Full text of Economic Review (Federal Reserve Bank of San Francisco) : December 1975

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The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly
by the Bank’s Research and Public Information Department under the supervision of
Michael W. Keran, Vice President. The publication is edited by William Burke, with the
assistance of Karen Rusk (editorial) and Janis Wilson (graphics). Subscribers to the
Economic Review may also be interested in receiving this Bank’s Publications List or
weekly Business and Financial Letter. For copies of these and other Federal Reserve
publications, contact the Public Information Section, Federal Reserve Bank of San Fran­
cisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 544-2184.

2

Inflation causes many severe problems, most
obviously by reducing the living standards of
individuals on fixed incomes. But not enough
attention has been paid to the way in which inflation undermines financial markets, twisting
out of shape the traditional relationships that
make it possible for people to do business with
one another. To call attention to this aspect of
the question, we present four articles dealing
with different aspects of how inflation affects
the financial system.
Edward S. Shaw describes the "dirty" type
of inflation that has beset our economy-especially by obstructing and distorting capital flows
and capital accumulation-and discusses ways
of cushioning or (better still) preventing such
inflation. He emphasizes that inflation typically
is not "clean"-that is, constant and perfectly
foreseen-but rather that it operates at unstable
rates on markets for output, factors and securities. "Financial markets are segmented; relative
financial prices are distorted; financial stocks
are destroyed; and financial adaptations to dirty
inflation are costly and inefficient." Money and
government securities are demoted from the
category of "safe" assets, thus destroying portfolio balance, since the accumulation of safe
assets is no longer complementary with the
accumulation of productive or risky assets.
Many other distorting effects of this type can be
cited.
Shaw argues that we cannot very well live
with inflation because "this disease of the price

system becomes worse when treated with benign
neglect." Thus, ways must be found of either
"cleansing" or preventing this disease. One obvious correction for inflationary distortions is
to turn old prices loose-removing price floors
or ceilings-to find their "market" level. Because of the objections raised to this procedure,
corrections are sometimes imposed by governments in the form of indexing, with individual
wages, prices and interest rates linked with some
market-basket index of free prices. But since
indexing at best provides only a temporary
solution for inflation, the search goes on for
ways of actually curing the disease.
Joseph Bisignano, in his contribution, analyzes the effect of recent inflation (whether
anticipated or unanticipated) on personal savings behavior. He shows that the attempt by
consumers to maintain a desired relationship
between real income and real wealth has
brought about a rise in the personal savings rate
in recent years. Helping to explain this development is the "surprise" nature of the inflation
that has occurred during this period.
This type of inflation represents an unanticipated decline in the real purchasing power of
income and wealth. Increased uncertainty
causes consumers to retrench on their spending
decisions and to increase their precautionary
savings balances. Only when unanticipated inflation declines, as in 1972, do we encounter a
significant decline in the savings rate. Thus,
Bisignano concludes, the savings rate in the

3

terminant of the risk premium.
Kurt Dew considers an important current
issue-to what extent deficit-inspired Treasury
borrowing replaces or "crowds out" private borrowing in U.S. credit markets. In this analysis,
he differentiates between long-run and short-run
considerations. In the long term, given the
assumption of a "neutral" fiscal-policy effect on
private savings behavior, persistent deficits are
seen to retard private capital accumulation, although this crowding-out effect is not reflected
in higher interest rates. Government crowding
out of private capital-market investment tends
to be analogous to government crowding out of
private expenditures in other markets.
In the short run, in contrast, fiscal policy's
impact on capital markets and interest rates
tends to be uncertain. Nonetheless, Dew's
analysis suggests that no damage results from
short-run fiscal stimulus, under certain carefully
specified and limited conditions. In the depths
of recession, fiscal stimulus is well advised. But
to avoid long-term damage, we should reduce
this stimulus as the economy recovers, balancing recessionary deficits with surpluses during
better times.

future may remain high unless there is a prolonged decline in unanticipated inflation.
Rose McElhattan provides an analysis of
term-structure theory, which explains why securities which are alike in all respects, except in
their term to maturity, should provide different
market yields. She reviews the "preferred habitat" model of the term structure, which hypothesizes that the long-term rate of interest is an
average of eXpected future short-term rates plus
a risk premium-and that expectations are primarily dependent upon the history of interest
rates and rates of inflation over several past
years. She then shows that this model can be
significantly improved with the introduction of
inflation uncertainty as an element determining
the risk premium.
McElhattan concludes that inflation uncertainty has been a significant determinant of longterm interest rates for the last two decades. In
the 1955-65 period, the term-structure risk
premium could be explained by variables designed to measure the uncertainty surrounding
expected future interest rates and inflation rates.
But in the 1966-71 period, inflation uncertainty
remained the only statistically significant de-

4

Edward S. Shaw*
Simon Kuznets remarked in his Capital in
The American Economy, " ... extrapolation of
inflationary pressures over the next thirty
years raises a specter of intolerable consequences.... "1 Fifteen of the thirty years are
over, and inflation has accelerated. The central
concern of this paper is whether Kuznets' prediction of "intolerable consequences" for capital
markets and capital accumulation is on track or
patently wrong. 2
Monetary theory distinguishes between "immaculate" inflation, "clean" inflation, and
"dirty" inflation. It is the last of these that
Kuznets dreaded and that we have endured. The
first section below deals very briefly with differences between the three styles of inflation.
The second section is a catalogue of ways in
which dirty inflation may obstruct and distort
capital flows and capital accumulation. The
third section considers some ways, including
"indexing," to cleanse a dirty inflation and some
ways to prevent it.

rate. There is physical wealth, its ownership
represented by an homogeneous financial asset
in the form of common stock or "equity," and
there is wealth in the form of real money balances. Accumulation of physical and monetary
wealth derives from a constant rate of saving
for the community. Inflation occurs because the
growth rate of nominal money exceeds the
growth rate of real money demanded.
The inflation is immaculate because its pace
is constant and perfectly foreseen and because
the inflation tax on real money balances is compensated precisely by a deposit-rate of interest
on money. It is fully anticipated, and it does not
impose a relative penalty on the money form of
wealth. Money-wage rates rise faster than output prices in the degree that labor productivity
is growing. The price of common stock rises
in precise accord with the marginal reproduction cost of corporate capital goods, and the
earnings-price ratio of corporations equals the
real marginal productivity of physical capital.
Stocks are a perfect hedge against inflation, and
so is money whether the rate of inflation is positive or negative, high or low. It is evidently not
immaculate inflation that bothered Kuznets.
Clean inflation is also constant and perfectly
foreseen. However, money-holders are not
compensated for the inflation tax, so that a rise
in the rate of inflation makes money wealth a
less attractive alternative, in the optimum portfolio, to human and physical wealth. Depend-

Styles of inflation

Immaculate inflation can be visualized most
easily for a competitive economy that is firmly
settled on a path of steady growth. Final outputs are produced by three forms of wealth.
There is human wealth, growing at a constant
"'Edward S. Shaw was Visiting Scholar at the Federal Reserve Bank of San Francisco (1974-75). He is Emeritus
Professor of Economics at Stanford University.

5

ing upon the functions attributed to money and
upon other considerations, the higher rate of
clean inflation may lower the growth rate of
output, the yield to human wealth, and the earnings-price ratio on equities or it may raise them.
For example, if money is a consumer good, an
uncompensated inflation tax can increase the
community's savings-income ratio and accelerate growth of wealth and output. On the other
hand, if money is a producer good, a negative
yield or tax on it can reduce the productivities
of complementary physical and human wealth.
Then workers and stockholders suffer along
with money-holders, and all of them should
dread the "specter" of inflation. They should
insist that the monetary system link growth of
nominal money precisely with growth in real
money demanded.
Immaculate and clean inflation are figments
of monetary theory. The real world is not firmly
settled on a stable growth path for output,
human wealth, and physical wealth. Wealth is
not riskless and homogeneous, its ownership
represented by homogeneous common stock of
gilt-edge quality. In particular, the growth
paths of price levels for output and wealth are
not straight lines into infinity. Inflation proceeds, instead, at unstable rates on markets for
output, factors, and securities. Its variance defies foresight and can be regarded as a disease
of capitalism's guidance mechanism, the price
system. The inflation tax is not compensated.
The inflations that we experience are dirty, and
an increase in the inflation rate or its variance
has real consequences that the simple models of
immaculate and clean inflation do not comprehend.

ital growth. We pass this by, because inflation
often reduces the social rate of saving and because more efficient devices to increase aggregate savings are available. Another alleged
gain is that inflation demolishes a complex and
awkward structure of claims against wealth and
permits a purified financial system to concentrate on incremental growth of capital. This
may be a benefit of once-and-for-all hyperinflation, but it is not the result of chronic infllati,ol1.
Still another gain is said to be that inflatilon
posed as a tax to yield government re\<'ennes
impedes efficient capital formation less
alternative sources of revenue. This is true for
some but not for all alternative taxes. To continue down our list, inflation of product prices
is said to be an essential, though second-best,
defense for full employment against autonomous inflation of factor prices. It must be not
merely tolerated but validated by monetary expansion until there can be a "social contract" to
inhibit monopoly practices in factor markets.
We pass this by, partly on the grounds that
monopoly in its various guises is characteristically laggard in adjusting its price demands to
inflation: autonomous inflation tends to be
catch-up inflation. Finally, there is Phillips-ism
which tells us that inflation is the right way to
reduce marginal real labor costs to employers
and so to excite demand for labor to the fullemployment level: unstable and unanticipated
inflation clears the labor market. This allegation we put aside because we do not know the
inflation-unemployment rate of exchange nor
how often the rate of exchange may vary, and
the evidence is strong that chronic unemployment responds less durably to inflation stimulus
than to improvement in labor training and
mobility.

Capital costs of inflation

We turn now to the obstacles that dirty infla.tion puts in the way of efficient wealth or capital
accumulation. The list of obstacles below is not
all-inclusive, and the costs they impose are not
measured. It is not balanced against a list of
social gains from inflation. One alleged gain is
that inflation shifts income from low-saving sectors to high-saving sectors and accelerates cap-

The safety principle
Every segment of economic theory about
finance emphasizes benefits that accrue to individuals and society from the existence of some
safe asset or assets; that is, of assets bearing
real yields of negligible unanticipated variance.
The hypothesis here is that dirty inflation deals

6

bnltally with safe assets
with financial markets.
se~:mleni:ed; relative financial
financial stocks are de:,tnJv(:d:
cial ad,iptatHJnS
inefficient.
The first
of monetary
benefits if some asset has a fixed
in terms of the nUJmeraiJre
zero variance in the numeraire
It is
for the efficient orf;aniz3ltio1n
of markets and for extension of th,;irboluil,darie:s
limits
of
a "C(lmlTIOn-cun'en,cy
which two or more local monies
an
rate of zero variance.

consumer
another. Inflation
to demonetize an ec()n()m:y
Portfolio
asset or assets,
the
frontier
Risk-averse investors
of their
if
asset for unsafe assets

pooled experience was that stock prices gained
approximately one-half of one percent for each
percentage point of inflation. Inflation reduced
the real value of equities. James Tobin has reported a reduction from 1.62 to .995, during
1965-1973, in the ratio of aggregate market
values for stocks and debt of American corporations to reproduction cost of corporate capitaL"
Data assembled by Henry Kaufman indicate
that the ratio of market value to stated book
value for Dow Jones industrials declined during
1965-1974 to its lowest level since World War
II.' Michael Keran, exploring quarterly data
for the United States during 1956-1970, found
a negative and highly significant relationship between Standard and Poor's 500 index and the
gross national product deflator lagged from one
to sixteen quarters. s These and other studies
leave little doubt that dirty inflation is not a
happy context for bulls on stock exchanges.
Complement-shift is by no means the only
explanation for the perverse response of stock
prices to inflation. That it does count is suggested by varying degrees of response in price
indices for stocks of different grades and qualities. If aversion to stocks arises from decay of
safe assets, one would expect aversion to hit
least the large, blue-chip issues, to hit hardest
the issues of relatively new and small firms. This
is what happens. From the end of 1972 to the
end of 1974, for example, the Dow Jones index
for thirty industrials declined by thirty-six percent, the NASDAQ index for over-counter
stocks by fifty-two percent. Dirty inflation increases the cost of capital to extraordinarily,
even infinitely high levels for industry on the
safety fringes. It tends to close the door of this
particular habitat to capital inflows.

an average deviation of 4.5 percent during
1960-1966. In view of the deteriorating yield
and quality of Treasury bonds in particular and
of other Treasury issues in smaller degree, it is
not surprising that private domestic investors
made no net purchases of Treasury issues during
1967-1973 and elected to hold in their portfolios only $ I 22 billion of Treasury debt, at
values in 1967 prices, in 1973 as compared with
$206 billion in 1967.
From the mid-1960's to the 1970's, dirty inflation has reduced the safety of money, claims
on intermediaries, and government bonds. Complementary investments with high-risky returns
have been affected as one expects. One particle
of evidence comes from the market for venture
capital, a principal source of finance for small,
new enterprise. The flow of funds to this market is down to a trickle, and the terms have
become more severe. The Department of Commerce is concerned that the effect may be to
inhibit technological innovation as well as competition with relatively large, established enterprise.' We consider this "complement-shift" at
greater length in the following section.
Complement - shift of Portfolios and the
Stockmarket. Some assets that qualify as "safe"
when inflation is negligible deteriorate along the
risk scale when inflation is substantial and dirty.
Asset portfolios are adjusted to this decay of
safety in two ways. For one, there is a shift
away from the assets with high-risky returns that
are complementary with assets qualifying as safe
when inflation is negligible. For the other, there
is a shift to assets that are relatively inflationproof. Disappearance of venture capital during
the past few years in the United States may be
one bit of evidence on the former or complement-shift. The behavior of stockmarket indices
during inflation is another bit of evidence.
Many studies have made it clear that stocks
are not a secure inflation hedge during dirty inflation. One study has regressed annual growth
rates in stock-price indices, during 1953-1969,
on growth rates of commodity prices and industrial production for twenty-two countries." The

Substitute-shift and The Term Structure of
Interest Rates. If inflation were immaculate or
clean, borrowers and lenders could not err in
forecasts of nominal or real rates of interest.
Information about forward rates of interest
would be just as precise and reliable as information about spot rates. Differences in trading
cost aside, short-term and long-term securities

8

would be perfect substitutes and occupants of
the same habitat. Issues at various terms to
maturity are not perfect substitutes in the real
world. One reason is that inflation imposed in
the past at random rates generates expectations
of inflation at unpredictably variable rates in
the future. Then nominal and real forward rates
cannot be forecast precisely. This means, of
course, that short-term securities provide a margin of safety for risk-averse investors over longterm securities. The latter lose gilt-edgeness,
and dealings in them take place in a distinctive
risk habitat.
When dirty inflation has done its mischief
with such safe assets as, say, money or Treasury
bonds or endowment life insurance, one can
count on a substitute-shift by investors. One
obvious way to retrieve an element of safety for
portfolios is to substitute short-term claims for
longer maturities. Security markets must respond to this shift with an increase in the liquidity premium on the longer maturities that can be
explained, in part, by the variance of past and,
hence, of expected inflation.
Especially since 1965, the liquidity premium
on longer-term securities has increased in this
country. Modigliani and Shiller have traced
part of the increase, for the premium on AAA
corporate bonds relative to prime commercial
paper, to growth in the rate of inflation. They
have traced part of the increase to growth in the
standard deviation of the market rate of interest
for commercial paper." This short-term rate has
become less stable because inflation has been
dirtier, but there are other reasons including
higher variability of the money supply. Whether
and by how much inflation's variance affects the
liquidity premium for long-term securities has
yet to be determined, but exploratory work by
Rose McElhattan indicates that the substituteshift does occur along the maturity spectrum.")
The maturity shift poses hazards for economic welfare. Shorter mean maturity of business debt can result in difficult cash-flow problems for both borrowers and lenders, especially
including banks. Even if financial crisis does
not result, the risks of borrowing and lending

short must put a damper on capital formation in
the private business sector.
The lag principle
In immaculate or clean inflation, the future
path of inflation can be foreseen precisely by
participants in all markets. In dirty inflation,
the mean inflation rate for some long period is
approached by successive accelerations of inflation interspersed with slow-downs of pricelevel growth. Current and past short-run inflation rates are not an accurate guide to expectations of the mean rate: historic price behavior
becomes unreliable information about prices in
the future. On general principle, of course, any
decline in the efficiency of the price mechanism
as a device for disseminating information and
for coordinating economic activities is bound to
have its social costs in the capitalist system."
Some of these costs must be evident on capital
markets where present prices of capital assets
depend in complex ways upon both prices in the
present and past and prices expected for the
future. We turn now to three examples.

Relative Prices of Debt and Equity. Michael
Keran has developed a subtle model, with
strong empirical verification, in which unstable
inflation generates changes in relative rates of
return to corporate debt and corporate equity.1:!
The market rate for corporate bonds of AAA
quality, a measure of both return to savers and
of capital's supply price to corporate investors,
is determined by expected rates of change in the
GNP deflator (with positive effect), by rates of
change in real GNP (with positive effect), and
by change in the real money stock (with negative effect). When inflation is unstable and
accelerating, this interest rate rises sensitively
in response to inflationary anticipations. The
supply price of capital on the stock markets responds even more sharply. Security buyers there
insist upon a rate of return that is competitive
with bond rate. They bid prices on the stock
exchanges to the low levels that will yield the
competitive rate, given anticipated corporate
earnings. However, they are relatively myopic

9

about the effect of inflatIOn in raising future
earnings: they are inflation-sensitive on the
bond market, inflation-insensitive on the stock
market. The result is that the supply price of
equity capital, computed from earnings that are
adjusted to inflation, is driven upward relative
to bond rate. In due time, as the higher inflation
rate is prolonged, the error in stock valuations
is corrected and a "normal" relationship is restored between yields on bonds and yields on
equities. Conversely, as inflation slows, market
returns to equities diminish temporarily relative
to bond rate, then rise as deflationary anticipations are applied to forecasts of corporate
profits.
The Keran model dramatizes the uneven impact of inflation and inflationary expectations
on different segments of the capital market. One
suspects that this model can be augmented, to
explain the impact of unstable growth rates in
nominal money. When monetary growth is
accelerated, there tends to be a "first" effect
reducing corporate bond rate and raising stock
prices. "Second" effects follow, including increases in real national product that tend to
raise bond rate and increases in real corporate
profits that tend to raise stock prices. Keran's
model is concerned mainly with "third" effects,
as inflation sets in, that tend to raise bond rate
and to raise the supply price of equity capital
even moreY Extended or not, the Keran model
generates a clear account of fragmentation on
capital markets during dirty inflation. Bond
markets and stock markets become more distinctive habitats as the result of changing lag
patterns in output, prices, profits, and inflationaryanticipations.
With increased variance in yield, equities slip
down the scale of safety relative to corporate
bonds, and there must be a trend during dirty
inflation toward the higher leveraging of corporate investment. In view of increases in the
liquidity premium against long-term debt that
develop during inflation, the higher leveraging
must involve a rising ratio of short-term debt to
equity. This trend involves obvious risks for
corporate liquidity and solvency, particularly

during periods when profits are depressed relative to interest payments.
Lags and Wealth Effects. Dirty inflation
leaves a trail of wealth effects. For the moment,
we are concerned only with those effects that
can be attribl,lted to imperfect foresight regarding inflation and to lags in anticipations regarding inflation's mean and variance. More wealth
effects follow from other aspects of in~ation,
especially from governmental pricing and tax
policies, and we turn to them later.
During economic growth, the private sector
generates a stock of debt and financial assets.
The public sector has become a chronic borrowing sector. Financial accumulation is the counterpart of private capital accumulation and expansion of the public domain. At low and stable
rates of inflation, only a negligible share of the
financial accumulation is explicitly "indexed."
As inflation increases and becomes more variable, indexing is extended in various guises, but
its costs are apparently so high that it lags behind inflation. It is discussed in a later section.
Indexing is perfect, of course, in immaculate
inflation.
Dirty inflation imposes a quadruple tax on
holders of the bulk of financial assets. First,the
real value of claims that promise a given flow of
nominal returns is diminished by each increment
of realized but unanticipated inflation. Second,
the value of such claims is diminished by increases in market rates of interest that reflect
anticipated inflation. Third, many varieties of
claims slip down the scale of security ratings.
Fourth, holders of equity claims are injured by
the lag of stock prices behind inflation of labor
and commodity prices. It may be noted in passing that claimants in such contingency contracts
as insurance bear inflation taxes along with
holders of financial assets. These penalties on
contingency contracts should be expected to
have effects on portfolio choice and substitution
similar to effects of dirty lnfl.ation on "safe"
.
assets.

No accurate and complete estimates of these
costs to holders of financial assets have been
10

made. Bach and Stephenson have published
estimates for the first taxon our listY For the
quarter~century 1946-1971, real capital losses
from unanticipated inflation may have amounted to $600~billion. For each one-percentage
point of inflation after 1971 in this country, the
cost to creditors may amount annually to $35
billion at the 1971 level of commodity prices.
Of course, this tax is objectionable on all canons
of taxation. For one thing, who the beneficiaries
are is not clear. They must include taxpayers
who benefit from government's debt exposure
or, when government does not pass on to taxpayers the benefits of its inflation windfall, users
of public goods and purveyors of various services to government. They seem to include, too,
stockholders of corporations with exceptional
debt leverage. Recipients of low and high incomes are taxed for the benefit of middle-income households, and elderly people are taxed
for the benefit of the young. The distribution of
benefits and burdens is not random, but it is
obscure and is not determined by explicit political choice or by efficient market choice. The tax
is biased against savings, and it is biased for
relative growth of the government sector.
The second, third, and fourth taxes on holders of finanCial assets have no benefiCiaries.
Their effect, it was argued earlier, is to distort
capital markets, twisting the structure of interest
rates against risky and long-term assets. In more
general terms, they add to the risks and hazards
of capital accumulation. The long-run result of
augmented risk can be only to diminish economic productivity and growth.

tax, may be overstated by at least $30 billion.
He suggests, too, that use of a constant dollar
in measuring profits would reduce the reported
increase from 40 percent to 10 percent in 19661973. 10 Terborgh reports that corporation profits during 1946-1970 were overstated by nearly
20 percent because of just one instance of
money-illusion, underestimation of depreciation
charges. 16 Bach and Stephenson note the remarkably diverse impact upon companies of
correcting income statements for bias in the dollar as measuring rod. '7 Valuations of aggregates
by the Department of Commerce have been no
more immune to illusion~error than micro-valuations by accountants and tax collectors. The
American Institute of Certified Public Accountants has nominated inflation-bias as the preeminent issue in reform of corporate accounting
procedures. 18
The economy travels through time with a
slowly changing stock of "old" tangible wealth
and "old" financial assets and debt. The stocks
are substantial multiples of annual flows of incomes, cost, and debt service. The ages of the
stock range from the new to the well-nigh infinitely old (land). One result is that, if assets
and debt are measured in original values, reported net worth of individuals, firms, and the
economy can vary substantially between periods
just because the vintage of assets and debts
changes. Reported income can be over-stated
or under-stated just because the current price
level differs from the weighted mean of price
levels at which old assets and debt were acquired. All by itself, the calendar produces
variance in net worth and income.
Instances of illusory valuation are familiar.
There is original-cost depreciation, which is correct only partially when depreciation charges
are accelerated. There is FIFO costing of inventory and costing of debt at contract instead
of market rates of interest. These and other
distortions in accounting information are the
heritage of more or less prolonged dirty inflation.
Bach and Stephenson have made the essential point about the effect of these distortions on

Valuation Lags. Valuation of assets, liabilities, and net worth of both companies and individuals is based on the principle that "a dollar
is a dollar is a dollar." They are afflicted with
money-illusion. They are rarely adjusted to the
fact that last year's dollar and this year's are
quite different when price levels are unstable.
The result is that levels of income and wealth
and change in the levels are misrepresented.
Fabricant estimates that corporate profits for
1973, reported as $118 billion before income

11

capital markets. They sought but could not find
evidence that stock markets discriminate successfully between business profits that are
illusory, based on the age-pattern of old assets
and debt, and profits that are corrected for
money illusion."! Stock markets are not efficient
enough, in valuing profits, to draw the line
where illusion ends and efficiency begins. They
cannot be as selective as we would like them to
be in allocating scarce savings.

The second tax effect depends on the progressivity of tax schedules. Inflation drives nominal
and real incomes along different paths. The
United States is aware, from its experience of
1973-1975, that nominal and real incomes may
move in different directions, the former rising
and the latter declining. Progressive taxation
pays no heed to the path of real incomes. It
imposes higher tax rates as nominal incomes increase, and government seems not to be concerned that, because real incomes lag, the progression of taxes against them is steeper still.
Real incomes, then, are subject to "double progression" as the result of dirty inflation. 20 The
double progression is especially notable for the
profit share of income since it is so sensitive to
change in real national product. Of course, the
impact of inflation cum progressive taxation on
after-tax, distributed real profits and the stock
markets' valuation of private capital formation
must be adverse to private investment. Since
the impact is variable, it increases the variance
of real yield to capital, the risk of investment,
and the aversion to investment at each mean rate
of return. Dirty inflation cum progressive taxation makes safe assets risky, risky assets riskier
still.
We observed earlier that business income
varies with the vintage of business wealth when
there is variable, unanticipated inflation. It is
overstated by original-cost depreciation and
FIFO accounting for inventory when prices are
rising, under-stated when prices are falling.
Business taxes are assessed on measured or
"vintage" income, and so they are progressive to
inflation at rates which vary from taxpayer to
taxpayer according to the vintage of capital
goods and inventory. After-tax incomes are not
unbiased measures of firms' relative efficiencies.
They are biased by the relative ages of business
assets.
The vintages of debt also count in measurements of income and assessment of taxes during
inflation. Any firm with debts that are not indexed, by the market or by contract, receives
real income from the inflation tax on its creditors. The tax is higher as the debt is older. Of

Inflation and government
Dirty inflation should be labeled, "Made in
Government." Inflation is generated by excessive growth rates of nominal money, dirty inflation by excessive and unstable growth rates of
nominal money, and the determination of these
rates is government's prerogative. In this section, we sample other government actions that,
by adding to the turmoil of inflation, distort capital markets. The hypothesis is proposed, in
passing, that dirty inflation increases the economic size of government relative to private sectors: in particular, it increases governmental
relative to private demands upon capital markets, governmental relative to private financial
intermediation, and governmental manipulation
of private financial choice. If government were
motivated to self-aggrandizement, dirty inflation
would be the instrument to use.
Tax Effects of Inflation. The list of tax effects
of inflation is long, and we draw only a small
sample from it. The most obvious, of course, is
that unstable inflation imposes unpredictable
rates of taxation upon private balances of government debt and high-powered money. These
private balances are depreciated during inflation
and, since income taxation is afflicted with money-illusion, the depreciation cannot be counted
by the private sector as a tax-deductible loss or
business expense. Government imposes the loss
and declines to allow relief for it in explicit
taxes, even declines to report it as a fiscal revenue. One result, as we have seen, is to take
away from investors the haven of safe assets,
and another is to reduce private savings, given
constant savings-income ratios.

12

course, this real income of private debtors is not
counted as income subject to government tax,
and the inflation costs of creditors are not deductible from income subject to government
assessment. Since the corporate sector at large
is a net debtor, this exemption of real income
from assessment is a partial offset against the
punitive tax effect of original-cost depreciation
and FIFO accounting for inventory. Musgrave
takes the position that, since there is offset in
some degree, tax assessments should not be corrected for vintage of either assets or debts. 21

inflation, of tax-exemption clauses in issues of
local government. Still, one notes that the mean
ratio of market rates of interest on U.S. Treasury
bonds to market rates on high-grade issues of
local government declined from 1.15 on the
average in 1960-1963 to 1.07 in 1970-1973.
During the same period, quality ratings were reduced for numerous issues of local governments
in response to lags in local revenues behind
local interest obligations. It may be more important, from an efficiency standpoint, that the
incidence of relative increases in cost of capital
was uneven among local governments, depending in some substantial way on differences in
styles of taxation and composition of tax bases.
Demands for revenue-sharing by the Federal
government must have arisen in part because of
the differential impacts of inflation on different
levels of public administration.

Inter-Government Finance. Inflation affects
in arbitrary and unexpected ways the relative
flows of real revenues and savings for different
levels of government and their relative ease of
access to capital markets. For example, only
central government collects the inflation tax by
issue of nominal money to excess. This tax is
one that state and local governments are precluded from using. However, there are more
important differences.
In the main, lesser governmental units do not
employ progressive taxation of private incomes
or the rate progression is gentler than the federal progression. They do not enjoy automatic
growth of real revenues from income taxation.
Again, much of local government depends only
to a slight degree on income taxation and relies
instead on property taxation. Revenues from
property taxes characteristically lag behind inflation because reassessments of property are infrequent and because collections are annual
rather than quarterly or by withholding. Still
again, local government bears first the brunt of
taxpayers' resistance to automatic growth of
total real tax burdens in inflation. In some degree, that is to say, growth of real federal tax
revenues turns out to be at the expense of real
local tax revenues.
Lags in revenue growth for local government
relative to expenditure growth tend both to increase government bids for funds on capital
markets and to lower the markets' valuation of
the debt offerings. Of course, the markets do
take into account the increasing value, during

Price Controls. Government is nourished by
inflation, then bites gently the hand that feeds
it by imposing selective price ceilings. Whether
the ceilings are numerous, as in Phases I-III
during 1971-1973, or more selective, their effect
is to differentiate the impact of inflation upon
various kinds of wealth and upon the markets
for wealth. In much the same way that old
assets and old debt affect gains and losses from
inflation, old prices stabilized by controls adjust
the relative burdens of inflation on the processes
of capital accumulation.
One expects two principal effects of specific
price ceilings on capital markets. Wealth yielding services that are subject to effective price
controls must yield declining real revenues during inflation and, at any discount rate, must decline in real market value. Probability that controls will be imposed must increase the risk of
wealth ownership so that a higher discount rate
is appropriate. Market values of wealth are
diminished, relative to reproduction costs, by
either the fact of control or by the prospect of
control.
There are numerous illustrations of the impact of inflation, dirtied by price controls, on
capital values. Private residential construction

13

has been damped in New York City since World
War II, as in Paris and London and elsewhere,
because of the lethal combination of rent ceilings and general inflation. Cattle herds in Argentina are destroyed as their effective rate of
return relative to free market rates of interest
is reduced by over-valuation of the peso on the
foreign exchanges and by controls on export
prices for beef and mutton. Cocoa plantings in
Ghana recede when price ceilings discriminate
against cocoa production during inflation and
then expand when ceilings are raised or inflation reduced. 22
Keran has demonstrated the impact of conventional "fair-return" pricing of services of
public utilities, during inflation, by regulatory
commissions. 23 The commissions have been
charged with responsibility for thwarting the
disposition of utility companies to price their
services monopolistically and so to extract excessive returns for their stockholders as well as
to supply smaller and poorer flows of services
than might be expected in a competitive context.
Of course, there is no perfectly competitive market for utility services that might generate
standards of price and output quality for the
non-competitive markets that commissions regulate. The regulators must look to competitive
capital markets for their criteria.
The common regulatory rule is that a utility
qualifies as competitive if the aggregate market
value of its equity issues is in line with book
value of net worth. Presumably then stockholders can realize, from the anticipated earnings of
their company, the rate of return that accrues
to stockholders of competitive and unregulated
industry. The rule guarantees that inflation will
reduce the market price of the utilities' stock
issues relative to prices for equities of unregulated firms. The reason is, of course, that the
equity market anticipates inflation in some degree-imperfectly in the short run, more adequately in the long run-and arrives at a rate of
return for unregulated industry that tends to
equate market value of equities with the reproduction cost, not the book value, of net worth.
Regulation depends on book value as the right

criterion for market value of utilities' net worth
while the free capital market, adapting to inflationary experience and expectations, depends
on reproduction cost. Here is another case in
which an old price distorts capital markets during inflation.
Keran's results demonstrate that, during inflation, the market values of utilities' equity
issues take the same path as the market prices
of old bonds. Book value of net worth is comparable with· the initial price of a bond, and
"fair return" is comparable with the bond's contractual interest yield. When unanticipated inflation sets in, the market prices of utility issues
and old bonds must decline, and the effective
nominal rates of return to investors must rise so
that the real rates of return do not decline. Regulatory commissions do not recognize the distinction between nominal "fair return," which
seems to them the appropriate criterion of competitiveness, and real competitive return. The
consequences of their money-illusion are an increase in the cost of new capital to utilities and
retardation of growth in the utilities' productive
capacity. It would be interesting to compare
the relative effects, on growth of power production, of OPEC's pricing policies for petroleum
and the commissions' "fair return" rule.

Disintermediation. Unanticipated inflation
deals roughly with financial intermediation,
shrinking its real and even its nominal volume
of characteristic indirect debt. Variance of inflation necessarily increases the supply price of
equity capital to intermediaries. Whether the
sources of funds are indirect debt or equity issues, their stocks and flows tend to be reduced
in volume, destabilized, and made more expensive. The impact upon savings and loan associations is familiar but not unique among classes of
intermediary; for example, the real value of life
insurance reserves declined during 1967-1974
as· well as in the earlier inflationary periods of
1946-1948 and 1950-1951.
Some intermediaries are victimized along
with taxpayers, public utilities, and others by
the familiar burdens of old assets, old debt, and
14

governmental price-fixing. Their problems are
not unique. Their portfolios are dominated by
long-term bonds and mortgages, acquired at low
contractual rates of interest, and by equities,
acquired before inflation has had its first effect
ofdepreciating equity prices. Unanticipated inflation generates capital losses for them, and it
raises operating expenses other than interest
costs relative to revenues of interest and dividends. Rates of interest on their debt are fixed,
by contract in some cases, by ceiling in the style
of Regulation Q in other cases. When free-market rates of interest are driven up by inflation,
creditors of intermediaries demand liquidation
of their claims in some substantial amounts at
prices fixed by contract or regulation. Unless
someone rides to the intermediaries' rescue,
their plight can be serious indeed, caught as they
are between constant revenues and rising expenses, depreciating assets and liquidation of
debts.
The public eye has been caught by episodes
of disintermediation. They disturb capital formation, at least in terms of its composition, but
the trend of disintermediation during prolonged
dirty inflation may be a source of more fundamental change. It reverses the secular increase
over a century in intermediation relative to direct finance of investment and of government
deficits.2+ For given aggregate ratios of savings
to income, secular disintermediation implies
that alternative modes of finance will develop.
They may include greater reliance on private
self-finance of investment from retained earnings, but that seems improbable while the trend
in after-tax real corporate profits continues
downward. They may include increasing substitution by consumers of durable goods for
financial assets, but that will be damped by the
rising price of energy. Of course, secular decay
of traditional intermediation may stimulate innovation of modes of indirect finance: the Eurodollar market is a case in point. The certainty
is that the government sector will substitute for
private intermediation either by taxation and by
issue of direct government debt to savers or by
proliferation of government financial intermedi-

aries. Inflation's effect on intermediation, like
its effect on taxation, expands the public sector
at the expense of the private. Even if ratios of
savings «(ad investment to income in the aggregate do not fall, the pattern of investment must
change, with emphasis 011 the production of
merit goods and public goods. Inflation and
government constraints, such as Regulation Q,
tend to shrink private intermediation, and government intermediaries are slipped into the financialgap, with at least qualitative effects upon
capital accumulation. e"
Decline in the real growth rate of their resources induces private intermediaries to innovate. Pension funds develop variable annuities;
mutual funds proliferate in variety; savings and
loan associations introduce long-term deposits
and payments services. Then there is pursuit of
these innovations by new government regulations. One may suggest the principle that government, imposing inflation, induces private financial innovation and pursues it with a net of
new regulations. Dirty inflation is a stimulus
both to growth of government finance and to
government regulation of private finance.
Palliatives and remedies for dirty inflation
Three ways of dealing with dirty inflation
come to mind: live with it, cleanse it, stop it.
This disease of the price system might simply be
endured or tolerated except for the probability,
discussed first below, that it gets worse when
treated with benign neglect. Alternatively, society might try to cleanse it and transform it to
immaculate or clean inflation. We consider
some cleansing techniques, such as indexing in
the second section below. Then the discussion
turns to methods and costs of stopping inflation.
Convalescence can be expensive.
Dynamics of Inflation. Inflation in the United
States is not damped, tending to wear itself out,
nor does it tend toward a steady state. It is a
rhythmic process, and the rhythm tends to become more violent. The driving force is fiscalized monetary policy. Fiscal deficits run in
cycles of increasing amplitude, and the Federal
Reserve, together with other central banks, fi-

15

both financial and non-financial sectors. It
would seem that rejuvenation of these relics
from the past could reduce inflation's costs substantially. In fact, there have been numerous
experiments with rejuvenation since at least the
early eighteenth century, and now it appears
that their use is spreading. 2G
Rejuvenation of an old price simply by
moving floors under it and ceilings over it is the
simplest of "corrections." Foreign-exchange
rates can be floated; usury and rental ceilings
can be lifted and Regulation Q discarded;
utility rates might be allowed to find their own
levels, and union contracts might be renegotiated oftener. Some of these corrections do
occur, at some times and places, but always in
the face of strong resistance.
Objections to turning prices loose, for markets to determine, are familiar. One is that
there are social costs. So frequent adjustments
of labor contracts would waste resources on bargaining and negotiation. Release of utility rates
from the control of regulatory commissions
would permit producers to exercise monopoly
power. Floating the dollar cleanly would disqualify it as a payments medium internationally
and raise costs of trading. Another familiar objection is that increases in liberated prices would
aggravate inflation of other prices. They would
add cost-push to demand-pull as a source of
inflation. A third objection is recurrent, that
there would be unfortunate results in terms of
equity: the poor would pay rents, interest rates,
and utility rates that they can ill afford. Still
another objection is that, without Regulation Q,
financial institutions would compete themselves
into insolvency and crisis. Good and bad, these
objections and others have such strong appeal
that this cleansing technique, turning old prices
loose, is not used effectively.
When markets are not trusted to correct old
prices, corrections are sometimes imposed by
public authority. Rules are adopted for the
linkage of controlled individual prices with market-basket indexes of free prices. The rules
vary. For example, they may link single prices
with cost-of-living indexes, indexes of wholesale

nances the deficits by issue of high-powered
money including currency and reserves of commercial banks. There is another, complementary force at work; namely, lags in the rate of
inflation behind changes in unemployment rates
and in real national product.
When growth in real national product is near
its cyclical low point and unemployment is at
its high, automatic fiscal processes increase federal deficits, and the Congress authorizes discretionary increases in spending and decreases
in rates of taxation. The discretionary measures
take effect, in the main, after recovery of output
and employment has begun. The Federal Reserve applies downward pressure upon interest
rates, as seems necessary for economic recovery,
by taking Treasury issues into its own portfolio,
and the volume of purchases increases well into
the recovery. Low interest rates in this country
and rising aggregate demand for goods and services including internationally traded items generate deficits in the official settlements account
of the balance of payments. Then a share of
fiscal deficits here is financed by central banks
abroad.
Cyclical recovery, with its rising output and
rising rate of inflation, eventually reduces fiscal
deficits. As deficits decline and as the rate of
inflation rises relative to growth of output,
monetary policy becomes restrictive. It is most
restrictive after the peak of the business cycle
and, in pursuit of accelerating inflation, depresses output and employment. When inflation
has been reduced and when unemployment has
reached unacceptable levels, the cycle of fiscalized monetary policy is over, and a new one is
ready to begin. Successive troughs of output
and employment occur at higher price levels and
rates of inflation, and the monetized deficits are
larger for each percentage point of unemployment. Fiscalized monetary policy generates unstable inflation along with a rising trend of inflation. The remedy is not benign neglect.

Cleansing Techniques. Old assets, debts,
contracts, prices, and tax schedules are the
source of numerous inflationary distortions in
16

prices, or foreign-exchange rates. They may
link single prices with experienced or anticipated change in general indexes. The linkage is
sometimes complete, sometimes partial or fractional. Price adjustments may be frequent or
infrequent, at regular or irregular intervals.
There is opportunity for administrative discretion, and it is commonly used for a variety of
purposes including production and export incentives for sellers at managed prices, income
redistribution, and fiscal effects. It can be and
usually is a technique of official intervention in
real aspects of economic behavior. 27 Then, of
course, it is not a cleansing technique.
Rejuvenation of old debts by indexing is
familiar where inflation has been unstable along
a rising trend. It is a way, perhaps, of reducing
the liquidity premium on securities of longer
terms and of pre~erving markets for them. It
might be a way of limiting or preventing disintermediation when market rates of interest rise.
It might give some protection to creditors
against redistribution of income and wealth to
debtors. The technique is to adjust each contractual payment on an old debt, for interest and
principal, to change in some index, partly or
completely, often or infrequently. There has
been no consensus about the appropriate index:
a short-term rate of interest, a foreign-exchange
rate, an index of commodity prices, and other
indexes have been tried.
Presumably the ideal correction for bonds
would protect the proportion of the creditors'
claims to the market value of wealth that they
have helped to finance. It would adjust the market value of claims in the same degree as inflation changes the market value of underlying
wealth. Any adjustment larger or smaller than
this would redistribute wealth between creditors
and equity-owners. However, there is no index
of inflation's and only inflation's effect on market values of wealth. Furthermore, since dirty
inflation tends to reduce market values of some
large aggregates of wealth, such as corporations,
the ideal correction could be punitive for creditors. The effect would be to increase the liquidity premium on long-term issues, not to reduce

it, and to shrink the market for such issues, not
broaden it.
Current yields on bonds and mortgages have
been adjusted to such indicators as market rates
of interest on short-term securities, including
Treasury bills. This variety of correction is
clearly defective. Change in the current or imminent rate of inflation is not the only component of change in bill rates. They can rise
because the central bank is constraining growth
of the money supply. They can rise, too, because the real national product is rising or because bill rates abroad are going up. Indexing
to bill rates does not cleanse yields on bonds
and mortgages and put them at levels which
would prevail during immaculate or clean inflation.
Argentina, Brazil, Canada, Denmark, the
Netherlands and other countries have developed
various styles of correction for nominal assessment values in property taxation as well as for
nominal exemptions, deductions, and income
brackets in income taxation. 28 It is not uncommon, in business taxation, to permit indexing of
depreciation charges, inventory valuations, and
capital gains. Corrections are imposed or permitted for a variety of purposes; to protect the
real value of tax collections, to manipulate the
value of collections, to protect the poor against
erosion of tax concessions, to prevent double
progression, to encourage business capital formation. Choice of correction indexes has varied,
from cost-of-living indexes to minimum wage
rates and foreign-exchange rates. There can be
no pretense that the corrections purge tax systems of distortion by inflation. The corrections
change the impact of unstable inflation.
All prices, taxes, and contracts are indexed in
a model of immaculate inflation. However, unstable inflation cannot be made immaculate by
indexing. One reason is that unstable inflation
involves different rates of response among individual prices to aggregate effective demand.
Then there is no neutral index of change in
money's purchasing power. Another reason is
that initial costs of indexing are not small: some
substantial investment is required in bargaining
17

about precise forms of insurance against the
contingency of inflation. Again, unless all contracts are on short term, indexing can increase
downward rigidity of prices and increase the
cost, in terms of unemployment, of shifting
from higher to lower inflation rates."" Finally,
it appears that government simply cannot resist
the temptation to manipulate indexing for social
objectives. Indexing becomes another instrument for aggrandizement of the public sector. 30,31

of its market rates of interest. There would be
indexing, too, of bases for federal taxation including especially brackets for progressive income taxation. The preferred index would include only prices for a basket of government
purchases. Furthermore, the federal budget
would include estimates of revenues from the
inflation tax. Finally, on the fiscal side, the
Federal Reserve would be required to pay interest, at a rate indexed to Treasury bill rate, on
members' reserve balances. The purpose of
these measures is to impose new constraints on
government expenditure in later phases of
cyclical recovery and to provide new incentives
for shifting the expenditure to recession and
early recovery. If the central bank were addicted to even-keeling, protecting interest rates
against disturbance from government financing,
its interventions would perhaps be cyclically
stabilizing, accelerating monetary growth in recession and early recovery, decelerating monetary growth in later phases of recovery. Evenkeeling, to stabilize market rates of interest, may
stabilize more important things, such as output
and employment, if it happens at the right time.
However, the second element of the damping
program would preclude even-keeling in the
money markets. It would impose, by legislative
prescription, a rule for steady growth of the
monetary base in the range of 6 to 8 percent
quarterly. Evidently, it sounds the melancholy notes of "taps" over six decades of experimentation in the United States with flexible, discretionary monetary policy. It takes the case
as proved by experience with monetary policy
in, for example, 1920,1931,1937,1957,1966,
1969, and 1972-1974 that contrived discontinuity of monetary growth is destabilizing. The
case for steady growth does not deny that control theory can design some superior rule of
money management in an hypothesized economy. It denies simply that monetary management will find and apply a superior rule before
public patience is exhausted.
The 6-8 rule, in combination with any reasonable trend of high-powered money's income
velocity, is compatible with an attainable growth

Damping. It one prefers cures to palliatives
for unstable inflation, three severe treatments
may be considered. They are damping, to stabilize the price level's growth path; financial
deepening, to r.educe the slope of the path; and
formalized linkage of monetary with fiscal policy, to fix the locus of responsibility for inflation.
These treatments work best in combination. In
the following paragraphs, we describe the first
two treatments in some detail, leaving discussion of the third treatment for another forum.
The rhythm of the American economy in the
past decade has consisted of an up-beat, driven
by fiscal and monetary ease, to correct unemployment at the cost of some inflation, and a
down-beat, driven by fiscal and especially monetary tightness, to correct inflation at the cost of
some unemployment. The rhythm appears to
be anti-damped so that successive rounds of
fiscal-monetary measures generate more inflation, in the process of reducing unemployment,
and more unemployment in the process of reducing inflation. One damping technique is
sheer sadism. It maintains monetary restraint,
at high levels of resource unemployment, long
enough to erase memories and expectations of
inflation. Experiments with this technique in
countries where anti-damped cycles have continued for a decade and more have been painful
indeed. The technique is applied at high risk of
social discord.
A preferable damping program would have
two elements, one fiscal and one monetary. On
the fiscal side, longer-term government debt
would be indexed, its yields linked to an index

18

rate of real national output and growth rate of
the price level that does not offend public taste
and tolerance. Its purpose is to take advantage
of the long-run neutrality of money that seems
to characterize the American economy, permitting the growth path of real output to cling more
closely than in the past to the path of resource
supplies and technology. Any inflation that results would at least be clean.
Deepening. When variance of fiscal deficits
and monetary growth rates, price levels and
output levels, interest rates and foreign-exchange rates has been increasing for a decade,
damping can hardly be expected to reduce it
quickly. Even before damping has been effective in straightening the paths of inflation and
output, deepening can be put to work in reducing the mean growth rate of inflation and raising
the mean growth rate of output. First straighten
the paths and then tilt them.
It is difficult not to be pessimistic about prospective relative changes in the price component
(P) and the output component (T) of growth
in nominal national income. The probability is
not small that, without effective "real" policies,
growth in nominal expenditure at the rate permitted by the 6-8 rule (M) and by the trend in
velocity of high-powered money (V) will raise
(P) relative to (T) as the years go by. Each
determinant of (T) is cause for worry. For one,
the cost of capital, which was falling from World
War II to the nineteen-seventies, seems to be
rising. 32 Again, the cost of labor inputs is under
upward pressure by, for example, minimum

wage laws and labor oligopoly. Still again, the
outlook is not bright with regard to terms of
trade for imported raw materials. There appears, moreover, to be retardation in technological change that economizes factor inputs. Costs
of intermediated inputs by government do not
decline. While all of these determinants of (T)
and some others are worrisome, only the cost of
capital and, marginally, the efficiency of capital
allocation concern us here.
Growth of capital relative to labor, or capital
deepening, obviously is inhibited by the cost of
capital. There are some things to do about deepening. Of course, damping inflation is one of
them. It would reduce the risk component of
the supply price of capital, invigorate financial
intermediation, and draw capital away from uses
that dirty inflation makes attractive. Another
deepening technique is a shift in the balance of
government budgets from the deficit to the surplus side, in the manner of Germany, Japan, and
other countries. A third technique is equilibrium pricing of the dollar in foreign-exchange
markets, avoiding the over-valuation that induces capital flight. The American economy,
one knows, resists pressures to increase the national ratio of savings to income, but incentives
to reduce the ratio can be eliminated. Since the
United States has used inflation to force savings
from holders of dollars here and abroad, one
knows there is excess demand for savings at full
employment of resources and at a modest rate
of growth in output. Deepening is an essential
substitute for the inflation tax.

19

FOOTNOTES
20. The impact of double progression on capital values of
income-producing assets is analyzed in Eric Schiff, op. cit.
21. Richard A. Musgrave and Peggy B. Musgrave, Public
Finance in Theory and Practice, pp. 288-289.
22. According to Friedman, "The great German economic
miracle of 1948 was produced simply by the elimination of
price controls. Ludwig Erhard, then the economics minister,
removed all the price controls one Sunday afternoon. He
did it on Sunday, because the offices of the American, British, and French occupation authorities were closed on Sunday, and he was sure that they would have countermanded
his order if they had been open." Milton Friedman, "Monetary Policy in Developing Countries," Nations and Households in Economic Growth (Essays in Honor of Moses
Abramovitz: David and Reder, eds.) p. 274.
23. Michael W. Keran, "Inflation, Regulation and Utility
Stock Prices," Bell Journal of Economics, (forthcoming,
Spring 1976).
24. Simon Kuznets, op. cit., pp. 421-423.
25. Joint Economic Committee, Achieving Price Stability
Through Economic Growth, December 1974, pp. 56-74.
26. For discussions and for references to a large literature,
see: Robert P. Collier, Purchasing Power Bonds and Other
Escalated Contracts, Utah University Press, 1969; Albert
Fishlow, "Indexing Brazilian Style: Inflation without
Tears?" Brookings Papers on Economic Activity, I, 1974,
pp. 261-282; Edward Foster, "Costs and Benefits of Inflation." Studies in Monetary Economics, Federal Reserve
Bank of Minneapolis, 1972; Milton Friedman, "Using Escalators to Help Fight Inflation," Fortune, July 1974, pp. 9497, 174-176; Herbert Giersch et al., Essays on Inflation and
Indexation, American Enterprise Institute, 1974; Jai-Hoon
Yang, "The Case for and Against Indexation," Review,
Federal Reserve Bank of St. Louis, October 1975, pp. 2-11.
27. Albert Fishlow, op. cit., p. 268.
28. Amalio Humberto Petrei, "Inflation and Personal Income Tax," Finance and Development, September 1974,
pp.38-41.
29. William Fellner, "The Controversial Issue of Comprehensive Indexation," in Herbert Giersch et. al., op. cit., pp.
64-68.
30. Albert Goltz and Desmond Lachman, "Monetary Correction and Colombia's Savings and Loan System," Finance
and Development, September 1974, pp. 24-26.
31. This paragraph comes very close (inadvertently!) to
plagiarism of Ludwig von Mises, in his The Theory of
Money and Credit, English edition, 1935, pp. 406-407. The
criticism of indexing had appeared in the German edition
of 1924.
32. William D. Nordhaus, "The Falling Share of Profits,"
Brookings Papers on Economic Activity, 1974, I, pp. 200,
212,215.

1. Page 460.
2. Nordhaus, for one, seems to say that Kuznets was wrong:
"There is, however, no evidence that the allocational effects
of the mild inflations observed in advanced countries are
significant." William D. Nordhaus, "The Effects of Inflation on the Distribution of Economic Welfare," Journal of
Money, Credit and Banking, 1973, p. 465.
3. John Hicks, Critical Essays in Monetary Theory, p. 28.
4. The Wall Street Journal, December 4, 1974, pp. I, 24.
5. Ben Branch, "Common Stock Performance and Inflation: An International Comparison," The Journal of Business, January 1974, pp. 48-52.
6. James Tobin, "Monetary Policy in 1974 and Beyond,"
Brookings Papers on Economic Activity, I, 1974, pp. 223227.
7. Henry Kaufman, "Financial Roadblocks to a New Economic Recovery," Hearings, Subcommittee on International
Finance, Committee on Banking and Currency, House of
Representatives, December 3, 1974, pp. 26-37.
8. Michael Keran, "Expectations, Money, and The Stock
Market," Review, Federal Reserve Bank of St. Louis, January 1971, p. 25.
9. Franco Modigliani and Robert J. Shiller, "Inflation, Rational Expectations and the Term Structure of Interest
Rates," Economica. February 1973, pp. 12-43.
10. See Rose McElhattan's article in this issue.
11. Harry G. Johnson, Inflation and The Monetarist Controversy, pp. 26-35.
12. Michael W. Keran, "Forecasting Stock Prices," October
1974.
13. For conclusions compatible with Keran's, see Bruno A.
Oudet, "The Variation of the Return on Stocks in Periods
of Inflation," JOl/rnal of Financial and Quantitative Analysis. March 1973, pp. 247-258.
14. G. L. Bach and James B. Stephenson, "Inflation and
the Redistribution of Wealth," The Review of Economics
and Statistics, February 1974, pp. 1-13.
15. Solomon Fabricant, "Inflation Accounting: Issues for
Research," National Bureau of Economic Research, 54th
Annual Report, pp. 10-15.
16. George Terbough, Essays in Inflation, pp. 53-54.
17. G. L. Bach and James B. Stephenson, op. cit., pp. 11-12.
18. Frank T. Weston, "Adjust Your Accounting for Inflation," Harvard Business Review, January-February 1975,
pp.22-29.
19. G. L. Bach and James B. Stephenson, op. cit., pp. 12-13.
See also Eric Schiff, Inflation and the Eaming Power of
Depreciable Assets, American Enterprise Institute for Public Policy Research, 1974, p. 28.

20

Joseph Bisignano
The period of the early 1970's was unprecedented in 20th century economic history in the
amplitude and variability of the behavior of consumer prices. The U.S. economy experienced a
rapid rate of inflation which sent shock waves
through real disposable personal income and
consequent ripples through savings and expenditure decisions. From the fourth quarter of 1973
to the first quarter of 1975, constant (1958) dollar disposable personal income fell from $622.9
billion to $591.0 billion. In per capita terms,
real personal disposable income declined by 6
percent over this period.
The intent of this paper is to analyze the effect
of the recent inflation on personal savings behavior. We begin by presenting a simple graphical analysis of a consumer's response to inflation
where it is assumed that consumers have a preferred real wealth - real income relationship
which they attempt to restore whenever actual
behavior departs from desired wealth-income
behavior. We also view evidence of the effect of
inflation on the real value of financial asset holdings of the public. The distinction is made between anticipated and unanticipated inflation
and the effects of each on personal savings behavior. A crude measure of these two types of
inflation indicates that a large portion of inflation in recent years has been unanticipated by
the public.

a bond will simply equal the inverse of the current market interest rate. The nominal value of
aggregate wealth will be given by
W M + Blr
(1)
where W is aggregate nominal wealth, M the
nominal value of money, B the total number of
bonds (each paying a one dollar coupon) and
Blr the nominal market value of bonds held by
the private sector. Deflating aggregate wealth
by a measure of the "general price level" we
obtain a measure of "real financial wealth," or
W = M +

1!

(2)

P
P
rP
The accumulation of wealth by an individual
or a society is not a random process. Individuals
have different savings behavior over their lifetimes and over business cycles. The rate of savings is greatly dependent on the level of wealth
and the relationship of wealth to income. Since
the value of wealth changes with changes in
aggregate prices, it would be expected that savings behavior would respond to changes in real
wealth induced by changes in prices.
If we broaden our definition of financial assets to include financial claims on real capital,
such as equity securities, we obtain a definition
of nominal wealth as follows:
W

=

B

M + -

r

+ -(IE

(3)

where we have added E, the expected earning
stream from capital discounted by a market determined "discount rate." The discounted earning stream is the value of privately held shares
of stock. The deflated version of (3) would
yield a measure of real financial wealth.
The desired money-income concept can be

A framework for analysis
To begin eur analysis let us consider an economy where there are two types of financial assets, money and government bonds. If we
assume, for convenience, that all bonds are perpetuities paying $1 coupons, then the price of

21

Chart I

broadened to include other forms of financial
wealth, resulting in a desired wealth-income relationship. The economic foundations underlying desired wealth-income behavior are quite
complex and will not be investigated here.!
What will be undertaken is to define in very
simple terms a consumer's "equilibrium"
wealth-income ratio and a description of the
mechanics by which the consumer restores his
desired· ratio after he is displaced from it by
some exogenous force, such as inflation.
How do we envision the wealth accumulation
process taking place? A simple illustrative answer can be given by considering an individual's
behavior, where it is assumed that the individual
receives a flow of constant real income each
period. He begins the period with a given stock
of real wealth (W IP). Let us picture the individual initially in "equilibrium"; that is, his ratio
of real wealth to real income is at its desired
value.
In Chart I is shown an individual's preference
curves for real consumption and real wealth,
along which the individual is equally well off.
(These preference curves are shown in blue.)
His income each pay period is OY* and initially
we assume that his real wealth is (W IP) * and
he consumes all of his real income, OY*. The
consumer's objective is to reach the highest
preference curve possible, given his real income
and real wealth. The individual may move
along the line ZZ, consuming more than his real
income, OY*, only by drawing down his real
wealth. Notice that the sum of an individual's
weekly income and his initial wealth gives us
the total amount of possible consumption, OZ.
His preference function for consumption and
wealth, UU, places him in "equilibrium" at F.
He is said to be in "equilibrium" at F because
at this point he is maximizing his utility; any
other point on the line ZZ would place him on
a lower preference curve. At any other point
on line ZZ there would be the incentive to move
towards F created by the consumer's attempt to
attain the highest utility. The line OX is made
up of the series of tangencies of all his preference functions with "unit budget-wealth lines,"

Real wealth

(W/Pl

Consumer Response to Inflation

z
v

u
(W/Pl* 1--~4
(W/Pl1 1-_

u

parallel to ZZ. That is, lines parallel to ZZ permit $1 of real financial wealth to trade for $1 of
real goods.
Having defined the consumer's equilibrium
we need to explore now the dynamics of his behavior. How will the consumer react if he is
moved away from point F? These simple dynamics create the incentive for the consumer to
change his savings behavior in an attempt to
return to equilibrium at point F. At F the individual consumes all of his income. Now let us
shock the system and describe his behavior.
Let the "shock" be an unanticipated increase
in the general price level. The immediate impact
is to decrease the value of the individual's total
financial wealth, for example, reducing it from
(W IP) to (W IP)". The consumer moves from
equilibrium point F to point A. The consumer's
new budget line is now VV, equal to his reduced
wealth (W/P)O plus his income, OY*. The
maximization of utility will lead the consumer to
choose a consumption point on OX, moving
from A to B, where he will consume OCo and
save BD, thereby increasing his wealth by the
amount of his savings. In the next period he will
again receive OY* in real income (which is assumed constant) and now his opportunities are
such that he may consume anywhere on a new
line parallel to VV and going through the point
D. The act of saving will continue to shift the
budget-wealth line outward and allow the indi-

22

Chart II

vidual to increase his satisfaction, until he arrives at his equilibrium point at F. At F he will
remain there, now consuming all of his income,
unless a price rise or fall should displace him.
This example illustrates that the consumer will
temporarily increase his savings rate in order to
reestablish his desired real wealth-income relationship at point F.
While the above illustration is admittedly
lacking somewhat in reality, because of the assumption of constant real income, it does illustrate a simple conceptual framework within
which to picture individual wealth adjustments
to price changes. Very simply, individuals respond to short-term changes in the real value of
their financial assets by increasing or decreasing
their level of real consumption. This gives rise
to the notion of "wealth effects in consumption,"
where here we have considered the effect on
consumption of changes in real financial wealth.

Real and Nominal (Par) Value of Privately Held
Public Debt*
1950=100

120

120

Nominal

100

100

80

80

Real valuer

60

40

60

5-'--'-'--L-L-L-L.-.LJ--'-.-'-'-_'--'--L-l-i--'_L-L-'-.-LJ-,-L,J

1950

* Less

1955

1960

1965

1970

40

1975

foreign official holdings

cline in real value is understated by way of the
fact that interest rates have risen significantly
since the 1960's, reducing the market value of
privately held public debt. In the early to mid1960's the long-term U.S. Government bond
rate moved between 4 and 5 percent, but moved
up to 7 percent in the first half of the 1970's.
The losses suffered by the private sector in
the government securities market found little
solace in the activities in the equities market.
Between 1965 and 1974 the Standard and
Poor's Combined Index of 500 stocks fell by
6 percent, but when deflated by the consumer
price index fell by 41 percent.
Rises and falls in the general price level
should be viewed as the consequence of the attempts of the private sector to adjust their holdings of real money balances. If real money balances are greater than desired the private sector
can only restore real money balance equilibrium
by pushing up prices, reflected in their excess
demand for real goods. While short-run changes
in the prive level may be influenced by exogenous forces, such as a rise in imported oil prices,
the long-run trend in prices is closely related to
the long-run trend in money growth.
If we consider the aggregate wealth portfolio

Some recent evidence of the wealth effect
A common economic adage tossed out when
discussing the effect of inflation on the value of
financial assets is that debtors gain and creditors
lose. Considering the nominal and real (deflated) value of the federal government's outstanding debt to the private sector, this adage
appears to have held painfully true in recent
years. If we consider the par value of all privately held public debt, that is, public debt held
outside of the Federal Reserve and government
agencies, less the portion of public debt held by
foreign official institutions, we see that federal
government indebtedness to the private sector
has increased by 20 percent from 1950 to mid1975 in nominal (par value) terms but declined
by 45 percent in real terms. (See Chart II.) To
obtain the real value of privately held public
debt we have deflated the nominal par value
series by the consumer price index. In real terms
this measure of privately held government debt
fell from $271 billion in 1950 to $147 billion in
1975.
Although a series on the market value of privately held public debt is not available, we can
readily argue that our observation on the de-

23

of the private sector in this light we notice that
the monetary authorities greatly influence the
quantity of nominal money balances held.
Through their influence on the holdings of nominal money balances they cause the private sector to respond to deviations between desired and
actual real money balances by bidding up or
down prices. These actions in turn cause
changes in the value of real private financial
wealth and the savings behavior of the private
sector.

tax on real money balances which would cause
us to reduce real money demand and increase
goods demand. However, this perfectly anticipated inflation would have no effect on future
allocations because the anticipated inflation is
already reflected in current spending decisions
and market interest rates.
Unanticipated inflation, or "surprise inflation" may, on the other hand, have a significant
short-run effect on spending decisions. Unanticipated inflation represents an unanticipated
decline in the real purchasing power of personal
disposable income and in real wealth. This increased uncertainty in the value of personal
income and wealth causes consumers to retrench
on their spending decisions and increase their
precautionary savings balances. This argument
would lead one to conclude that the larger the
unanticipated inflation, the greater the personal
savings rate, while the larger the anticipated inflation the lower the saving rate.
In order to obtain rough estimates of anticipated and unanticipated inflation we have relied
on Irving Fisher's theory of the relationship between nominal (market) interest rates and
anticipated inflation. Simply stated this relationship is

Personal savings and inflation
A cursory look at the data would suggest that
there is a positive although not always contemporaneous relationship between the personal
savings rate and the rate of inflation. As inflation accelerated in the 1970's over the 1960's,
the personal savings rate out of disposable personal income rose from about 6 percent to
around 7% percent. Personal savings as measured as a percent of gross national product
similarly increased from 4.1 percent in the Sixties to 5.4 percent in the Seventies. During these
two periods the average annual rate of growth
in the CPI went from 2.5 percent to 6.7 percent.
The acknowledgment that the personal savings rate is sensitive to inflation is reflected in the
recent statement by Federal Reserve Governor
Henry Wallich.

rt

=

rrt

+(*);

(4)

where rt is the observed market rate of interest,
rr t the "real rate of interest," and i.e. (P/p)fthe
expected or perfectly anticipated rate of inflation. The observed rate of interest will equal the
real rate only when prices are not expected to
change.
In order to obtain an estimate of anticipated
inflation equation (4) was used. The nominal
market interest rate estimate was provided by
using Standard and Poor's high grade bond
yield. Standard and Poor's composite dividend
yield was used as an estimate of the real interest
rate. Subtracting the dividend yield from the
high grade bond yield provides us with a crude
approximation of anticipated inflation.". This
estimate of anticipated inflation was then subtracted from the actual rate of inflation, our

Personal savings in recent years have amounted to about
one-third of total savings. They have varied with the business cycle but have otherwise been fairly stable at about
5% of GNP. At the present time, personal savings have
tended to rise above these long-term savings rates, probably
reflecting concern of savers about the stability of their jobs,
inflation-induced uncertainty about future living standards,
and an effort to make up for the loss in the purchasing
power of past savings. As inflation abates and the economy
recovers, personal savings, if precedent is a guide, are
likely to move back to their long-term rate. 2

In order to more clearly understand the relationship between inflation and savings behavior
we must make the distinction between anticipated and unanticipated inflation. Perfectly anticipated price inflation to which people have
had time to adjust should be reflected in the
current allocation of disposable income and
have no effect on future allocations. For example, a perfectly anticipated price inflation is a
24

to support the positive savings effect of unanticipated inflation and the negative savings effect
of fully anticipated inflation. Juster and Wachtel
have found that for the period mid-19 54 to mid1971 a one percent rise in unanticipated inflation would increase real ($1958) savings per
household by $21.50.± A one percent increase
in fully anticipated inflation, on the contrary,
decreased real savings by $15.10 per household.
Chart IV displays the movements in the savings
rate and unanticipated inflation since 1960.
While these two series do not always move together contemporaneously, the average personal
savings rate has moved up significantly during
the 1970's as the average rate of unanticipated
inflation has increased. These results suggest
that there is an important empirical as well as
theoretical distinction to be made between fully
anticipated and unanticipated inflation when
discussing the effects of inflation on personal
savings.

Chart III
Annual %

Recent History of Inflation

rate of growth

10 r - - - - - - - - - - - - - - - - - - - , 10

Unanticipated inflation

~

8

6

4

2

-2

-2

measure being the CPI, thereby obtaining an
estimate of the unanticipated rate of inflation.
Chart III plots our measures of anticipated
and unanticipated inflation. During the first half
of the 1960's anticipated inflation went from
about one to two percent. In mid-1967 anticipated inflation grew rapidly and reached four
percent by 1970, after which it appeared to
stabilize between 4 and 5 percent.
A look at the unanticipated inflation component displays how the public gradually
learned to adjust to price rises. From 1960 to
1967 unanticipated inflation averaged less than
one-half percent and then rose to an average 2.2
percent from 1968 to the third quarter of 1975,
indicating that a large element of the recent inflationary experience was unanticipated. During
the early 1970's people began to anticipate price
changes with some degree of accuracy and unanticipated inflation fell, actually becoming negative in 1971 and 1972 during the period of
wage and price control. After that, however,
actual and unanticipated inflation sky-rocketed,
the latter exceeding 9 percent in 1974. This rise
in unanticipated inflation is a major reason for
the average personal savings rate in excess of
8 percent from 1973 to 1975.
There is also some solid statistical evidence

Chart IV
Annual %
rate of growth

Unanticipated Inflation and the
Personal Savings Rate

Percent

8
Unanticipated inflation

...

6

4

10

2

8

-2

L-L-L-L--'-----'------'----'---'-----L---L---L-....L-L-L-J

1960

25

1965

1970

4

1975

FOOTNOTES
1. The article by Kurt Dew in this issue explores in more
detail the economic arguments lying behind a desired income-wealth relationship.
2. Statement by Henry C. Wallich, Member, Board of
Governors of the Federal Reserve System, before the Joint
Economic Committee and the Senate Select Committee on
Small Business, Washington, D.C., November 21, 1975.
3. For a more detailed discussion of this use of the Fisher
equation see Michael Keran, "Inflation, Regulation and
Utility Stock Prices"; Bell Journal of Economics (forthcoming, Spring 1976) and S. B. Gupta, "The Portfolio
Balance Theory of the Expected Rate of Change of Prices,"
Review of Economic Studies, April 1970.
4. "Inflation and the Consumer," F. Thomas Juster and
Paul Wachtel, Brookings Papers on Economic Activity,
No.1, 1972.

Summary
The attempt by consumers to maintain a desired relationship between real income and real
wealth has resulted in a rise in the personal savings rate in the 1970's. The rise in unanticipated
inflation from the mid-1960's is one reason for
the rise in the personal savings rate. The only
period in the 1970's which saw a significant decline in the personal savings rate was the same
year, 1972, in which unanticipated inflation fell.
The personal savings rate in 1975 will average
in excess of 8 %, This savings rate can only be
expected to decline when there is a prolonged
decline in unanticipated inflation.

26

Rose McElhattan
Term structure is the name applied to the pattern of yields on securities which differ only in
their term to maturity. There are rather obvious
reasons why market yields on different securities
should not be the same, aside from maturity
dates. Among the more important factors would
be default risk, tax considerations, differences
in coupon rates and marketability. Very simply,
term-structure theory concentrates upon why
securities which are alike in all respects, except
in their term to maturity, should provide different market yields.
Term-structure theory can be used to explain
the spread between long- and short-term interest rates or to explain the determinants of a
long-term rate of interest. In this paper, we
focus upon the latter application. Our analysis
concentrates upon the functional specification
and estimation of a long-term interest rate, specifically the new-issue corporate bond rate.
The term-structure theory used in this paper
is the preferred-habitat model first proposed by
Modigliani and Sutch in 1966. 1 More recently,
Modigliani and Shiller have shown that the
measurement of the term structure, based upon
this theory, can be significantly improved when
explicit allowance is made in the original
Modigliani-Sutch equation for two additional
factors, designed to measure the expected value
of future inflation and the market's uncertainty
about the future course of interest rates. The
purpose of this paper is to make an addition to
the Modigliani-Shiller equation which is in

keeping with the preferred-habitat theory. We
introduce into the term structure model a factor
designed to measure the impact of changes in
uncertainty about the future course of price inflation on the risk premium.
Our findings support the contention that the
determinants of the risk premium, at least the
systematic part of the risk premium estimated
III the term-structure equation, can be explained
by factors designed to measure inflation uncertainty and the uncertainty with which market
participants foresee future interest rates. We
conclude that inflation uncertainty has been a
significant determinant of the term-structure
risk premium-at least since the latter part of
1954 when our estimation period begins. A
corollary is that changes in inflation uncertainty
have changed the cost of capital investment, and
that monetary authorities should begin to consider the influence of their policy actions on inflation uncertainty. The rest of this paper is
devoted to a brief review of term-structure
theory, the findings of Modigliani and Shiller,
the extension of the model to cover inflation uncertainty, and our empirical results.
Theories of the term structure
The theory of the term structure is not a
settled matter, as is seen from the principal
models advanced to explain the relationship.
Major models of the term structure include the
pure-expectations, the liquidity-premium and
the market-segmentation theories. Modigliani

27

expectations of these rates. Once uncertainty of
future interest rates is introduced in the model,
purchases of a long-term security will involve a
risk of capital gain or loss over the holding
period of the bond. The model further asserts
that market participants are risk averters-that
is, investors prefer to assume less risk rather
than the chance of greater risk for a given expected return. Or, put another way, investors
will assume more risk only if they anticipate
greater expected returns. The twin assumptions
of uncertainty and risk aversion imply that lenders of funds will prefer to purchase short-term
investments in order to avoid the risk of capital
loss associated with holding longer-term securities. Borrowers, on the other hand, generally
have a strong preference for borrowing long,
since borrowing is typically undertaken to finance long-term projects and borrowers wish to
hedge against risk of fluctuations in interest
costs. The theory concludes that if investors are
to hold long-term securities, they must be compensated for the risk of capital loss which they
assume. Under this theory, long-term rates will
be greater than that implied by the pure-expectations theory by this risk or liquidity premium.

and Sutch combined major elements of each of
these to provide a theory of the term structure
which they refer to as the preferred-habitat version of the expectations model, or simply the
preferred-habitat theory. We will briefly review
these several theories, since the term-structure
equations in this paper are based upon the basic
postulates of these models.

Pure Expectations Theory. The pure-expectations theory begins with the assumption of a
perfect or free market in securities-that is a
market in which there are no default risks and
no transaction costs, and in which securities are
free of all other features which would lead one
investment to be preferred to another, such as
tax and call features, different coupons or marketability. In short, securities will be alike in all
particulars except in their maturity dates. In
this market, it is assumed that the behavior of
each participant is motivated by the desire to
maximize profits. The theory also asserts that
although market participants do not know what
actual interest rates will materialize in the future, they do form expectations of what future
short-term rates will be, and they hold to these
expectations with complete confidence. In such
a market, an investor will be able to obtain the
same yield, for a given holding period," regardless of whether he purchases a security with a
maturity date equal to the desired holding period, or any combination of maturities which he
may hold over the same period. It follows that
under such circumstances, the structure of
yields on different securities can be explained by
a very simple relationship-the current yield on
a long-term bond of a given maturity is an average of the current short-term rate and all future
expected short rates over the term to maturity.

Market Segmentation Theory. The marketsegmentation theory criticizes the above assertion that risk-aversion produces only a positive
compensation for risk which must be paid to
holders of long-term securities. This theory emphasizes that investors have different maturity
preferences, and that some lenders prefer longterm rather than short-term investments. Investors, such as life-insurance companies or
pension funds, are concerned with guaranteed
certainty of income over the long run, and risk
aversion on their part would lead to a preference
for long-term securities. Other investors such
as commercial banks would prefer to protect
themselves against the risk of capital loss on
securities, and would thus prefer to invest in
short-term securities. In its extreme form, this
model holds that regardless of the relative interest rate, investors will never shift out of their
preferred markets. Accordingly, the yield struc-

The Liquidity Premium Theory. The liquidity premium theory modifies the above assumption of complete confidence in one's forecasts
of future rates. This theory asserts that market
participants form expectations of future rates
but are uncertain about what actual rates will
materialize, believing that future rates actually
may turn out to be above or below their current
28

ture is determined by the pressure of supply
and demand within each of the segmented markets, since securities of different maturities constitute noncompeting groups.

past actual values. Specifically, the relationship implied by the preferred-habitat model can
be written as:

N

Preferred Habitat Theory. The preferredhabitat model combines elements of all of the
above theories. The current yield on a longterm bond of a given maturity is considered an
average of the current short-term rate and all
future expected short-term rates over the term
to maturity. However, risk premiums must be
taken into account. Different transactors are
assumed to have different maturity preferences,
with risk aversion leading a market participant
to stay in his maturity habitat, unless other maturities offer an expected premium sufficient to
compensate for the risk and cost of moving out
of one's preferred maturity. According to this
theory, the long term rate is expressed as an
average of current and expected short term rates
plus a risk premium, which may be positive or
negative and which can vary with different
maturities.

R

N

=L

t

wI. +

J=O

J

t-J

LvP

j=O

j

t-j

+ Kt

(I)

R = long term bond rate
I = real interest rate
P = rate of change in prices
K risk premium factor
The model implies that the sum of the price
weight ( I v) should be unity, since if past rates
of inflation remained constant over a sufficiently
long time, the expected future rate should tend
to coincide with it. By the same reasoning, the
sum of the real interest rate weights (I w) will
be unity. However, Modigliani and Shiller assert
that the sum of the weights, w, may fall somewhat short of unity if the short term rate is expected eventually to regress toward some longrun normal level. In this latter case, the sum of
the weights on the real interest term would be
less than unity, and a constant positive value
would be added to the equation.
Since the real rate of interest in equation I is
not directly observable, MS eliminate the real
rate from the equation by replacing it with the
nominal rate less the rate of inflation (r - P),
which leads to the following equation:

Modigliani·Shiller formulation
The securities whose yields are described in
the term structure should be alike in all respects
except in term to maturity. Accordingly, Modigliani and Shiller (MS) considered the relationship between the AAA corporate bond rate and
the 4-6 month prime commercial-paper rate.
The preferred-habitat theory leads one to express the AAA corporate bond rate as an average of current and expected future commercialpaper rates and a factor expressing a risk
premium. Since expected nominal rates of interest can be expressed as equal to expected
real rates of return plus the expected rate of
inflation, MS express the expected commercial
paper rate as the sum of the expected real rate
and the expected rate of inflation. In their
model of the formation of expectations, MS
contend that market expectations of future
values are based on the history of past values
of the variable in question. Therefore, expected
values in the term structure model can be replaced with weighted functions of current and

N
R =
t

L

J=0

N
w r .
J

t-J

+.L
J =0

v*P . +
J

t-J

K

t

(II)

where: r = nominal short term interest rate
v* = v-w
The value of the sum of the newly defined
inflation weights (~v*) should be zero if the
sum of the weights w is unity, or should be close
to zero in the case where the sum of these
weights implies an expectation of a return to a
long-run normal rate of interest.
Next, MS represent the risk factor, K, by a
constant term and by a measure of the variation
of the short-term interest rate over the recent
past. The variation in the short-term rate is
considered a reasonable measure of uncertainty

29

We continue this method in all the equations in
this paper, unless otherwise stated.
Modigliani and Shiller's estimation results
are reported in equation 1, Table 1. MS found
a good fit for their equation over the period
1955.3-1971.2, with a standard error of 12.7
basis points. The equation was able to account
for 99 percent of the variation in the long rate,
and the form and the sum of the weights of the
lag structures conformed to the MS model of
the formation of expectations. However, the
Durbin Watson statistic for this equation is
quite low (1.01), which indicates the presence
of positive serial correlation in the error term
and suggests the exclusion from the equation of
an explanatory variable in determining the
spread between the short and long interest rates.

regarding expected future rates. That is, the
greater the variation observed in the short-term
interest rate in the recent past, the greater is the
probability that the actual future rate may differ
from the expected rate. The variation in the
short-term rate was measured by MS by an
8-quarter moving standard deviation of the
commercial-paper rate. Finally, for estimation
purposes, we are able to express the MS equation in the following manner:
N
N
RCB = c + l.~ w.RCP. +.I 0 v*P +
J

J=O

t

RCPSD + u
t

t-J

J=

j

t-j

(III)
t

where: RCB AAA corporate-bond rate
c = constant term
RCP = 4-6 months commercial-paper
rate
P = rate of change in the price deflator
for consumption in the MIT-PennSSRC (MPS) quarterlyeconometric model of the U.S. The deflator
differs from the Implicit Price Deflator for consumption in the NIA
accounts in that consumption in
the MPS model includes depreciation and net imputed rent on consumer durable goods which are
excluded from the NIA calculation.
RCPSD
u=
N=

Removing serial correlation
One factor which may affect the AAA corporate bond rate and which is excluded from
equation I is the favorable tax status of seasoned
bonds represented in the AAA corporate bond
rate. Because coupon-seasoned issues sell at a
discount below par, the holder has a proportion
of his interest income taxed as a capital gain.
With tax rates on capital gains considerably below those on ordinary income, bondholders
should prefer seasoned issues to new issues of
corporate bonds. The favorable tax status of
seasoned bonds, therefore, might be an added
influence on the yield spread. For this reason,
we re-estimated the basic MS equation, using
for the long-term rate the new issue corporatebond rate-rather than the AAA corporatebond rate-in the hopes of reducing if not removing the serial correlation. The results are
presented as equation 2 in Table 1.
First, the Durbin Watson statistic of 1.83
implies the absence of serial correlation, which
supports our contention that the favorable tax
status of seasoned bonds is a factor affecting the
term structure estimation. Next, the remaining
estimation results are consistent with the original MS findings, and support the preferredhabitat model description of the term structure.
Specifically, the equation is able to account for

8-quarter moving standard
deviation of RCP
stochastic error term
18 quarters
=

The length of the distributed lag is 18 quarters for both the commercial paper rate and the
rate of inflation. The coefficients of the 17
lagged values are estimated by Almon's polynomial technique, while the current value of
each variable is estimated separately. This
method was used by MS, since this appeared
the best way to capture the shape of the lag
distribution implied by a combination of extrapolative and regressive elements in the formation of expectations, as suggested by deLeeuw.
30

Table 1

Estimated Term Structure Equations

Eq. No.

Period
oUit
(2)

Dependent
Variable
(3)

RCP
Sum of'"
Lagged
Current
Coeff.
(7)
(8)

Current
(9)

Sum of'"
Lagged
Coeft'.
(10)

.691
15.02

.022
1.16

.304
10.02

.553
11.06

.258
2.30

.316
10.63

.666
3.92

-

-.172
-.479

.323
1.91

-

Constant
(4)

RCPSD
(5)

PSD
(6)

1955.371.2

RCB

.726
9.68

.24
2.00

-

.265
8.28

2

1954.471.2

RCBNI

.724
7.52

.529
3.75

-

3

1954.471.2

RCBNI

.513
3.93

.391
2.62

4

1954.465.4

RCBNI

.793
2.62

5

1954.465.4

RCBNI

6

1954.465.4

RCBNI

7

1966.171.2

RCBNI

8

1966.171.2

RCBNI

(1)

w

.......

9

p

R"

D.W.
(12)

S.E.

(11)

.137
2.21

.993

1.01

.127

.069
2.91

.271
4.30

.987

1.83

.175

.583
11.66

.045
1.78

.264
4.33

.987

1.84

.169

.313
6.44

.553
6.91

.042
1.18

.193
2.38

.899

1.88

.160

.625
3.85

.332
8.02

.769
8.74

.014
.383

.180
2.65

.928

2.38

.136

.338
2.05

.571
4.96

.328
8.23

.733
16.29

.012
.383

.175
2.61

.929

2.33

.134

-4.28
-.88

.822
1.40

-

.170
1.02

2.98
1.44

.123
1.65

-1.62
-1.00

.982

2.88

.168

-2.82
-.664

.743
1.46

.605
2.26

.190
1.32

2.18
1.20

.147
2.25

-.946
-0.665

.987

3.51

.145

(13)

RCBNI
.717
.632
1966.1.987
3.41
.168
1.02
.176
-.241
.141
1.45
2.44
1.23
2.18
3.71
-.747
71.2
Definition of Variables and Sources
RCB
= AAA Corporate Bond Rate
RCBNI
New issue rate, AAA Utility Bond. Federal Reserve Bulletin, Table A36. Data begins in 1960. Before 1960 the series was extended backward using an
unpublished new issue series for all corporations compiled by the Federal Reserve.
RCP
= Commercial Paper rate. Federal Reserve Bulletin, "Money Market Rates, Prime Commercial Paper 4-6 Months." Quarterly averages of monthly figures.
RCPSD = 8-quarter moving standard deviation of RCP.
P
= Annual rate of change in the price deflator for consumption in the MIT-Penn-SSRC Econometric Model of the U.S.
PSD
= 8-quarter moving standard deviation for PSD.
*Method of estimation = Almon Third Degree Polynomial Distributed Lags, constrained to be zero at the left-hand tail of the distribution, 17 quarters.
S.E.
= Standard error of the equation.
D.W.
Durbin Watson statistic.
R2
= Adjusted Correlation Coefficient.
The first line ot numbers represents estimated coefficients; the second line represents the t-statistic of the coefficients.

The vanatlOn in past inflation rates is intended to account for that portion of the risk
premium due to the uncertainty with which market participants view the future course of inflation. We have measured this variation by an
8-quarter moving standard deviation of the rate
of change in prices. As noted above, this is the
same function used to estimate the uncertainty
surrounding the commercial-paper rate. This
variable was introduced into the basic model
and the results are presented as equation 3,
Table 1.
This measure of inflation uncertainty is statistically significant, with a t-statistic of 2.3. The
introduction of this determinant of the risk premium reduces the standard error of the equation
by a small but statistically significant amount.
The inclusion of the inflation uncertainty variable also reduces the value of the constant term,
which as we noted above captures some of the
risk elements not specifically mentioned in the
equation. Once we explicitly introduce the
standard deviation of the rate of inflation into
the equation, we reduce the importance of the
constant term. In addition, some of the risk
premium due to inflation uncertainty had been
captured by the standard deviation of the commercial-paper rate, and the coefficient of this
latter term decreases once inflation uncertainty
is expressly considered in the estimation. This
was to be expected since changes in the standard
deviation of the commercial paper rate had captured changes in the uncertainty with which the
market foresees both future real rates of return
and rates of inflation. When we introduce the
standard deviation of the rate of inflation as a
separate determinant, changes in the variation
of the commercial paper rate are left to reflect
only changes in uncertainty about future real
rates of interest. There are only minor differences in the other estimated coeflicients.

about 99 percent of the variation in the long
rate and, considering the greater variation in the
new-issue rate as compared to the seasonedbond rate, the fit is very close. The equation
predicts the new-issue rate with a standard error
of only 17.5 basis points for the entire sample
period. The sum of the coefficient of the commercial-paper rate is less than unity, and the sum
of the coefficients (v), which represents the
weights in the formation of price expectations,
is 1.20 (the sum of the coefficients in columns 3
through 10) -slightly higher than the 1.12 estimated by MS.
The estimated lag distributions for both the
commercial-paper rate and the inflation rate
also conform to the MS model of expectations;
both indicate that there is a combination of
extrapolative and regressive elements in the formation of expectations of future rates. That is,
extrapolative elements form expectations when
a rise in current rates leads to an expectation of
a further rise and vice versa. Regressive expectations hold when the market expects the interest rate to regress toward a "normal" level based
on past experience. The relatively high weight
on the current values of the commercial-paper
rate and inflation rate, followed immediately by
lower weights, implies that the market expected
some continuation of recent trends followed by
a return towards prevailing past levels. In light
of these results, we will use the yield on newly
issued securities rather than the AAA seasoned
corporate-bond rate to represent the long-term
rate in the rest of this paper.
Introduction of inflation uncertainty

As noted earlier, the determinants of the risk
premium in the basic MS equation are represented by the standard deviation of the commercial-paper rate, while other factors which may
be important in determining the risk premium
are captured in the constant term or the error
term. However, in the spirit of the model,
which considers changes in interest and inflation rates separately, we introduce the standard
deviation of the rate of inflation over the recent
past.

Inflation uncertainty as risk element?
The significance of the variation in inflation
might reflect our economic experience since the
mid '60's. Prices and the variation in the rate of
inflation have been advancing rapidly since

32

then, which suggests that changes in inflation
uncertainty have been only a relatively recent
phenomenon in the term-structure risk premium. The model was therefore tested over the
shorter time span from 1954.4-1965.4, before
the recent rapid advance in prices began.
The term structure equation was estimated
without including the standard deviation of
the inflation rate as seen in equation 4 in
Table I-and then by including that measure
(equation 5). In this earlier period, the fit of
the equation is significantly improved when the
variation in the inflation rate is included in the
explanation of the term structure. The correlation coefficient increases from .90 to .93, and
the standard error over the sample period is
reduced from 16.0 basis points to 13.6 basis
points. Also, the coefficient of the inflation
standard-deviation variable is very significant,
having a t-statistic of 3.85. Once this inflation
risk factor is included, the constant term becomes insignificant. Apparently, during this
period, the risk premium in the term structure
can be explained basically by two factors-the
uncertainty surrounding the future expected
course of interest rates and the uncertainty surrounding the future expected rate of inflation.
When we drop the constant term from equation 5, the significance of the two standard-deviation variables increases, as shown in equation
6. The t-statistic for the standard deviation of
the commercial-paper rate increases from 1.91
to 2.05, and the significance of the standard
deviation of the inflation rate increases from
3.85 to 4.96. These results indicate that, far
from being a recent and novel phenomenon, the
uncertainty with which the market foresees future expected inflation has been an important
determinant of the term structure in the past.

change in the standard deviation of the inflation
rate commands a higher risk premium during
the 1954.4-1965.4 period than over the period
as a whole. The constant term also behaves
quite differently in the two equations. It is
significant over the entire sample period, but
insignificant over the shorter period.
This behavior suggests that we may have improperly identified the determinants of the term
structure for the 1954.4-1971.2 period with
equation 3. Important differences may arise
concerning the contribution of some or all of
the determinants between the earlier period
(1954.4-1965.4) and the later time span
( 1966.1-1971.2). In testing this hypothesis, we
found that a statistically significant difference
had occurred between these periods, and that
equation 3 failed to portray the changing relationship between the long rate of interest and its
determinants.::
We also tested equation 2, the basic MS type
equation, and found that it failed to pass the
statistical test for structural stability for subsets
of its coefficients. In particular, for equation 2,
we could not accept the hypothesis (at the 5 percent level of significance) that the estimated
Almon-distributed lag coefficients for both the
commercial-paper rate and the inflation rate remained unchanged over the two periods 1954.465.4 and 1966.1-71.2. Hence, neither representation of the term structure-the MS type
function (equation 2) or the extended version
with an added inflation-uncertainty term (equation 3 )-remained unchanged over the full sample period. 4 In short, when one functional relationship is estimated over a span of time, in this
case from 1954.4-71.2, it is assumed that the
estimated specification remains unchanged in
different sub-periods within the entire time span.
If this assumption is put in the form of a statistically testable hypothesis, which is then rejected,
we can only infer that significant changes have
taken place in the estimated relationship between the sub-periods which are not captured
in our estimates. We would therefore be misled
by the estimated relationship if we used its results to interpret the importance of particular

Stability in the term structure equation

Some interesting comparisons are evident between the two overlapping periods. Comparing
equations 3 and 5, we note that the coefficient
of the standard deviation of the commercialpaper rate shows little change, unlike the standard deviation of the inflation rate. A given
33

tion of the commercial-paper rate and inflation
rate appear to account for the entire term-structure risk premium in the 1954.4-65.4 period.
We therefore estimated the term structure model
over the 1966.1-71.2 period without the constant term, which was statistically insignificant.
The results are reported in equation 9, Table 1.
Dropping the constant term leads to an estimated regression more in line with what we
would expect. For example, the sum of the
lagged coefficients of the commercial-paper rate
is closer to unity (1.19) and the sum of the
lagged coefficients of the inflation rate closer to
zero (-.065) than in the previous two equations. However, the standard deviation of the
commercial paper rate remains statistically insignificant in determining the risk premium during this time. These results imply that the termstructure risk premium over the 1966.1-71.2
period was basically due to inflation uncertainty.6
Finally, the sample period was ended in
1971.2 because wage and price controls went
into effect in 1971.3 and remained in effect until
the spring of 1974. Thereafter, prices were materially affected by the oil crisis. One would expect that, after 1971.3, other factors in addition
to past history would be material in the determination of prices. Our preliminary results with
later quarters included in the sample substantiate this inference. Since we are interested in
testing the preferred-habitat model and the
model of the formation of expectations, we
chose to end the sample period in the second
quarter of 1971, as did Modigliani and Shiller.

variables in the determination of long-term interestrates for the entire period.
Term structure estimates for 1966.1-71.2
Since statistical tests indicated a significant
change had occurred in the term-structure equation between the two periods, 1954.4-65.4 and
1966.1-71.2, we report the term structure estimates for the latter period, also. The results are
shown in equations 7, 8 and 9 in Table 1.
First, as mentioned above, the statistical test
applied to the MS type equation 2 revealed that
a significant difference had occurred between
the two sub-periods in the estimates of the
distributed-lag coefficients for both the commercial-paper rate and the inflation rate. These
differences can be observed by comparing
equations 4 and 7. In equation 7, the sum of the
weights for the commercial-paper rate is 3.15,
while we would expect them to sum to unity, or
close to unity, as they did in the earlier period
(equation 4). Also in equation 7, the sum of
the coefficients for the rate of inflation is -1.5,
rather than close to zero as expected. However,
none of the estimated coefficients in equation 7
are statistically significant. It appears, therefore, that during the period from 1966.1-71.2,
the MS-type specification of the term structure
does not support the preferred-habitat model or
the MS model of the formation of expectations,
although the opposite is true for the earlier estimation period. 5
Equation 8 reports the results of adding the
standard deviation of the inflation rate to the
basic MS type equation. We find that the addition of the inflation uncertainty measure adds
significantly to the determination of the newissue corporate-bond rate; the t-statistic of the
estimated coeffiCient is 2.26. The addition of
this term has also changed the significance of
the current rate of inflation (column 9). The
coefficient of the current inflation rate is .147
and its t-statistic is 2.25. Along with the standard deviation of the inflation rate, this is the
only other variable which is statistically significant in the determination of the long rate.
We concluded above that the standard devia-

Conclusions
In this paper, we have reviewed the preferredhabitat model of the term structure. This theory
is based upon the hypothesis that the long-term
rate of interest is an average of expected future
short-term rates plus a risk premium-and that
expectations are primarily dependent upon the
history of interest rates and rates of inflation
over several past years. The major conclusion
is that the Modigliani-Shiller specification of
this term-structure model can be significantly

34

improved with the introduction of inflation uncertainty as an element determining the risk
premium.
We further found that a significant change
had occurred in the term-structure equations between the two periods, 1954.4-1965.4 and
1966.1-1971.2. In the earlier period, 1954.41965.4, the term-structure risk premium could
be accounted for by variables designed to mea-

·sure the uncertainty surrounding expected. future interest rates and inflation rates. However,
in the latter period, 1966.1-1971.2, inflation uncertainty remained the only statistically significant determinant of the risk premium. Overall,
it appears that uncertainty costs with respect to
inflation have been a significant factor in the determination of long-term interest rates since
1954.4.

FOOTNOTES

BIBLIOGRAPHY
Culbertson, J., "The Term Structure of Interest Rates,"
Quarterly Journal of Economics, November 1957.
deLeeuw, F., "A Mo~el of Financial Behavior," in J.
Duesenberry, et. al. (eds.), The Brookings Quarterly
Econometric Model of the United States, Chicago, 1965.
Hicks, J. R., Value and Capital, Oxford, 1939.
Klein, Benjamin, "The Recent Inflation and Our New
Monetary Standard: The Mirage of Steady 'Anticipated'
Inflation," prepared for a University of Rochester Center
for Research in Government Policy and Business Conference on Money, Unemployment and Inflation, April 5-6,
1974.
Malkiel, Burton Gordon, The Term Structure of Interest
Rates, Princeton: Princeton University Press, 1966.
Meiselman, D., The Term Structure of Interest Rates.
Englewood Cliffs, N.J., 1962.
Modigliani, F. and R. J. Shiller, "Inflation, Rational Expectations and the Term Structure of Interest Rates,"
Economica, vol. 40 (1973), pp. 12-43.
Modigliani, F. and R. C. Sutch, "Innovation in Interest
Rate Policy," Amnican Economic Review, vol. 56 (1966),
Papers and Proceedings, pp. 178-197.
Nelson, c., The Term Structure of Interest Rates, New
York: Basic Books, Inc., 1972.
Rea, John D., "The Yield Spread Between Newly Issued
and Seasonal Corporate Bonds," Monthly Review, Federal
Reserve Bank of Kansas City, June 1974.

1. Bibliography given in accompanying column.
2. Holding period refers to the length of time between purchase and sale of a security by an investor, regardless of
the maturity.
3. In a recent paper referenced in the bibliography Benjamin Klein addressed the question of whether price
changes have been more predictable since the mid-1950's
than previously. Klein's data extended back to the 1880's.
He concluded that, "although variability in the annual rate
of price change is now relatively low, long-term price unpredictability is significant and the uncertainty costs associated with the current inflation no longer seem to be
trivial." Our regression estimates are consistent with this
conclusion at least as far as we have attempted to measure
the impact of changes in inflation uncertainty upon the
term structure risk premium.
4. The MS equation 1 was also tested for structural stability
over the two periods, 1955.3-65.4 and 1966.1-71.2 and the
hypothesis of overall structural stability (Chow test) was
rejected. at both the 5 and 1 percent levels of significance.
5. Equation 1, the MS equation using the AAA seasoned
corporate bond rate as the long rate, was estimated over
the 1966.1'71.2 period and only the constant term was
statistically significant, with other results similar to those
reported in equation 7.
6. Reestimation of equations 7, 8 and 9 to correct for negative serial correlation did not change' our conclusions.

35

The Capital Market Crowding Out
Problem in Perspective
Kurt Dew
The large Federal deficit of 1975-76 has inspired a critical debate. The issue-to what
extent does deficit-inspire~ Treasury borrowing
replace or "crowd out" private borrowing in
U.S. credit markets? Private borrowing is
crowded out in one sense whenever an increased
Federal deficit inspires the Treasury to raise an
additional dollar in the market for private savings.For that matter, when any borrower enters this market with an increased need for
funds, other borrowers must compete more
keenly, and pay more for available savings. In
this way, credit is rationed and savings increased. The presence of the Treasury in the
credit markets is the direct effect of fiscal policy
upon interest rates, but there are indirect effects
of fiscal policy upon interest rates as well.
This paper, like other discussions of crowding
out, attempts to consider the totality of the Federal Government impact upon capital markets.
To do this we analyze two time periods over
which government policies may have distinct
effects upon capital markets-the short run and
the long run. By short run effects, we mean the
temporary effects of government policies to reduce the impact of a recession-policies whose
effects would be neutralized by other policies at
other stages of the business cycle. An example
would be a recessionary Federal deficit, which
would be offset by a surplus at the peak of the
business cycle. Long run policies, on the other
hand, are at work through all stages of the business cycle. Examples would include the average
rate of growth in the money supply over a
decade, or the tendency of the Federal budget
to be in deficit throughout the business cycle.

In the first part of the paper we analyze the
long-run effects of fiscal policy upon capital
markets. From these conclusions, we move to a
discussion of the effects of short run fiscal stimulus upon an economy in the depths of a recession. The strength of the short-run impact of
fiscal stimulus upon economic growth is still a
matter of debate among economists. Wetherefore present two extreme positions-first the
argument, that fiscal policy.has no impact upon
economic. growth, then the argument that fiscal
stimulus is essential to promote recovery from a
recession. In each of these two cases, we consider the implications of the assumed behavior
of the economy for capital markets and for the
central issue-the question of crowding out.
This leads to some interesting conclusions about
the use of fiscal policy.

The long run fiscal policy effects
To analyze the long run effects of fiscal policy
upon capital markets we consider a permanent
increase in the average level of government borrowing. In our analysis, we draw an extended
analogy, comparing the long run effects of increased government demand upon the market
for capital to the long run effects of increased
government demand upon the market for current production.
What is the long term effect of government
entry into the marketplace? Economists are
generally agreed that if the government increases its expenditures, the long term rate of
real economic growth remains unaffected. That
is, fiscal policy cannot permanently raise the
aggregate demand for goods and services in

36

either real or nominal terms. If government
expenditures increase permanently, the eventual
effect will be that government expenditures will
replace, or "crowd out" an equal quantity of
private expenditures, leaving the rate of growth
in·GNP unchanged..The basis for this proposition is that over the long term, GNP growth
depends upon things more fundamental than
fiscal and monetary policy, such as technology,
individual tastes, and the supply of factors of
production. The long-run neutrality of fiscal
policy effects upon GNP growth also has implications for the effects of fiscal policy upon inflation. Since fiscal policy cannot increase aggregate demand over the long term, it also cannot increase the rate of inflation.
If fiscal policy has a neutral effect upon GNP,
it also has a neutral long-run effect upon capital
markets. That is, a permanent increase in government borrowing may not permanently increase the rate of growth in private saving.
Private saving will remain unchanged from its
long-term trend regardless of the extent of government borrowing. When increases in government borrowing are neutral, in the sense that
they have no effect upon the rate of increase in
private saving, a permanent increase in government borrowing will necessarily create an equal
reduction in private investment. Interest rates
must therefore play a long term role similar to
prices. An increase in government borrowing
has no long term effect upon interest rates because it is offset by an equal reduction in private
investment, leaving the long term net demand
for savings unchanged.
Unlike the government expenditure effect, a
long-term increase in the rate of monetary expansion does have an effect upon prices. Prices
go up, bringing the real value of money balances
in line with long term trends in GNP growth.
Since money growth determines the long term
growth in prices, monetary policy alone can increase nominal GNP. Similarly, while a permanent increase in government borrowing does
not raise interest rates over the long term, a
permanent increase in the rate of monetary expansion does raise interest rates permanently.

This is a result of the well-known Fisher effect.
A permanent increase in the rate of money
growth leads to a permanent increase in the expected rate of inflation and therefore to an increase in interest rates, so that savers may retain
the purchasing power implicit in their interest
payments.
This analysis leads to some reasonable conclusions about the long-term realities of crowding out in capital markets. First, a permanent
increase in government borrowing does not permanently increase interest rates. Instead, there
is a permanent decrease in the level of private
investment at old rates of interest. In other
words, although increased government borrowing in the long run crowds out an equal amount
of private investment, this crowding out does
not result in higher rates of interest, although
the government share of private saving is permanently increased. On the other hand, a permanent increase in the rate of monetary expansion does increase interest rates via the Fisher
effect.
These conclusions appear to fly in the face of
much of the current analysis of the crowdingout question. Often in these analyses-where
the focus is on the short rather than the long run
-responsibility for increases in interest rates,
and therefore for crowding-out, is laid at the
feet of tight monetary policy rather than easy
fiscal policy. The argument is that with sufficient monetary expansion, increased government borrowing need not lead to increases in
interest rates and therefore need not create
crowding out in capital markets.
Indeed, analysts of the crowding out question
frequently base their arguments on one of two
options: (I) assume the Federal Reserve will
decide to create sufficient credit through monetary expansion to hold short-term interest rates
low, so that crowding out will not occur; or
(2) assume the Fed, out of concern for inflation,
will stick to a money growth path insufficient to
hold interest rates down, so that crowding out
will occur.
Our analysis suggests that interest rate increases are, over the long term, a poor measure
37

of the effect of government borrowing on private
borrowers' share of the market for private savings. Government borrowing does not create
crowding out at higher interest rates; rather,
government borrowing leads to a reduction in
the private share of national savings at the old
rates of interest. Therefore, those authors who
consider deficits as placing upward pressure
upon interest rates and monetary policy as placing downward pressure upon rates refer to
short~run phenomena, rather than long~run
phenomena.

and wealth to be "normal" goods. That is, when
income declines, individuals attempt to maintain their current consumption, at the expense
of investment, thereby depressing interest rates.
Savings. will decline as well, due to the com~
bined effects of falling interest rates and falling
income.
The effect of an unexpected decline in wealth
with income unchanged is in some respects sim~
ilar to the effect of a decline in intome. Both
savings and investment will decline.. But again,
because income and wealth are normal goods,
the decline in investment will not be sufficient to
return the relative price of income to its old
level. The rate of interest must increase.
Capital markets are simply the place where
people trade to adjust their claims between income and wealth. If the resources of an economy are reduced, either through a reduction in
present production or through a reduction in
capacity to produce in the future, ind~viduals
will reduce their holdings of both present and
future income. The source of the initial reduction, be it income or wealth, will become relatively more expensive thereafter, until income
and wealth are returned· to their old balance.
In sum, an unexpected decline in income tends
to reduce interest rates, while an unexpected
decline in wealth increases interest rates.
This construction gives us a framework for
determining the short term effects of fiscal pol~
icy upon capital markets, and helps lay bare
the different views of economic behavior that
lead economists to disagree upon the question
of crowding~out. But the analysis skirts some
critical questions. For example: (1) Is a recession simply a decline in income, or does wealth
decline as well? (2) What are the effects of
monetary and fiscal policy upon the levels of
income and wealth?
It would be easier to discuss the relevance
of crowding out if we could be sure of the role
of wealth in the U.S. economy and the effect of
government policies upon it. Unfortunately, it
would also be presumptuous to do so. We will
consider crowding out within the context of two
poles of current opinion, but will find that these

Short term crowding out
While the long-term effects of government
borrowing upon capital markets may be clear,
the short-term effects are not. Private savings
and investment depend upon three basic variables: (1) the current level of income, (2)
wealth, or the present value of the flow of future
consumption, and (3) interest rates, a cost to
investors, but a return to savers. Roughly speaking, interest rates are the relative prices that
bring about the desired balance between present
income and wealth to be used in the future,
while investment measures the amount of present expenditure for the purpose of increasing
wealth.
Short run crowding out depends upon the
relative levels of savings and investment-and
ultimately upon the underlying economic vari~
abIes that affect savings and investment.
We consider first the effects of the variables
income and wealth upon savings and investment, and also their effects upon interest rates.
We consider two cases (1) a temporary decline
in income with wealth unchanged, and (2) a
decline in wealth with income unchanged.
If income should decline unexpectedly, due
to some outside "shock" that did not affect
wealth, what would happen to capital markets?
Without some additional assumptions, we are
not sure. Savings will decline and so will investment, but without knowledge of the relative
magnitude of these declines, we cannot be certain of the effect upon interest rates. In this
circumstance, it is reasonable to suppose income

38

two extremes have an unfortunate propertyone cannot look at the data and tell which is the
correct point of view. We shall suppose that
the economy is separated into three entities :
the household, which earns, spends and saves;
the firm, which organizes production, and distributes capital; and the government, which
spends, taxes and borrows.
Alternative 1: "Deficits do not spur economic
growth" In a world so defined, consumers and
producers behave rationally given the information at their disposal. Their desires are communicated easily and efficiently through signals
transmitted in various markets. Through the
prices they accept and the quantities they trade,
market participants express their accurate judgment of the amounts of each item they wish to
buy and sell, given limitations on their various
resources. A summary measure of the availability of future resources to the consumer is his
wealth, the capitalized value of the income he
expects to receive in the future. Wealth plays
an important role in consumer behavior in this
world where deficits do not "work." It contributes stability to the economy'. When income
declines temporarily in a recession, individuals
react by cutting their spending less than they
would if the decline in income were permanent.
They cut spending relatively little because the
wealth upon which the spending decision is
based depends upon future income as well as
present income. The recession is not expected
to affect income permanently. Since consumers
base their spending decisions upon wealth, consumption'declines less than income and helps
to increase demand for present goods and
services.
This phenomena is the primary force that accounts for the economy's natural tendency to
bring itself out of a recession. In this world, a
federal deficit cannot help the recovery because
deficits do not increase total wealth. A deficit
is government borrowing to be paid out of
future taxes. That is, the government borrows,
gives the proceeds to taxpayers, and pays for
the debt incurred out of future tax revenues. As
a result, lower present taxes are purchased at

the expense of higher future taxes, leaving the
taxpayer with more income during the deficit,
but less income as the deficit is repaid. Over the
long haul, the taxpayer breaks even, so that a
deficit does not increase wealth.
Example of an impotent deficit
Consider the' case of a consumer who expects a disposable
income (income after taxes and transfer payments) of $200
per year in perpetuity. Out of this income, he consumes
$180 and saves $20. Now, as a result of a recession; he
experiences a one year decline in income, say to $150. Since
this decline is temporary, he nonetheless expects to receive
$200 in sU'cceeding years. Our consumer realizes he is
going to be worse off, but sees no reason to bear, the entire
brunt of his misfortune in the present. He therefore decides
to bormw $29 from· past savings' and consumes his entire
income (now $179) in the present, reducing his future
consumption by enough to replace his savings. Assuming
his repayment schedule is to be $1 per year in perpetuity, 1e
will consume $179 henceforth out of an income, net of
interest payments, of $199. His consumption expenditures
in the present have risen fmm $150 to $179, a natural force
for recovery from the recession. However a tax cut would
not affect this consumer's current consumption expenditures.
Suppose he received an extra $':1.9 tax cut at this point. He
knows the government borrowed to pay ,him this $2<;), so
that he will owe $1 more in taxes each year to repay the
government loan. This $29 tax cut enables him to payoff
his previous loan and to replace his $1 interest payment
with a $1 increase in taxes. His reduced private borrowing
is replaced by government borrowing in the same amount.
He still spends $179 per year now and if! the future. Crowd"
ing out has occurred because his private demand for savings
has been replaced by an equal amount of government demand for savings. Interest rates would remain unchanged,
however, since total net borrowing is unchanged.

In this example, the consume.r has already
expressed his preference for present and future
income in the marketplace for savings and investment. In fact, in this exalllple the consumer,
in effect, "saves" his entire tax reduction. But
if the consumer saves the entire proceeds of the
deficit, the deficit will have no, effect upon
sp~nding~and it was to increase spending that
the deficit was incurred in the first place! The
deficit is impotent.
In this world larger government deficits do
nothing except perhaps ease the lot of elected
officials. Consumer spending decisions are unaffected. It is worth noting, however, that while
government borrowing replaces private borrow~
ing in this world, there is no effect upon
interest' rates. For every dollar the Treasury
borrows, consumers save an extra dollar. The
amount of savings available to private borrow-

39

ers is the same as it would have been without a
deficit.
Crowding out is important in this scenario.
Crowding out definitely occurs in the sense that
for every dollar borrowed by the government,
the private sector reduces its net borrowing by
a dollar. But iI).terest rates are unaffected. In
essence, the private sector simply replaces a net
loan from. itself with a loan from the government. This loan takes the form of reduced taxes,
and is repaid in the form of higher future taxes.
In sum, this short-run analysis has the same
implication about a deficit's neutral effect upon
GNP and interest rates as the long-run analysis
does.
Alternative 2: "Deficits are important"
There is another way to look at the worlda way that views fiscal stimulus as very important. This cosmology has been framed by
Axel Leijonhufvud. 1 He posits a crucial role for
government deficits in the smooth running of an
economy, based on the view that a recession is
a communications failure. In this world, the
firm is a creature of the moment. During a recession the firm tends to ignore the possibility
of future pressure upon capacity in deciding
upon current capital expenditures. When use
of capacity is low, this myopic firm does not
take advantage of low interest rates to borrow
ahead for future expansion needs. It waits until
its sales approach its productive capacity before
entering bond and equity markets to fund capital outlays. If the recession is not a permanent
condition, this decision is irrational, since it increases the eventual cost of capital to the firm.
The consumer, according to Leinjonhufvud,
may be guilty of this same sort of myopia. He
does not reduce wage demands as rapidly as the
firm reduces its desires for labor, because he is
not aware that reduced desires for labor are a
prevalent condition, rather than simply a phenomenon peculiar to his own employer. Furthermore in contrast to the consumer of the first
cosmology, he believes the recession-induced
decline in income to be permanent. The result
of this myopia is disastrous. Because producer
and consumer see the recession as permanent,

they lower their expectations of future income
or wealth and make spending decisions accordingly. As a result of (his lowering of planned
spending, the recession becomes permanent!
This permanent decline in income has an interesting property. If consumers and producers
could be persuaded that a decline in income and
spending is temporary, it would in fact be temporary. Thus they need some outside force to
increase their incomes. In the right circumstances, an increase in income will be seen as
permanent and therefore will be permanent,
since the economy has the ability to sustain such
an increase once it is set upon the right track.
This is the critical role of the deficit. When a
tax cut increases income temporarily, the effects
of the added future taxes are not important,
because the consumer expects his income to rise
to a greater extent than his tax bill, thereby making him better off despite the extra tax payments.. An example of the· behavior of a consumer in Leijonhufvud's world helps to clarify
this notion.
/~

Example of an effective deficit

Consider the consumer of example 1. He expects to make
$200 per year in perpetuity. A recession reduces his income
to $150. Because he views this reduction as permanent, he
considers himself to be permanently poorer. He therefore
reduces spending. His new level of spending is consistent
with lower total wealth and lower income. There is no
reason to expect this economy ever to return to the old level
of income~ At this point we suppose the government introduces a $50 tax cut, raising the consumer's disposable income to its old $200 level. Since the myopic consumer views
this increased income as permanent, he revises his plans
and assumes a permanent flow of income of $200. He will
be slightly disappointed since his taxes will go up to some
extent to repay the government borrowing-his future disposable income will actually be about $199 per year, the
same as the consumer in the first example-but he will be
far better off than he would have been, had there been no
tax cut.

Crowding-out is more a problem in the
Leijonhufvud cosmology than in the world of
impotent deficits. The deficit in our second example is a large one, sufficient to restore the
consumer to his old level of disposable income,
but $20 of this increase in disposable income is
saved, so that only $30 of the deficit is required
in additional savings to support it. Interest rates
will therefore rise to induce the additional
savings.
40

In the world where deficits matter, crowdingout in the. form of. higher interest. rates is a
serious possibility. Indeed, a tax. Cl,lt serves to
increase. present income, but it has no direct
effect ·upon wealth. As indicated earlier, in the
case of increased income •with wealth unchanged, interest rates will rise, bringing a recovery to a premature halt.• In this circumstance
it is necessary to induce an increase in wealth
as well, to convince the consumer· that. his increased income is permanent. This goalll1ay be
accomplished through expansion in the money
supply, since money is part of total wealth. For
this reason Leijophufvud gives monetary policy
an important role in government anti-recession
policy.. As the qu~ntityof money expands,
wealth increases and future taxes decline because of reduced government borrowing from
the private sector. As wealth increases relative
to income, interest rates fall, and the recovery
is undeFway.

fiscal stimulus (which actually had no effect)
and monetary stimulus (which does affect income indirectly through its effect upon wealth).
In the second world, where income increases
because of fiscal and monetary stimulus, government's share of savings is increased through
a deficit-financed tax cut, but the level of private
investment is actually higher than it would
otherwise be. Fiscal and monetary policy have
permanently increased both income and wealth,
and have •therefore increased private saving
enough to leave plenty of added savings for the
private sector. Although the government slice
of the savings pie is greater, the pie itself has
grown through fiscal and monetary stimulus.
What's a policy-maker to do?
This picture of the uncertain effects of fiscal
stimulus seems to leave the policy-maker very
much at sea. To leave this impression would
be unjust. In fact, the choice of policy at any
given time is less doubtful than the above analysis suggests because the risks involved in being
"wrong" about. the effects of fiscal stimulus are
far from symmetrical. If the Alternative 1 is
correct-i.e., deficits are not stimulative-and
we choose Alternative 2, no important adverse
effects will occur. Households will simply reduce private borrowings by an amount equal to
the Government deficit. However, if Alternative 2 is correct-i.e., deficits are stimulativeand we choose Alternative 1, there will be a
more severe recession than otherwise. In this
circumstance the sensible policy response is to
assume deficits are stimulative and reduce taxes
in a recession. What is needed is a balanced
government budget or surplus at the peak of the
business cycle to reduce the long-term government demand for private savings to its prerecession level.
Furthermore one important assumption underlying the theory that fiscal policy does not
stimulate recovery is actually mistaken. Government borrowing implicit in fiscal policy is
not a perfect substitute for private borrowing.
The risks involved in a loan from one private
citizen to another are greater than the risk of

Who is right?
With. differences of opinion of this magnitude,
one wo tl1d expect that by looking at the behavior
of the economy during a recession, we could
draw some broad conclusions about the comparative strength of the two opposing positions.
Unfortunately this is not an easy matter. First,
fiscal policy is "automatically" stimulative during a recovery. Indeed, a large part of the increased deficit during a recession has little to do
with the policy maker's intent to stimulate the
economy, but is rather a consequence of the
structure of pre-recession legislation governing
Federal payments and receipts. This "automatic" portion of the deficit occurs largely because of the decline in tax receipts associated
with the recessionary decline in income, and because of increased expenditures associated with
various measures intended to reduce the burden
ofunemployment. In our first world, where this
stimulus does not matter, it also does not harm
the recovery. The damage done is long termthe government share of private saving is permanently increased. In other words, the recovery behaves as though it occurred as a result of

41

lending to the. U.S. Government. As a result,
private lending is accomplished only at a higher
rate of interestthan public borrowing. The substitution of fiscal policy for private borrowing
works to reduce the interest cost of transferring
funds from saver to spender.

provides no assistance in speeding an economic
recovery and (2) where without a deficit there
is no momentum provided by the economy itself
to recover. We discover the unfortunate fact
that, given the policy decisions of fiscal and
monetary policy to be stimulative, it is impossible to tell which of these two possibilities is
correct. .Nonetheless, our analysis suggests that
under the worst circumstances (fiscal policy
impot~nt) there is nO damage in short-run fiscal
stimulus) while under the best circumstances
there is much to be gained. In the depths of a
recession, fiscal stimulus is well advised. But to
avoid long-term damage, it is equally necessary
to reduce this stimulus as the economy recovers,
balancing recessionary deficits with surpluses
during periods of economic health;

Summary an<;l conclusion
We have considered. the issue of crowding out
ill both thelorigterni andthe shortterni. In. the
long term, we adopt the common assumption
ofa "n.eutral" e.ffect of fiscal policyuponpiivate
savings behavior. Given this assumption, we
have found that persistent deficits would indeed
retard private capital accumulation. However,
this crowding out would not be reflected in
high~r interest rates. Thus deficit crowding out
of private investment in capital markets is entirely analogous to the crowding out of private
expenditures by those of the government.
In contrast, our analysis suggests that the
short-term effects of fiscal policy upon 'capital
markets and interest rates are uncertain.. We
examine two polar cases: (1). where the deficit

FOOTNOTES
1. Leijonhufvud, Axel, On Keynesian Economics and the
Economics of Keynes. New York: Oxford University Press,
1968. Clower, R., and Leijonhufvud, A., "The Coordina-

tion of Economic Activities: A Keynesian Perspective,
American Economic Review, Papers and Proceedings, May
1975.

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