of the postwar Japanese financial system and the
process of deregulation, see Feldman (1986) and Hamada and Horiuchi
(1987).

MORENO AND KIM/MONEY, INTEREST RATES AND ECONOMIC ACTIVITY: JAPAN

prior to the mid-1970s is uncertain, whereas it is apparent that a high weight was attached to curbing inflation
since then.
To achieve its credit objectives, the BOJ relied largely on
two instruments. First, it sought to influence interest rates
in the interbank market. Second, it provided direct guidelines for commercial bank lending. 8
Interbank Interest Rates. On a day-to-day basis, the BOJ
sought to influence the supply of credit and money by
targeting the call money rate in the interbank market. 9 To a
large extent, the transmission mechanism relied upon
interest rate rigidities in the system and the heavy dependence of the corporate sector on bank lending. Loan as well
as deposit rates were subject to administrative controls, so
banks could not easily pass on to corporate borrowers
changes in the interbank rates. In this setting, changes in
the call money rate had a direct and immediate impact on
bank profitability, and consequently on the growth of
money and credit. For example, a rise in the call rate
resulting from BOJ tightening would reduce the marginal
profitability of lending. In response, banks would ration
credit, forcing corporations to curtail investment, and the
process·would.ultimately result in a reduction in the broad
money supply. 10
Accounts of BOJ's operating procedures suggest that
reserves were supplied elastically at the call market rate
consistent with the targeted level of credit. Monetary
authorities paid particular attention to the "reserve progress ratio," which measures reserves accumulated by
banks relative to those required within a maintenance period. II Notably, call transactions in Japan involved money
market brokers (Tanshi kaisha). These brokers maintain
close informational contact with the BOJ and, in close
consultation with the BOJ, set the rate at the opening of the
markets each day. If the initially quoted rate failed to equate
demand and supply, the BOJ typically would adjust the
supply of reserves to achieve. equilibrium at its target
interest rate. 12

In the absence of a short-term market for government
debt, discount window lending by the BOJ was the main
instrument for short-run adjustments of bank reserves. A
rationing scheme governed this method of monetary control. The BOJ provided loans to financial institutions
(mainly city banks) at the official discount rate (ODR),
typically at a rate below the interest rates in the interbank
market. BOJ lending thus amounted to a subsidy and
Japanese banks naturaHy preferred to rely on the central
bank for liquidity. 13 Consequently, in contrast to the U.S.,
where the ratio of borrowed reserves to required reserves
seldom exceedS 5 percent, the level of discount window
borrowing by Japanese banks often has exceeded the level
of required reserves.
Direct Control of Bank Credit. Another instrument of
monetary control by the BOJ was the direct quantitative
control of· commercial bank lending through so-called
"window guidance." To tighten the supply of money and
credit, the BOJ would impose individual ceilings on new
lending by commercial banks, in particular, the city banks.
In formulating these ceilings, the authorities used information garnered during day-to-day contacts through deposit
and lending transactions with individual financial institutions, such as their future loan plans and prospective fund
positions. In addition, the BOJ received from city banks
reports on a longer-term basis (monthly until 1963 and
quarterly thereafter) which included forecasts of future
fund-raising activity and the outlook for deposits and
loans.
The BOJ had a number of ways to dissuade banks from
lending in excess of their prescribed ceiling, such as
curbing its discount window lending, thus compelling a
bank to borrow in the more expensive call money market or
to sell commercial bills. In practice, banks complied with
BOJ guidelines with little need of persuasion because of
their heavy reliance on BOJ discount window loans for
their funds. Thus, according to Suzuki (1980), in no case
did a bank exceed the limits imposed up to the late 1970s.

8. The BOJ occasionally also resorted to changes in required reserves.
These changes were relatively infrequent, and the use of this instrument
was discontinued in 1982.

Monetary Control under Financial Liberalization

9. The call market rate is a short-term market comparable to the Federal
funds market in the U.S. It is still the BOJ's primary operating target.
There is also a bill discount market where commercial bills are
discounted.
10. For an authoritative discussion of the transmission channels of
monetary policy in Japan, see Suzuki (1980), parts II, ill, and IV.
11. The reserve maintenance period in Japan is one month that straddles
two calendar months. It runs from the 16th day of a month through the
15th day of the following month.
12. Under such a system, interbank rates could not fluctuate on a daily
basis. See Dotsey (1986) and Fukui (1986) for details. Similar operating

The mid-1970s initiated a process of financial deregulation
and innovation that continues to date. From the vantage
point of conducting monetary policy, three changes have
been particularly significant. First, the importance of bank
arrangements are in place today except that interbank rates fluctuate
more freeiythan in the past. See footnote 18.
13. The BOJ decided on the level of bank borrowing (up to a predetermined quarterly ceiling), the term of borrowing, and the interest rate
associated with borrowing. Officials at the BOJ could call up each city
bank as frequently as daily to indicate how much they could borrow.

FRBSF ECONOMIC REVIEW

1993,

NUMBER

loans has sharply declined as a result of the slowdown in
corporate investment and the move toward securitization.
This, coupled withthe large flotation ofgovernment bonds,
has weakened the link between corporate lending and the
monetary aggregate. Second, banks have been able to raise
funds from a wider array of financial instruments and markets, such as the CD and euroyen markets, thus reducing
their reliance on BOJ credit and eroding BOJ lever-

as well. The use of discount window guidance, in theform
of the central bank instructing individual banks in their
lending plans, was curtailed, although a more limited form
of window guidance, through which the BOJ communicated its aggregate lending plans and. overall policy stance
to individual banks, continued into 1991.
In the wake of financial liberalization, the BOJ also
extended its intervention outside the interbank market. The

age in using credit rationing under window guidance.

BOJ began open market operations in CDs in 1986,

Third, assets with market-determined prices have come to
predominate the portfolios of all sectors of the economy. The disintermediation between administered and
market-priced assets has weakened BOl's traditional transmission channel of altering the spread between interbank
rates, on the one hand, and the administered loan and
deposit rates, on the other.
These developments have led to a gradual shift from the
late 1970s through the 1980s in the objectives of monetary
policy. The BOJ began to pay more direct attention to the
behavior of monetary'-as opposed to credit-aggregates,
and in 1978 began announcing "forecasts" of the growth in
M2 + CDs. However, it is not clear that the BOJ has fully
embraced monetary targeting, as might be inferred from
the writings of some influential observers. (Friedman
1985, Meltzer 1986.) First, as BOJ officials emphasize
repeatedly, these announced figures are projections rather
than targets. 14 There is evidence suggesting that the BOJ
has not tried systematically to offset differences between
actual and targeted money (Ito 1989, Judd and Hutchison
1992). Second, broad money has not been the sole target,
but has served as one of the primary indicators among a
group of financial variables (Hamada and Hayashi 1985,
Hutchison 1986, and Kasman and Rodrigues 1991). In fact,
the BOJ appears to have gradually reduced its emphasis on
broad money in recent years while focusing a great deal of
attention on market interest rates (e.g. the call rate, the
gensaki or repurchase rate, and the CD rate). 15
Concomitant with these changes in the policy targets or
indicators, the BOl's operational procedures have evolved

gensaki in 1987, and commercial paper in 1989, when

14. For example, Suzuki states (1986, pp.192-193) that the BOJ focuses
on control of the broad money supply but does not set a target. He
indicates further that the BOJ "does not follow an operating procedure
rule of constant money supply growth." Also, as noted by Judd and
Hutchison (1992), these "annual" forecasts which were announced on a
quarterly basis actually extended only one quarter ahead; that is, the
forecasted annual growth rates are averages ofthree quarters ofrealized,
and one quarter ofprojected, money growth. As such, these projections
contained relatively little new information on monetary policy stance as
compared to, say, the Federal Reserve's targets.
15. The increased attention paid to market interest rates is officially
acknowledged by the BOJ staff itself. Nakao and Horii (1991) note, for
instance, that the BOJ "has increased the number of reservations it

active operations in short-term government securities were
also initiated. 16 Nevertheless, the call money rate (along
with the interbank commercial bill rate) is still the most
important interest rate target of the BOJ, and BOJ discount
window lending is still the primary mechanism for regulating the quantity of bank reserves. I? Indeed, the effectiveness of the call market appears to have been enhanced by
the greater flexibility in interbank· interest rates resulting
from deregulation in the late 1970s. 18

Monetary Control: Summary and Implications
Our discussion sheds light on two important elements of
the BOl's approach to monetary policy in the postwar
period. First, with respect to targeting, there is some
uncertainty about the precise features of BOJ credit or
money targeting. During the earlier periods, credit targets
were reportedly consistently met. However, these targets were not announced, so it is unclear whether they were
exogenous or adjusted to accommodate shocks to money
demand. There also has been disagreement on whether the
Bank of Japan actually adopted monetary targeting after
1978. However, BOJ statements suggest that there was no
strict targeting as such, and that the behavior of monetary
applies to its interpretation of money supply, bank credit and other
volume indicators of finance. . . [whilelit has enhanced attention given
to market interest rate developments."
16. Because of the relatively underdeveloped market for short-term
government securities, open market operations in Japan necessarily have
relied upon private short-term instruments.
17. See for example, Ohkubo (1983), Suzuki (1986), and Suzuki, et al.
(1988).
18. Notable changes in the interbank market include: allowance for
more frequent quotations on the call rate and the resale of bills allowed
after one month from purchase (June 1978); the introduction of sevenday call money with a freely determined interest rate (October 1978);
and the introduction of one-month bills at unregulated rates (November
1978). The process of liberalizing the interbank market was largely
concluded in 1979 with the abolition of quotation systems in the call
market and the introduction of shorter-term (2-6 days) call money
(April) and the liberalization of rates on 2-month bills (October). From
late 1979, therefore, rates in both the call and bill market have fluctuated
daily (Dotsey 1986).

MORENO AND

KIM I MONEY,

aggregates was monitored along with ot~er. indicator~,
such as interest rates. BOJ statements also mdlcate that m
recent years the weight assigned to interest rates has
increased.
Second, in the credit-dominated regime prior to the
onset of financial deregulation and innovation, the BOJ
depended more heavily on nonmarket mechanisms for
monetary control, such as window guidance, to control
money and credit. Tnere were also few substitutes for bank
deposits, so portfolio shifts were less likely to aff~t the
behavior of monetary aggregates. It seems plaUSIble to
argue that the BOJ's ability to control monetary aggregates
precisely was greater during this earlier period than it. was
later when the BOJ deemphasized nonmarket mechamsms
for c~ntrol and when the development of financial markets
broadened the spectrum of assets available to savers.
Given these characteristics, it seems reasonable to expect that monetary aggregates are unlikely to serve as a
good indicator of monetary policy since the late 1970s or
early 1980s, when financial innovation b~g~ in J~pan.
Monetary aggregates.will serve as a good mdlcator m the
earlier period if credit targets did not accommodate demand shocks which, as stated previously, is not entirely
clear. The reason is that during this earlier period financial
markets were relatively less developed and the BOJ relied
more heavily on direct, nonmarket· instruments that are
likely to have significantly enhanced .the. pr~cision of. its
control. As for interest rates,our mstItutIOnal reVIew
provides no clearcut basis for deciding whether they might
serve as useful policy indicators. However, the reader may
note that the BOJ appears to have consistently used an
interest rate as an operating target, and appears to have
paid closer attention to the implications of interest rates for
aggregate economic activity as the 1980s progresse~. !he
empirical analysis may clarify some of these uncertamtIes.

II. THE MODEL
Structural Model and Identification
To motivate the approach followed in this paper, consider
an economy described by a vector of nonpolicy variable~,
Zt' that may be represented by indicators of econOI~llc
activity like output and inflation, and a vector of pohcy
variables, It, that can be influenced by monetary authorities, such as a monetary aggregate and an interest rate.
The interaction by the variables is summarized by the
following two. equations 19
(1)

Zt = BOZt

+ B1Zt - 1 + COlt + Clt - I + ut

19. See Bemanke and Blinder (1992) for a similar discussion.

(2)

INTEREST RATES AND ECONOMIC ACTIVITY: JAPAN

It = DoZt

+ D1Zt -

+ Glt - l + vt

where u, v are orthogonal disturbances.
One way of identifying this model is to assume that
contemporaneous I does not enter equation (1) (Co = 0), so
policy actions affect real variables only with a lag: However, policymakers respond to contemporaneous mnovations in macroeconomic activity.

(4)

+ DoCI - BO)-IBl)Zt_l
+ (G + DoCI - BO)-lC1)It _ 1 + vt
+ Do(I - BO)-IUt

It = (D l

In equation (4) It is contemporaneously affected by the
policy innovation vt and also by contemporaneous macroeconomic shocks ut • Identification as proposed above can
be obtained by estimating a VAR comprising Z, I. The
orthogonalized innovations that satisfy the recurs~ve s~c
ture assumed in equations (3) and (4) can then be IdentIfied
by applying the Choleski decomposition. to the v~an~:
covariance matrix of the residuals, puttmg I last m me
ordering.
The model described above can be used to assess the
predictive ability of alternative possible measures of monetary policy by: (i) testing for the significance of exclusion
restrictions on monetary policy variables in the industrial
production equation, (ii) estimati~g t~e respective.contributions of orthogonalized innovatIons m money or mterest
rates to the variance of the forecast error of output at
various horizons. Similar procedures for assessing predictive ability are used by Sims (1980,1992) and by Bernanke
and Blinder (1992).
To ascertain whether responses to monetary variables
conform to theoretical expectations, the VAR model can be
inverted to obtain the impulse responses (the coefficients
of the moving average representation of the model) to
orthogonalized innovations in money and interest rates. A
comparison of these responses can then be used to assess
the extent to which the responses to innovations in these
variables conform to the monetary transmission model
described earlier.
As is well known, the Choleski identification procedure
proposed here has been criticized on a number of grou~~.
One potential difficulty is that the results can be senSItIve
to the ordering of the variables. 20 Another difficulty, reflected in the sometimes counterintuitive responses to

20. This criticism does not apply to the model used in this paper because
the contemporaneous correlations of the residuals of the estimated VAR
model are low.

FRBSF ECONOMIC REVIEW

1993,

NUMBER

shocks cited earlier in the introduction, is that it is not
entirely clear how innovations identified using this procedure are to be interpreted. For example, orthogonalized
innovations in money may reflect shocks to money supply
or money demand.
At least two responses may be offered to these criticisms. First, the application of these identification methods to Japanese data can actually shed further light on the

As discussed earlier, financial liberalization and changes
in the Bank of Japan's approach to monetary policy are
likely to have affected the relationship between money and
interest rates and economic activity. This suggests that it
would be desirable to estimate the model over two subsampIes. The first subsample would correspond to the period
when financial markets were undeveloped, commercial
banks were heavily dependent on the BOJ for funding, and

plausibility of the Choleski identification procedure, which

the BOJ emphasized credit targets and sought to influence

is still widely used in empirical VAR models of the U. S.
(The users include authors who have also lised alternative
identification procedures explicitly based on economic
theory, such as Bernanke and Sims). If the responses to
shocks broadly conform to theoretical expectations, it can
be argued that the Choleski procedure is a reasonable
approximation to a model that is identified on the basis of
economic theory.
Second, efforts to identify VAR models using economic
theory have also been criticized on various grounds. As
pointed out by Sims (1986), any empirical study raises
debatable questions about identification that will leave
readers more or less uncomfortable about applying the
conclusions. Under these circumstances, researchers may
be well advised to experiment with different approaches to
identification. The present paper can then be seen as one
step in allowing the data "to speak" about Japanese macroeconomic behavior. 21 Future studies that attempt to utilize alternative identification procedures are not ruled out.

bank behavior directly through window guidance. The
second would correspond to the period when financial
markets were more developed, commercial banks had
more access to sources of financing outside the BOJ
(including external financing), and the BOJ paid more
attention to money and interest rates (rather than credit)
and began to rely more heavily on market-based mechanisms for monetary control.
Given the gradual pace of financial innovation in Japan,
there is no obvious single candidate for a break date. Likely
candidates for a break date are somewhere between 1975,
when large quantities of government bonds were first
issued, and 1981, when Japan's foreign exchange controls
were first liberalized. The date 1981.1, which is the first
month after foreign exchange controls were liberalized in
Japan, is selected as a reasonable candidate. At that time,
the liberalization of controls loosened the dependence of
Japanese commercial banks on the Bank of Japan by allowing them to draw on foreign sources of funding. Also, the
impact of gradual financial liberalization on macroeconomic relationships is more likely to have been manifest by
then. Thus, the first sample period spans 1961.1~1980.12,
and the second, 1981.1-1992.8.
To account for non-stationarity in the data, the model
was estimated in first differences of the logs of the variables, with the exception of the interest rate, where the first
difference of the series was used. 23 As the frequency of the
data was monthly, lag lengths were set at 12 for both subsamples. No other criterion was used in setting the lag
length.

The Model
A four-variable monthly VAR model for Japan was estimated, comprising industrial production (IP) to represent
output, the consumer price index (CPI) to represent price,
a broad monetary aggregate (M2 + CDs) to represent
money, and the interbank call money rate (CMR) to
represent interest rates. The variables were entered in this
order in identifying the orthogonalized innovations. 22 The
data span the period 1961.1-1992.8. Data and sources are
described in the Appendix.

ill.
21. Structural VAR models of the Japanese economy have been estimated by Hutchison and Walsh (1992), Hutchison (forthcoming), and
Moreno (1992). However, none of these models are explicitly designed
to analyze monetary policy.
22. The ordering places M2 + CDs prior to CMR, which assumes that
the former is contemporaneously unaffected by innovations to the latter.
However, the correlation between residuals in the M2 + CDs and the call
money rate equations is small, about 8 percent in the first subsample and
18 percent in the second. Thus, the results are not likely to be very
sensitive to the ordering assumed.

RESULTS

Predictive Ability
To assess the predictive ability of alternative monetary
indicators, Table 1 reports the results of tests for exclusion
restrictions on the right-hand-side variables of the output
23. As is by now well-known, however, there is a great deal of
uncertainty. surrounding the stochastic properties of macroeconomic
data (Cochrane 1991, Rudebusch 1992).

MORENO AND KIM/MONEY, INTEREST RATES AND ECONOMIC ACTIVITY: JAPAN

(industrial production) equation and the results of variance
decompositions of the forecast error of output.
In· the first subsample, tests of exclusion restrictions
indicate that money is a good predictor of output; in fact, it
is better than the interest rate. The evidence offered by
variance decompositions is mixed. Money and the interest
rate make similar (and relatively small) contributions to the
variance of the forecast error after two years, after which
the contribution of money falls off, while the contribution
of the call money rate remains. about the same. It is worth
noting the Japanese economy experienced relatively large
supply shocks during this period (notably, large declines in
productivity and growth), and also fiscal policy shocks,
and these may have tended to reduce the observed contribution of the monetary indicators (money or interest rates) to
the variance of the forecast error of output.
For this sample, money and the interest rate are both
generally good predictors of output, so the criterion of
predictive ability does not allow us to choose unambiguously between the two. An analysis of responses to
innovations in .each of these variables is needed to shed
further light on which variable may be a better indicator of
monetary policy in Japan in this sample period. This is in
contrast to Sims's (1980) well-known result for the U.S.
case, which found that interest rates rob the monetary
aggregate of predictive power. According to the criterion
of predictive ability, in the U. S. the interest rate is favored
over money as an indicatorof monetary policy innovations.
In the second subsample, tests of exclusion restrictions
as well as the variance decomposition results indicate that
the monetary aggregate is a much better predictor of output
than is the call money rate. At a two-year horizon, money
accounts for 58 percent of the variance of the forecast error
of output in the second sub-sample, compared to 1 percent
for the. call money rate. In fact, the predictive power of
money is much larger in the second subsample (58 percent)
than in the first subsample (13 percent).
Our findings on predictive ability are consistent with
some previous studies of the Japanese economy that use
similar techniques and also replicate some ambiguities
observed in this literature. In particular, the finding that
money is a good predictor of real GNP according to
exclusion restrictions in both subsamples is consistent with
Suzuki, et al. (1988) which findings are based on a fivevariable VAR over the period 1968.Q1':"'1987.Q4. 24 It is

24. The Suzuki, et al. (1988) model comprises base money, the weighted
average of the call money rate and the bill rate, M2 + CDs, real output,
and the GNP deflator. Other studies have focused largely on the ability of
money to predict nominal output. See also the survey by Okina (1985).

TABLE 1
INDUSTRIAL PRODUCTION
TESTS OF EXCLUSION RESTRICTIONS

CPI

M2 + CDs

1960.1-1980.12

8.7 X 10-6

.04

8.4 x 10-4 2.7 X 10-3

1981.1-1992.8

.02

.14

CMR

.04

.56

VARIANCE DECOMPOSITION (PERCENT)

Months

CPI

M2+CDs

CMR

12
24
36

79
27
16

1
15
16

12
24
36

54
26
15

7
15
21

39
58
64

1
1
0

1960.1-1980.12

1981.1-1992.8

NOTES:
** Significant at 1%
* Significant at 5%

also interesting that our finding that money is not a good
predictor of output according to variance decompositions
for the first subsample is similar to Ito's (1982) findings
using M1 over a similar period.
To sum up, the preceding findings provide mixed evidence that both money and interest rates are good predictors of output in the first sample. Money is a much better
predictor of output in the second sample. These findings
support the view that money may be a useful indicator of
monetary policy, perhaps better than the interest rate.
However, such a conclusion is valid only if innovations to
money satisfy the predictions of the monetary transmission
model, while innovations in interest rates do not. We tum
to this question now.

Do Responses Conform to the Monetary Model?
To assess whether innovations to money or interest rates
conform to the predictions of the monetary transmission
model, Figure 1reports the point estimates ofthe responses
of the variables to innovations in monetary aggregates in
the first and second samples, while Figure 2.illustrates the
corresponding responses to interest rate innovations.
The shaded area illustrates one standard error band around

FRBSFEcoNOMIC REVIEW 1993,

NUMBER

FIGUREl
RESPONSES TO INNOVATIONS IN MONEY

1960.1-1980.1

1981.1-1992.8

LOGxlOO

4.0 ]

3.0

INDUSTRIAL PRODUCTION

2.0

2.0
INDUSTRIAL PRODUCTION

1.0

0.0

-1.0

-1.0
4

LOGxlOO

LOGxlOO
CPI

0.5

0.0

,CPI

0.0

-0.5

-0.5
4

LOGxlOO

LOGxl00

3.0

2.0

MONEY

1.0

MONEY

2.0

1.0

0.0

0.0
12

Percent

1.60

1.20

0.80

0.80
INTEREST RATE

0.40
0.00

-0.40

-0.40
4

MORENO AND KIM/MONEY, INTEREST RATES AND EcONOMIC ACTIVITY: JAPAN

FIGURE 2
RESPONSES TO INNOVATIONS IN INTEREST

RATES
1981.1-1992.8

1960.1-1980.1

LOGxlOO

INDUSTRIAL PRODUCTION

-0.6

-1.2

-1.8

-1.8
4

LOGxlOO

LOGxlOO
CPI

0'1

"'1
0.5

0.5

CPI
0.2

0.2

-0.1

-0.1
4

LOGxlOO

0.4

0.4
MONEY

0.2

MONEY

0.2

0.0

-0.2

·0.2

-0.4

-0.4
-0.6

-0.6
4

Percent

Percent
0.80

0.80

0.60

0.40

0.20

INTEREST RATE

0.00

0.00
4

FRBSF ECONOMIC REVIEW 1993,

NUMBER

the point estimate. The standard errors are obtained using a
bootstrapping procedure. 25
Focusing on the point estimates, in the first subsample
an innovation to money is associated with a fall in the interest rate below its initial level that persists for about a year
and a half, followed by a persistent rise that is subsequently
reversed.· Thus, there appears to be a "liquidity effect" in
this model. Other responses to innovations in money are
broadly consistent with the monetary transmission model.
In response to a monetary aggregate shock, output rises
temporarily, while prices rise after about one year.
In response to a positive interest rate innovation, money
falls, and output falls. However, there is an extended
increase in the price level that is difficult to interpret. A
similar "price puzzle" was found by Sims (1992, 1986) for
Japan and the U.S. While the responses to innovations in
interest rates are difficult to interpret, one possibility is that
they reflect aggregate supply shocks. This would account
for a set of events where interestrates rise, output falls, and
the price level rises. An alternative explanation, offered by
Sims, is that interest rate innovations reflect an effort
by monetary authorities to offset anticipate'A increases in
prices. However, the inflationary pressure is not entirely
offset so an increase in price is observed following the
increase in the.interest rate.
Figure 1 indicates that in contrast to the first subsample,
in the second sub-sample an innovation in money is associated with an increase in the interest rate. Thus, there
appears to be no liquidity effect. As in the first subsample,
output, prices and money increase; however, the responses
of output and money are much larger and more persistent
than in the first subsample. The direction of the responses
suggests that money innovations are demand shocks. However, the persistence of the responses suggests the presence
of permanent supply shocks. Thus, innovations to money
are not easily interpreted in this sample. Figure 2 reveals
that all the variables in the model now rise in response to an
innovation in interest rates (in the case of output, after

25. To construct the standard error band, we bootstrapped the residuals
of the VAR. The residuals were used to construct artificial series for the
variables in the models. The VARs were then rerun using the artificial
series and the impulse responses were recomputed. The simulations
were repeated 1200 times. The one standard error band was computed
by taking the square root of the mean squared deviation of the artificial
impulse responses (above and below) from the point estimate at each
step. By construction, the impulse responses obtained using the original
data are inside the band. They are also asymmetric. This resembles the
procedure used by Blanchard and Quah (1989). It may be noted that in a
few cases, the actual responses to shocks fell partly outside the space
spanned by the artificial impulse responses. In these cases, the standard
error bands are not shaded over the applicable horizons. This difficulty
should be borne in mind in interpreting the results.

an initial decline). These results suggest that an increase in
interest rates reflects increases in the demand for money
rather than a tightening in policy.
To sum up, the responses to innovations in money in the
first sample fit the predictions of the monetary transmission model, but do not do so in the second sample. Responses to innovations in interest rates do not consistently
fit the predictions of the monetary transmission model in
either period. Taken together with the results on predictive
ability cited earlier, money appears to be a relatively useful
indicator of monetary policy shocks in the first sample. In
contrast, the methods used in this paper do not successfully
identify a monetary policy indicator in the second sample.
The results for the first sample should be interpreted with
caution, because estimates are in some cases imprecise.
Nevertheless, they are quite interesting, as they suggest
that financial market development may have contributed to
reducing the usefulness of money as an indicator of monetary policy in Japan.
The preceding results may also be compared to those
reported in Sims (1992) which studied several industrial
economies, including Japan. SirIls finds that the response
of output to a monetary innovation is negative and is not
associated with a liquidity effect. To isolate the reasons for
the differences, we reestimated the model using Ml over
two subsamples, and found that Sims's results differ from
ours largely because he uses Ml rather than M2 + CDs as a
monetary aggregate.

IV.

CONCLUSIONS

This paper provides suggestive evidence that a broad
monetary aggregate is a better indicator of monetary
policy than an interest rate during the period when Japan's
financial markets were less developed, the BOJ focused on
a credit target and relied more heavily on nonmarket
instruments for monetary control to achieve its policy
target. During this period, there is mixed evidence that
both a monetary aggregate and an interest rate are good
predictors of output. However, analysis of the responses to
shocks suggests that the monetary aggregate is the better
indicator of monetary policy; Responses to money shocks
broadly conform to the implications of the monetary transmission model, whereas the responses to interest rates do
not. In particular, point estimates indicate the existence of
a liquidity effect in response to innovations in a monetary
aggregate. Responses to interest rate innovations suggest
that such innovations may reflect aggregate supply shocks
or policy responses to anticipated inflation.
In the second period, when Japan's financial markets
became more developed, and the BOJ appeared to adopt a
more eclectic approach to monetary policy, money is

MORENO AND

KIM / MONEY, INTEREST RATES AND EcONOMIC ACTIVITY: JAPAN

unambiguously a good predictor of output, whereas the
interest rate is not. However this does not imply that money
is a good indicator of policy, as the responses to innovations do not conform to the monetary transmission model.
In particular, there is no evidence of a liquidity effect,
suggesting that money innovations are better interpreted as
reflecting shocks to demand rather than policy changes.
Interest rate innovations also appear to reflect shocks to
demand.
As is often the case in this type of analysis, the estimates
are in some cases imprecise and should be interpreted with
caution. Nevertheless, they are quite interesting, as they
suggest that financial market development may have contributed to reducing the usefulness of money as an indicator of monetary policy. As discussed in our institutional
review, this may have occurred because financial market
development encouraged the Bank of Japan to pay greater
attention to interest rates and. also loosened the control of
monetary authorities over the monetary aggregate. Similar
forces may explain why researchers have had difficulty in
identifying an indicator of monetary policy in the U. S. ,
where financial markets have been much more developed
than Japanese financial markets in the postwar period.

ApPENDIX

Data Description and Sources
Consumer Price Index, Seasonally Adjusted (CPI): Index
of consumer prices covering the whole country excluding single-person households and those engaged mainly
in agriculture, forestry, and fishing. Base year is 1985.
Seasonally adjusted by Federal Reserve BilI-ue of San
Francisco staff using X-ll filter. Source: International
Monetary Fund, International Financial Statistics
(IFS).
Industrial Production, Seasonally Adjusted (IP): Index of
monthly production by 9 mining and 523 manufacturing
industries, weighted by 1985 value-added data. Base
year is 1985. Seasonally adjusted by Federal Reserve
Bank of San Francisco staff using X-ll filter. Source:
IFS.
Call Money Rate (CMR). Rate in interbank call money
market. Source: Bank of Japan.
M2 + CDs, Seasonally Adjusted: Ml plus quasi-money
(time, savings,· and foreign currency deposits of resident
sectors other than central government) plus certificates
of deposit in trillions of yen. End of month. Seasonally
adjusted by Federal Reserve Bank of San Francisco Staff
by applying X-II filter. Source: IPS.

FRBSF ECONOMIC REVIEW 1993,

NUMBER

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The Output-Inflation Trade-off in the United States:
Has It Changed Since the Late 1970s?

John P. Judd and Jack H. Beebe
The authors are Vice President and Associate Director of
Research, and Senior Vice President and Director of Research, respectively. They would like to thank Timothy
Cogley, Frederick Furlong, Ramon Moreno, John Roberts,
and Bharat Trehan for helpful suggestions on an earlier
draft, and Sean Kelly and, Andrew Biehl for research
assistance.

In recent years, the Federal Reserve has become more
explicit in stating a goal ofgradually reducing inflation to
near zero rates. An important consideration in seeking
lower inflation is the transition cost (lost output and
employment) incurred in the process. In this paper we ask
whether the output-inflation trade-off in the US. is any
more favorable now than it was in the high-inflation
environment ofthe late i970s and early i980s. Our empirical estimates suggest that this trade-off is about the same
as it was in the earlier period. in light ofthese results, we
consider ways in which policies might be designed to
reduce the amount of lost output associated with further
disinflation.

Since late 1979, the Federal Reserve has pursued disinflationary monetary policies that can be characterized as
occurring in two stages. First, in 1979-1981 the Fed successfully reduced inflation from double-digit to moderate
rates of around 3Y2 percent in 1983-1985. Beginning in
1988, the Fed began explicitly stating that it intended to
achieve a second period of disinflation, gradually moving
the inflation rate from a moderate level of about 4 percent
at that time to very low levels ("near" price stability) over a
number of years. In 1992, CPI inflation was 3 percent,
before dropping to about 212 percent in the first ten months
of 1993, indicating modest progress toward this goal.
An important consideration in seeking lower inflation is
how to design policies that minimize the size of the
transition costs that will be incurred in the process. These
costs depend importantly on the credibility of the disinflation policy, i.e., on whether the public believes that the
central bank actually will adhere to that policy. Thus a
more (less) credible disinflation policy will translate more
(less) quickly into lower inflation expectations, and therefore will have smaller (larger) effects on economic output. l
The costs associated with the policy of the early 1980s
appeared to have been large, since the U. S. economy
experienced the deepest recession of the post-World War II
period in those years. This is not surprising. Over the prior
decade the inflation rate had reached serious proportions,
and thus the public may have needed to see some results
before it began to believe in the Fed's resolve.
In this paper, we ask whether the transition costs have
been any smaller in the recent disinflationary period than
they were during the episode of the early 1980s. If so, it
may be because the Fed's policies gained some credibility
from its earlier disinflationary success, which reduced the

1. For an extensive review of the literature on monetaty policy and
policy credibility, see Blackburn and Christensen (1989). In their
introduction, they note that", .. the argument that figures prominently
in contemporaty discussions of deflationaty management-namely that
greater credibility of an anti-inflationaty policy reduces the costs of
disinflation-is persuasive" (p.2). Two approaches to designing an antiinflation policy are discussed-gradualism, which implies a steady,
predictable reduction in inflation, and irmnediacy, which aims at a more
radical policy of cutting inflation more quickly. In this paper, we focus
on the gradualist approach favored by the Fed.

FRBSF ECONOMIC REVIEW 1993, NUMBER 3

size of the transition costs. If the costs were not smaller,
then it may be because while the public believed that the
Fed would not let inflation get out of control as in the late
1970s, the public was not convinced that it would reduce
inflation from the moderate rates of the mid- to late-1980s
to near zero.
We address this empirical issue by estimating the size of
the short-run trade-off between output and inflation in the
U. S. Our results suggest that this trade-offis about the same
now as it was in the early 1980s. In addition, we point out
that surveys oflong-term inflation expectations suggest that
the public expects inflation to rise a bit from present levels
rather than decline according to the Fed's stated goal.
In light of these results, we consider ways in which
policies could be designed to enhance credibility and
thereby reduce the amount of lost output associated with a
given amount of disinflation. First, and foremost, credibility is established through results: i. e., actually reducing
the rate of inflation (Beebe 1991). However, it is possible
that within the context of achieving a measure of success,
lost output could be limited during disinflation if the Fed
were more explicit about its disinflation goals. Thus having
an explicit year-by-year inflation goal or range might help.
Going a step further, we also discuss the potential enhancements to credibility of finding an intermediate policy
target to supplant the monetary aggregates, which have become less useful in recent years due to well-known instabilities. Consistently employing an intermediate target that
is linked directly to the longer-term goal of reducing
inflation might contribute to an expeditious enhancement
of the credibility of that goal. Thus we suggest a class of
intermediate-targeting approaches that might prove useful.
This paper follows with four sections. Section I is a brief
discussion of Fed disinflationary policy since 1979. Section II provides evidence on the output-inflation trade-off.
Section III provides evidence on long-term inflation expectations. Section IV offers suggestions on how credibility
might be enhanced.

THE EVOLUTION OF THE
FEDERAL RESERVE'S DISINFLATIONARY
MONETARY POLICY

By the time Paul Volcker became Federal Reserve Chairman in mid-1979, the expansionary monetary and fiscal
policies of the late-1960s and 1970s had allowed consumer
inflation to rise well into double digits (see Figure 1). These
rates of inflation were very high by post-World War II
standards and disrupted U.S. and world financial markets.
U.S. long-term interest rates (for example, as measured by
20-year Treasury bond yields) rose from 414 percent in

FIGUREl
. U.S.

INFLATION AND UNEMPLOYMENT

Percent

ili;;:um'(Cr:nl
: : ,:,:,:;:Index

6
3

,:,<lDP Deflatot

0
-3

~: !
50

::::::
.:.;.:
~{:

111I11

:1111111

Iii

11111111

111

Shaded areas represent recessions as defined by the NBER.
Inflation rates determined by a year/year calculation.

1964 to lOY4 percent in late-1979, the dollar depreciated by
nearly 25 percent between 1970-1979, and the price of
gold rose to an historic high of over $800 an ounce in 1979
before settling back to over $400.
In response to these problems, the Fed dropped its
practice of targeting the federal funds rate and instituted a
new operating procedure under which it manipulated the
quantity of reserves supplied to banks in an attempt to hit
pre-announced ranges for several monetary aggregates.
The main aggregate used was the narrow measure, Ml,
which includes currency in the hands of the public and
fully checkable deposits. The new disinflationary policy
consisted of attempting to achieve annual target ranges for
Ml, which would be gradually lowered over time.
The policy was successful in achieving its main goal: Between 1980 and 1983, CPI inflation fell from 12.7 to 3.1 percent (annual averages over the prior year). The cost was the
most severe recession in post-World War II history, in which
the civilian unemployment rate peaked at 10.8 percent in
late-1982 and averaged over 9Y2 percent in both 1982 and
1983 (Figure 1).
By 1983 the operating procedures of monetary policy
had shifted. First, the Fed de-emphasized Ml in favor

JUDD 'AND BEEBE / OUTPUT-INFLATION TRADE-OFF IN THE UNITED STATES

of a broader aggregate, M2. Problems with Ml appear
to have stemmed from both financial innovation and deregulation. Such new instruments as repurchase agreements
and money market mutual funds were close substitutes for
the deposits in Ml, and therefore led to instability in its
velocity. The availability of these new instruments was a
major impetus behind the removal of deposit interest rate
ceilings, mainly from 1978 to 1983. However, deregulation
also created problems by blurring the distinction between
transactions and savings balances held at depository institutions. The rationale for emphasizing M2 was that it
was broad enough to internalize much of the portfolio
substitution that had disrupted Ml.
Second, in day-to-day operations, the Fed began to focus
on.the quantity of reserves borrowed from Reserve Banks
as its operating instrument, which is similar to using the
federal funds rate as the instrument of policy (Wallich
1984). Moreover, the degree of precision in monetary
targeting was reduced, and money once again became one
among a number of important indicators for policy, including data on developments in the real economy and prices, as
well as in the domestic and international financial markets
(Heller 1988).
The explicitness of a "price stability" goal did not
appear until late in the 1983-90 expansion. Early in the
expansion, official statements of Chairman Volcker generally were vague as to an inflation goal. For example, the
February 6, 1984 Monetary Report to Congress stated that,
"The (monetary) ranges for 1984 are intended to be
consistent with the basic objective of achieving long lasting
economic expansion in a context of continuing control of
inflationary pressures."
However, after becoming Chairman in 1987, Mr. Greenspan stated explicitly in his monetary reports to Congress
that the Fed's long-term goal was price stability, although
neither a time frame nor specific annual goals for inflation
were established. In his testimony ofFebruary 23, 1988, accompanying his first monetary report to Congress, Chairman Greenspan stated,"Progress toward price stability is
the foundation on which the longest peacetime expansion
in our nation's history has been built, and continued efforts
along this line will be the framework for future economic
advances." The February 20, 1990 Monetary Report to
Congress stated that, "The Federal Open Market Committee is committed to the achievement, over time, of price
stability." Moreover, Chairman Greenspan and a number
of Reserve Bank Presidents supported a bill introduced by
Congressman·Neal requiring the Fed to achieve price stability within five years. Given the focus of the Greenspan
Fed on price stability, it may be instructive to think of two
disinflationary sub-periods since 1979: the early 1980s in

which inflation was reduced to around 3Y2 percent, and the
period since the late-1980s in which a further reduction has
been sought.
Over the 1983-1990 expansion, little or no progress was
made in reducing inflation below the 4 percent rate that had
been established by 1984. In fact, following temporarily low
inflation in 1986, caused by a sharp drop in the oil price, inflation began rising somewhat again, reaching over 5 percent on a consumer price basis by 1990 (although the latter
rate was boosted by a temporary surge in the oil price.)
By mid-1989, the U.S. economy had slowed substantially, growing at less than a 2 percent rate, until it fell into
recession in mid-1990. The recession, which was relatively
mild and lasted three quarters, was followed by a long
period of slow, but positive, growth in 1991 through mid1993. In response to the overall pattern of slow economic
growth since 1989, inflation has shown signs of a downward
trend, averaging about 3 percent in 1992 and 2Y2 percent
over the first ten months of 1993.
Since the onset of the 1990-1991 recession, Fed policy
has focused on boosting economic growth moderately,
although it has retained its long-run goal of gradually
reducing inflation to very low levels. M2 growth has
remained extremely weak. Especially in 1991 and 1992,
M2 came in near the bottom of, or below, its annual range.
However, low M2 growth has not been considered a reliable measure of monetary tightness, since M2's relationship
to other economic variables appears to have shifted significantly. Like the earlier problem with Ml, the problem with
M2 seems to have arisen primarily from financial deregulation and innovation (Judd and Trehan 1992).
For these reasons, M2 has been de-emphasized in policy
decisions by the Fed in recent years. In essence, the Fed
has not had any monetary aggregate considered reliable
enough to use as a primary guide to monetary policy.
Instead, in recent years, it has relied on purely discretionary adjustments to the federal funds rate to find a delicately
balanced policy geared toward promoting moderate economic growth, while making further progress in reducing
inflation.

II. EMPIRICAL EVIDENCE
ON THE OUTPUT-INFLATION TRADE-OFF
In this section, we assess whether the output-inflation
trade-off has shifted downward since the late 1970s, when
the Fed increased its emphasis in public statements and
actions on the goal of reducing inflation. To do so, we
analyze an equation commonly used to estimate the tradeoff, and we review movements in inflation expectations as
measured by surveys.

FRBSF ECONOMIC

REVIEW

1993,

NUMBER

To estimate the trade-off, we use:
(1) ~.pt

= ex + x-aXt + f3 aPt-I + "Y(Yt-I - Yt-I)

where, x t == Pt + Yt; X = log of nominal GDP;p = log of
aggregate price level; Y = log of real GDP; and Y = log
of trend real GDP.
This equation has been used to estimate the trade-off
by authors with such diverse views about the structure
of the economy as Lucas (1973), Gordon (1983), Gordon
and King (1982), Schultze (1984), and Ball, Mankiw, and
Romer (1988). 2 Thus equation (1) appears to be consistent with both "new" and "old" Keynesian theory as well
as demand-oriented, or monetarist, equilibrium business
cycle theory. Correlations of the type expressed by the equation should be evident in both (1) an economy in which expectations are adaptive, so that an expectations-augmented
Phillips-curve would apply, and (2) an economy in which
expectations are rational, so that the "trade-off" represents
only an observed short-run correlation that is not exploitable by policymakers. Thus Lucas (1973) derives a relationship like equation (1) from a monetary-misperceptions
model with rational, optimizing agents, and Gordon (1983)
shows how equation (1) can be viewed as a rearranged
version of an adaptive-expectations Phillips curve. 3
The key assumption underlying the equation is that
growth in nominal GDP is exogenous with respect to
inflation. As such, it would capture the effects of aggregate
demand on inflation, and would be independent of aggregate supply shocks. (The viability of this assumption is
assessed below.) Then, for a given lagged inflation rate and
state of the business cycle, the coefficient X- measures the
proportion of the change in aggregate demand that affects
prices in the short-run as opposed to output. The outputinflation trade-off is calculated as 'T = (1- X-)/X-. It measures the percentage point change in output per percentage
point of change in inflation resulting from a given change
in aggregate demand. If the Fed's disinflation policy has
gained credibility over the.I980s, then X- should have risen
and'T should have declined over this period. Other coeffi-

2. Other papers dealing with this issue are Ball (1991,1993), Friedman
(1984, 1988), and Okun (1978).
3. In Judd and Beebe (1993, pp. 306 and 317), we tested for the stability
of an inflation-augmented Phillips curve, which expressed wage inflation as a function of slack in the labor market (as measured by the
unemployment rate relative to its estimated full employment level), and
expected wage inflation (as measured by past wage inflation). These
tests can be considered an alternative way of testing for the stability of
the inflation-unemployment trade-off. Similar to the results discussed
below for equation 1, we failed to reject stability of the wage inflation
Phillips curve.

cients in the equation also might have changed. However,
following the earlier literature, we will focus exclusively on
X- and its implications for 'T.

Estimating the Trade-off
Table 1 presents the results of estimating various forms of
equation (1) using annual data over 1949 to 1992. The
simplest estimated equation is shown in column 1. In this
column, the cyclical variable (y - Y) is formed by linearly
de-trending real GDP. (An alternative de-trending method
is discussed below.) All of the explanatory variables have
the expected signs, are highly significant, and together
account for about 82 percent of the variation in annual
inflation. This regression suggests that 'T averaged about
1.7 (.63/ .37) in the U.S. in the post-World War II period. 4
However, in order to feel comfortable with the assumption that x is exogenous with respect to p, it is necessary to
investigate the issue of whether supply shocks are likely
to be biasing estimates of X-. A supply shock causes P and
Y to move in opposite directions. If these variables do
not move by equal (proportional) amounts, then there will
be a resulting movement in nominal GDP, which will produce a correlation between nominal GDP and inflation that
would be misinterpreted by the equation as reflecting the
trade-off. In other words, supply shocks will bias estimates
of X- unless the aggregate demand function has a (negative)
unitary elasticity.
Columns 2 through 6 represent attempts to see if supply
shocks present a problem in estimating X-. First, we introduce supply shock variables to see if the estimate of Xis altered substantially. Second, we use two-stage least
squares estimation to eliminate possible reverse causation,
and again observe whether this affects the estimate of X-. In
column 2, we add a dummy variable that attempts to
capture the effects of major oil shocks, by taking on the
value of 1 in 1974 and 1979 and -1 in 1986. This variable is
significant in the equation and has the expected sign, but
does not significantly alter the estimate of X-. Column 3
shows two-stage-Ieast squares estimates of the same equation that was estimated with OLS in column 2. Again, the
estimate of X- is not materially affected. Column 4 introduces changes in the relative price of oil (from the Producer
Price Index), and has no effect on X-. In column 5, we test

4. Using monte carlo methods, we calculated the t statistic for the test of
whether this estimate of'T is different from zero, based upon the estimate
of Aand its standard error in column 1. The t statistic for'T was estimated
to be 4.33, suggesting that 'T is different from zero with a high level of
confidence.

JUDD AND BEEBE/OUTPUT-INFLATION TRADE-OFF IN THE UNITED STATES

TABLE 1
OUTPUT-INFLATION TRADE-OFF EQUATIONS: ALTERNATIVE SPECIFICATIONS

1949-1992
(1)

(2)

(3)1

-1.07**

-0.96**

-0.95**

0.37**

0.36**

0.37**

0.44**

0.41 **

0.42 **

0.15 * *

0.13 **

-0.0041 **

-0.0036**

0.013 *

0.012*

0.82

0.84

SEE

O.OlD

0.0099

Q(ll)

8.08

7.39

7.59

Constant

y,-j

Y'-l-Y'-l

Marginal significance levels: * = .05; * * = .01.
1. This equation was estimated with a two-stage least squares procedure. Instrumental variables used for .lx, include .lx,_j, .lb'_l' .lDEF,•
.lp,-l' y,_j, T" DO.
2. This equation was estimated with a two-stage least squares procedure. Instrumental variables used for .lx, and .lforex, include .lx,_j, .lbt _ j,
.lDEF,• .lp,_j, y,_j, T,. DO and .lforex,_j'
3. ywas estimated as the permanent component of Y from a VAR for Y and the six-month commercial paper rate as in ludd-Trehan (1990).
Because of well-known problems associated with using generated regressors (Pagan 1984), the t statistic on y,_j in column 6 is biased upward.
NOTE:

Definition of variables:
x = log of nominal GDP == p
P = log of GDP deflator

Y = log of real GDP
y = log of trend real GDP
T = time
poil = log of relative price of energy, producer price index
forex = real trade-weighted exchange rate beginning in 1969, zero from 1949 to 1968

DO =

1 in 1974, 1979
- 1 in 1986
oelsewhere

b = log of monetary base (FRB St. Louis)
DEF = log of nominal federal defense expenditures

FRBSF ECONOMIC REVIEW 1993,

NUMBER

for possible effects of changes in the real trade-weighted
value ofthe dollar. Using two-stage-Ieast squares methods,
we again find no significant effect on the estimated size of
'A. We conclude from these exercises that the basic equation
does not appear to be distorted by the effects of supply
shocks.
A second issue in estimating A has to do with how to detrend real GDP to form the business cycle variable (see

One potential problem with the tests in columns 7 and 9
is that the period from 1949 to 1979 encompasses years
in which inflation was low (1949-1965), as well as years in
which inflation increased (1965-1979). The tests in column 7 and 9 ask whether 'A was different in 1980-1992
from the average ratio in the entire prior period, whereas
we are more interested in seeing if it rose in 1980-1992
compared with the period in which inflation rose (1965-

Rudebusch 1993). In the estimated equations discussed

1979). Columns 8 and 10 attempt to address this question

above, we used a linear time trend to represent equilibrium
real GDP. In a second somewhat more complex approach,
we used the method ofBlanchard-Quah (1989) to extract the
trend component. This method involves estimating a structural VAR with the identifying restriction that there are two
types of shocks-a permanent and a transitory shock. 5 The
permanent shock is associated with trend real output, while
the transitory shock is associated with the business cycle.
Thus, we introduced the transitory component of real GDP,
as estimated by this method, into the equation in column 6
in place of Yt-l and T in column 1. Based upon the estimates of 'A in columns 1and 6, this substitution reduced the
estimate oh by 19 percent «1. 70 - 1. 38)/1.70). In the discussion below, we test for possible shifts in A using both
methods of de-trending y, to be sure that this factor does not
affect our results.

by including slope dummy variables (on ~x) for 1965-1992
and for 1980-1992. Although column 8 shows a decrease
in 'A beginning in 1965, neither column 8 nor 10 suggests a
significant shift since the late 1970s. 6
As a final check, we consider the possibility that A may
have changed gradually following the late 1970s as the
public learned of the Fed's increased resolve to reduce
inflation. In Table 3 (p. 32) we test for a shift in A in blocks
stretching from each year in 1980-1992 to the end of the
sample. Again, we do not find any single dividing point in
which there is a significant change in 'A, even at the 10 percent level of significance.
In summary, despite a considerable search for a shift in 'A
after the late 1970s, we have found none. It appears that the
Fed faces about the same output-inflation trade-off today in
attempting to reduce inflation from its present moderate
level that it faced at the height of the inflation and financial
instability in 1979.

Tests for Shifts in the Trade-off
In Table 2, we present tests for shifts in 'A. First, we take
columns 2 and 6 in Table 1and introduce a dummy variable
times the growth in nominal GDP, which yields columns 7
and 9. These latter columns provide a test for a decline in A
over 1980-1992 compared with 1949-1979. Column 7
(like column 2) uses linearly de-trended real GDP while
column 9 (like column 6) uses the Blanchard-Quah method
of de-trending. In both equations, the estimated A rises
somewhat (from .36 in 2 to .42 in 7 and from .42 in 6 to .46
in 9), but neither change is statistically significant even at
the 10 percent level.
Using monte carlo methods, we calculated the t statistics
for a change in 'T in1980-1992 based upon the estimates of
'A and their standard errors in columns 7 and 9. The results
were the same qualitatively as those for A: We were not able
to reject stability even at the 10 percent level.

5. Following Judd-Trehan (1990), we estimated a two-variable VAR for
log changes in real GDP and the change in the commercial paper rate,
using six lags of each variable. This system yielded impulse response
functions similar to those commonly found in the literature. Thus, for
example, positive transitory (demand) shocks cause output to rise
temporarily before returning to trend, while positive permanent (supply) shocks cause output to rise permanently.

INFLATION EXPECTATIONS

Our conclusion that the output-inflation trade-off has not
shifted seems consistent with the evidence from surveys of
inflation expectations, which have been slow to adjust to
disinflationary results. As shown in Figure 2 (p. 32), expectations in 1980 through 1982 of average inflation over the
next ten years were well above subsequent actual ten-year
average inflation rates for the ten-year-ahead period. Even
by 1982, average inflation expected over the next 10 years
was 6% percent, while the ex post realized average turned
out to be only 4 percent.
A decade later, long-run inflation expectations remain
well above the 1992 inflation rate of around 3 percent. Financial decisionmakers, as represented by the
6. Ball, Mankiw, and Romer (1988) argue that the sacrifice ratio should
rise (fall) as inflation falls (rises) because of menu costs, and they
present cross-sectional evidence from a number of different countries
that such a relationship exits. However, using time-series data, Ball
(1993) fails to find this effect. We tested for this effect by induding both
Llx and Llx2 in regressions 7 and 9, Table 2. The combination of these
two variables means that the sacrifice ratio can vary with the growth rate
of nominal demand. Like Ball, we failed to find a significant effect in
our time-series data.

JUDD AND BEEBE/ OUTPUT-INFLATION TRADE-OFF IN THE UNITED STATES

TABLE 2
TESTING FOR CHANGES IN THE OUTPUT-INFLATION TRADE-OFF BEGINNING IN

Constant
~Xt

(7)

(8)

(9)

-1.08**

-1.56**

-0.015**

-0.014**

0.35**

0.48 **

0.43 **

0.41 **

-0.22**

!:!XD65 t
~xD80t

y,-!

1965 AND 1980
(10)

0.02

0.073

0.D75

0.026

0.022

0.41 **

0.49**

0.65**

0.15 **

0.21**

-0.0043*

-0.0059**

Yt-l-Yt-!

0.42*

DO
0.81

SEE

0.010

Q(ll)

6.90

NOTE:

Marginal significance levels: * = .05; ** = .01.

Definition of variables:
D65 = { 11965-1992
.
0 elsewhere

D80 = { 11980-1992
oelsewhere
Other variables are defined in Table 1.

Hoey/Philadelphia Fed survey, expect inflation to average
3% percent over the next ten years (survey of 1993.Q2),
while the Michigan survey suggests that households expect
a 5Y4 percent average inflation rate over the same period
(average of January through May 1993 surveys). It appears
that the public remains unconvinced that the Fed will
achieve inflation much below 4 percent, despite the stated
goal of price stability.

IV:

WHAT CAN BE DONE
TO MAKE DISINFLATION LESS COSTLY?

Apparently, the Fed faces the same output-inflation tradeoff now that it faced in the early 1980s as it sought to bring
inflation down from double-digit rates. Of course, one
reason for this may be that it has yet to produce clear results
in reducing inflation significantly below the level estab-

lished in the mid-1980s. Although it seems unlikely that
the public fears another outbreak of double-digit inflation,
evidence has not yet· been observed supporting the view
that inflation will move to a level much below those that
have prevailed since the mid-1980s.
Doubts about lower inflation may be magnified by large
actual and projected federal budget deficits since the early
1980s. There may be concern that in the long run, persistently large deficits will lead to higher inflation, even
though the Fed generally is credited with not having
succumbed to pressure to monetize the federal debt to date.
In addition, the current design of monetary policy may
not make it easy for the public to discern how much
emphasis is being placed on inflation reduction. Although
the Fed has stated for. a number of years that its main
objective is to eliminate inflation, it also has paid attention
to output stabilization. The expressed intent of mitigating

FRBSF ECONOMIC REVIEW 1993,

TABLE

NUMBER

TESTING FOR CHANGES IN THE OUTPUT-INFLATION
TRADE-OFF IN

1980 THROUGH 1992
CHANGE IN COEFFICIENT ON

I1x

PERIOD TESTED

(8)

1980-92

.076 (0.25)

.022 (0.68)

-tn01
n ....
l~Ol-~~

.021 (0.76)

- .006 (0.91)

(10)

.121 (0.18)
.117 (0.20)
.071 (0.43)
.101 (0.34)
.038 (0.73)
.048 (0.64)
.022 (0.84)
.006 (0.96)
.019 (0.91)
.052 (0.81)
- .067 (0.76)

1982-92
1983-92
1984-92
1985-92
1986-92
1987-92
1988-92
1989-92
1990-92
1991-92
1992

.049 (0.47)
.048 (0.47)
.041 (0.55)
.043 (0.59)
.017 (0.84)
.002 (0.98)
.025 (0.80)
.024 (0.84)
.009 (0.96)
.011 (0.96)
- .014 (0.55)

NOTE: Marginal significance levels shown in parentheses. For example, a marginal significance level of 0.10 would suggest that stability
could be rejected with the probability of 10 percent that the equation
is stable. Tne power of these tests declines as the dividing point in the
sample moves toward the end of the sample.

FIGURE 2
EXPECTED AND ACTUAL CPI INFLATION
FOR TEN YEARS AHEAD

Percent

HoeYJPhila.1
Fed Survey~1

--_.~ i ~ .i

Shaded areas represent recessions as defined by the NBER.
Expected and actual data are for averages over the next 10 years, not
for the 10th year out.

cyclical downturns inevitably raises the issue of whether
this goal will take precedence over disinflation at any
particular time. Given the discretionary approach followed
by the Fed, in which it resolves conflicts between the two
goals on a case-by-case basis, it may be difficult for the
public to be sure that the Fed's resolve to reduce inflation
has not flagged.
One approach that might help convince the public that the
Fed is serious about disinflation would be to announce
specific inflation targets, or at least target ranges, for the
years ahead. 7 By showing a willingness to commit itselfto a
particular path ofdisinflation, and thereafter, to a particular
range for inflation, the Fed might be making its resolve
more credible. Moreover, it would be providing the market
with a benchmark for judging progress in meeting that goal.
A related issue concerns intermediate targets for monetary policy. As discussed above, although the Fed establishes target ranges for the monetary aggregates, it often
does not take actions to achieve those targets, since rapid
financial change has made it inadvisable to adhere to rigid
targets for these variables. As a consequence, however; the
market has received ambiguous and confusing signals
about what the Fed is doing to achieve its long-run disinflation goal. If the Fed had been able to pursue its monetary
target variables more aggressively, it might have enhanced
the credibility of its disinflation goal by providing the market with timely feedback on whether it was acting in the
short run in a way that would achieve its long-run inflation
goal (Cukierman-Meltzer 1986).
Given the problems with the monetary aggregates, it
seems worthwhile to evaluate the usefulness of alternative
intermediate target variables and targeting procedures.
Recent research outlined briefly in the accompanying box
suggests that nominal GDP possibly could be used effectively as an intermediate target in a context in which the
Fed retains its use of a nominal interest rate as its instrument of policy (Judd and Motley 1992 and elsewhere in this
Review). Essentially, the approach involves raising (lowering) a short-term nominal interest rate whenever growth in
last period's nominal GDP exceeds (falls short of) a preestablished target for nominal GDP growth. The targeted
growth rate for nominal GDP would be chosen to be consistent with a goal for inflation and made explicit ex ante.
A monetary policy rule such as this offers several
potential advantages. First, nominal GDP would not be
disrupted by shifts in the velocity of money. Second, to
construct such a rule, the Federal Reserve would first have
to specify an inflation goal. Moreover, by linking specific
7. In this discussion, we confine ourselves to ways ofimproving the credibility of gradualist disinflation policies. For a discussion ofthe merits of
"cold-turkey" approaches, see Ball (1993) and Sargent (1983).

JUDD AND BEEBE/OUTPUT-INFLATION TRADE-OFF IN THEUNlTED STATES

LINKING AN INFLATION GOAL
TO AN INTERMEDIATE TARGET AND
OPERATING PROCEDURE

The following rule is used to illustrate an approach to
policy that might have advantages from the point of
view of expeditiously establishing credibility. The
feedback rule links movements in a short-tew1 interest rate to nominal GDP:

8[Axt _ 1 -: AX;_d·
The variable R denotes the policy instrument,
which in this case is a short-term nominal interest
rate such as the federal funds rate that is under the
direct short-run control of the monetary authority.
The variable x represents the intermediate target
variable of policy, which in this case is (the log of)
nominal GDP. The rule specifies that the change in
the interest rate each quarter is a function of last
quarter's deviation between the growth rate of nominal GDP (Ax) and its target growth rate (Ax*).
The targeted growth rate of nominal GDP would
be set according to:
ARt

Ax; = Ap; + AYt,
where Ap* is the central bank's inflation target and
Ay is the estimated trend growth rate of real GDP.
The strength of the monetary authority's response to
deviations between Ax and Ax* is defined by 8, and
can be selected by the central baIlk. Based upon
stochastic simulations of two small macroeconomic
models, this rule appears to be capable of holding
long-run inflation to within fairly narrow bounds,
without substantially increasing volatilities in real
GDP or interest rates above those observed in the
post-war period (Judd-Motley 1992 and this issue.)

policy actions (i.e., changes in a short-term interest rate) to
an intermediate target that is simply and clearly linked
to the inflation goal, the public would have a simple way to
monitor the Fed's resolve to achieve and maintain that
inflation goal. Finally, the rule either could be followed
explicitly by the Fed or be used to guide and assess a
discretionary policy, should the Fed wish to diverge from
the policy prescribed by the rule. While a full assessment
of such an approach would involve issues other than
credibility, it appears that an approach ofthis type, whether
used as a rule or as a baseline for discretion, might reduce
the cost of disinflation.

In conclusion, the empirical tests in this paper suggest
strongly that the output cost of reducing inflation is about
the same as it was at the height of the inflationary period
from the late 1970s to the early 1980s. It is possible,
however, that this cost might be reduced if the Fed were to
make a public commitment to an explicit inflation target
and perhaps if it also were to commit itself to an intermediate target and operating procedure linked explicitly to the
inflation target.

FRBSF ECONOMIC REVIEW 1993, NUMBER 3

REFERENCES

Judd, John P., and Jack H. Beebe. 1993. "The Credibility of the Federal
Reserve's Disinflation Policy in a Period of FinanciaLChange." In

Ball, Laurence M. 1993. "What Detennines the Sacrifice Ratio?" Paper
presented at the Conference on Monetary Policy, January 21-24,
Islamorada, Florida, National Bureau of Economic Research.

Financial Deepening and Economic Growth in the Pacific Basin
Economies, eds. Yang Wenyou and Zhang Fengming, pp. 287-317.

_ _ _ _ _ . 1991. "The Genesis of Inflation and the Costs of Disinflation." Journal ofMoney, Credit and Banking (August, Part 2)
pp. 439-452.

_ _ _ _ _ , and Brian Motley. 1992. "Controlling Inflation with an
Interest Rate Instrument." Federal Reserve Bank of San Francisco
Economic Review 3, pp. 3-22.

Ball, Laurence N., Gregory Mankiw, and David Romer. 1988. "The
New Keynesian Economics and the Output-Inflation Trade-off."
Brookings Papers on Economic Activity, pp. 1-82.

_ _ _ _ , and
. 1993. "Using a Nominal-GDP Rule
to Guide Discretionary Monetary Policy." Federal Reserve Bank of
San Francisco Economic Review, this issue.

Beebe, Jack. 1991. "Comments on 'Japanese Monetary Policy during
1970-90: Rules or Discretion?' by Kazuo Ueda." Proceedings of
the Bank ofJapan Monetary Coriference, October 24-25.

_ _ _ _ , and Bharat Trehan. 1992. "Money, Credit and M2."
Federal Reserve Bank of San Francisco Weekly Letter (September 4).

Blackburn, Keith, and Michael Christensen. 1989. "Monetary Policy
and Policy Credibility: Theory and Evidence." Journal of Economic Literature (March) pp. 1-45.

_ _ _ _ _ , and
.1990. "What Does Unemployment
Tell Us about Future Inflation?" Federal Reserve Bank of San
Francisco Economic Review (Summer) pp. 15-25.

Blanchard, Olivier 1., and Danny Quah. 1989. "The Dynamic Effects
of Aggregate Demand and Supply Disturbances." American
Economic Review (September) pp. 655-673.

Lucas, Robert E., Jr. 1973. "Some International Evidence on OutputInflation Tradeoffs." American Economic Review (June) pp.
326-334.

Board of Governors of the Federal Reserve System. 1984, 1988, 1990.

Okun, Arthur M. 1978. "Efficient Disinflationary Rules." American
Economic Review (May) pp. 348-352.

Monetary Report to Congress Pursuant to the Full Employment
and Balanced Growth Act of 1978, February 6, February 23, and
February 20, respectively.
Cukiennan, Alex, andAlianH. Meltzer. 1986. "TheCredibilityofMonetary Announcements." In Monetary Policy and Uncertainty, ed.
Manfred Neuman. Baden"Baden: Nomos Verlagsgesellschaft Gw.
Friedman, Benjamin. 1988. "Lessons on Monetary Policy from the
1980s." Journal of Economic Perspectives (Summer) pp. 51-72.
_ _ _ _ . 1984. "Lessons from the 1979-82 Monetary Policy
Experiment." American Economic Review (Papers and Proceedings) (May) pp. 382-387.
Gordon, Robert 1. 1983. "A Century of Evidence on Wage and Price
Stickiness in the United States, the United Kingdom, and Japan."
In Macroeconomics, Prices and Quantities, pp. 85-133. Washington: The Brookings Institution.
_ _ _ _ , and Stephen R. King. 1982. "The Output Cost of
Disinflation in Traditional and Vector Autoregression Models."
Brookings Papers on Economic Activity pp. 205-244.
Heller, Robert H. 1988. "Implementing Monetary Policy." Federal
Reserve Bulletin (July) pp. 419-429.

Foreign Affairs Department, People's Bank of China.

Pagan, Adrian R. 1984. "Econometric Issues in the Analysis of
Regressions with Generated Regressors." lnternationtil Economic
Review (February) pp. 221-247.
Rudebusch, Glenn D. 1993. "The Uncertain Unit Root in Real GNP."
American Economic Review, forthcoming. (Currently available in
Finance and Economics Discussion Series, Number 193, Board of
Governors of the Federal Reserve System, April 1992).
Sargent, Thomas 1. 1983. "Stopping Mod<:lrate Inflations: The Methods
of Poincare and Thatcher." In Inflation, Debt, and Indexation, eds.
R. Dornbusch and M. Simonsen pp. 54-95. Cambridge, Mass:
MIT Press.
Schultze, Charles L. 1984. "Cross-Country and Cross-Temporal Differences in Inflation Responsiveness." American Economic Review (Papers and Proceedings) (May) pp. 160-165.
Wallich, Henry. 1984. "Recent Techniques of Monetary Policy." Federal
Reserve Bank of Kansas City Economic Review (May) pp. 21-30.

Adapting to Instability in Money Demand:
Forecasting Money Growth with a
Time-Varying Parameter Model

Timothy Cogley
Senior Economist, Federal Reserve Bank of San Francisco.
I am grateful to Hopi Huh, Mark Levonian, and Bharat
Trehan for helpful comments on an earlier draft and to
Desiree Schaan for computational assistance.

Conventional money demand models appear to be unstable, and this complicates the problem of conducting
monetary policy.. One way to deal with parameter instability is to learn how to adapt quickly when parameters
shift. This paper applies a time-varying-parameter estimator to conventional money demand models and evaluates its usefulness as aforecasting tool. In relative terms,
the time-varying-parameter estimator improves significantly on ordinary least squares. In absolute terms, we
continue to have difficulty tracking money demand through
turbulent periods.

According to the quantity theory of money, nominal spending depends on the supply of money and on velocity, and
velocity is determined by money demand. Ifmoney demand
is stable, monetary aggregates can be used as indicators
of fluctuations in nominal aggregate demand. Furthermore, if money demand is functionally invariant to changes
in money supply, then the Federal Reserve may be able
to adjust the money supply in order to offset fluctuations in nominal spending that are due to non-monetary
disturbances.
Conventional models of money demand appear to be
unstable, however, and this greatly complicates the problem of conducting monetary policy. In particular, since
money demand models are functionally unstable, it is
difficult to interpret the information in monetary aggregates. For example, in recent years, the Federal Reserve
System's money demand models have consistently underestimated M2 velocity. As a consequence~ the Federal
Reserve has overestimated the rate ofM2 growth needed to
sustain the projected growth in nominal GDP, and therefore actual M2 growth has fallen below its target range.
Ordinarily, the unexpected shortfall in M2 growth would
be a sign of serious weakness in theeconomy. However, in
this case, it simply reflected the fact that velocity turned out
to be higher than expected. Thus instability in money
demand models makes it difficult for the Federal Reserve
to keep money within its target range while still trying to
achieve its goals for the economy.
As a theoretical matter, there is no reason to believe that
conventional money demand models should be stable. For
example, since conventional representations are subject to
the Lucas critique, changes in central bank operating
procedures can alter money demand parameters. Similarly,
financial innovation may alter the relation between velocity
and opportunity costs. Thus it seems appropriate to treat
conventional money demand models as time-varying parameter models.
Roughly speaking, there are two ways to deal with timevarying parameters. One is to seek a deeper theoretical
structure whose parameters are time invariant. So far,
monetary economists have had little success with this
approach. Another way to deal with parameter instability is to learn how to adapt to functional changes

FRBSF ECONOMIC REVIEW 1993, NUMBER 3

in money demand by allowing estimated parameters to
change quickly when the model begins to show signs of
instability. This paper takes the latter approach. It explores
a time-varying parameter estimator that gives more weight
to recent data and less weight to older data, so that
estimates can change quickly when parameters change.
The goal is to improve the predictive performance of
money demand models.
Tnis intuition is formalized in terms of discounted
least squares (DLS). The paper applies recursive DLS
to a number of conventional money demand models and
compares its predictive performance with ordinary least
squares (OLS). In relative terms, DLS compares favorably
to OLS. For example, in cases where instability is especially important, DLS reduces the mean square error of
one-quarter-ahead forecasts by 55 to 60 percent. Thus DLS
can provide an important hedge against gross instability.
In absolute terms, however, conventional money demand models still have a great deal of trouble forecasting
through turbulent periods. Thus DLS represents only a
partial solution to parameter instability. In particular, since
we continue to have difficulty tracking M2 demand, it will
continue to be difficult to use M2 as an indicator of
economic conditions.

TIME-VARYING PARAMETERS

This section interprets conventional money demand functions in order to motivate the empirical approach taken in
the paper. In conventional money demand models, demand
for real balances depends on a scale variable, such as
income, consumption, or wealth, and on opportunity cost
variables. For example, Meltzer (1963) studied variations
on the following model:

In (m t / Pt) =

130 + 131 In (rt ) + 132 In (wt) +

where mt denotes nominal money balances, Pt is the price
level, rt is a nominal interest rate, wt is either real wealth or
income, and 130' 131' and 132 are parameters.
Most of the empirical literature assumes that the parameters are time invariant. In practice, however, estimated
money demand models appear to be unstable. For example,
there was the famous "case of the missing money" in the
mid-1970s (see Goldfeld 1976, or Judd and Scadding
1982). More recently, Feinman and Porter (1992) report
evidence that M2 demand models have gone off course.
From a theoretical point of view, the instability of
empirical money demand models is not puzzling. On the
contrary, it is exactly what monetary theory predicts. Two
kinds of arguments generate time-varying parameters, one
based on the Lucas critique and another based on financial
innovation.

The first argument concerns identification and is due to
Cooley and LeRoy (1981). Traditional money demand
models describe an. equilibrium between money supply
and money demand. In order to interpret the· parameters
solely in terms of money demand, however, money supply must be predetermined or exogenous. This condition
seems dubious. If money supply is endogenous, tbe estimated parameters will depend at least in part on supply
factors. Furthermore, if there are changes in the deteuuinants of money supply, such as a change in monetary
policy operating procedures, the parameters of conventional money demand models will also change. Thus, when
money supply is endogenous, a necessary condition for
parameter stability is that monetary policy rules not change
during the sample. Since post-war U.S. data probably do
not satisfy this condition, parameter instability is to be
expected.
A second argument emphasizes financial innovation
(e. g. , Ireland 1992). For example, in cash-in-advance models, agents can buy some goods only with money and other
goods with either money or credit. The cash-in-advance
constraint gives rise to a transactions demand for money. A
financial innovation expands the set of goods that can be
bought on credit and thus (other things equal) reduces
demand for real balances. Thus financial innovation alters
the relation between money, interest rates, and expenditures. Since conventional money demand models do not
fully capture the effects of financial innovation, one should
expect parameter instability during periods of financial
innovation.
Recently, a number of authors have argued that financial
innovation may account for the recent bout of instability in
M2 demand. In particular, the increased availability of
mutual funds may have altered the relation between M2
velocity and interest rates (e.g., Feinman and Porter 1992
or Duca 1993). For example, banks have begunto market
mutual· funds to retail customers. As these funds become
more accessible, the transactions costs of switching between M2 and various non-M2 securities are reduced. This
increases the substitutability between M2 and stock and
bond funds and thus increases the interest elasticity of M2
demand. The unusually steep yield curve of the last few
years also may have induced some investors to switch into
mutual funds.
These arguments suggest that we should treat conventional money demand functions as time-varying parameter
models. Broadly speaking, there are two ways to deal with
time-varying parameters. One is to seek a "deep structural" model of money demand, i.e., one that is invariant to financial innovation and monetary policy regime
changes. In order to achieve invariance, however, a deep
structural model would have to incorporate decision rules

COGLEY / ADAPTING TO INSTABILITY IN MONEY DEMAND

that govern financial innovation as well as rules that govern
monetary policy regime changes. This approach is attractive in principle, since it would enable economists to
evaluate the effects of policy changes. But this route does
not seem promising at present, since monetary theory has
not yet advanced to the point where it can deliver empirically useful representations for these decision rules.
Given the state of knowledge, it may be worthwhile to seek

an alte111ative solution.
Another approach is to learn to adapt to functional
instability. There are at least two ways to think about
adaptation. The most common approach is to respecify the
model's functional form when it goes seriously off course.
For example, recent efforts to respecify M2 demand models are described in Feinman and Porter (1992) and Duca
(1993).1 Another approach is to apply time-varying parameter estimators to conventional models in order to allow
parameter estimates to adapt quickly when shifts occur.
The time-varying parameter approach may prove useful for
forecasting, even if its role in evaluating proposed changes
in policy rules may be limited.
These two approaches should be regarded as complementary. FUnctional respecification is an ex post activity
and therefore is not useful· at the onset of a turbulent
period. It generally takes many years to recognize model
instability andto correct the problem, and the time-varying
parameter approach may pay important dividends in the.
interim. Furthermore, when a model is respecified, it may
be worthwhile to re~estimate bya technique that gives
greater weight to recent data and less weight to older
data, and this is precisely what time-varying parameter
estimators do. On the other hand, if new financial instruments are introducedor if there are important omitted variables, time-varying parameter estimators may never fully
adapt, and functional respecification may be necessary.
This paper concentrates on the potential usefulness of
time-varying parameter estimators and does not explore
functional respecification. My goal is to provide some
insight into the marginal value of time~varying parameter
estimators, but I do not claim that this is the only way·
to proceed.

n. RECURSIVE ESTIMATORS
In real time, Federal Reserve economists reestimate money
demand models as new data become available. Since I want
to study the reestimation process, it is useful to pose the
1. Feinman and Porter investigate alternative measures of opportunity
cost with an emphasis on modeling effects of the steep yield curve. Duca
proposes that mutual funds· be added to M2 in order to internalize
portfolio substitutions.

problem in terms of recursive estimators. Begin by writing
the model as

where xt and bt are kx 1 vectors, Yt and U t are scalars. The
vector bt denotes the OLS parameter estimate based on
data available through date t. If the model is reestimated by
OLS each period, then bt evolves as

bt = bt - l

+ Pt-lXt (Yt - x; bt - l) I (1 + x; Pt-lXt),

Pt = Pt - l - Pt-lXtx; Pt - l / (1

+ x; Pt-lXt ),

where Pt = (X,'Xt)-l and Xt = (Xl' ... , xt )'. This is
simply the formula for recursive OLS.
Recursive OLS might be appropriate if b were time
invariant. However, theory and experience do not support
time invariance. We regularly experience parameter shifts
in money demand models. After a shift, the model tracks
real balances poorly for a while, until the OLS recursions
catch up with the parameter shift. The problem with
recursive OLS is that it takes too long to catch up. Thus it
seems worthwhile to consider alternative estimators that
catch up more quickly.
Recursive OLS gives the same weight to all observations
in the sample. When the model is subject to parameter
shifts, it may be more sensible to give more weight to
recent observations and less weight to distant ones. This
intuition can be formalized in terms of discounted least
squares (DLS) (Harvey 1981). That is, choose the vector b
which minimizes the discounted sum of squared errors:
T

DSS

I 1 8T - t (yt t=

X'b)2.
t

The parameter 8 is a discount factor. If 8 = 1, each
observation is given equal weight, and this simplifies to
OLS. If 8 < 1, observations close to the end ofthe sample
(i.e., those close to the present) get more weight than those
in the distant past. If the model is reestimated period by
period by DLS, the parameter vector evolves as follows:

bt =

bt - l + Pt-lx,(Yt

- x;bt - l) I (8

Pt = 8- lPt _ l - 8- 1 Pt-lXtX;Pt-l I (8

+ X;Pt-lX t) ,

+ x; Pt-lXt ),

where b2 denotes the DLS estimate based on data available
throughperiodtandPt-l = IJ=18t-hjXi. When 8 = 1,
these recursions simplify to recursive OLS. When 8 < 1,
the most recent observation gets more weight in the updating formula than it does under OLS. 2

2. This technique is similar to the random walk parameter model of
Cooley and Prescott (1976). One advantage of the Cooley-Prescott

FRBSF ECONOMIC REVIEW 1993,

NUMBER

The rationale for using DLS is that it will adapt more
quickly to a parameter shift than will recursive OLS. But
this comes at the expense of a loss in precision. For
example, if the parameters were time invariant, DLS
would discount useful information contained in the early
observations, and this would increase the variance of the
estimates. The parameter 8 controls the terms of the tradeoff. A value close to 1 favors precision over adaptability. A
value far from 1 aliows the model to adapt quickly but may
produce highly variable estimates even when no shift has
occurred. The discount factor must be chosen to balance
adaptability against precision.

cursive DLS estimates are computed using the discount
factors determined above, and they are compared with
recursive OLS estimates. The principal reason for choosing 1989 as the beginning of the test period is a desire to
have several years of data available for evaluating the timevarying parameter forecasts, and the results are not sensitive to the precise choice of sample split. Conventional M2
demand functions were unstable over this period. If my
intuition is correct, the DLS algorithm should adapt more
quickly than OLS, and recursive DLS forecasts should
therefore have lower mean square error than recursive OLS
forecasts.

ill.

EXPERIMENTAL DESIGN

Robert Lucas warns economists to "beware econometricians bearing free parameters," and the DLS algorithm has
a free parameter. Thus it is important to impose some
discipline on the choice of 8. In particular, 8 must be
chosen based on information that is available before the
forecast period begins. This section explains how 8 is
chosen and how the DLS algorithm is evaluated.
I divide the sample into three subperiods. The first
covers the period 1954 to 1980 and is used to generate
initial parameter estimates. M2 was redefined in 1980, and
one of the criteria was that the new aggregate have a stable
demand function (see Judd and Trehan 1992). Since parameter instability is not a problem for this subperiod, initial
estimates are computed by OLS.
The second subperiod covers 1981 to 1988, and it is used
to determine an optimal value for 8. I experiment with
values of 8 ranging from. 8 to .99 and choose the value that
minimizes the mean square error of recursive DLS forecasts. 3 M2 demand functions were relatively stable during
this period. By choosing 8 to optimize goodness of fit over
this period, we ensure that the DLS algorithm produces
reasonably stable parameter estimates during stable times.
This is an important criterion. An algorithm that produced
unstable estimates during stable periods would be of no use
to anyone.
Some data are saved at the end of the sample to test
the DLS algorithm. For the period 1989 to 1992, re-

approach is that it implicitly allows different discount rates for different
parameters. However, this would violate Lucas's dictum to avoid
proliferating free parameters. When the Cooley-Prescott model is
restricted so that there is only one discount factor, it is basically the same
as DLS. I prefer DLS because it is more intuitive.
3. I also experimented with an a priori choice for 8, which was
determined by the criterion that the discount function have a halflife of5
years. In general, this produced out-of-sample results that were superior
to OLS but inferior to the data-detennined value of 8.

RECURSIVE ESTIMATES
OF MONEY DEMAND

Basic Specification
This section applies recursive OLS and DLS to a number of
standard money demand models. I assume that· all the
relevant variables are integrated processes and that there is
a stable long-run relation between real balances and the
scale variable. 4 Given these assumptions, money demand
can be expressed as an error correction model. I consider a
number of simple specifications which differ according to
their scale and opportunity cost variables. The· general
specification is as follows:

In(m t / Pt) = ao + al In(wt) + zp
bo(L)t1ln(m t / Pt) = bi + b2 (L)St + b3 (L)t1ln (w t)

+ b4zt - I +

where St is a vector of interest rate spreads and Zt is the longrun "equilibrium error," in the language of Engle and
Granger (1987). The first equation defines the long-run
equilibrium relation between real balances and the scale
variable. 5 Interest rate spreads are stationary and thus do
not belong in the cointegrating relation. The second equation describes the short-term dynamics. The presence of
the long-run "equilibrium error" in the second equation
ensures that the short-run adjustments in money growth
ultimately lead back to the long-run equilibrium level of
real balances; hence the name "error correction" model. 6

4. The data do not contradict these assumptions.
5. I also examined models in which al was set equal to one. This
restriction implies that velocity is stationary and is equal to z,. This had
little effect on the result.
6. See Mehra (1991) for a more detailed exposition of error correction
models of money demand.

COOLEY/ ADAPTING TO INSTABILITY IN MONEY DEMAND

One can write this as a single equation by substituting Zt
from the first equation into the second.
I consider various combinations of scale and opportunity cost variables. The opportunity cost of holding M2
depends oli the spread between returns on alternative
assets and the own rate of return on M2. The .latter is
calculated by the Federal Reserve Bank of Richmond as a
weighted average of the returns on the components of M2

(e.g., Mehra 1991). Foraltemative rates, Iexperiment with
the six-month commercial paper rate and the lO-year
Treasury bond rate.
For scale variables, I experiment with GDP and personal
consumption expenditures. GDP is the standard scale
variable in the money demand literature. Consumption can
be motivated in two ways. First, consumption is the appropriate scale variable in cash-in-advance models (e.g.,
Lucas 1988). Second, as an empirical matter, various
authors have emphasized that permanent income performs
better than current income (e.g., Meltzer 1963), and consumption is a natural, observable proxy for permanent
income.
To complete the specification, each version ofthe model
also· includes dummy variables for the second and third
quarters of 1980, during which credit controls were binding, as well as a dummy variable for.the first quarter of
1983, whenMMDA accounts were introduced. Finally, the
lag polynomials in the second equation are assumed to be
of order 1. This is sufficient tocapture the dynamics of real
M2 growth during the initial estimation period. 7

The Experimental Period
Each of these models was estimated by recursiveOLS and
DLS, using quarterly data, and the results are reported in
Table 1. The first two columns report the mean square error
of recursive one-quarter-ahead forecasts for the various
models and time periods. Mean square error is· standardized by dividing by the variance of the dependent variable;
thus R2 statistics are equal to 1 minus the mean square
error. R2 statistics are useful for evaluating absolute performance, and mean square error is useful for evaluating
relative performance.
The first column of Table 1 reports results for the experimental period 1981-1988. During this period, the
various models accounted for roughly 35 to 65 percent of
the variation in real balance growth. GDP appears to be
superior to consumption, reducing the mean square forecast error by roughly 20 percent. Furthermore, the short-

7. Fonnally, this is sufficient to generate white noise residuals during
this period.

TABLE 1
PREDICTIVE POWER AND BIAS

MSE(81-88)

MSE(89-92)

BIAS(89-92)

1. Six-Month Commercial Paper Rate

GDP
1\ = 1.00
0=0.82

0.471
0.358

3.655
1.430

- 5.42 (.000)

Consumption
1\ = 1.00
1\ = 0.80

0.601
0.510

1.564
1.316

-3.14 (.002)

2. Ten-Year Treasury Bond Yield

GDP
1\ = 1.00
1\ = 0.99

0.637
0.638

1.267
1.270

-1.35 (.176)

Consumption
1\ = 1.00
1\ = 0.99

0.679
0.681

1.290
1.269

-1.42 (.154)

3. Six-Month Commercial Paper and Ten-Year Treasury Bond Rates
GDP
1\ = 1.00
1\ = 0.80

0.482
0.361

3.768
1.704

-5.47 (.000)

Consumption
1\ = 1.00
1\ = 0.93

0.648
0.613

1.149
1.109

-2.71 (.002)

NOTE: The first two columns report the mean square error of recursive prediction errors scaled by the variance of real M2 growth. The
third column reports the statistic YkE(vt)/a, with normal probability
values shown in parentheses. When 1\ = I, this corresponds to recursive OLS.

term interest rate appears to perform better than the
long-term rate. For example, when GDP is the scale
variable, the mean square error for the short-rate model is
approximately 35 percent lower than the mean square error
for the long-rate model. Including long rates as well as the
short rate has no effect on forecast performance. Thus,
during the experimental period, the two best models were
the ones based on GDP and short-term interest rates.
Even during this period, when M2 money demand was
relatively stable, recursive DLS often worked significantly
better than recursive OLS. In particular, for the models that
include short rates, DLS reduces mean square error by an
average of approximately 15 percent. In the long-rate
models, the optimal discount factor turns out to be .99, so
there is essentially no difference between DLS and OLS.
Recall that DLS trades precision for adaptability. Even
during the relatively stable subperiod, the gain from adaptability often outweighed the loss of precision.

FRBSF ECONOMIC REVIEW 1993, NUMBER 3

The Test Period
The second and third columns of Table 1 report results for
the test period 1989-1992. These columns reveal four
results. First, when estimated by recursive OLS, the performance of all the models deteriorates badly. The mean
. square error of recursive OLS forecasts increases dramatically, and "out-of-sample" R2 statistics are negative in
every case (see the second column). 8
Second, during the test period, the recursive OLS models consistently overestimated real M2 growth. One can
test for bias in recursive OLS by computing the mean of
normalized OLS prediction errors:
Vt = (Yt - x; ht - I) / fl12,
where!r= (1 + x;Pt_IXt ). Ifthemodelis stable, vthasmean
zero, is serially uncorrelated, and has the same variance as
the regression disturbance. Further, if the regression disturbance is normally distributed, then Vt is also normally
distributed (see Harvey 1981). LetE(vt ) denote the mean of
vt over the test period: E(vt) = (11k)IT=V+ I Vt. Given these
assumptions, E(vt ) is normally distributed with mean zero
and variance equal to (f2/k. Thus ilkE(vt)/(f is distributed
as a standard normal random variable. 9
Bias statistics are reported in the third column of Table 1. The mean recursive residual is negative in all models, and the means are statistically significant in four of the
six cases. Since stable models have unbiased recursive
residuals, this result confirms our belief that conventional
money demand models should be treated as time-varying
parameter models. 10
Third, compared with OLS, DLS performs relatively
well, and the percent improvement appears to be positively
related to the degree of model instability. For example, the
two models that had the lowest mean square error during
the period 1981-1988 (i.e., the GDP-short-rate models)
tum out to have the highest mean square error during the
test period. For these models, DLS reduces the mean
square error of one-quarter ahead forecasts by 55 to 60 percent. Thus DLS can be an important hedge against gross
instability.

Figure 1 illustrates one of these cases. This is derived
from the model that uses GDP as the scale variable and the
six-month commercial paper rate as the opportunity cost
variable (i.e., the first model in Table 1). The solid line
shows real M2 growth, and the dotted lines show forecasts
generated by recursive OLS and DLS, respectively. In the
second half of 1989, both models systematically begin
to overestimate real M2 growth. Recursive OLS is slow to
catch on to the apparent structural shift, and it continues
to overestimate real M2 growth until the end of 1992.
Recursive DLS is more adaptable. It begins to recognize a
structural shift around the second quarter of 1990, and its
forecasts begin to edge downward. By the second half of
1991, this model seems to be back on track. Whether it
stays on track remains to be seen. In this model, recursive
DLS reduces mean square error by 60 percent relative to
recursive OLS.
DLS is least useful in models that are relatively stable.
For example, in models that omit the short-term interest
rate, DLS and OLS produce basically the same results. It is
worth noting DLS does not significantly hurt forecast
nerformance when applied to relatively stable models,so
discounting appears t~ be essentially·costless.
Fourth, despite the relative improvement due to DLS,
the absolute performance of the DLS models also deteriorated badly during the test period. These models also
consistently overestimate real M2 growth and also have
negative out-of-sample R2 statistics. Thus, while DLS is

FIGUREl
RECURSIVE FORECASTS

0.015

.o ...

. ..

: I,

:, .'

0.010

: I

,',

" .....

....

'.'

····....?LS

0.005
" DLS
8. Recall thatR2 equals 1minus mean square error. Recursive prediction
errors do not necessarily have mean zero, so their mean square error can
be larger than the variance of the dependent variable.
9. E(v t ) is asymptotically normal even if the regression error is not
normally distributed, provided that the re~ession ~rror sat~sfies a
mixing condition (e.g., White 1984). Thus, VkE(vt)/a IS approxImately
normal for reasonably large k.
10. This result contrasts with Mehra (1992), who fails to reject parameter stability in a similar model.

0.000 -1--+------'Ir----I-+~~--r

-0.005

COGLEY / ADAPTING TO INSTABILITY IN MONEY DEMAND

better than OLS, it do~s not appear to generate enough
improvement to revive the use of M2 as an indicator of
short-term fluctuations in nominal aggregate demand.
In retrospect, it is clear that completely naive, atheoretical forecasts would have worked about as well as any of
these money demand models over the period 1989-1992.
For example, forecasts based on a random walk model
of real balance growth would have produced a mean square
error of 1.387 over this period, which is comparable
to the performance of these models. This simply highlights
the difficulty of using historical relationships to forecast
during turbulent periods.

REFERENCES

Goldfeld, S.M. 1976. "The Case of the Missing Money." Brookings
Papers on Economic Activity 3, pp. 683-730.

CONCLUSION

Conventional money demand models often exhibit parameter instability, and this complicates the implementation
of monetary policy. Applied macroeconomists might respond to this in two ways. They might seek time-invariant,
deep structural representations, or they might apply timevarying parameter estimators to conventional representation in order to allow parameters to adapt quickly when
shifts occur. Tnis paper takes the latter approach, exploring
the properties.of recursive discounted least squares. This
technique is designed to give greater weight to more recent
data and less weight to older data, and this makes it more
adaptable than recursive OLS.
The results suggest that DLS may have a useful but
limited role to play in policy moqeling. During unstable
subperiods; DLS works better than OLS, and the gains can
be substantial. For example, in a standard money demand
model, in which the scale variable is GDP and the opportunity cost variable is the spread between commercial paper
rates and the own return on M2, DLS reduces the mean
square error of one-step-ahead forecasts by 60 percent. On
the other hand, the absolute performance of DLS estimators also deteriorates badly over the last few years, and the
models do not deliver reliable forecasts of M2 money
demand. Thus it will continue to be difficult to interpret
fluctuations in money growth.

Cooley, T.F., and S.F. LeRoy. 1981. "Identification and Estimation of
Money Demand." American Economic Review 71, pp. 825-844.
_ _ _ _ , and E.C. Prescott. 1976. "Estimation in the Presence of
Stochastic Parameter Variation." Econometrica 44, pp. 167-184.
Duca, IV. 1993. "Should Bond Funds Be Included in M2?" Working
Paper No. 9321. Federal Reserve Bank of Dallas.
Engle, R.F., and C.W.I Granger. 1987. "Cointegration and Error
Correction: Representation, Estimation, and Testing." Econometrica 55, pp. 251-276.
Feinman, IN., and R.D. Porter. 1992. "The Continuing Weakness in
M2." Working Paper No. 209. Board of Governors of the Federal
Reserve System.

Harvey, A.H. 1981. Time Series Models. London: Philip Allan.
Ireland, P.N. 1992. "Endogenous Financial Innovation and the Demand
for Money." Working Paper 92-3. Federal Reserve Bank of
Richmond.
Judd, I, and I Scadding. 1982. "The Search for a Stable Money
Demand Function: A Survey of the Post-1973 Literature." Journal
ofEconomic Literature 20, pp. 993-1023.

_ _ _ _, andB. Trehan.1992. "Jv1oney, Credit, andJv12."Federai
Reserve Bank of San Francisco Weekly Letter (September 4).
Lucas, R.E. 1988. "Money Demand in the United States: A Quantitative Review." Carnegie-Rochester Series on Public Policy 29, pp.
137-168.
Mehra, y.p. 1991. "An Error Correction Model of U.S. M2 Demand."
Federal Reserve Bank ofRichmond Economic Review 77, pp. 3-12.
_ _ _ _ .1992. "Has M2 Demand Become Unstable?" Federal
Reserve Bank of Richmond Economic Review 78, pp. 27-35.
Meltzer, A.H. 1963. "The Demand for Money: The Evidence from the
Time Series." Journal ofPolitical Economy 71, pp. 219-246.
White, H. 1984. Asymptotic Theory for Econometricians. New York:
Academic Press.

Water Policy in California and Israel

Ronald H. Schmidt
and Steven E. Plaut
The authors are, respectively, Senior Economist, Federal
Reserve Bank of San Francisco, and Senior Lecturer in
Business Administration, University of Haifa, Israel.

Water policies throughout the world often avoid marketdetermined allocations. In this article, we focus on case
studies of Israel and California. Despite major cultural
and political differences, it is found that water is heavily
controlled through similar administrative mechanisms in
both areas. Moreover, in both cases, these controls have
led to inefficient allocation schemesfavoring agriculture at
the expense ofother uses. This article examines the institutional factors that have led to such· controls, and argues
that adopting a new regulatory framework similar to that
used to regulate electricity can still meet social concerns
while dramatically improving economic efficiency.

Throughout history and in many parts of the world, water
has been treated differently from other· COUllllodities. In
fact, there are many that argue that water is not a commodity, but is special because of the role it plays in human
survival and development. Dry areas that have been able to
gain access to water have turned from deserts to gardens,
while areas that have been deprived of water become
wastelands.
Because of water's importance to dry regions, access to
water istypically a matter of public policy. As suggested by
the old saying in the West, "whiskey is for drinking; water
is for fighting over," allocation of the resource tends to be
the result of contentious historical experience. Development of water tends to be the outcome of publicly sponsored efforts aimed at achieving larger social aims, and
allocation of that resource is closely monitored.
It .is the heavy restrictions placed on the allocation of
water that make the resource so unusual, particularly in
market-driven economies. Other resources have been developed in partnership with the government, and the government often has a say in how that resource is used. But,
in most cases, government is concerned with initial allocations, and allows subsequent trading to occur to achieve
improved outcomes for the recipients. In the case of water,
such trading is restricted to a much greater extent.
This unusual control over allocation and use is especially apparent when viewed across cultures. In this article
we examine water allocation and use in two very different
political and cultural systems-Israel and Californiawhich, despite major differences in nearly all other social
and economic institutions, have remarkably similar policies for allocating water. Furthermore, population pressures have increased sharply in both of these areas, placing
increasing stress on available water supplies. Additional
insights, therefore, are possible by viewing how the two
regions are coping with the growing shortages.
While the focus is on these two very different regions,
the lessons are more broadly applicable. For example, most
parts of the western United States face similar challenges
with water allocation. Details of water administration vary
by region, however, putting an exhaustive evaluation of all
approaches to water allocation beyond the scope of this
paper. Moreover, although there are some differences in
practice-Jor example, Colorado allows some trading in a
formal market, while Arizona ties water rights to property

SCHMIDT AND PLAUT / WATER POUCY IN CALIFORNIA AND ISRAEL

rights in some cases, making it possible to buy agricultural
land and transfer the water to the cities-for most dry
regions, the same basic problems dominate.
This article compares water policy in Israel andCalifornia to the U.S. allocation policy of electricity, another good
characterized by increasing returns to scale. As discussed
in section II, water shares many physical characteristics with electricity, particularly in the infrastructure and
institutions· needed to develop and get the product to
consumers.
The major finding is that water policy differs from
electricity policy in one key respect: After the initial
allocation, water is much more controlled than electricity,
with significant limitations on trading. Thus, it is allocated
by quantity rationing. Electricity allocation, on the other
. hand, has some aspects of social allocation, but, ultimately, prices are used to ration demand (even if they are
subsidized prices for some users).
Because of this administrative control, we argue that
high efficiency costs are observed in the water delivery
systems of the two regions-costs that are directly attributed to the restrictions on trading. In both regions,
water is used in ways that force the development of inefficient, high-cost alternatives.
The purpose ofsuch public micromanagement is apparently to control more fully the pattern of economic developmentin the region. Reform efforts in the two regions
provide a useful contrast in this respect. In California,
economic forces have become increasingly important in
pushing for water allocation reform. Major efforts are
underway to change the allocation mechanism to increase
the role of market forces-that is, to allow trading. And
one factor contributing to the success of those efforts is the
declining relative importance of the state's primary water
user-agriculture-'--and the growing political and economic power of cities and industries. In Israel, however,
such reform efforts remain weak, and the government's
need to control the use of water-for strategic and political
purposes-continues to dominate the economic factors
that are pushing for reform.
This article is organized as follows. Section I presents
institutional details on current water allocation systems in
the two regions, including both the physical structure of
the water delivery systems and the economic and political
infrastructures used to allocate the water. Section II compares those allocation mechanisms to the relatively more
market-oriented mechanisrns used to allocate electricity in
the United States. We look at the reasons for government
involvement in developing and allocating a resource like
water, and we examine the extent to which the regulation of
electric utilities provides a viable alternative model for
water allocation. Section III discusses the costs of not

using an electric utility-style allocation scheme, pointing
out the inefficiencies resulting from the implicit ban on
exchange. Section IV discusses traditional responses to
rising shortages, and indicates the problems that have
arisen in continuing "business as usual" in the two regions' water policies. Section V discusses some of the
reform efforts underway in California, and Section VI
presents conclusions.

WATER INSTITUTIONS AND POLICY
IN CALIFORNIA AND ISRAEL

California and Israel share a number of similarities in water
policy, despite other cultural and economic differences.
Both have large semi-arid areas, mountain ranges, and
mild, wet winters (except in extreme elevations) combined
with dry rainless summers. Both regions experience rainfall that is concentrated in the north, and which then must
be transported and pumped to drier southern regions. Both
use extensive networks of aqueducts, pipelines, and pumping stations, and both have extensive experience with
"high-tech" irrigation technology and biogenetic engineering in agriculture. Moreover, despite very different
political cultures, both regions rely extensively on political
and not economic policies for water allocation.

Israel
In an average year, Israel draws 1.2 to 1.3 million acre feet
(MAP) of fresh water; 60 to 75 percent is consumed by
agriculture (depending on supply conditions each year)
and the residual goes to urban and industrial consumers.
This water is obtained from several sources. The main body
of fresh water in Israel is the Kinneret, or Sea of Galilee,
which provides about half of the total supplies. It is located
in the Jordan rift and sits well below sea level. This means
that expensive pumping and transport is required to move
water from the Sea to the country's farming areas, most of
which are above sea level. The Sea is fed by the Jordan river
and also empties into the same Jordan river, which then
flows south into the Dead Sea. The latter is even further
below sea level; indeed, it is the lowest point on earth and
resembles somewhat California's Mono Lake. Water is
conveyed from the Jordan River to the southern part of
Israel through the National Water Carrier (a pipeline and
aqueduct system), which was completed in 1964.
In addition to the Jordan river and the Sea of Galilee,
there are two large underground aquifers, the Coastal and
the Mountain aquifers, the latter encompassing central
Israel and much of the West Bank. Water drawn from these
sources accounts for the bulk of the remaining supplies. A
variety of wells, oases, and dams capture water from

FRBSF ECONOMIC REVIEW 1993, NUMBER 3

additional sources, but provide relatively small quantities.
Israel also makes considerable use of recycled waste
water, particularly for irrigation purposes, as well as some
brackish water from wells near the seacoast and near Eilat.
Desalination of sea water has been used only on a limited
or experimental basis.
Proposals for new sources of water that have been
considered include large-scale desalination, water imports
from Turkey, and even a canal from the Mediterranean to
the Dead Sea, that would allow complete diversion of the
Jordan river for commercial purposes .. Other possibilities
include new ground water discoveries, and diversions from
the Litani River (Wolf and Ross 1992). In all of these cases,
however, the projects may not be commercially viable and
there are fears that they could cause extensive environmental damage. 1
Under Israeli law, water is a nationalized public good.
As specified in the 1959 Water Law, all water is the
property of the state, including waste, sewer, and runoff
water that can be commercially used. An owner of land
does not own water under the land, and there are no
riparian rights. 2 This legal status of water continues practices incorporated into the Fundamental Law defining the
rules of government in 1949, and those embedded in
the British Mandatory laws. The 1959 law essentially
perpetuated the then-existing water allocation pattern,
with water set aside for planned future settlements and
activities. Water is supplied by Mekorot, Ltd., a public
corporation that pumps and supplies about 60 percent of
the nation's water, and by small private suppliers.
The Minister of Agriculture is the supreme statutory
authority charged with formulation of water policyincluding consumption, pricing, and allocation-subject
to oversight by a Knesset water committee that must
approve water pricing changes. The Minister appoints the
Water Commissioner and an advisory Water Commission,
and also the directors of other public sector agencies that
play a role in water development, pricing, and supply. 3
Some analysts have argued that this arrangement has
fostered an automatic conflict of interest in water alloca-

tion. Because the natural tendency of the Ministry of
Agriculture is to work as an advocate on behalf of farm
interests, water policies also tend to be formed by agricultural interest groups (Galnoor 1978). In part because of
this tendency, water policy in recent drought years has
allowed substantial over-consumption of water supplies by
agriculture, even though these actions have polluted and
damaged the structure of the underground aquifers.
Even when cuts are made in supplies, the policies
appear to be crafted with farm welfare in mind. For
example, in 1991, the Minister of Agriculture implemented
across-the-board cuts of 25 percent in agricultural water
allocations since the Sea of Galilee's surface level had
dropped below its "red line," a somewhat arbitrary level
selected as the minimum allowable level. 4 Farmers whose
allocations were cut were eligible for compensation from
taxpayers for lost revenues that would have been generated
with the water.
In Israel, water allocations tend to be political. Historical allocation is one guiding principle, with water users
generally able to receive the same allotment in future years
if they use the supplies they are granted in the current
period. Apportionment of additional water often takes
place subject to political pressure.
Once granted, water allocations in Israel are extremely
inflexible. Farmers are allocated water to grow specific
crops. If a farmer wants to change his crop mix, he must
apply to the Ministry for permission to apply the water to
that different crop. Allotted water not used cannot be
sold-it is explicitly illegal to sell water or water rights in
Israel. Violators are subject to criminal prosecution. Moreover, farmers who temporarily consume less than their full
allotments may find their future allotments cut in subsequent years, creating theincentive for farmers to use all of
their allocation of water to preserve future deliveries, even
if the use is wasteful. Finally, a farmer who sells his land
cannot sell his water allotment with. the land, and must
include a clause in the contract where the buyer attests to
having been forewarned of this.

California
1. According to a feasibility study by the Israeli government in 1983,
additional use of water from the Dead Sea could cause minerals to cake
on the surface. (The Dead Sea has salt concentrations 55 times that ofthe
Pacific Ocean.) In addition to environmental damage, they concluded
that such efforts would damage the tourist trade and mineral extraction
processes in the vicinity.

2. Riparian rights are based on English law, and grant a landowner the
right to use water that passes through his or her property. In most Middle
East countries, mineral and water rights under one's land belong to the
state.

3. At the present time, the powers of the water committee are being
transferred to the Finance Committee of the Knesset.

Water allocation in California is similar to that in Israel. On
average, 80 to 85 percent of net water consumption occurs
in the agricultural sector. Urban users consume 10 percent,
with the residual allocated to industry.
California has one of the most intricate water supply
systems in the world. Most of the rainfall and snow
4. Despite its designation as a minimum, the Ministry approved even
further pumping below the "red line" in 1990 and 1991 because of low
rain levels.

SCHMIDT AND PLAUT / WATER POLICY IN CALIFORNIA AND ISRAEL

accumulate in the northern and eastern parts of the state,
while most of the population is in the western and southern, semi-arid regions. A series of dams and reservoirs
capture and store water in the Sierra Nevada and the
northern part of the state for transport in a vast system of
canals and aqueducts to the populated coastal and central
agricultural regions.
California's water is developed and supplied by a variety
of different agents. The two largest projects, the Central
Valley Project (CVP) and the State Water Project (SWP),
provide 27 .5 percent of the net water supplied in the state
inan average year. The CVP was developed and is operated
by the federal government, while the SWP was developed
and is operated by the state. The two systems provided 7.0
and 2.4 MAP of water, respectively, in 1985, the last year
of relatively normal supplies.
In addition· to those projects, individual cities have
developed reservoirs and delivery systems, such as the
Hetch Hetchy reservoir for San Francisco and the Lake
Cachuma and Gibralter reservoirs for Santa Barbara. Los
Angeles also has aggressively redirected water from other
sources. Los Angeles receives water from the Owens
Valley and Mono Lake through the Los Angeles Aqueduct,
as well as some water from the Colorado River. Recent
court decisions, however, have reduced future deliveries
from these sources. Total withdrawals from the Colorado
River were around 5 MAF in 1985; that total is expected to
drop to 4.2 MAF by 2010.
Finally, complementing these surface water sources is an
extensive supply of ground water in aquifers. In 1985,
sustainable ground water supplies were estimated to be
around 6 MAF of the state's total of 32.2 MAP. An
additional 2 MAF was overdrafted in that year, to yield
total supplies of 34.2 MAE During drought years, ground
water is drawn more heavily, smoothing supplies from year
to year.
.
Several new sources of supply are under consideration.
According to the California Department of Water Resources (Department of Water Resources 1987), an additionall.4 MAF will be needed by the year 2010 to meet
existing and projected needs of an additional 6.5 million
people, Most of that gain depends on further development
of the state and federal water systems, including the Kern
water bank, construction of the Auburn dam, and completion of Los Banos. Grandes reservoir. Other potential
sources include further conservation efforts, development
of waste water re-use, and desalination plants.
California's water resources are administered by a large
number of overlapping state and federal agencies. CVP
water is federally administered by the US. Bureau of
Reclamation, with water delivered to CVP contractors.
SWP water is administered by the state. The state's Water

Resources Control Board is the agency most directly involved in determining possible shifts of water from one
user to another, but the Department of Fish and Wildlife
and the federal Environmental Protection Agency, among
others, also have critical input into the process. At the local
level, water districts have the power to reallocate water
within a district and often have veto power over shipments
out of the district.
Rights are an accumulation of historical precedents.
Riparian rights, establishing the right to use water that
passes through one's land, apply to many of the water
resources claimed early in California's development. Appropriative rights apply to most of the state's water, although the rules governing those rights differ depending on
the date granted. Appropriative rights allow the user to
divert water for "beneficial use," with rights sequentially
based on when the right was granted. These rights. were
designed to protect early developers located downstream
from losing water because of newer upstream diversions.
As in Israel, however, rights do not include automatic
ownership. Water is deemed a public good owned by the
people of the state. The "Public Trust Doctrine" is frequently cited by the courts in water disputes. With roots in
Roman law, the doctrine of public trust holds that certain
resources are the property of all. In a 1983 decision
(National Audubon Society vs. Superior Court), the California Supreme Court held that the state has a duty to
consider public trust values before it approves water rights
applications or adjustments. This doctrine has been used
most recently to guarantee water for in-stream, environmental uses.
Appropriative rights allow users to apply the water for
beneficial purposes, but do not allow the rights holders to
treat the resource as an asset. Thus, most water supplies
cannot be sold or traded to other users without explicit
approval of a variety of agencies, including the local water
district, the Bureau of Reclamation, the state Water Resource Control Board, and possibly the EPA, US. Department of Fish and Game, and the state's Department of Fish
and Wildlife. Moreover, water that is not used by a rights
holder may be interpreted as surplus water that is not beneficially used. Like Israel, therefore, California's incentives
are structured to "use it or lose it," with users that use less
than their full allotment potentially losing that surplus in
future years. 5

5. Recent examples of this interpretation have emerged in California,
Some rice farmers that idled fields and sold their water to the state's
Emergency Water Bank in 1991 are reporting efforts by the state to
reduce their allocation on these grounds.

FRBSF ECONOMIC REVIEW 1993,

NUMBER

n. Is WATER SPECIAL?
As discussed above, water allocation is highly controlled in
Israel and California. Water is allocated according to
historical precedent, with modifications to reflect changes
in available supplies or competing uses made by administrative fiat. In drought years, for example, some users are
given only partial allotments, with cutbacks either across
the board or applied sequentially across classes of users.
Economic forces are largely ignored. Water transfers are
difficult, even when they are arranged to the mutual benefit
of both parties. Prices do not change to reflect growing
scarcity, and hence, prices are not used asa tool to
encourage conservation or as a mechanism to evaluate new
infrastructures. 6 Differences in prices across regions and
users are not used as signals to encourage transfers of water
from low-priced to high-priced regions. In fact, those
facing limited supplies are encouraged to develop new
(usually higher cost) sources, rather than to purchase
supplies from existing users, even when both parties could
gain from the exchange. 7
This treatment of water, which differs significantly from
the way other resources are allocated in market-oriented
economies, is typically justified on the grounds that water
is special. In this section, we examine two related issues. First, we discuss the reasons that government typically intervenes in water delivery, drawing parallels with
other regulated natural monopolies-particularly electricity. Second, we examine the differences between the
allocation of water and of electricity and identify the root
difference between regulation of those industries.

Arguments for a Governmental Role
in Water Delivery
Several arguments are put· forth in favor of involving
government in the allocation of water in dry regions. Three
issues typically are cited: the cost structure of water
investments, other noneconomic public policy goals, such

6. In fact, prices are used in what appears to be a punitive fashion by
many water districts. During the height of the drought in California, for
example, moral suasion (rather than price increases) and threats of
restricted service caused urban users to reduce consumption sharply.
Water districts then were faced with revenue shortfalls, since prices had
not adjusted. They then had to raise rates to consumers. Thus, water
districts were in the awkward position ofpenalizing consumers fordoing
what the water districts had requested. Obviously, if the districts had
instead used higher prices to discourage water consumption, this
problem would have been avoided.
7. Interestingly, while lack of transfers often forces urban areas to
consider more exotic technologies, pricing policies make those investments appear unreasonable. For example, Israel recently· decided

as encouraging migration and directing land use decisions, and concerns about equity and economic disruptions
("third party effects"). As we argue, however, each of
these arguments also could be-and is-applied to electricity allocation, and the more successful experience of
that industry in adjusting to growing and competing needs
appears to offer a useful guideline to improving the current
system.
Water Investment Costs. Public investment in new water
facilities often is justified on the grounds of increasing
returns to scale. Typically, the infrastructures needed to
store and deliver new water supplies-dams, pumps, and
canals-are governed by decreasing marginal cost structures. Slightly increasing the size of a dam or a canal can
cause a large increase in capabilities since, in general,
volume does not increase linearly with increased investment, but roughly geometrically. Consequently, marginal
costs tend to fall with increasing project size up to some
point.
Often the point of minimum marginal. cost requires an
investment too large for an individual or group of individuals to coordinate. 8 In those cases; the government often is
asked to step in on behalf of its constituents. 9 For example,
after considerable lobbying, the California Legislature
authorized the Central Valley Project as a state water
project in 1933, which the federal government eventually
built and operated. The other major water projects in
California also are the result of state or local government
efforts, including the SWP.

against a major water resource development project in the southern port
city of Eilat because it was not viable at current water prices. However,
since prices often are based on pumping and transportation costs, and
ignore the social opportunity costs and scarcity value of the resource,
those prices may understate the value of a new facility. Consequently,
this project rnight have been viable with proper pricing.
8. According to Reisner and Bates (1990), the federal government tried
to encourage private water development in the nineteenth century by
offering free or highly subsidized land to those that would undertake
such development. However, because of the large costs involved, private
efforts were largely unsuccessful. "At the eighth National Irrigation
Congress in 1898, one speaker compared the western landscape to a
graveyard, littered by the 'crushed and mangled skeletons of defunct
irrigation companies . . . which suddenly disappeared at the end of
brief careers, leaving only a few defaulted obligations to indicate the
route by which they departed'" (p. 13).
9. Work by Buchanan and Tullock (1962) and Olson (1982) has argued
that the process by which projects such as these are developed can be
explained by special interest group models. Concentrated single-issue
interest groups often are able to obtain political support and suffiCient
votes to pass legislation favorable to that group because the costs
. imposed on the non-beneficiaries are spread thin, making political
opposition weak. The beneficiaries of new water projects typically are
relatively concentrated. In California, for example, the CVP delivers

SCHMIDT AND PLAUT/WATER POLICY IN CALIFORNIA AND ISRAEL

In Israel, the government also has been the principal
agent of water development. Galnoor (1978, p.343) characterized the rationale for government involvement as
follows:
Divergences between the private side and the public side
of water costs andlor benefits, as well as the need for
high initial investments and the characteristics of a
natural monopoly, contribute to the necessity of some
form of public intervention in the management of water
resources. In Israel, government intervention is also
required because water is a part of the infrastructure for
(a) the ideology of nation building based on farming and
new settlements and (b) economic development.
The Israeli government, therefore, has taken upon itself
the responsibility for planning, constructing, and maintaining new facilities. Through 1970, gross investment in
water projects by the government was estimated to be equal
to between 3 and 5 percent of total gross capital investment
in the country. Costs of new supplies were so high that
expansion plansinvolving the United States as a partner in
a joint venture to build large desalination plants were
developed in themid-1960s, although the plans were never
implemented (Tahal 1972).
Development Tool. A second motivation for government
control over water allocation is water's power as a tool to
influence migration and land use. In Israel and the western
United States, pro-growth forces were very strong during
the periods of water development. Often one of the most
powerful inducements to potential migrants was access to
cheap land in peripheral areas. In much of California and
Israel, the available peripheral land was not particularly
attractive to settlers unless water could be provided to
irrigate crops. Thus, in both regions, policies often were
designed to create large supplies of dependable water for
agricultural purposes. 10
In Israel, strong priority was given to encouraging
immigration and population dispersal. Development of
available agricultural land has been an important goal
(Galnoor 1987, p. 345):
water primarily to agricultural users. Similarly, in Israel, farmers
consume three-fourths of the total supply. The water is subsidized by
. other sectors of the economy, which bear the residual cost of operating
and constructing supply facilities. Additional federal projects continue
to be proposed and constructed, where the costs are borne nationally
and the benefits are concentrated in specific regions and groups of
consumers. Thus, according to this theory, projects can be approved that
provide subsidized water for some users that would be prohibitively
expensive to the beneficiaries if they were developed privately by those
beneficiaries.
10. According to Reisner and Bates (1990), part ofTheodore Roosevelt's
motivation for developing water projects in the west was to build up
"America's weak western flank" (p. 14).

In the context of Zionist ideological objectives, water
has never been regarded as merely another economic
resource, but as a prerequisite to efforts to create a new
society in the (cultivated and redeveloped) Land of
Israel. The selection of one water project over another
was not determined on the basis of relative economic
returns. This ideology stressed a "productive occupational pyramid" based mainly on farming in the collective Kibbutzim and in the smallholders' communal
settlements.
As discussed by Plaut (1992, p. 16), Israeli policy also has
sought to encourage active cultivation and occupation ofits
lands for national security reasons:
There is an ancient and broad consensus in Israel that
survival of the state requires" settlement" of the land by
Jews. In many cases, "settlement" is taken to mean
farming. The origins of the doctrine go back to the early
phases of the Zionist movement, when the boundaries of
"settlement" were believed to establish the geographicpolitical blueprint for a later state.
Once Israel came into being, its borders were determined .by either diplomacy or force of arms, but no
longer by farm settlement. Nevertheless, the belief that
land settlement provides political and strategic control
of territory has survived. It is closely linked with the
ideological consensus in favor of population dispersal
policies.
Initially, dispersal of farm settlements along frontiers
played a strategic role, making border patrol and surveillance easier. Later, it was argued that these settlements could provide support and services for army units
stationed near the frontiers. After 1967, agricultural
settlements were established in the Territories for the
express purpose of creating political "facts" and new
strategic realities. In any case, it is widely believed that
an absence of Jewish settlement in .any part of the
country may lead to loss of that region through international pressure andlor Arab insurgency.
More recently in California, water policy has been used
in the reverse direction-preventing growth. Barriers are
raised to converting agricultural water use to urban use, in
part to prevent conversion of agricultural land tourban and
industrial purposes. Opposition to water markets in California's Central Valley, for example, is driven by fears that
water markets would encourage the transition away from
agriculture and bring major changes in the industrial and
social fabric of the valley communities. In other cases,
suchas in Santa Barbara, the city council chose in the early
1970s not to hook up to the State Water Project, arguing
that access to additional sources of water would allow more

FRBSF ECONOMIC REVIEW

1993,

NUMBER

people to move to the area and create excessive growth. ll
Fairness. Athird argument for government allocation of
water is concern over fairness and the potential costs
of changing existing allocations. Fairness issues arise
whenever reforms are considered. Since current policies
explicitly state that water is a public good, held in trust by
the State and is not owned by any individual, any change
whereby an individual gained legal title to the water would
involve a change in the distribution of wealth and income.
In such cases, it becomes possible to ask whether current
subsidized water recipients "should be" entitled to those
resources, or whether another allocation is more fair.
Fairness also appears in the debate because of fears that
pricing the resource would make water unavailable or too
costly to low-income persons and farmers. Some interest
groups voice concerns that market prices would be too high
for many consumers, so only the wealthy would be able to
afford the resource.
More generally, pricing policies of many projects explicitly recognize other social goals relating to fairness. For
example, prices of CVP water are heavily subsidized. Most
contracts called for fees that often Vlere designed to pay the
nominal cost of the construction over time. While initially
designed as a lO-year repayment period, most Bureau of
Reclamation projects eventually extended terms for as
much as 80 years. Moreover, interest costs, under the
Reclamation Act of 1902, were not charged (Reisner and
Bates 1990).
In Israel, water "doctrine" has always been based on
pricing formulas that reflect the farmer's "ability to pay"
and not the scarcity value of water as a resource. Under this
doctrine, a drought that reduced a farmer's ability to pay
should produce lower water prices, not higher prices to
farmers, whereas in a market system the price would rise
due to the reduction in supply. Hence, "fairness" to farmers, rather than efficient use of the water, appears to be the
predominant sentiment guiding water policy in Israel.
A related issue involves potential disruptions that any
change in allocation might create, or "third party effects."
Policymakers predict that the use of water markets would
decimate agriculture and the agricultural communities by
encouraging farmers to sell all of their supplies (causing
large third party effects on other rural businesses). Large
differentials in prices between cities and agricultural water
districts are taken as evidence that markets would lead to
large diversions between farms and cities, with water costs
11. This policy has changed as a result of the recent drought. Extreme
reductions imposed on homeowners led to political pressure to add new
supplies. Santa Barbara did connect a small pipeline to southern
California in 1991 to purchase water from the Metropolitan Water
District, and it is exploring desalination options.

pricing agriculture out of water. And experience in Owens
Valley, where Los Angeles acquired rights to water from
the valley and transferred it to the city at the expense of the
local economy, is frequently cited as a warning for the potentially negative effects of allowing transfers.

Water vs. Electricity
While these arguments have been powerful justifications
for current allocation policies-and may argue for some
governmental involvement in the system-they are not
unique to water. In fact, these same arguments can be
applied to electricity and other utilities, and yet those
industries appear to be more adaptable and efficient than
the water delivery system. In many instances, water appears to share more similarities than dissimilarities· with
electricity; the major exception is the way it is controlled
after the initial allocation.
Natural Monopoly. Water and electricity have similar
physical and technical characteristics. Indeed, they often
are joint products of large dams constru9ted along rivers.
Water and electricity both fioVJ in complicated grids over
long distances, and are delivered to municipal customers
through a centralized utility. Technical characteristics are
similar: Storage (dams and reservoirs), transportation (canals and pipelines), and distribution networks all exhibit
economies of scale that lend themselves to the creation of
natural monopolies. Marginal costs tend to fall over a large
range, often making it inefficient to promote competition
in many parts of the system.
But in the case of electricity, considerable work has gone
into designing regulations that maximize the efficiency of
the utility while recognizing these scale economies. Utilities that build generating plants are allowed to add costs of
approved facilities into the rate base, and owners of the
utilities are granted a rate of return on that capital.
Nonetheless, while highly regulated, electricity demand
is rationed by price-except in the rare instance of power
failures and shortages. Users are charged in ways to
generate the necessary rate of return, cost of maintaining
the facilities, and costs of inputs. Pricing schemes typically
rely on average cost of delivery. Moreover, reforms are
constantly being evaluated. For example, time-of-day pricing has been tested in several sites to match marginal costs
more closely to prices charged for the resource. 12
12. The key advantage of using prices with subsidies to ration demand,
as opposed to direct allocation, is that in a pricing environment trading
occurs. Even though a system with subsidies results in a distorted use
pattern, it is still the case that recipients of the resource balance their
valuation of the water against that of all other potential users. In direct
quantity rationing without trading, mutually welfare-enhancing improvements from the initial distribution are not allowed.

SCHMIDT AND PLAUT / WATER POLICY IN CALIFORNIA AND ISRAEL

Major reforms also have been suggested (and elements
tested) to introduce more market forces into electricity
distribution. As reviewed by Schmidt (1987), increasing
interlinkages between power grids have made bulk power
sales among utilities at market prices a least-cost mechanism to avoid unnecessary construction of costly new
facilities. Other parts of the system also have the potential
for injecting additional market forces to improve the oper-

ating efficiency of the

system-~

In many ways, the regulatory structure used for electricity appears applicable to allocating water. A regulated
monopoly could be granted to the producers, transmitters,
and distributors of the water. In principle, rate of return
compensation could be arranged (paid to the government
in the case of state or federal projects), with the price to
consumers ultimately serving to ration supplies among
consumers. Moreover, like bulk power, water could be sold
among primary owners of water at market prices, and
moved (analogous to "wheeling" in the electric utility
industry) along the canal network to its final destination.
Development Tool. Water allocation often is intended to
guide economic development. Prices are established to
subsidize and encourage use in particular areas. The power
of water has been readily apparent in both California and
Israel.
Electricity has been used for similar purposes. The
Tennessee Valley Authority was created in the United
States to generate low-cost power to a large underdeveloped rural area. Similarly, the Rural Electrification program has the objective of bringing low-cost power to rural
areas to help speed development in those areas.
Electricity, like water, is viewed by many governments
as one of the basic infrastructure ingredients necessary to
promote economic growth. Encouraging access to electricity networks has been a central part of many economic
development programs. Thus, the electricity model of
allocation appears rich enough to encompass these additional goals of water development.
Fairness. Concerns about social equity often work
through water pricing policies. Prices for water generally
are tied to historical construction costs-costs that are
typically well below the economic value of the resource. 13
In Israel, even this tenuous link to construction costs
is missing. The Water Law requires that "in spite of
differential costs, water prices in the various regions be

13. A report by the Western Governor's Association (1987, p. iii)
concluded: "The structure of the West's water system at federal,
state, 'and local levels was designed to promote economic development
through assuring a secure supply of water and to protect property rights
in water once they were established. Laws, policies, and practices are
largely silent on increasing efficiency of use."

equalized. In practice, water charges have been relatively
uniform and quite often nominal" (Sadan and Ben-Zvi
1987, p. 3).
In electricity allocation, similar goals exist and are
accommodated through pricing policies. The same concerns often are voiced about low-income consumers. In
many states, electric utilities are prohibited from cutting
off service to low-income consumers during the winter if

they are unable to pay_ Similarly, lifeline rates are offered to
low-income, elderly, and handicapped individuals to as~
sure their access to the resource. Finally, prices charged to
industrial, commercial, and residential consumers are
allowed to be structured in different ways to encourage
certain uses.
In periods oftemporary shortages, electricity policy also
is designed to recognize social objectives. Since prices
cannot be instantly adjusted and communicated to users,
temporary surges in demand are met by graduated cutbacks
to particular users. Heavy industrial users are cut back
first, with critical needs (for example, hospitals) the last to
be curtailed. Contingency plans for "brown-outs" and
similar emergencies are established by utilities and approved by regulators to be consistent with social policy;

ill.

IMPLICATIONS OF TRADING

Water policy and electricity policy, therefore, share many
of the same objectives and characteristics. Both often rely
on government investment policies, seek to direct the
pattern of economic development, and seek to redress
social inequities by designing pricing and access policies to
protect certain interests.
The key institutional difference between water and electricity results from the assignment of ownership rights. In
the case of electricity, the units are clearly owned by some
entity, and that entity has the right to distribute units to any
customer or other utility; Even in the case of a publicly
constructed facility, such as the Tennessee Valley Authority or Bonneville Power Administration, a public entity
has clear ownership of the electricity, which it sells to
utilities-sometimes subsidized, and sometimes according to allocation formulas. But there is no requirement that
the receiving party must use that electricity, and thereby
prevent the utility from transferring the power elsewhere.
In the case of water, transferability is severely restricted.
As noted earlier, allocations are determined administratively, for the most part, and those allocations then are
fixed. Contractors must use the water, or lose the rights
to it.
Consider how such a policy would work in the electricity industry; Customers would receive a given supply of
electricity at a particular time. If the customers did not use

FRBSF ECONOMIC REVIEW 1993,

NUMBER

that electricity, they would forfeit future rights to that
resource. Such a system would lead to inefficient optimizing .behavior on the part of consumers similar to that
observed in the former Soviet bloc. In Poland, for example,
heat was supplied at very low cost at specified times. The
incentives built into the system, therefore, led to a practice
of regulating temperatures by opening windows, rather
than adjusting heat consumption. In other words, the
incentives win lead consumers to use all or the subsidized
electricity made available, since the alternative is to lose
access to the power in the future.
The regulation applied to electric utilities demonstrates
the potential to separate efficiency concerns-how the
resource is used-from equity concerns. This separability
is well-developed in the economics literature. This latter
point is attributed to Coase (1960), who examined the
importance of initial endowments in determining the final
consumption distribution of a given resource. He demonstrated that if trading were allowed and transactions costs
were small, the final allocation of a resource would. be
efficient regardless of the initial distribution of rights. This
efficiency would be achieved through trading among potential consumers until the resource was finally used in its
highest valued uses.
The "Coase Theorem" predicts that if trading were
allowed, the assignment of ownership rights to water
would have little effect on how it ultimately would be used
(although that outcome could be considerably different
from the current mix of production resulting from inefficient allocation of the resource). Whether farmers were
granted ownership and allowed to sell to cities, or vice
versa, the ultimate outcome in water use would be approximately the same. Clearly, wealth would be distributed
differently under the two cases, but the Coase theorem
argues that such ownership assignment only affects how
the final basket of goods is distributed among consumers,
not what or how much is in the basket. 14 Thus, it is possible
to allocate rights in the interest of boosting equity, with the
recognition that trading will promote efficient use of the
resource.
In the case of electricity, initial allocations often are
granted with redistribution as a goal, and limits are placed
on trading to ensure that those goals are not circumvented.
For instance, utilities can sell trade surplus power, but they
14. Some researchers have disputed this claim, arguing that different
initial assignments of rights would lead to different final consumption
bundles. In particular, if there is a difference between the amount a
farmer would pay to get a unit of water ("willingness to pay") and the
amount she would accept to sell a unit to another person ("willingness to
accept compensation"), the outcome would depend on whether she had
the initial right to the resource or whether she had to purchase that right
from another.

must first satisfy local demand. However, utilities also have
incentives to make local demand more efficient by subsidizing insulation and energy conservation efforts.
In the case of water, similar limitations could be put in
place. But if the water districts had ownership rights to the
water, they would have more incentives to encourage water
conservation to make additional water available to sell
outside the district.
Tne principal benefit or assigning ownership rights to
water is to permit exchange. After choosing an allocation
scheme that satisfies desires. for fairness, individuals can
collectively be made better off by allowing them to engage
in mutually beneficial trade. Even with regulatory restrictions in place to favor particular uses, the ability to trade
encourages all parties to recognize the opportunity. cost
embedded in any given use of the water.
The cost of not allowing trading is well-documented
(Reisner and Bates 1990, Schmidt and Cannon 1991).
Agricultural water is heavily subsidized in California,
with the price of water to urban users on the order of 10
to.20 times that of most agricultural users-even accounting for differences in transportation costs and processing
facilities.
These apparent inefficiencies are illustrated by use
patterns in both regions. In Israel, cotton uses a major
portion of the country's water supply. Yet, according to
some analysts, cotton generates negative value-added in
Israel, with the implicit subsidies granted to the sector
exceeding the revenues from selling the crop. In California,
40 percent of the state's water is used to grow rice, alfalfa,
cotton, and pasture, even though these. crops altogether
account for only 0.2 percent of total state income.
Moreover, lack of transferability has made it necessary
for cities to plan construction of desalination plants. Such
plants would yield water at a cost in excess of $2,000 per
acre foot at the same time that water used for some lowvaluecrops is priced at $8. Since costs of transportation are
on the order of$100 per acre foot between many potential
transfer sites, this price differential suggests that both
parties could be made better off by trading. The cities
could forgo constructing expensive new facilities, while
the agricultural sector would be encouraged to increase its
efficiency in water use to free up the resourceto sell to the
cities.
Potential gains from trading water have been demonstrated in several recent cases. A classic example of the
gains to be made from trading is the 1'988 agreement
between the Metropolitan Water District of Southern California (MWD) and the Imperial Irrigation District (lID). In
that arrangement, MWD agreed to pay the cost of lining
irrigation ditches in the Imperial Valley in exchange for the
right to buy the saved water.

SCHMIDT AND PLAUT / WATER POLICY IN CALIFORNIA AND ISRAEL

Interestingly, this case provides strong evidence of the
magnitude of ineffiCiency that resides in the current administrative system. Both parties were made better off by
the transaction. Indeed, it was sufficiently in MWD's interest to make the trade that they were willing to pay for the
infrastructure improvements as well as pay for the water.
Clearly, lID also gained in the process, since they were
faced with no additional cost, yet gained a windfall profit
from selling water that would otherwise have been lost to
the district. But the incentives in the current systemincluding uncertainty about future rights to water-prevented this transaction from occurring automatically. 15
Similarly, in the recent drought, California experimented
with an Emergency Water Bank:, where water districts
could sell water to a state body, which then could resell the
water to other districts with shortages. According to work
by Howitt (1991), the effect of the Water Bank was to idle
some acreage of rice and pasture, while permanent crops
and high-value crops continued to receive sufficient water.
Such transfers were voluntary, and resulted in farmers
receiving compensation automatically from urban water
districts.
In sum, the key difference between allocation schemes
for water and electricity-and the cause of the high level of
inefficiency in water use-is the result of failure to assign
ownership rights to water users, and hence, to allow
trading of those rights. Granting water rights holders the
ability to engage in mutually beneficial trades would put in
place incentives to increase efficiency in use.

IV.

RISING SHORTAGES:
FAILURES OF TRADITIONAL REMEDIES

Drought conditions in the 1980s and early 1990s revealed
serious deficiencies in the water delivery systems of both
Israel and California. Both regions experienced extended
droughts that stressed the available supplies beyond normal
experience. Large cutbacks in water deliveries to farmers
were required, and extensive conservation and rationing
schemes were imposed on urban and industrial users.
In both cases rains finally arrived and eased short-term
conditions, but the public in both Israel and California have
become increasingly sensitized to the inefficiencies and
costs associated with centrally planned and allocated water. Water policy in both regions, therefore, is facing
intense public scrutiny, with the public less willing to leave
decisions to the "experts." Moreover, the droughts also
highlighted the increasing scarcity of existing supplies

15. For a description of the events in this case, see Reisner and Bates
(1990). While heralded as a success by those advocating increased use of

over the long term, with growing populations likely to
make responses to future droughts even more difficult and
costly. Both Israel and California expect growing populations, while few new sources of supply are scheduled to
come on line without further investments.
Traditionally, the response to shortages has been to
locate and develop new supplies. California's Department
of Water Resources, for example, projects the need for 1.4
MAF of new water by the year 2010, based on the assumption that the needs of a growing population are met by new
sources, rather than through reallocation of existing supplies. Estimates in Israel in the mid-1970s called for a
shortfall of about 0.25 MAF developing by 1985, again to
accommodate new uses, not to reallocate existing supplies.
Projections of population growth imply that by the early
twenty-first century water may suffice for urban users only,
with no agricultural water in Israel.
The traditional response-to meet growing demand by
adding capacity-has faced resistance in recent years,
however. Three related reasons have combined to make
new facilities increasingly difficult to undertake.

First, the environmental movements in California, and
to a lesser extent in Israel, have challenged additional water
development by focusing attention on the previously ignored environmental consequences of water projects. In
California, current water use patterns have caused widespread damage to the San Francisco Bay Estuary (the
Delta). Agricultural runoff has degraded water quality by
increasing the nitrogen content of the water. Low flow
conditions caused by excessive pumping of water through
the Delta to the southern portion of the state have caused
periods of reverse flow, where salt water is pulled into the
Delta. Moreover, periods of low flow have raised water
temperatures in the rivers, a development that has been
linked to a sharp decline in the number of salmon that
spawn in the Sacramento River. Finally, past development
policies have reduced wetlands areas, destroying the habitat of a wide variety·of fish and migratory wildlife.
Changes in operating practices in the Delta, which are
likely to be mandated by the EPA and the federal Department of Fish and Game, may have a profound impact on
California's water supply. Currently, over half of the state's
fresh water passes through the Delta. Improved environmental quality is likely to result in reduced shipments of

voluntary transfers, this agreement also highlighted the problems with
the current system of regulation. Rather than happening voluntarily in
response torecognition of the mutually beneficial trade possibilities, the
agreement was triggered by a legal challenge by one of the farmers and
an order by the State Water Resources Control Board. The process took
over eight years to complete.

FRBSF ECONOMIC REVIEW

1993,

NUMBER

water to the southern portion of the state. 16 As much as 1.1
MAF of the state's water may be removed from consumption and applied for environmental purposes.17
In Israel the main ecological policy issue has been the
destruction of its aquifers. Overconsumption of water from
those underground resources has begun to damage the
geological structures of the aquifers, threatening to destroy
future water supplies. Moreover, additional use of water
from the Dead ·Sea could cause further environmental
damage to that body of water.
Second, new supplies are expensive. The relatively
inexpensive projects have already come on line. Currently,
planners are considering new dams in California (although
with little likelihood of success given environmental opposition), water banking in ground water basins, and the
development of some new facilities to store water south of
the Delta. But most plans for new supplies also involve
desalination plants that can cost in excess or $2,000 an
acre foot, and waste water treatment facilities that also
yield high-cost water. Other choices involve forced rationing in urban settings, particularly in new construction
(limits on landscaping, plumbing requirements, and so
forth).
Israel faces similar choices, although options are more
limited because of its geography. Desalination plants can
be constructed, but they yield water at very high costs.
Moreover, desalination plants also increase dependence on
oil, which is needed to operate the facilities. Wastewater
treatment facilities arealready used and others are under
consideration to recycle some water, but demand management to reduce water use remains the primary tool for
meeting projected shortfalls. 18

Water rights are now a major issue in the Israeli-Arab
dialogue. A separate panel is working exclusively on the
issue of water and important issues remain unresolved.
Until those issues are resolved, options involving transfers
from outside Israel also are unlikely until Israel's international situation changes.
Third, complementing the other two factors, is the fact
that the urban populations in the two regions have become
better educated about water policy trade--offs. Urban users
have been forced to examine the system in light of the
high costs that resulted from rationing during the recent
droughts. As a result of that examination, there is widespread understanding that most water is applied to agriculture, with much of it going to field crops that are relatively
low-value crops.
In California, early water politics led to an alliance between agricultural interests in southern California against
interests in northern California. Most battles for changing
water allocations were between the north and the south.
Recently, though, the alliances have changed. Increasingly,
the political conflict has shifted to agricultural versus urban
uses, with cities pointing to the rising relative value created
by water in industrial uses compared to thatin agriculture.
Similarly in Israel, the political power of the agricultural
interests has found increasing opposition among other
groups in the matter of water policy.
These factors have made it increasingly difficult to meet
growing demands for water through the addition ofcapacity.
Moreover, the increased political power ofthe environmental groups in California already has forced reallocations
of water to the environment that will reduce available
supplies.

V.
16. Total shipments through the Delta need not necessarily be affected
by new practices, although the timing of shipments probably will be.
Two alternatives that have been considered are (1) a peripheral canal to
divert water around the Delta, and (2) storage facilities south ofthe Delta
to bank increased shipments in the wetter winter months to use in the
summer months when demands on the system are greater. Both projects
face strong political opposition, particularly in the northern part of the
state where residents fear that the new facilities would make it possible
for increased transfers from the north to the south at the expense of
consumers and the environment in the north.
17. Congressional bill H.R. 429, signed into law in October 1992, sets
aside 800,000 acre feet for environmental purposes from the CVP,
while a proposed ruling by the State Water Resources Control Board (to
comply with EPA rulings) may take an additional 300,000 acre feet
from other sources.
18. There have been reports that Israel and Jordan currently are considering a new canal from the Red Sea to funnel water to the Dead Sea and
generate electricity, but this is viewed largely as a political gesture
promoting peace efforts, rather than as a major effort to increase water
supplies.

REFORM EFFORTS

Because these· problems cannot be answered with traditional solutions, interest has emerged in determining new
allocative mechanisms to improve the use of the water that
currently is available. Public awareness of the inefficiencies of the current system have bred a large number of
groups to reform water policy in the state. 19 Most proposals
seek to achieve consensus between agricultural, urban,
industrial, and environmental interests. Typically, these
consensus approaches call for a mixture of new facilities,
conservation ("Best Management Practices"), waste water
recycling, increased allocations for environmental protection, and some transfers of water.
19. In California, these groups include The Three-Way Process, Californians for Water, Committee for Water Policy Consensus,Southern
California Water Committee, Farm Water Coalition, and the Bay Delta
Oversight Committee, among others.

SCHMIDT AND PLAUT / WATER POLICY IN CALIFORNIA AND ISRAEL

In most cases, "transfers" are treated as only part of the
solution, but water marketing has been rising rapidly to
the front of the list of alternatives. Some environmental
groups and business groups (such as the Environmental
Defense Fund, the Bay Area Economic Forum, the Bay
Area Council, and the California Business Roundtable), as
well as some of the more prominent urban water districts
(most noticeably MWD), pushed hard to bring market

approve all pumping from the West Bank. Clearly, should
that area no longer fall under Israeli jurisdiction, such
control would be jeopardized. Diversions from the Litani
River in southern Lebanon also involve strategic interests.
While such strategic considerations do not preclude
permission to trade water, they tend to increase the government's interest in monitoring the uses of the resource.
Moreover, the kibbutz system has a strong place in the

forces into water allocation, arguing that the resale of water

cultural and political structure oflsrael. Changes in water

offers the potential for greater efficiency, with the prospect
that nearly all agents can be made better off (Schmidt and
Cannon 1991, Mitchell 1993).20
These interest groups, were instrumental in obtaining
passage of recent federal legislation (H.R. 429), frequently
known as the "Bradley-Miller bill," which has strongly
embraced the market point of view. The bill, signed into
law on October 30, 1992 by President Bush, allows individual contractors to sell up to 20 percent of their allocations without approval by water districts, along with other
provisions that.allocate water to environmental purposes,
create a fund for environmental restoration, and shorten
contract periods.
In Israel some steps toward water reform were begun in
1991. These efforts, however, were halted after the change
in government following the 1992 election. At present, no
significant reforms are under consideration.
This lack of reform efforts in Israel reflects the different
social and political interests in the two regions. In California, water policy is increasingly addressed as an economic
issue. While arguments still are voiced about the importance of maintaining agriculture in the state, increasingly
the discussion has migrated toward economic issues. Arguments opposed to trading emphasize economic dislocations and third party effects, rather than simply relying on
statements about the importance of maintaining a way of
life for those in the agricultural communities.
In Israel, on the other hand, water remains a strategic
resource and the state is vitally concerned with its allocation. As discussed by Wolf and Ross (1992), water policy
has been· an important consideration in Israel's dealings
with its neighbors. For example, according to their analysis, water complicates resolution of the West Bank dispute.
The West Bank sits above the Mountain· aquifer, and
pumping in that region affects supplies to much of central
Israel. Under current policies, the Israeli government must

policies that might lead to a shift away from agriculture to
industrial uses could pose a threat to that system.
Cost of reforms. The speed with which reforms are
adopted depends critically on the transitional costs that
arise in implementing new policies. Experimentation with
additional transfers under the Bradley-Miller legislation
should provide strong evidence of the potential gains and
disruptions that can result from limited resale of water. By
allowing resale of water by CVP contractors, the bill
converts water rights into marketable assets, much like
electricity from federal projects. Thus, as with electricity,
the new structure of rights should encourage marginal
transfers among water districts, which may be sufficient to
eliminate the need for major new water storage facilities. A
key question facing potential reform options is the magnitude of disruptions that such reforms might generate.
Would market forces lead to large shifts in water use and to
large changes in prices?
Research on California's water system suggests that the
quantity of water transferred would be relatively small and
the effect on prices to agriculture relatively minor. Howitt,
Watson, and Adams (1980) found estimated elasticities of
demand for agriculture that were well above those of urban
users. Agricultural demand elasticities for water prices in
the range of $62 to $87 per acre foot (in 1992 dollars)
ranged from - 0.98 to -1.5, and prices below this level
had even larger elasticities. In contrast, urban users were
estimated to have price elasticities close to - 0.4 (Vaux
and Howitt 1984). Given that agriculture currently consumes somewhere in the range of 80 to 85 percent of the
water in California, relatively small percentage reductions
in agricultural use resulting from small increases in average water prices would relatively quickly satisfy urban
demand: Even a doubling of urban water consumption
would reduce agricultural water by only around a fifth from
current levels.
In a simulation model embedding these statistics, Vaux
and Howitt (1984) estimated that price effects on agriculture and the magnitude of water transferred in California
would be relatively small. Using updated figures from
Vaux and Howitt's article, Schmidt and Cannon (1991)
found that average agricultural prices might increase as
little as $2.60 per acre foot-from $54.61 to $57.23. Less

20. The extended drought led to the establishment of an emergency
water bank in California in 1991. While not a pure market, the bank did
provide a mechanism to facilitate transfers from agricultural to urban
users, demonstrating the potential for mutually advantageous trade. The
water bank, however, is viewed as an emergency measure, and is not
generally perceived as a model for marketing water permanently.

FRBSF ECONOMIC REVIEW 1993,

NUMBER

than one MAF moved from agriculture to other uses in the
simulations. Obviously, some farmers receiving water at
well below that price would face a larger increase, but even
in those cases, that suggests that those farmers may have
the potential to profit from selling more water. These
elasticities also are short-run elasticities. Over the longer
run, elasticities are likely to be significantly larger as
farmers install new technologies that save water.
More recent evidence from Howitt (991) provides further arguments supporting the low-price impact of a market. According to this research, rice farmers in California
could make the same income from selling water at a price
of $58 per acre foot (including avoiding production costs),
while the break-even price for alfalfa was $114 per acre
foot. Given that these commodities, along with irrigated
pasture, account for about a third of California's total water
use, those prices put a ceiling on the likely level to which
prices would rise, since demand by urban areas would be
expected to be satisfied well before all of that water would
be purchased. Moreover, Howitt found that relatively little
water was transferred from agricultural producers of highvalue and permanent crops.
Similarly, in Israel, a study by Sadan and Ben-Zvi
(1987) examined the implications of allowing water to be
traded. They found significant changes occurring in water
use across regions, with less used in the northeastern end
of the system, and more used in the south.· Nevertheless,
their study concluded (p.8):
The findings presented demonstrate the low economic
cost of the institutional· alternative relative to that provided through new resource development. In the case of
Israel, the cost of a given quantity of irrigation water
reallocated through institutional change appears to be
only half as expensive as that same quantity provided
through the implementation of projects for sewage water
treatment and recycling, flood control, etc.
While allowing trading would result in some reallocation of resources, and hence some "third party effects" on
agricultural communities, concern about such effects must
be placed in perspective. Some changes in production and
consumption practices would occur, but the indirect effects
of those actions on others are likely to be small relative to
others that occur regularly in agriculture. For example, the
introduction of mechanical tomato harvesters sharply reduced the demand for labor, thus generating third party
effects well in excess of those likely to be generated by
introduction of a water market (Mitchell 1993).

VI.

CONCLUSIONS

Israel and California share similarities not only in their waterdelivery systems and their institutions, but in their public
attitudes. In both cases, water infrastructures have relied
heavily on public investments, where costs have been
spread widely. Moreover, in both regions political involvement has expanded beyond the construction of facilities to

include close controls on allocation alld use ofthe resource.
Agriculture has been the biggest beneficiary of past institutional arrangements, typically receiving the bulk of the
water and paying lower unit prices for that water.
In both states, serious reform of water policy has proven
very difficult. Among the reasons for this difficulty is the
ingrained public attitude that because water is "important" it should be allocated administratively. The public
seems to believe that this is "more fair" even though actual
allocations seem to belie this fairness concept. Despite
water's importance in semi-arid areas, policy has opted for
this "fairness" over efficiency.
We have argued, however, that concerns over fairness
need not preclude trading. As demonstrated in the electric
utility industry, it is possible to achieve social policies
through differential pricing and through government development of new facilities. Yet, efficiency can be boosted in
that system by allowing trading to take place. Fairness can
be handled by choosing how to allocate the rights to the
resource; efficiency is achieved by granting those rights
holders the right to sell to others.
Examination of Israel and California suggests that the
willingness to experiment with water reforms-specifically to allow trading-may be increasing in California,
while little momentum is apparent in Israel. In part, this
may be the result ofthe trade-off that exists in control ofwater markets. Direct allocation of water gives tremendous
control over development. to governmental agencies. The
cost of such control, however, is to increase drastically the
efficiency losses and encourage poor resource allocation.
In the case of California, momentum is building for
increased decentralization of control. This momentum
results, in part, from the declining relative economic importance of the primary user-agriculture-and the growing importance of environmental values. Since the latter
have had· the effect of reducing available supplies and
making new supplies more difficult to acquire, the efficiency costs implicit in administrative control over water
use have risen to the point that other industries and consumers have been forced to address the issue. Moreover, at
least in California, evidence suggests that the cost and

SCHMIDT AND PLAUT / WATER POLICY IN CALIFORNIA AND ISRAEL

disruptions resulting from watertrading are not likely to be
that large.
In Israel, while economic costs of administrative water allocation also are high, strategic concerns and the
political strength of the agricultural sector continue to

make reform options politically unpalatable. However, as
demand for the water continues to rise with Israel's population, and as other industries become increasingly important relative to agriculture, it is possible that reforms will
become more attractive there as well.

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Full text of Economic Review (Federal Reserve Bank of San Francisco) : 1993, Number 3

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