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Federal Reserve Bank
of San Francisco
EconOIIlic Review

Fall 1983

Num.ber 4

Opinions expressed in the Economic Review do not necessarily reflect the views of the
management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of
the Federal Reserve System.
The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the Bank’s
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Phone (415)974-3234.

Challenges to Monetary Policy

Introduction and Su m m ary................................................................. 4

II.

Monetary Policy Regimes and International Term Structures of
Interest Rates ....................................................................................... 7

Joseph Bisignano
.. .a country whose long-term rates are linked to another country’s short-term rates via
expectations of the central bank’s long-run exchange rate objectives is one which, to some
degree at least, has lost the independence floating exchange rates were thought to
promise.

III.

Deregulated Deposit Rates and Monetary Policy ....................... 27

John P. Judd
The substantial evidence that does exist suggests that Ml has not been ruined by
deregulation... and that it would be advisable for the Federal Reserve to return to its
former practice of using Ml as its primary monetary aggregate.
Editorial Committee:
Adrian W. Throop, Michael Hutchison, and James A. Wilcox.

Two challenges to monetary policy are explored
by the authors in this Economic Review. In the first
article, Joseph Bisignano tests for international
linkages among interest rates that may affect the
ability of central banks to pursue domestic policies
independent of those abroad. The conventional
view in economics has been that floating exchange
rates allow countries to insulate their economies
from foreign disturbances, but Bisignano points out
that since 1979 there has been increased financial
interdependence among countries, creating difficult
policy choices given the strong performance of the
U.S. dollar. In the second article, John Judd
examines the extent to which recent domestic deregulation of interest rates on bank and thnft
deposits has impaired the usefulness of MI as the
Federal Reserve's primary monetary policy guide,
as well as the likely impact of future deregulation
on that aggregate.
Bisignano focuses on the significant increase in
U.S. interest rates that occurred in late 1979 and the
difficult set of policy choices it posed for foreign
policy makers. Foreign central banks faced the dilemma of whether to allow this shock to be transmitted to interest rates in their own country, or to
allow their exchange rates to depreciate to insulate
their domestic financial markets. The choice of
higher interest rates would have meant reduced
economic activity at home, while a depreciating
currency implied higher domestic inflation. Which
tradeoff was perceived as the more palatable therefore would condition the extent \0 which foreign
central banks would allow the shock of higher
interest rates in the U. S. to be transmitted to their
domestic economies.
The author examines the relationships between
U.S. and German interest rates, and between U.S.
and Canadian interest rates, for evidence of how
much the German and Canadian central banks
accommodated their policies to developments in the
U. S. rather than pursued independent policies.
Specifically, he looks at the extent to which unanti-

cipated changes in U.S. rates provide information
about the behavior of long-term interest rates in
Germany and Canada.
Bisignano uses the expectations hypothesis of the
term structure of interest rates, and asset market
exchange rate determination, to argue that the rate
on a long-term German government bond, for
example, depends on U.S. short-term rates and
expectations about the dollar-mark exchange rate.
These expectations in turn are conditioned by
perceptions about how much the Bundesbank
would be willing to insulate German interest rates
from foreign shocks.
Bisignano finds that after the Federal Reserve's
adoption of its new Monetary Control Procedure in
October 1979, unanticipated changes in the U. S.
3-month Treasury bill rate enter significantly in
regressions explaining movements in market interest rates on German federal government securities
of differing maturities ranging from one year to ten
years. Interestingly enough, however, they are not
significant in regressions for the period 1973-1979.
Thus, after the October-1979 change in Federal
Reserve operating policy, expectations in the foreign market apparently were that the German authorities would not allow a long-term depreciation
of the mark, preferring to allow interest rates to rise
in Germany as they had in the U.S. Bisignano
conjectures that these expectations were based on
the belief that the Bundesbank was willing to follow
the U.S. lead, taken after 1979, to pursue a long-run
anti-inflation strategy.
In the case of Canada, Bisignano finds that both
before and after October 1979, unanticipated movements in U.S. rates often provide explanatory
power for movements in Canadian long-term rates.
Thus market perceptions appear to have been that
the Bank of Canada attempted to protect the Canadian dollar from U. S. developments and as a result
was forced to pass U. S. interest rate charges
through to Canadian rates. Canadian and U.S. financial markets, therefore, were linked together

and Canadian monetary policy was at least partially
subordinated to U. S. policy.
John Judd focuses on the most recent and most
far-reaching episode of deposit rate deregulation
in his article. Both the Money Market Deposit
Account, introduced in late 1982, and the SuperNOW account, introduced in early 1983, are
accounts on which depository institutions can pay
market rates of interest. The argument frequently
has been made that the deregulation they represent
fundamentally alters the public's demand for transactions money, potentially ruining Ml as a guide for
monetary policy.
Judd categorizes this deregulation argument as
having three parts. The first is that deregulation may
have induced a flow of savings balances into MI,
and compromised its traditional character as primarily a transactions medium. As a result, the
demand for MI may become less stable in the sense
that it would be less tightly related to income and
prices than before.
The second part of the deregulation argument
focuses on the point that presumably the demand for
Ml would be less interest-sensitive because flexible
rates on deposits could be adjusted to offset changes
in market rates. One effect of this would be to
change the relationships between money and prices
and other economic variables. MI, therefore,
would be a more uncertain guide to policy until the
new relationships were understood. A less interestsensitive demand also would make the economy
more vulnerable to money demand instability, although by the same token, it would insulate the
economy better from other shocks.
Finally, Judd notes that a less-interest sensitive
Ml demand poses potential problems for short-run
control of MI. Thus, relatively precise control
might be infeasible because the associated interest
rate variability would be too high as well. There is
risk that an interest-insensitive money demand
would mean that Ml was no longer a leading indicator of policy, further reducing its usefulness as
a guide for policy.
Judd points out that theory cannot indicate
whether these potential problems actually exist, or,
if they do, whether they are important enough to
matter. These important issues are empirical ones.

Unfortunately, because deregulation is not complete, the evidence accumulated so far cannot be
conclusive. Nevertheless, Judd argues that on
balance " ... substantial evidence ... does
exist ... that use of M I as an intermediate target has
not been ruined by deregulation ..."
Judd examines several pieces of evidence to support this conclusion. He begins by noting that the
size of the upward shift in M I demand after deregulation may be an indication of the extent to which it
has been "contaminated" by an inflow of savings
balances. He refers to an earlier study of his which
showed that episodes of deregulation in the 1970s
and in 1981 showed small upward shifts; such findings are consistent with the hypothesis that the
mixing of transactions and savings balances in M I
had been slight.
To analyze the November 1982 introduction of
Super-NOWs and MMDAs, Judd estimates monthly MI demand equations for the period up to the
period of the change, and uses these regressions to
forecast MI demand during and after the change.
If the demand for M I had shifted up because of
the new accounts, the regressions should underpredict Ml after November 1982. Judd estimates
two money-demand regressions: one in which the
interest elasticity of money demand is constant and
one in which it is allowed to vary positively with
interest rates. The variable elasticity regression
shows a small over-prediction of M I after November 1982, which is in the wrong direction if MI
demand had shifted up. The constant elasticity
specification does show under-prediction, but the
result is too small to be significant. Judd draws two
implications: "First, instability in MI demand
does not appear to have significantly distorted
mQnetary policy in 1983. Second ... deposit deregulation has not materially changed the transactions
nature of MI."
Finally, Judd notes that problems of short-run
monetary control posed by an interest-sensitive MI
could be less severe than suggested if money plays
an important buffer-stock role in the public's portfolios. He argues that evidence from the moneydemand function in the San Francisco Money
Market Model is suggestive, at least, that money
does play such a role.

Joseph Bisignano*
Changes in macroeconomic policy have had unexpected consequences in recent years. The move
to floating exchange rates among industrial countries in 1973 may not have led to the predicted
greater policy independence among countries, nor
did it completely insulate countries from real and
monetary disturbances emanating from abroad.
Indeed, some studies have found that monetary
growth rates and interest rates across countries have
become more, rather than less, correlated since the
change to floating exchanges rates. 1 As a result, we
have learned more about how alternative exchange
rate systems change the nature of real and financial
interrelationships and the channels by which shocks
and policy changes spill over from one country to
another. This article will explore some of these
international linkages.
In October 1979, the Federal Reserve changed
monetary control procedures to one that de-emphasized the need to target interest rates to influence
monetary growth and which placed more emphasis
on the control of bank reserves. An unexpected
consequence was the increased level and volatility
of nominal interest rates in the United States. Some
increased volatility in the federal funds rate was
anticipated, but the new behavioroflong-term U.S.
interest rates was not. They appeared to become
more sensitive to movements in short-term rates. It
is, of course, debatable whether the unexpected
interest rate behavior was directly attributable to the
change in monetary control procedures, but the
coincidence was surprising.

The level of both real and nominal interest rates
in the U.S. following October 1979, together with a
renewed anti-inflationary objective of the Federal
Reserve, caused some international agencies to attribute the high level of world interest rates since
1980 to u.s. policies. As an example, the 1982
Annual Report of the Bank for International Settlements states:
"Nonetheless, it can be argued that without
the American influence, nominal and real interest rates. in two major countries at leastJapan and the Federal Republic of Germanywould, in the spring of 1982, have been at
levels more consistent with the requirements
of domestic balance." 2
One implication of the BIS concern is that a
major rise in U.S. interest rates could lead to a
policy conflict between domestic and external balances in other large industrial countries. In response
to a large rise in U.S. interest rates, a foreign country can permit its exchange rate to adjust, or allow
domestic interest rates to adjust and leave the exchange rate unchanged. However, both exchange
rates and interest rates are asset prices and are
strongly influenced by expectations, particularly
expectations of the future value of the currency.
Thus, not changing domestic interest rates after
foreign interest rates have changed can result in a
large exchange rate movement. This movement depends upon expectations of the currency's future
value which, in tum, is heavily influenced by private market expectations of public policy. A central
bank's concern with the private market's expectation of the long-run value of a currency can be seen
in the following statement by G. Thiessen regarding
the Bank of Canada's response to a rise in u.S.
interest rates:

*Vice President and Associate Director of Research. Research assistance was provided by Ms.
Eileen Dixon and Ms. Mary Byrd Nance. My
thanks to the editorial committee, Professors Roger
Craine, Tom Mayer, Ross Starr, Mr. Kevin Hoover
and participants in the UCLA Money Workshop for
helpful comments on earlier drafts of this paper.

" ... it is useful to look at the options facing
the Bank of Canada when, for example, there
7

is a snarp rise in snort-tenn U. S. interest rates.
If the policy response is to maintain Canadian
interest rates unchanged, the Canadian dollar
would come under downward pressure. In a
potentially inflationary situation, the appearance of benign neglect toward the exchange
rate by the authorities would risk a substantial
overshooting ofthe exchange rate decline. The
less firmly held are the market expectations
about the future value of the currency, the
greater the overshooting is likely to be;"
(emphasis ourS)3
We conjecture that linkages between short-tenn
rates in the U.S. and longer-tenn rates abroad depend on what private market participants in the
financial markets assume to be the long-tenn exchange rate objectives of the central bank. Given
the rapid rise in U. S. nominal and real interest rates
after October 1979, and the increased strength of the
U.S. dollar in the foreign exchange markets, foreign central banks had to consider two prospects:
that of moving their short-tenn rates, over which
they have some control, into line with U.S. rates, or
observing a major depreciation of their currency.
Since a depreciation of the currency for a very
open economy can lead to rapid increases in domestic prices, the policy question of whether to adopt a
strong exchange rate "objective" is similar to confronting the short-run inflation-output trade-off
question. If a foreign country should raise interest
rates in response to a major rise in U. S. rates, it
would risk reducing real output. Alternatively, if it
chooses to pennit its exchange rate to depreciate, it
would face more inflation, at least in the short run.
A country that moves its short-rates to prevent a
currency devaluation may find that the U.S. short
rates strongly influence expected short-tenn rates in
its domestic financial markets because foreign short
rates contain useful infonnation in fonning expectations about future domestic short-tenn interest
rates. In this manner, a country's entire tenn struc-

ture of interest rates may move in response to a
change in U. S. short-tenn rates.
Purpose and Organization
How short-tenn interest rates in the U .S. , prior to
and after the change in U. S. monetary control procedures, affect interest rates along their entire tenn
structure for Canada and the Federal Republic of
Gennany. is the major empirical concern of this
study. Investigating these relationships requires that
we briefly review two areas of economic theory, the
expectations hypothesis of the tennstructure of
interest rates and the asset market approach to exchange rate detennination. These two areas are related via the international arbitrage of financial
assets which results in movements in interest rates
and exchange rates that equalize expected rates of
return on financial assets with similar underlying
risk characteristics, regardless of their currency of
denomination. These financial interrelationships
can then create policy interdependencies. Policy
interdependencies and conflict between internal and
external policy objectives can better be understood
when, as this paper will attempt, we consider how
interest rate movements in one country are transmitted along the maturity spectrum of interest rates
of its financial, interdependent foreign partners.
This paper is organized as follows: Section I will
briefly review the expectations hypothesis of the
tenn structure of interest rates. Section II will describe an asset market approach to exchange rate
expectations equilibrium and how long-tenn interest rates are related to private market expectations
of central banks' exchange rate objectives. Section
III will review exchange rate behavior for Canada
and Gennany in relation to the U. S. dollar since the
introduction of the new Federal Reserve monetary
control procedures. The fourth section will statistically test the impact of changes in U.S. short-tenn
interest rates on the maturity spectrum of interest
rates in the Federal Republic of Gennany and Canada. Section V provides a summary and considers
policy implications of the study.

I. The Expectations Hypothesis of the Term Structure
ances. Demands for such items as long-term household assets, such as housing, or business capital
assets are often conjectured to be determined. by
"long-term interest. rates.." A term structure. relationship, which .defines the long-term bond rate as
dependent on the current and past short-term interest rates, is often treated as a "structural" relationship in empirically estimated models and .is estimated by the regression of the long rate on a distributed lag of short-term interest rate~.
A recent criticism of the standard empirically
implemented term structure relationship is that it
cannot be taken to be a structural economic relationship with fixed coefficients. As emphasized by
a number of critics of the standard expectations
approach to the term structure, the expectations
described in Equation (I) are conditional on policy
rules, and hence, the expectations structure will
change if there is a change in the policy rule or an
expected change in the policy rule. Such "policy
rules" may involve domestic monetary control
rules or exchange rate intervention rules. In any
case, the relationship between the long-term bond
rate and short-term rates is argued to be crucially
dependent on both monetary and fiscal rules. Since
part of the transmission mechanism of monetary
policy to the real economy depends on how changes
in policy feed to the long-term segment of the term
structure, the role of the policy rules in affecting this
relationship is of considerable importance to
policymakers .6
Consider a typical term-structure equation of the
following form
n
R, =.:2: cjr, ~i + v,
(2)

Simply stated, the expectations hypothesis of the
term structure of interest rates suggests that individuals arbitrage financial assets (bonds) of varying
maturities and that this .results in an "equilibrium"
in which the (known) return on a long-term bond
equals the average of the return on an available
short-term bond and the expected returns on future
short-term bonds over the same holding period.
This hypothesis implies that bonds of like risk characteristics, but different maturities, are goodsubstitutes for one another. Hence, their average expected
return over a given time horizon should be approximately equal.
Formally, the term-structure relationship as of
period t between the yield on an n-period discount
bond, R, and the yield on one-period bonds, r, is
often written:

R, == E,(r, +r'+1 + ... +r,+0_111,).

(I)

This equation is written as an approximation
since the original relationship is multiplicative,
with the approximation being that In( 1+r)=r. This
relationship must be modified if the bonds are coupon-bearing, in which case the long-rate would be a
weighted, and not a simple, average of current and
expected future short-term interest rates. The symbol E denotes that the relationship requires the explicit specification of how expectations of future
short-term rates are formed, conditioned on some
set of information I available at time t. 4 This information set is assumed to include the policy rule of
the central bank.
Equation (I) is often empirically implemented by
regressing the level of the long-term bond rate on
the levels of current and past short-term interest
rates. One argument for the use of past short-term
interest rates as explanatory variables is that a forecast of future short-term rates can be formed by an
appropriate weighting of past interest rates. 5 The
structure of the weights on past short-term interest
rates depends, in theory, on the stochastic structure
of short-term interest rates and the economic structure (e.g., the monetary control regime) determining the short-rate.
Most formal textbook macroeconomic models
"determine" one interest rate, usually that which
influences the public's desire to hold money bal-

1=0

where v is a stochastic error term. First differencing
(2) yields

R, -

R'~I

n-l
= co(r,-r H ) + .:2: Cj(rH_j-r,_,~~J
1=0
-

+ (v,-v H

)·

(3)

Written in this form the term structure equations
state that the change in the long-term bond rate in
period t depends on the current change in the short
rate and previous changes in the short-term rate. It is
this latter implication which is currently in dispute.
That is, it is argued that only new information (or

"surprises' ') should change the long-term rate. Previously available information, such as the level of
short-term rates, or their changes, should not cause
the current long-term rate to change; such previous
information is presumably already captured in RH .
Having said this, we must note that it may be an
overly strong statement, not completely supported
by the theoretical literature on the determination of
the term structure interest rate under the assumption
of rational expectations.7 For our purposes, it is
sufficient to say that we expect the coefficient on the
most recent change in the short-rate, co' to dominate
all other coefficients on past changes in the short-rate.
The basic point of the above argument is that if
individuals form their expecations in (I) in an efficient manner, that is, by exploiting all available
information, any information that was available
"yesterday" should not cause security prices to
change "today," if the movement in the short-rate
follows a random walk. Similarly, only information
that was unavailable "yesterday" should cause the
long-term bond yield to change "today." Technically, changes in past short-term rates may affect
the change in the current long-term rate in an efficient market if the short-rate does not follow a
random walk. For our purposes, it is only necessary

to assume that most of the movement in the longrate will be due to the current change in the shortrate, that is, the short-rate is close to a random walk.
Our testing of the international interrelationships
between long- and short-term interest rates thus
mustacknowledge current criticism of the standard
expectational statement of the term-structure of interest rates. These criticisms, to repeat, are that: (I)
the term-structure relationship cannot be considered
a" structural" macroeconomic relationship, since
such an interpretation is not consistent with the
assumption that capital markets are "efficient"; (2)
the relationship between long- and short-term interest rates (both within and between countries) depends on the policy rule, which will influence the
formation of expectations of future short-term interest rates; and (3) "new information," such as
contemporaneous change in short-term rates,
should dominate past information in causing longterm interest rates to vary. Point (3) simply says that
the long-term bond rate moves quickly to reflect
fully any new information. In our empirical work
we will begin by assuming that past changes in
short-term interest rates do not significantly explain
the contemporaneous changes in the long-term
interest rate.

II. Asset Markets and the Term Structure of
Exchange Rate Expectations
The above example illustrates what should be an
obvious interrelationship: long-term bond rates in
country A will be influenced by movements in
short-term rates in country B only if the central bank
of country A is perceived as having a long-run
desired exchange rate objective in relation to the
currency of country B. Interest rate interrelationships between two countries depend on the extent to
which the two central banks will not permit their
bilateral exchange rate to move away from some
desired level. To see the formal interrelationship of
short- and long-term rates between countries, we
begin by reviewing some theory on the term structure of exchange rates.
Just as in the standard term structure of interest
rate argument, an arbitrage relationship holds for
assets of identical maturity but different currency
of denomination in exchange rate term structure

If financial assets in Germany and the U. S. were
reasonably good substitutes and the U.S. and Germany were to agree to fix their bilateral exchange
rate, short-term interest rates in the two countries
would be identical by reason of interest rate parity.
The long-term interest rate in Germany could then
be said to be a function of expected future shortterm rates in either country, and the exchange rate
system would determine this dependency. The
German central bank could also create the impression that it desired a long-run exchange rate objective in the absence of a formal agreement with the
u. S. It could intervene periodically in the exchange
market, or reposition its short-term interest rates in
line with movements in U.S. short-term rates. In
either case, U.S. short-term interest rates again
would likely be significant in explaining German
long-term bond rates.
10

theory. Again, in equilibrium, the assets' riskadjusted expected returns should be equal in the
absence of transaction costs. Consider the relationship between the returns on two n-period bonds, one
denominated in the domestic currency and one denominatedina foreign currency. For the two returns
to be equivalent in equilibrium, the compounded
yield differential between the two securities should
exactly equal the expected change in the rate at
which the two currencies can be traded, that is, the
expected change in the exchange rate. We can write
this relationship as follows:

I+~)n = E,(SS+nI, I ,)

( I+R,

R* = 1 [E,(r,+r'+I+'" +rt+n_III,)
, n
(E,(s,+nII,) - s,) ]

Equation (6) states that the foreign (n-period) longterm rate is equal in equilibrium to the average of
current. and ·e:x;pected future .domestic Short4erm
interest rates less the average expected change in the
excha.l1gerate over the existing maturity of the bond.
Equation (6) is the statement of two arbitrage
conditions and cannot be empirically estimated until
the hypothesis of how expectations of future shortterm rates in the "domestic"· economy and the
future exchange rate are made explicit. The two
components of the long-term "foreign" bond rate
are expectational variables. The set of information
which conditions these expectations will have a
good deal to say about the form of the estimating
equation and the assumed stability of that equation
to changes in policy rules.
To empirically use Equation (6), we first assume
that it is a stochastic relationship; that is, arbitrage
will make the long-term bond rate approximately
consistent with the two expectations. Second, we
assume that in forming expectations ofjuture short·
term interest rates, it is primarily information
unavailable in the previous period that will significantly change the current long-term interest rate.
International financial arbitrage implies that expectations of future domestic interest rates will depend
on expectations of foreign rates and the expected
changes in the exchange rate. We, therefore,also
assume that expectations of exchange rate change,
particularly short-run expectations, depend on
perceptions of the exchange rate policy of the
central bank.
Equation (6) may be rewritten to show more
clearly how the "foreign" long-term rate is linked
to expected future" domestic" short-term rates plus
the expected future short-term (period-by-period)
exchange rate changes. Consider the expected exchange rate change in equation (6); it is obvious that

(4)

where a star indicates the foreign variable. In (4), S
is the spot exchange rate, the domestic currency
price of a unit of the foreign currency. Rand R*, the
market yields on the domestic and foreign bonds,
respectively, are defined in decimal units, for example, 0.05. The numerator on the right-hand side
of Equation .(4) is the expected exchange rate n
periods hence, given information available in period t. Let us rewrite Equation (4) by first taking logs
and using the approximation In(l + R)= R:
R,

R*, = E,(s'+nI I ,) - S,
n

(6)

(5)

where the small s denotes the log of the exchange
rate, S. Equation (5) states that arbitrage will force
the yield differential between two similar assets of
like maturity but different currency of denomination
to equal the expected average annual change in the
exchange rate.
Equation (5) is an arbitrage condition. It cannot
be interpreted as implying that interest rates cause
exchange rate changes, or the reverse. This arbitrage condition depends on a statement of exchange
rate expectations. As stated in Equation (5), the
exchange rate in period t expected to hold in period
t+n depends on some set of information available in
period t.
To derive a relationship between long-term rates
in one country and short-term rates in another country, we can begin by combining the two interest rate
arbitrage conditions discussed above, defined in
Equations (I) and (5). Solving Equation (5) for R,
and equating this to Equation (I), we have for R~,
the foreign n-period bond rate:

E,(s'+nII,)-s, = EJ(s'+I- s,) + (S'+2- St+I) + ... +
(7)
(s,+n -s,+n_l) II,]
That is, the expected change in the exchange rate
between period t and period t+n given information
available at time t is equal to the sum of the expected
changes for each intervening period. Using this
II

fact, we can rewrite Equation (6) using (7), as:

R~ = ~ t E,

[r, - (S'+I - s,) +

r'+1 - (S't2 S'+I) + ... +
r,+n_1 - (s,+n - s,+n_l) II, ]}

(9)
(8)

Equation (9) suggests that only new and/or unanticipated information will alter expected future
German short-term rates and, by implication, the
current long-term bond rate. The ZUS variable represents the unanticipated component in U.S. shortterm interest rates. Since (9) holds for aH future
periods, with coefficients differing for different
future periods, we can rewrite an approximation to
Equation (8) in first difference form as:

Equation (8) states that the long-term, n-period,
bond rate in, say, Germany, is equal to the average
of the expected future short-term interest rates in the
U. S. , plus expected exchange rate changes between
OM and the U.S. doHar. The long-term bond rate in
Germany thus captures both expectations of future
U.S. short rates and future movements in the exchange rate.
H is the potential for central bank action to prevent the exchange rate from moving that is useful in
forming expectations about future German shortterm rates. Expected future changes in the exchange
rate depend on perceptions of the exchange rate
objectives of the central bank. If the central bank is
perceived not to have any exchange rate objective,
short-term interest rate movements in the United
States would convey no information for the German
bond market independent of the current German
short-term rate. In such a case, expected movements in the exchange rate and U. S. rates would be
extraneous information; all the relevant information
would be captured in the current German short-term
rates. If, on the other hand, the German central bank
is perceived to have some exchange rate objective,
U. S. interest rates, as signals of potential future
interest rate movements initiated by the German
central bank, would contain useful information to
the German bond market.
The expectation in Equation (8) is conditioned
on some information set 1. This information set
includes the assumed policy rule of the central bank
and some knowledge of the central bank's exchange
rate objectives. Changes in these objectives would
alter the way unanticipated changes in U.S. rates
affect German long-term rates.
Since the components on the right side are nothing more than current and expected future German
short-term interest rates, conditional on current
information, we argue that these expectations will
change in response to changes in the current German short rate and unanticipated movements III
U.S. short rates. That is:

Ll R*, -_ a

AUS
+ a l Llr*, + a 2 Z,
+ w,

(10)

This formulation tests, for example, whether German bond holders perceive the German central bank
as following an exchange rate rule and, hence, as
partially dependent on U.S. central bank interest
rate policy. Such a dependence would be revealed in
the significance of the coefficient on the unanticipated component of U .S. short-term interest rates,
a 2. Analogously, Equation (10) can be estimated for
the changes in U.S. long-term rates as dependent,
for example, on the change in U. S. short-rates and
the unanticipated change in German short-rates.
We wiH estimate Equation (10) with changes in
Canadian and German long-term bond rates dependent on, respectively, changes in Canadian and
German short-term rates and the "surprise" or unexpected movement in U.S. short-term rates. And
we will reverse the relationship to see whether the
long-term U.S. bond market used unexpected
changes in foreign short-term rates as information
variables in forming expectations about future U.S.
short-term rates. 8
If the German short-term rate were found to be
statistically significant in (10), and the unanticipated U.S. short-term rate not, we could assume
that holders of long-term German bonds are revealing their expectation that the German central bank is
following a policy that is at least partially independent of U.S. monetary policy-independent in the
sense that the German central bank is allowing some
flexibility in exchange rate movements. If, on the
other hand, U. S. short-term interest rates were also
statistically significant in explaining German longterm bond rates, the holders of long-term German
bonds would be revealing their expectation that the
Bundesbank may have a long-run exchange rate
12

objective with regard to the U.S. dollar. Strong
"Ieaning-against-the-wind" exchange rate policy
could be detected in the coefficient in the U.S.
interest rate variable.
Since our equation will be estimated in firstdifferenced form, wearguethatthe current changes
in the short-term rate should be the primary explanation for movements in the long-term bond rate.
For this reason, we do not include lagged short-term
interest rates as explanatory variables. 9
One final empirical approximation is made
to implement equation (10). We assume that only
unanticipated changes in U.S. short-term interest
rates affect German and Canadian bond rates. As an
approximation for this unanticipated change in
the U.S. short-term rate, we regressed the U.S.
three-month Treasury bill rate on itself, lagged one
and two periods, and treated the estimated residuals from this equation as our unanticipated U. S.
short-rate variable. This unanticipated U.S. interest rate variable is defined as Z. (Alternative
methods of deriving this "sllrprise" variaple did
not appear to make a significant difference in the
empirical results.)
Evidence that long-term German bond holders
should be concerned with Bundesbank exchange
rate policy can be obtained from statements by

the German central bank regarding its exchange
rate intentions.
"But the Bundesbank has not been under any
obligation to intervene against the U.S. dollar
since the Spring .• of 1973. However, the
Bundesbank has intervened in the dollar
market ever since the dollar rate was freed,
largely to smooth out erratic day-to-dayexchange rate fluctuations and so maintain orderly market conditions. In addition, .. the
Bundesbank has on occasion intervened more
heavily in the foreign exchange markets in an
attempt· to curb exaggerated exchange rate
movements and thus ease the adjustment pressure on the economy." 10, II
If holders ofGerman bonds perceive the German
central bank to be running an independent monetary
policy with no overriding exchange rate objective.
only changes in German short-term interest rates
should contribute to changes in longer-term German interest rates. However, if the German central
bank does have a major exchange rate objective,
movements in foreign (for example, U.S.) shortterm interest rates contain important information
aboutjUture German short-term rates. In this manner, movements in U.S. short-term rates can affect
foreign long-term rates.

III. The Ter.m·Structure of Exchange Rate Expectations
Shortly after the Federal Reserve's change in
monetary control operating procedures, a major
policy dilemma emerged. The cause of the dilemma
was the major, and largely unexpected, rise in both
short- and long-terrri U.S. interest rates.Thenature
of the dilemma for foreign central banks was whether to raise their domestic interest rates or to permit
their exchange rates to depreciate.
The U.S. 3-month Treasury bill rate averaged
10.26 percent in September 1979. It rose after the
change in monetary control procedures of October
6, 1979, and, as seen in Chart I, continued to rise to
a monthly average high of 15.20 percent by March
1980 before credit controls were imposed. Considerably more surprising than the behavior of
short-term rates was the level to which long-term
rates rose. Some economists had anticipated that a
switch to a reserve control procedure by the Fed

would result in a "decoupling" of interest rates.
Short-rates were expected to rise due to a more
stringent supply of bank reserves but, some
thought, long-term rates would be stable since they
were thought to be influenced primarily by inflationary expectations.
Instead, long-term rates rose by over 300 basis
points in six months, from a monthly average of
9.33 percent in September 1979 to 12.75 percent in
March 1980, for the U.S. Treasury's ten-year constallt maturity bond rate. While both short- and
long-tel1Jl r;:ites fell sharply after the imposition of
creditsontrolin the spriflgof 1980, bothrose sharply after the removal otcont[()l and surpassed their
March highs by December 1980.
The extent.to which there might have been any
linkage between U.S. short-term rates on the one
hand and German and Canadian long-term rates on
13

exchange rate over the maturity of the asset. 12
The U.S. dollar had depreciated substantially
against the Deutschemark from early 1976 through
the fall of 1979. In early 1976, interest differentials
between U.S. and German government bonds suggested that the DM/$U.S.rate was expected to
remain around 2.6 OM/$U.S., with some modest
depreciation over the long run. It was not untiUate
1977, when the U. S. dollar had depreciated rather
steadily for two years against the OM that the
DM/$U.S. exchange rate term structure changed
considerably. The long-term outlook then was that
the U.S. dollar would depreciate steadily against
the OM, reaching a 2.0 DM/$U.S. rate by the end
of 1987. The long-run view of the U.S. dollar in
relation to OM, measured by a ten-year horizon,
continued to worsen in 1978 and 1979. The DM/$U.S.
rate was expected to fall to nearly I. 5 by 1987.

the other depends on how private market participants view the longer run behavior of the exchange
rate. Expectations of the exchange rate over the
longerrun, in turn, are tied to expectations of the
central bank's desired exchange rate objectives.
Cqusider >uow how expectations of the exchange
rate for the Canadian dollar and Deutschemark in
relation to the U. S. dollar changed after October
1979.
Charts 2 and 3 describe the bilateral exchange
rates for Germany and Canada, respectively,
ag~inst the U.S. dollar, together with the evolving
tennstructure of exchange rate expectations. The
tenn structure of exchange rate expectations can be
roughly captured by assuming that the compounded
interest differential between two fixed-term financial assets with different currency denominations
approximates the expected percentage change in the

Chart 1
Treasury Bill and Treasury Bond Rates
Percent

20
18
16
3-month Treasury Bill ..
14
12

10
10-year Treasury Bond

8
6

4 ....._ ....._ ...._ ....._ ..._ ...._ ...._ ...._ ....._ .........- 1974

1976

1978
14

1980

1982

1983

The case of Canada is in many ways different
from that of Germany. While the U.S. dollar was
depreciating against DM from 1976 to the Fall of
1979, the U.S. dollar appreciated significantly
against the Canadian dollar ($C) during the same
period. In addition, a major depreciation of the
Canadian dollar did not follow the rise in U.S. rates
late in 1979 to the end of 1980. The $C/$U.S. rate
averaged 1.16 in September 1979 and 1.197 in
December 1980. Both short- and long-run expecta
tions of a depreciation of the Canadian dollar exist
ing prior to October 1979 continued to persist after
that date. The only exception was the term structure
of the expected exchange rate as of December 1980,
which slopes downward; it implies a $C apprecia
tion. In general, Chart 3 implies that the Candian
dollar was expected to depreciate even further after
October 1979. It cannot be argued, however, that

During the Fall of 1980, the U.S. dollar started a
rapid climb against DM. Interestingly, even given
the major appreciation of the U.S. dollar, DM was
still expected to appreciate against the dollar over
the long-run. Market participants apparently did not
expect the levels the U.S. dollar reached against
DM to be sustainable. Even by late 1982, when a
2.5 DM/SU.S. rate was reached, the longer-run
view was for DM to appreciate towards 2.0. Market
participants were expecting the German central
bank to pursue policies over the long-run that would
result in a major appreciation of DM against the
U.S. dollar. Overall, the impression one obtains
from Chart 2 is that during the period of the major
depreciation of DM against the U.S. dollar— 1980
through 1982—the market expected the German
central bank to follow policies that would result in a
longer-run appreciation of the Deutschemark.

Chart 2
German Term Structure of Exchange Rates*
Deutschemark/U.S. Dollar

* Expected exchange rate term structures are calculated from December data.

sequence of the term structure of exchange rate
expectations seen in Germany. “ Weak currency
expectations” could be used to describe the ex
pected exchange rate term structure for Canada; its
currency was expected to depreciate against the
U.S. dollar even during a period of relative ex
change rate stability.
Studying the term structures of exchange rate
expectations permits us to conjecture whether the
financial market might think short-run interest rate
movements in a large nation like the U.S. contains
information that could signal future interest rate
movements, short- and long-run, in other countries.
Such a linkage between short-term interest rates in
the U.S. and long-term rates in another country are
likely to occur if financial markets perceive that the
“ other country” will attempt to maintain its cur-

expectations of a Canadian dollar depreciation were
results, or indeed closely associated with, the
change in Federal Reserve operating procedures.
The picture that emerges from Charts 1-3 is that
the rise in U.S. interest rates, across the entire term
structure after October 1979, appear related to the
considerable depreciation of the Deutschemark
against the U.S. dollar, but not, at least through
1981, with a similar depreciation of the Canadian
dollar. Despite actual exchange rate movements,
market participants expected DM to appreciate after
1979 over several years, but they thought $C would
depreciate. The German central bank appears to
have been expected to resist a long-run depreciation
of its currency against the U.S. dollar, even after a
major depreciation occurred. Thus, “ strong cur
rency expectations” might be used to describe the

Chart 3
Canadian Term Structure of Exchange Rates*

0.95 -

0 90 I— I__ H___ 1— 1___I__ I — I__ I__ I__ I __ I___I__ 1
1976

1978

1980

1982

1984

* Expected exchange rate term structures are calculated from December data.

1986

1988

1990

rency within a given range in relation to the U.S.
dollar. The term structure of exchange rate expectations viewed in Charts 2 and 3 imply that a rise in
short-term interest rates in the U.S. is not likely to
worsen the long-run view of the DM/SU.S. rate,
even if the Deutschemark depreciates in the shortrun. Individuals in the post-1979 period apparently
did not expect the U.S. dollar to remain strong. We
may surmise that the •Bundesbank is viewed as
unwilling to permit a "permanent'.' depreciation of
its currency against the dollar, where permanent
means lasting for more than five years. In contrast,
in the Canadian case, the rise in U.S. rates after
October 1979 and the subsequent depreciation
of the Canadian dollar was expected to lead to a
"permanent" depreciation, in spite ofthe fact that
the Bank of Canada resisted a depreciation of the
Canadian dollar after the change in U. S. monetary
control procedures.
These conjectures imply that short-term rate
movements in the U. S. after October 1979 were
likely to affect German long rates. If this were not
the case, Chart 2 would have shown the expected
DM/SU.S. term structures sloping upward. That is,
expectations of a weak DM in the future would
imply that U.S. short-rates could move without
being followed by similar movements in German
interest rates. The "strong currency expectations"

effectively linked German long-rates to U.S. shortrates. The "weak currency expectations" for the
Canadian dollar may have broken such a link. The
empirical analyses will decide whether these linkages in fact resulted after October 1979.
It is. important to note, finally, that a clear case
cannot be made from Chart~i.2and 3 that a change in
the term structure· of exchange rate expectations
occurred shortly after October 1979. In the German
case, . we see an upward sloping term structure in December 1976 reversing and sloping downward in December 1977. In the Canadian case, all
exchange rate term structures, save one, remain
upward sloping.
While visual evidence may not demonstrate that
exchange rate expectations changed after October
1979, it is possible to determine statistically how the
rise in U.S. short-term rates may affect foreign
long-term rates. Our expectation is that German
long-term rates will rise with a rise in U.S. short
rates but Canadian long-term rates will be unaffected because of the market view that the Canadian
authorities would allow the Canadian dollar to absorb fUlly the impact of U.S. interest rate changes
and not intervene in the foreign exchange market or
adjust domestic interest rates in response. In other
words, the market thought that the Canadian authorities did not have an exchange rate objective.

I\J. Term Structure Interdependence: The Empirical Evidence
The estimation of Equation (10) for Germany for
the period 1973.03 to 1979.09 is seen in Table I.
During this period the Federal Reserve may be
interpreted as having had a monetary control regime
which placed primary emphasis on the management
of the Federal funds rate. Policy-induced variations in this rate were designed to influence the
domestic demand for money and credit. The dependent variables in the Table I regressions are the
change in the average market yields on bonds of the
German federal government (including the Federal
Railways and Post Office) for maturities of one to
ten years. The explanatory variables are the change
in the three-month German interbank rate and the
unanticipated change in the three-month U.S. Treasury bill rate. 13
The results of Table I confirm the hypothesis that
changes in the longer-term German bond rates were

influenced primarily by movements in German
short-term rates prior to October 1979. The contemporaneous change in the German three-month interbank rate has a statistically significant impact on
bond yields extending from maturities of one to five
years; the remaining maturities showed little sensitivity to the change in the German interbank rate.
Table I also suggests that the unanticipated
change in U.S. short-term interest rates had no
impact on German long-term rates. The coefficients
on the unanticipated change in the U.S. threemonth bill rate are consistently statistically insignificant and very small.
When the German term structure equations were
estimated over the period following the change in
Federal Reserve operating procedures, the results
were drastically different. Estimated over the period 1979.12 to 1982.12, we found considerably
17

this impact does not die out the longer the maturity
of the asset. The "surprise" of a one percentage
point rise in U.S. short rates appears to have lifted
the entire German term structure by about 17-22
basis points. U.S. short-term interest rate "surprises" therefore appear to have contained more
relevant information about future German short
rates than in the earlier sample period.
Another surprising result in Table 2 is the improvement in explanatory power of the equations
over those seen in Table I, particularly for the longer
maturities. Forty to fifty percent ofthe variance in
the change in German rates of five- to ten-year

reduced significance for the coefficients on the
German three-month interbank rate. As shown in
Table 2, only in the first three maturity classes is the
German interbank rate statistically significant at the
5 percent level for a one-tail test.
Contrary to the results for the earlier period,
we find in Table 2 that the coefficient on the
unanticipated component of the three-month U.S.
Treasury bill rate was significant throughout the
German term structure. An unanticipated one percentage point increase in the U.S. three-month bill
rate was found to have increased one-year German
rates by about 20 basis points. Quite surprisingly,

Table 1
German Term Structure Equations in Response
to Unanticipated U.S. Interest Rate Movements
(Sample Period 1973.03-1979.09)+
Explanatory Variables

Years to
Maturity

Constant

.\US

RHO

D.W.

SER

.000
(01)

.372
(4.43)

.145
(1.32)

-.20
(-1.79)

189

2.01

.463

.002

.159
(2.62)

.006
(.12)

.44
(4.40)

.365

2.21

.250

(.04)

.006
(-16)

.136
(2.07)

-.011
(-.19)

.15
( 1.34)

.136

2.07

.278

.005
(-12)

.145
(2.57)

-.040
(-.84)

.36
(3.39)

.237

2.14

.237

-.011
(-.29)

.132
(2.32)

-.004

.23
(2.14)

.144

2.07

.250

(-.08)

-.010
(-25)

.074
(1.32)

-011
(-.23)

.35
(3.32)

.162

2.02

.234

.009
(-23)

.090
( 1.54)

.038
.71)

.27
(2.47)

108

2.04

.254

-.007

.060
( 1.05)

-.057
(-1.13)

.30
(2.77)

.099

2.10

.244

(-.17)
9

.010
(-.28)

.069
(1.17)

.035
(-.61)

.178
(1.61 )

.039

2.06

.264

-.008
(-.18)

.133
(1.79)

.040
(.48)

.025
(.22)

.027

1.99

.362

6.r~

A U S .
Dependent Variable is the change in the German "longer-term" bond rate. (Z ) is the set of residuals from the following regreSSIOn
for the U. S. three-month Treasury bill rate, on a bond-equivalent basis:
rUS
t -

.136+
(2.23)

R = .969; DW.

lJS
1?9?r
.- - . t- I
(25.58)
1.86; SER

0315rlJS
.
1"-2 +ZAUS
I
(-6.23)

= .625

Sample period: 1953.06-1983.01
In all cases t-statistics appear in parentheses. r* is the rate on 3-month interbank loans in the Frankfurt am Main money markets.

prises" had no statistically significant impact on
U. S. rates, with all coefficients in the German interest rate surprise variable clearly insignificant at
conventional significance levels.
Moreover, the coefficients on the change in the
U.S.· three~month bill rate do not appear to have
changed greatly between the two sample periods,
although U. S. interest rates were consider-ably more
variable in the post-October 1979 period, as seen by
the large increasein standard errors. These results
may be interpreted as suggesting that in both periods German short-term interest rates contained no
information of use in forming expectations of future
U.S. short-term interest rates. U.S. monet~pol
icy, in this sense, appeared "independent" of interest rate and exchange rate policy in the Federal
Republic of Germany.
Using data on Canadian government securities,
where the Canadian short-term rate is the threemonth Treasury bill yield, we estimated Equation

matuntles is explained for the 1979.12-1982.12
period, compared with only 3 to 16 percent in the
pre-October 1979 sample period. For example, 45
percent of the variance in the change in the ten-year
German rate is now accounted for by the equation,
compared with only 3 percent in the earlier sample
period. If one relied on the expectations hypothesis
to explain German long-term rates, expectations of
future German short rates would ~ppear to have
been greatly influenced by unanticipated movements in contemporaneous U. S. short rates. 14
To determine whether U.S. rates over the term
structure were influenced by unanticipated changes
in German short-term rates, Equation (10) was estimated for U.S. Treasury securities with maturities
of I, 3, 5, 7, IO and 20 years. We used the change
in the U. S. three-month Treasury bill rate and
the unanticipated component of the German threemonth interbank rate as explanatory variables.
Table 3 reveals that German interest rate "sur-

Table 2
German Term Structure Equations in Response
to Unanticipated U.S. Interest Rate Movements
(Sample Period 1979.12-1982.12)
Years to
Maturity

Constant
~.028

Explanatory Variables
AUS
dr~

RHO
~.05

D.W.

SER

.414

2.00

4.87

.382
(3.30)

.203
(4.20)

(-.33)

.254
(2.52)

207
(5.06)

.14
(.87)

.480

1.91

.408

(-.35)
-.025
(-.32)

.186
(1.96)

.221
(5.77)

.20
(1.21 )

.519

1.89

.383

.020

.160
(1.76)

.220
(6.02)

.18

.529

1.88

.366

(-.27)

(1.11)

-.012
(-.18)

.151
(1.71 )

.209
(5.82)

.14
(.84)

.509

1.90

.358

-.012
(-.20)

.153
( 1.80)

.209
(6.02)

.09
(.53)

.520

1.94

.347

-.013
(-.19)

.093

.197
(5.87)

.22
(1.35)

.504

1.87

.337

(I. 10)

-.015
(-.21)

.076
(.90)

.189
(5.60)

.23
( 1.43)

.480

1.88

.339

.011

.090
(1.09)

.182
(5.44)

.159
(.98)

.463

I. 91

.334

(~.16)

-.010
(-.15)

.095

.176
(5.39)

.131
(.80)

.455

1.94

.326

(I. 18)

(-37)

2
3

9
10

~.028

(10) for the four maturity segments of the Canadian
term structure, with maturity breakdowns of 1__3,
3-5,5-10 years and 10 years and over. Theestimated regressions appear in Table 4.
The two Canadian sample periods are the same as
those in the German case, the floating rate period
before and after October 1979 ending in 1982.12.

The regressions for the earlier period show that the
unanticipated <:;hanges in the U. S. Treasury bill rate
significantly influenced Canadian longer-term interest rates ov.el' the entire term structure, unlike the
German case for the same period. While Canadian
short rates also had a significant effect on thatcountry's longer rates, the impact ofachange in the

Table 3
U.S. Term Structure Equations in Response
to Unanticipated German Interest Rate Movements+
Vearsto
Maturity

Explanatory Variables
Constant

ar,us

RHO

D.W.

SER

Sample Period
1973.03-1979.09
.006
(.23)

.793
(15.14)

.049
(-.88)

-.08
(-.70)

.734

2.00

.228

.006
(.25)

.483
(9.21)

.092
( -1.64)

-.05
(- .45)

.505

2.01

.227

.010
(.45)

.362
(7.86)

.091
(-1.86)

.01
(09)

.439

2.01

.198

.015
(.71)

.284
(6.95)

-.071
(-1.63)

.07
(.66)

.392

2.00

.176

.019
(1.01)

.218
(6.07)

.054
1.40)

.07
(.59)

.324

1.98

.155

.016
(.98)

.201
(6.40)

.028
(-.85)

.05
(.48)

.341

1.98

.135

.010
(-.10)

.714
(1428)

089
(71)

.14
(.86)

.862

1.88

.513

.019
(.18)

.477
(8.57)

.147
(1.06)

.13
(83)

.699

1.87

572

.022
(.20)

.376
(6.91)

.129
(.96)

.16

.611

1.83

.557

(1.00)

.028
(.26)

.319
(5.82)

.083
(60)

.13
(.77)

.515

1.88

.564

.029
(.29)

.287
(5.64)

.060
(.48)

.14
(89)

.497

1.88

.522

.034
(.34)

.247
(5.00)

.046
(.38)

.19
(1. 17)

.447

1.86

.503

Sample Period
1979.12-1982.12

+ Dependent Variable is the change in the U.S. longertenn bond rate. (;p)
German three-month interbank rate:
G

r, =

.188+ 1.414r'_I.44lr'_2+Z,
(1.96)
(21.46)
(-6.69)

R,2

.971; DW

2.08; SER = .526

Sample period: 1967.10-1982.12

is the set of residuals from the following regression forthe

Canadian three-month bill rate tapered off significantly the longer the maturity of the government
security considered.
It has been argued that Canadian interest rates
following October 1979 were "more influenced by
swings in U.S. rates than were those of the European countries and Japan." 15 The results in Table 4
for the post-October 1979 period provide some confirmation of this opinion. Unlike the earlier period,
changes in the three-monthCanadian Treasurybill
rate had no statistically significant impact on Canadian bond rates beyond the 1-3 maturity class. We
found that the unanticipated U.S. short-rate variable is significant primarily at the short-end of the
maturity spectrum and that the coefficients are
larger than in the earlier sample period. Whereas
in the pre-October 1979 period an unanticipated
change of 100 basis points in the U.S. bill rate
would raise Canadian 1-3 year rates by about 16

basis points, the effect in the post-October 1979
period was 25 basis points.
The impact on longer maturities also was considerably larger. In fact, the coefficients on the U.S.
interest rate surprise variable for the second sample
period were larger and more significant than the
coefficients on the Canadian short-rate variable for
all but the shortest maturity. It is interesting to note
that after the change in U. S. monetary control procedures, the impact on Canadian and German term
structures of a 100 basis point "surprise" increase
in the U.S. three-month Treasury bill rate Were
quantitatively not that different. An unanticipated
one percentage point increase in the U.S. bill rate
causes a rise in both German and Canadian fiveyear bond rates of about 20 basis points. Expected
future short-term Canadian rates appear to have
been strongly influenced by U.S. rates after October 1979. The similarity with the German results

Table 4
Canadian Term Structure Equations in Response
to Unanticipated U.S. Interest Rate Movements+
Years to
Maturity

Constant

Explanatory Variables
AUS

6.rt

RHO

-2

D.W.

SER

Sample Period

1973.03-1979
.829
(8.92)

.161
(2.49)

-.06
(-.52)

557

2.00

.272

(-.64)

3-5 years

.019
(-.81)

.691
(9.29)

.140
(2.54)

.14
(-1.23)

558

1.95

.227

5-10 years

-.022
(-.85)

591
(7.50)

.161
(2.84)

-.09
(-.83)

.485

2.02

.235

-.004

.381
(7.09)

.101
(2.70)

-.04

.469

1.98

.157

(-.23)

(-.38)

1-3 years

-.055
(-.35)

.344
(2.10)

.256
(2.05)

.01
(.08)

.410

1.99

.923

3-5 years

.037
(-.24)

.229
(135)

.252
( 1.89)

-.06
(-.39)

.273

2.02

.989

5-10 years

.001
(-01)

.195
(1.39)

.212
(1.94)

.05
(-.33)

.288

2.01

.811

.023
(.19)

.165
(1.25)

.182
(1.74)

.07
(-.45)

.240

2.01

.775

1-3 years

10 years & over

.019

Sample Period

1979.12-1982

10 years & over

Dependent Variable is the change in the Canadian "longer-term" bond rate. t-statistics in parentheses.

dependent variable. The resultsforthe pre-October
1979 period suggests that the financial markets considered unanticipated movements in Canadian rates
to carry useful informationaboutfutureU. S. short
rates. This is quite plausible if the U.S. central bank
was considered to have had an exchange rate objec-

also extends to the lack of significance of the German or Canadian short-term rate except for. the
shorter maturities.
To test the hypothesis that U.S. rates were influenced by unanticipated Canadian short-term rates,
we estimated Equation (10) with U.S. rates as the

TableS

U.S. Term.Structure Equations•.in.Respcmse
to Unanticipated Canlldian Interest Rate Movements+
Explanatory V/ilriables

Years to
Constant

~rt

-.017
(-.80)

.712
(14.23)

.388
(4.43)

-.009
(-.39)

.411
(768)

-.004
(-.17)

Maturity

RHO

-2

D.W.

SER

-.13
(-1.l4)

.786

2.03

.204

.292
(3.10)

.06
(-.51)

.545

2.00

218

.302
(6.44)

.259
(3.13)

-.02
(-.18)

.480

1.99

.191

.003
(.17)

.239
(5.75)

.213
(3.89)

.04
(.38)

.432

1.98

.170

.010
(.54)

.183
(4.97)

.157
(2.40)

.07
(.65)

.355

1.96

.151

.007
(.44)

.169
(5.34)

.150
(2.66)

.06
(.56)

.392

1.95

.130

-.018
(-.18)

.659
(8.70)

.116
(1.02)

.17
(1.08)

.864

1.81

.509

.010
(.08)

.415
(4.87)

.136
(1.06)

.17
( 1.07)

.699

1.78

.572

.015
(.13)

.328
(3.96)

.105
(.85)

.20
(1.22)

.610

1.76

.558

.021
(.19)

.277
(3.29)

.089
(.69)

15
(.93)

.517

1.83

.562

.023
(.22)

.245
(3.17)

.088
(.75)

.16
(1.01)

.502

1.84

.520

.032
(.31)

.236
(3.17)

.025
(.22)

.21
(1.29)

.446

1.83

.504

Sample Period

1973.03-1979

3
5

Sample Period

1979.12-1982

Dependent Variable is the change in the U.S. "Ionger-tenn" bond rate.
the Canadian three-month Treasury bill rate:

r C=

.081 +
(1.96)

1.388 rT_1
(29.33)

.400r'_2 + Z
(-8.45)

R- = .986; DW = 1.97; SER

.471

Sample period: 1951.03-1982.12

('2;C) is the set of residuals from the following regression for

tive in relation to the Canadian dollar. Given the
long history of near parity between the two currencies, such a result is not surprising. Nonetheless,
there is little evidence in policy records to suggest
that the U. S. monetary authorities had such an
exchange rate objective. '6 In the post-October
1979 period, the Canadian interest rate surprise
coefficient is much smaller and insignificant in
all equations.
Putting the results of Tables 4 and 5 together, one
is led to the conclusion that in the post-October 1979
period, financial markets viewed the Bank of Can-

ada as being strongly influenced by unanticipated
movements in U.S. rates. U.S. rate movements
were, in a sense, good leading indicators of future
Canadian short-term rates under the assumption that
the Bank of Canada had some exchange rate objective with regard to the U.S. dollar. Thus, the results
for Canada in the post-October 1979 period are
similar to those found for Germany: unanticipated
movements in U.S. interest rates provided useful
information in forming expectations of future
foreign short-term interest rates, expectations
which were then translated to the foreign long-term
bond markets.

v. Summary and Policy Implications
The empirical results above suggest that, following the October 1979 adoption by the Federal
Reserve of alternative monetary policy control procedures, the Federal Republic of Germany found
that its financial markets were more "tied" to U.S.
financial markets than before. One could interpret
the results as suggesting that the linkage emerged
because of strong expectations that the German
central bank would not permit a long-run currency
depreciation against the U.S. dollar. In this manner,
expected future short-term interest rates in Germany were strongly influenced by changes in U.S.
short-term rates. This linkage depends on a reliance
on the expectations theory of the term structure and
the assumption that international interest rate differentials approximate expected rate changes.
Section Ill's analysis suggested that even during
significant OM depreciation from 1980-1982, financial markets expected OM to appreciate against
the dollar five to six years into the future. This
implies that if the U.S. were to follow a tight monetary policy which in the short-run might lead to
higher short-term rates, German monetary policy
would follow the U.S. lead. Thus, U.S. rates appeared to have influenced the entire German term
structure because of expectations that the German
central bank would not permit a long-run depreciation of its currency against the U. S. dollar.
Canada was pictured in Section III as having
"weak currency expectations" in the sense that
interest rate differentials implied a long-term depreciation of the Canadian dollar. Nonetheless, the
statistical results suggest that unanticipated interest

rate movements in the U.S. continued in the postOctober 1979 period to result in substantial increases in Canadian interest rates across the term
structure. Contrasting these two facts, the empirical
results of Table 4 with Chart 3, suggest that even
though the Canadian dollar was expected to depreciate over the long run, the Bank of Canada resisted
any further depreciation. That is, despite a "weak"
currency, the exchange rate objectives of the Bank
of Canada were as strong as Germany's.
The results of Section IV also revealed that there
was a substantial rise in both German and Canadian
short-term rates following the October 1979 Federal
Reserve policy move. Indeed, as noted in a Federal
Reserve staff study of the effect of the new monetary control procedures, when the Bank of Canada
raised its Bank Rate on October 9, 1979, Governor
Bouey mentioned the change in Federal Reserve
operating procedures as part of the reason for the
rate increase. With respect to Germany that Federal
Reserve staff study argued that,
" ... when dollar interest rates rose, German
interest rates seemed to rise in response, but
the rise in German interest rates seemed to
be based on domestic considerations, as was
noted by the Bundesbank at the time .... In
sum, authorities in continental Europeancountries wereaffeGted by the new operating procedures; they were affected by both the higher
level and, to a much lesser extent, the volatility
of U.S. interest rates. However, the problems
caused were not great, given that internal and
external objectives were broadly consistent.

Any problems stemmed primarily from Germany policy actions and conflicts and were
thus at most only indirectly related to the Federal Reserve's new operating procedures .17
If the private market thinks that the central bank
has a long-run objective of not accepting a higher
rate of inflation via a major depreciation of their
currency, short-term rates in the country pursuing
strong anti-inflation objectives cali become a "detenninant" of long-term rates in foreign countries.
Such a linkage, in our view, is firmly based on
expectations of the long-term objectives of the
central bank.
The empirical results above imply that following
October 1979 the new "linkage" between German
and U.S. financial markets arose because private
financial markets viewed the German central bank

as having a strong anti-inflation objective and that it
would, in the long-run, link DM to the dollar as long
as the Federal Reserve and the Bundesbank shared
the same long-term inflation objectives. Indeed, in
the post-October 1979, German financial markets
appear as closely linked to U. S. financial markets as
were those of Canada. 18
At the policy level, a country whose long-term
rates are linked to another country's short-term rate
via expectations of the central bank's long-run exchange rate objectives is one which, to some degree
at least, has lost the independence floating exchange rates were thought to promise. The existence of an international business cycle through
suc;1l interest rate linkages becomes more plausible
and may be a reason to promote greater coordination of international monetary policies.

FOOTNOTES
1. See R. Dornbush, "Flexible Exchange Rates and Interdependence," and A. K. Swoboda, "Exchange Rate Regimes and U.S.-European Policy Interdependence," in
Conference on Exchange Rate Regimes and Policy
Interdependence, IMF Staff Papers, (March 1983).

nomic Activity, 3 (1978). One of the first to warn that the
simple one-sided distributed lag term structure relationship
should not be treated as a structural relationship was R.
Shiller. See "Rational Expectations and the Term Structure
of Interest Rates: A Comment," Journal of Money, Credit
and Banking, (1973). On the methodology of testing for
rationality and market efficiency in the face of changes in
policy rules see F. S. Mishkin, A Rational Expectations
Approach to Macroeconomics, the University of Chicago
Press, (1983).

2. Bank of International Settlements, Fifty-second Annual
Report, (14 June 1982). p. 6, Basle.
3. G. Thiessen, "The Candian Experience With Monetary
Targeting," in Central Bank Views on Monetary Targeting, p. 103, P. Meek, editor, Federal ReselVe Bank of New
York, (1982).

7. L. Phillips and J. Pippenger, the "Preferred Habitat vs.
Effici.ent Market: A Test of Alternative Hypotheses," Federal
ReselVe Bank of St. Louis, (May 1976), were among the
first to test an equation similar to equation (3) and argue that
past short-term rates provided little if any explanatory
power in explaining the movement in long-term rates, as,
they suggest, isan implication of the efficient market theory.
For a contrary view of such tests, see F. Modigliani's comments on Mishkin's Brookings Papers article cited above.
J. E. Pisando argues that the Phillips-Pippenger argument
is correct if the current change in the short-term rate is
exactly equal to the innovation in the short-term rate: that is,
that the change in the short-term rate is a random walk.
However, he argues that the proposition that the change in
the short-rate follows a random walk in an efficient market
can only be established by assumption. See "On the Random Walk Characteristics of Short-and Long-Term Interest
Rates in an Efficient Market," Journal of Money, Credit
and B~.tnking, (November 1979).

4. T. J. Sargent, "Rational Expectations and the Term
Structure of Interest Rates," Journal of Money, Credit and
Banking, (February 1972, Part I) and F. Modigliani and R.
Shiller, "Inflation, Rational Expectations, and the Term
Structure of Interest Rates," Economica, (1973), were two
of the early articles to emphasize the rational expectations
efficiency argument, underlying equation (1) in the expectational statement of the term structure. A strong attack on the
expectations theory of the term structure may be seen in R.
J. Shiller, J. Y Campbell and K. L. Schoenholtz, "Forward
Rates and Future Policy: Interpreting the Term Structure of
Interst Rates," Brookings Papers on Economic Activity,
1, (1983).
5. Regarding the structure of optimal linear forecasts, see
P. Whittle, Prediction and Regulation by linear leastSquare Methods, D. Van Nostrand Co., Inc., (1963) and T
J. Sargeant, Macroeconomic Theory, Chapter X, Academic Press, (1979).

8. A lagged long-rate was alternatively included in equation
(9). When the model was estimated in first-difference form it
was rarely significant and therefore it is dropped in the
above exposition. One can obviously make a theoretical
case for its inclusion.

6. For example, see W Poole, "Rational Expectations in the
Macro Model," Brookings Paper on Economic Activity, 2
(1976) and F. S. Mishkin, "Efficient-Markets Theory: Implications for Monetary Policy," Brookings Papers on Eco-

nents of this technique is M. G. Porter, "A Theoretical and
Empirical Framework for Analyzing the Term Structure of
Exchange Rate Expectations," IMFStaffPapers, (November 1971). The expected percent change in the exchange
rate over the next n periods is computed as simply

9. See F. S. Mishkin, A Rational Expectations Approach
to Macroeconomics, Chapter 4, The University of Chicago Press, on the role of "new information" in affecting, in
our case here, the change in the long-term bond rate. A
purely econometric argument for why the term structure
equation should be estimated in first-differential form can
be obtained from C. W J. Granger and P. Newbold, "Spurious Regressions in Econometrics," Journal of Econometrics, 2, (1974).

[(::~*r -

x 100,

where A is the domestic n-period bond yield and R* the
n-period foreign bond yield. Another paper which emphasizes how the term structure of domestic interest rates
reflects the foreign term structure and partiCUlarly how the
rate differential is related to maturity is P. Minford, "A
Rational Expectations Model of the United Kingdom Under
Fixed . and Floating Exchange Rate," in On the State
of Macro-Economics, .Carnegie-Rochester Conference
Series on Public Policy, Volume 12, K. Brunner and A. H.
Meltzer, eds., North-Holland, (1980).

10. The Deutsche Bundesbank: Its Monetary Policy
Instruments and Functions, Deutsche Bundesbank SpecialSeries No.7, (October 1982). On the subject of Bundesbank· intervention in the DM/$ market see F. Scholl,
"Implications of Monetary Targeting for Exchange Rate
Policy," in Central Bank Views on Monetary Targeting, P.
Meek, ed., Federal Reserve Bank of New York, (1982).
11. The relationship between German and Canadian "longterm" bond rates and U.S. short-term rates is subject to the
Lucas criticism that behavioral coefficients in econometric
models are themselves functions of perceptions of current
and expected future government policy. Because the expectations formed in equation (8) are dependent on the
policy regime, in the particular case here, the U.S. monetary control regimes prior to and after October 6, 1979, this
criticism is important for our purpose here because we.
argue that the Federal Reserve's change in monetary control procedures in October 1979 fundamentally changed
the expectational structure described generall in equation
(6). On that date the Federal Reserve changed its techniques from controlling monetary growth via control of the
rate on Federal funds to the control of money by controlling
the reserve growth of the banking system. Whether this
change in control procedures had an impact on the relationship described in equation (10) will be empirically tested by
estimating equation (10) with data prior to and following the
change in U.S. monetary control procedures. See Robert E.
Lucas, Jr., "Econometric Policy Evaluation: A Critique," in
The Phillips Curve and Labor Markets, K. Brunner and A.
H. Metzer, eds., North-Holland, (1976). The Lucas argument implies that the "informational content" of the two
interest rates can change with a change in policy rules. A
variable representing the policy rule does not explicitly
appear on the right-hand side of (6) and therefore we cannot capture directly how the policy rule alters the relationship between essentially endogenous variables, the
domestic and foreign short-term interest rates and their
relationship to long rates. However, a change in the policy
regime will alter the underlying stochastic distribution of
endogenous variables and thereby change the estimated
coefficients. The policy regime could be thought of as a
missing variable in (6). A change in the correlation between
the missing variable, the policy regime, and the included
variables, the short-term rates, will cause the estimated
coefficients in (6) to change.

Note, however, that the existence of risk aversion will cause
domestic and foreign bonds to be less than perfect substitutes reSUlting in the foreign-domestic interest rate differential not being equal to the expected rate of depreciation.
See C. A. Wyplosy, "The Exchange and Interest Rate Term
Structure Under Risk Aversion and Rational Expectations,"
Journal of International Economics, (1983).
13. My thanks to Dr. H. Dudler of the Bundesbank for
providing the German term structure data. Two review articles of use in understanding the behavior of the German
bond market are "Interest Rate Movements and Changes
in the Interest Rate Structure in the Federal Republic of
Germany Since 1967," Monthly Report of the Deutsche
Bundesbank, (April 1978) and "Interest Rate Movements
Since 1978," Monthly Report of the Deutsche Bundesbank, (January 1983).
14. One minor technical note needs mentioning. Above we
argued that the estimated residuals from an autoregression
of the U.S. three-month Treasury bill rate could be considered to be the "news" or the "unanticipated" element which
might influence German long-term interest rates. As a
check on this assumption we reestimated equation (10)
using simply the first difference of the three-month Treasury
bill rates. The results were very similar to those reported
here. Moreover, we obtained similar results when lagged
(changes in) German short-term rates were included as
explanatory variables.
An unpublished study by Dr. W GeBauer, of the Deutsche
Bundesbank, provided to me by Dr. H. Dudler, found an
insignificant sum of the coefficients on changes in lagged
short-term rates for a German term structure equation. See
"Empirische Uberprufung von Zinsstrukturhypotheses,"
(April 1978). My thanks to Ms. Mary Byrd Nance for help in
translation. The change in the role of the German interbank
rate in the long-term rate expectations could also be reflecting the fact that the change in the Federal Reserve's operating techniques affected the risk characteristics of U.S. and
German financial assets, and thereby affected the structure
of asset demand equations for these securities. On how
such changes in asset demand equations might occur

12. The term structure of exchange rate expectations are
obtained by using interest rate date for December dates,
from 1975 to 1982, on comparable maturity U.S., Canada
and German government bonds. One of the earliest propo-

given a change in policy regimes, see C. E. Walsh, "The
Effects of Alternative Operating Procedures on Economic
and Financial Relationship.," Monetary Policy Issues in
the 1980s, a Symposium sponsored by the Federal Reserve Bank of Kansas City, (1982).

ing Procedures: An External Perspective," by Edwin M.
Truman and others, published in New Monetary Control
Procedures, Federal Reserve Staff Study-Volume II,
Board of Governors of the Federal Reserve System, February 1981.

15. Quoted from C. Freedman, "The Effect of U.S. Policies
on Foreign Countries: The Case of Canada," in Monetary
Policy Issues in the 1980s, Federal Reserve Bank of
Kansas City, (1982).

18. While it is arguable that the post-October 1979 relationship between unanticipated U.S. rate movements and
changes in German and Canadian long-term bond rates
could have been related to some change in policy other
than the October 1979 change in monetary control procedures of the Federal Reserve, this is not easy to establish
by selecting other pivot dates on which to split the available
sample. For example, using data prior to the period of
floating exchange rates and estimating relationships similar
to those above, the move from fixed to floating exchange
rates in 1973 had little, if any, effect on the foreign bond
market's response to U.S. interest rate movements. The
policy move of October 1979 was closely followed by a rise
in real interest rates in the U.S. and real appreciation of the
U.S. dollar. These facts made U.S. interest rates important
"leading indicators" of interest rates for those countries VJith
strong exchange rate objectives.

16. While it is admitted that the significance of the unanticipated Canadian interest rate variable in the U.S term structure equations is surprising, this result is consistent with
earlier work by Kevin Hoover and the author. This earlier
work suggested that U.S. interest rates were not insensitive, as might be expected, to the stocks of Canadian financial assets. See "Some Suggested Improvements to a
Simple Portfolio Balance Model of Exchange Rate Determination with Special Reference to the U.S. Dollar/
Canadian Dollar Rate," Weltwirtschaftliches Archiv, Heft
1, (1982).
17. Quoted from "The New Federal Reserve Operat-

John P. Judd*
Events in recent years have highlighted the important relationships between monetary policy and
the regulations governing financial markets and
institutions. In particular, deposit-rate ceilings have
emerged as one of the most important of these
financial regulations, and the deregulation of these
ceilings has triggered speculation as to the continued usefulness of the narrow transaction measure
of the money supply-MI-that has most often
been used by the Federal Reserve as its primary
monetary policy guide. This paper analyzes how the
effectiveness of MI targeting has been affected by
the recent round of deposit rate deregulation which
occurred with the introduction of Super-NOW and
Money Market Deposit Accounts. It also assesses
the prospects for successfully implementing an MItargeting approach to policy in the future, when all
deposit-rate ceilings are removed.
Some economists and policymakers have argued
that deposit rate deregulation is prima facie evidence that targeting the monetary aggregates, especially the narrow MI aggregate, will no longer be
desirable. In the second half of 1982, the Federal
Reserve expressed its doubts about the reliability of
MI by placing less than the usual weight on this
measure in formulating policy.
Some analysts have argued that deregulation will
make the relationship between money and economic activity unstable by fundamentally altering a key
relationship in the economy-the public's demand
to hold transaction money. I There are two basic
ways in which the demand for money, as measured
by Ml, may be permanently altered by deregulation. First, deregulation may induce a flow of sav-

ings balances into MI, and thus contaminate its
basic transactions function. This could make the
public's demand for MI highly unstable because
savings balances tend to be more sensitive than
transaction balances to small changes in the broad
range of interest rate spreads and in investors' sentiments. If this occurred, it would make the relationship between money and the economy more
difficult to predict. However, the results of the
empirical tests presented in this paper cast doubt
on the view that such contamination has already
occurred. The analysis also demonstrates that it is
by no means certain that M I will be seriously contaminated even when all deposit rate ceilings are
removed in the future.
Another important effect of deregulation is that
with flexible deposit rates, the opportunity cost
of holding MI may become fairly insensitive to
changes in the general level of market rates of
interest. The associated decline in the responsiveness of the quantity of money demanded to changes
in the level of market interest rates has both disadvantages and advantages. One temporary disadvantage is that more flexible deposit rates would change
the (reduced-form) relationships going from money
to income and other variables. This would increase
the uncertainty in policy decisions for the Federal
Reserve until it understands and becomes proficient
at working with the new relationships.
A permanent disadvantage is that the economy
would become more sensitive to instability in
money demand. However, the evidence thus far
indicates that deregulation has not made Ml noticeably less stable. Moreover, the lower responsiveness of MI demand to the overall level of interest
rates has the advantage that it insulates the economy
from instability in the public's demand for goods
and services and from unexpected changes in inflation expectations.
Given these pluses and minuses, it is inappropriate to conclude that an economy with flexible

*Research Officer, Federal Reserve Bank of San
Francisco. David Murray provided research assistance. The opinions expressed are those of the
author, and not necessarily those of the Federal
Reserve Bank of San Francisco or the Federal
Reserve System.
27

deposit rates is not conducive to MI targeting. Although it is too soon to tell for sure, there appears to
be an equally good chance that Ml will have an even
closer relationship with the macroeconomic variables when deposit rates are completely deregulated.
Deposit deregulation also raises issues concerning short-run monetary control. A lower interestresponsiveness ofMI demand could possibly make
it less feasible or desirable for the Federal Reserve
to achieve monetary targets in any precise way,
since this precision might involve an unacceptably
high degree of interest rate volatility. Moreover,
even if precise control were exercised, Ml might
become only a contemporaneous or even a lagging
indicator of economic developments, rather than a
leading indicator as it has been in the past. In this
case, even a perfectly predictable demand for
money would not be of high value for monetary
targeting.
The analysis in this paper shows that the seriousness of this potential problem in part depends on
whether or not MI plays the role of a buffer-stock in
the public's portfolio. If it does play this role, these
problems are not likely to be great. If buffer-stock
effects are small, Ml targeting could be seriously
hampered by deposit rate deregulation. Only a

small amount of evidence on this issue is now available, but it does support the existence of significant
buffer-stock effects.
The conclusion that we draw from the arguments
and evidence in this paper is that theory is silent on
whether or not Ml-targeting is more or less effective under flexible deposit rates. The test is an
empirical one. Unfortunately, because deregulation
is not yet complete, conclusive evidence is not
available. The substantial evidence that does exist
suggests that the use ofMI as an intermediate target
has. not been ruined by deregulation and that it
would be advisable forthe Federal Reserve to return
to its former practice of using MI as its primary
monetary aggregate.
The rest of the paper is organized as follows.
Section I presents the theoretical framework used
for analysis in the paper. Section II discusses the
effects of deregulation on the stability of money
demand. Section III concerns the effects of deregulation on the responsiveness of money demand to
market interest rates, and how this responsiveness
alters the sensitivity of the economy to various types
of uncertainty. Section IV analyzes potential monetary control problems. Finally, conclusions and
policy implications are discussed in Section V.

I. Framework of Analysis
The model used in this paper is the standard
IS-LM representation of the economy expanded to
include a flexible deposit interest rate. The IS-curve
represents combinations of nominal market interest
rates (i) and real income (y) that produce equilibrium in the goods market, for given levels of expected
inflation (p*) and the high employment federal
expenditures (G) (Equation I). The LM-curve represents combinations of nominal market interest
rates and real income that equate the public's
demand for money with the quantity supplied by the
Federal Reserve, given the rate of return on deposits
(z) and the level of prices, P (Equation 2).
The relationship explaining the rate of return on
the deposits in the money stock is contained in a
third equation (Equation 3). In the absence of deposit rate ceilings, the banking system is assumed to
pay the competitive rate of return on these deposits.
This competitive return is held below market rates

by the extra costs and risks incurred by banks in
(I) y = y(G,

i-P*)

(2) M/P = M(y, i- z)

(3) z = z ( L, i )

offering transaction deposits as compared with
other debt instruments. These extra costs fall into
two categories: those that vary systematically with
market interest rates and those that do not. The
importance of this distinction will become clear in
the analysis below.
Reserve requirements are the primary example of
costs that vary with market yields. 2 If transaction
deposits carry a reserve requirement of x percent,
banks incur a reserve requirement "tax" of xi per
dollar of deposit. In a competitive banking system,
banks will pass this "tax" on to the depositors by

holding the rate on deposits (z) below the rate on
market instruments to the extent of xi. For example,
if the reserve requirement ratio is 12 percent and the
market interest rate is 10 percent, the reserve requirement wedge between market and deposit rates
would be 1.2 percentage points. Thus, reserve requirements can be an important factor in determining the opportunity cost of holding money (i-z),
which, in turn, is a key determinant of the public's
demand for money (Equation 2). Reserve requirement costs also cause the opportunity cost of holding money (i-z) to vary positively with market rates.
For example, with a reserve requirement ratio of 12
percent, an increase in the market rate of I percentage point induces a rise in the deposit rate of 0.88
percentage point. The opportunity cost of holding
money therefore increases by 0.12 percentage point.
There also may be factors holding interest rates
on trasaction deposits below market rates that do not
vary systematically with market interest rates
(represented by the variable L in Equation 3). The
primary example is the liquidity premium that
can be expected to stand between transaction
deposit rates and rates on less liquid substitutes.
From the bank's viewpoint, this premium should
exist because of the added risk incurred when institutions borrow funds through instruments payable
on demand (transaction deposits) and lend the funds
out through longer-term instruments. 3 Banks' 'produce" liquidity by transforming maturities in this
way. However, the "production" process involves
the risk of potential losses that would occur if (market determined) borrowing costs rose above (fixed)
lending rates. Banks protect themselves from this
added risk by maintaining equity cushions, and by
making the yield on transaction deposits lower than
that available on other less liquid deposits and on
open market instruments. The depositor is willing
to accept a lower interest rate on a transaction
deposit because its added liquidity has economic
value. The price that this liquidity commands in the
market is the reduction in the interest rate on transaction deposits. Thus, for example, a liquidity premium can be expected to stand between the yields
on transaction deposits and Treasury bills in much
the same way as a premium stands between threemonth and one-year Treasury bills.4
When deposit rate ceilings are in place, the parameters of Equation 3 obviously are different from

when deposit rates are deregulated. If fixed deposit
rate ceilings (such as the 5% percent ceiling on
regular NOW accounts) were fully effective, the
variable L simply would represent the negative of
the constant ceiling rate, and the variable i would
drop out of the function. However, it is unrealistic
to assume that deposit rate regulations have been
fully effective in the U.S., since there are va..-ious
ways in which implicit fonns of compensation can
be paid by banks. It is reasonable to assume that
competition for deposits will induce banks to exploit these methods. Thus, even under deposit-rate
ceilings, it is more accurate to assume that z varies
with i (although not as fast as without regulations)
and that the level of compensation is above the fixed
legal ceiling by some unspecified amount.
A final characteristic of all three equations is that
they are not known with certainty. If this uncertainty were not present, the Federal Reserve would
always be able to achieve what ever nominal
income goal it set for itself. In other words, the
uncertainty is the source of monetary policy problems. Although uncertainty cannot be eliminated,
there are means of altering its probable effects on
the economy. These include changing the way in
which monetary policy is conducted by the Federal
Reserve (for example, using monetary aggregates
rather than interest rate targeting), or changing
the regulations and laws that govern the financial
system. The latter issue is the main subject of this
paper.
The complete model can be summarized in terms
of the familiar IS-LM diagram in Chart I. The
IS-curve is simply the plot of Equation I in terms of
interest rates and income, for given levels of expected inflation and fiscal policy stimulus. A band
is plotted to reflect the degree of uncertainty. The
LM-curve is obtained by substituting the deposit
rate setting Equation 3 into the money demand
Equation 2. A band is plotted to denote the degree of
uncertainty. For given monetary policy settings,
defined by M under monetary aggregates targeting,
the model predicts an outcome for real income ofY.
However, the uncertainty about the relationships in
the model means that y could end up anywhere in
the range of YI to Y2 with some specified confidence
level.
The analysis below focuses on how deposit rate
deregulation affects the risks present in a monetary

potential "instability" effect and its influence on
the effectiveness of monetary aggregate targeting is
discussed in Section II. Second, deregulation could
reduce the responsiveness of the LM-curve to
changes in market interest rates by allowing the
deposit rate to move more closely with market rates.
This "interest-elasticity" effect, which makes the
LM-curve more vertical, is discussed in Sections IiI
and IV.

policy conducted in terms of monetary targeting. It
shows how deregulation affects the width of the
YI -Y2 range. Deposit-rate deregulation potentially
can alter these risks by changing two important
properties of the LM-curve. First deregulation
could affect the stability or predictability of the
public's demand for money, both temporarily during a transition period, and also pennanently. In
other words, deregulation might increase the size of
the band of uncertainty around the LM-curve. This

II. Effects of Deregulation-Stability of Money Demand
In cataloging the effects of deposit rate deregulation on money demand, it is useful to distinguish
between the adjustment effects during the transition
period after a regulatory change and the equilibrium
effects which persist after full adjustment has been
made. During the adjustment period, the level of
M I the public wishes to hold at given levels of
income, prices and market interest rates may
change. These changes have been called "shifts" in
the demand for money. The deregulation of yields
on transaction deposits temporarily causes the demand for Ml to shift up, as the public pursues the
more attractive yields. The introduction of NOW
accounts on a national basis in 1981 is a case in
point. It raised the questions, by how much would
the demand for Ml (including NOWs) rise in response to the higher ceiling rate available on checkable deposits, and how long would this adjustment
take to run its course? Whenever such an upward
shift is taking place, the LM-curve shifts to the left
and tends to make policy more contractionary than
would otherwise be the case. This can temporarily
throw monetary policy off course as it is difficult
to estimate the size and duration of the shift while it
is occurring.
More important than the transitional problem is
the potential permanent instability in money demand that could result from deregulation: it could
become more difficult to predict the quantity ofMI
the public demands. This problem could arise because higher yields on the deposits in M I could
induce the public to use it as a savings vehicle to a
more significant degree than in the past.

Conceptually, one would expect the public's demand for a transaction aggregate (such as MI) to
have a closer relationship with income and prices
than a savings-type aggregate (such as M2) because
there are few close substitutes for the medium of
exchange. But if the public were to comingIe in
Ml the funds it holds for investment purposes, MI
would become more like the various financial assets
held for investment purposes, and changes in MI
could be dominated at various times by shifts in the
composition of the public's portfolio rather than by
changes in income and prices.
For example, the demand for Ml might become

Chart 1

more highly responsive to fluctuations in the
, 'normal" spreads between the rate of return on M1
and rates paid on a wide range of liquid financial
instruments not included in Ml. It also might
become more sensitive to changes in yields on longterm bonds and common stocks. Shifts in investors'
preferences for various maturities and liquidity
characteristics would have larger effects on rvH
demand, as would changes in precautionary motives
over the business cycle. Since the demand for Ml
might respond sensitively to a number of difficultto-measure incentives, it might be difficult to predict the quantity ofMl demanded by the public. Put
differently, an Ml demand function estimated in
terms of the traditional arguments of income, prices
and a market interest rate might frequently show
signs of instability.
The problems that such instability can cause for a
monetary policy oriented around M I-targeting can
be illustrated with the IS-LM diagram in Chart 1.
Greater instability in Ml demand would show up as
a wider band of uncertainty in the LM-curve. This
wider band would increase the range of outcomes
for income (YI-Y2 would become larger) for any
given setting for M 1.

found that these effects on M 1 demand have been
relatively small. In New England's case, NOW
accounts caused an upward Ml shift of not more
than 5 percent over five years; in the nationwide
case, NOWs raised the demand for Ml by no more
than 3 percent in 1981. Moreover, some evidence
suggests that the effect on M1 in 1981 was far
smaller than the study quoted or even non-existent.6
The most recent and far-reaching example of
deposit-rate. deregulation occurred when federal
regulators authorized commercial banks and thrift
institutions to issue the Money Market Deposit Account (MMDA) in December 1982 and the SuperNOW account in January 1983. The MMDA is free
of interest rate ceilings, has a $2,500 minimum
denomination, and allows six transfers to third parties per month (three of which may be checks). The
Super-NOW account (which is not available to businesses) is also subject to a $2,500 minimum denomination and is free of interest rate ceilings. An
important distinguishing feature is that it has unlimited check-writing privileges.
Taken together, these two accounts mean that for
the first time since the Great Depression, depository
institutions are permitted by law to offer checkable
deposits that are not subject to interest rate ceilings.
This case of deregulation differs from the introduction of nationwide NOWs in 1981 in two important
respects. First, the recent case completely removed
interest rate ceilings instead of imposing anew
higher, but fixed ceiling. (This feature of SuperNOWs is the focus of the analysis in Section III.)
Second, ceilings were removed not only from transaction accounts (Super-NOWs), but also from close
substitutes for transaction accounts (MMDAs).
The latter point means that unlike earliercases of
deregulation, the direction of the potential shift in
money demand cannot be determined from theory.
The effects of the introduction of Super-NOWs
should induce positive flows of funds into Ml from
unregulated instruments and especially from
accounts that carry interest rate ceilings. Other
potential sources of funds include passbook savings
accounts and time deposits with interest rate ceilings, and money market mutual funds.
In contrast, the introduction of the MMDA
should temporarily depress Ml growth. The public
may, for one, use it as a cash management tool to
reduce holdings of true transaction balances. With-

NOWs, Super-NOWs, and MMDAs
There is a considerable amount of evidence available concerning the effects of deregulation on
money demand during transition periods. This evidence also sheds light on the seriousness of potential permanent problems with instability in money
demand resulting from the mixing of savings and
transaction balances. If Ml were contaminated by
savings balances, this would show up first as a
temporary shift in the demand for Ml, as savings
balances were shifted into that aggregate. There
should therefore be a positive association between
the size of upward shifts during the transition period
following deregulation and the probability that Ml
has been permanently contaminated.
An earlier paper surveyed and analyzed the evidence of money demand instability during the transition periods following two episodes of deregulation prior to 1982-83.5 Both episodes were related
to growth in regular NOW accounts (with fixed
ceilings): the introduction of NOW accounts in New
England in the 1970s and the nationwide introduction of NOW accounts in January 1981. The study

in the regulatory limitations on MMDAs, regular
transfers of funds between them and the fully checkable deposits in Ml would allow the public to reduce the level of Ml needed to conduct a given
volume of transactions. Another reason for shifts
out of Ml into the MMDA is that the new account
is, to a limited extent, a transaction instrument
itself. Use of the MMDA to write a few large
checks, such as mortgage or credit card payments,
would mean that some transaction funds in the new
account never have to pass through an Ml balance.
Finally, Ml presumably contains some savingstype balances that are not actually used by the public
for making transactions. These funds are probably
lodged in traditional NOWs, which carry maximum
yields that are competitive with passbook savings
accounts. The higher yields and liquidity of
MMDAs, however, should attract most of these
funds away from MI.
In sum, shifts into MMDAs add up to a potentially significant reduction in the public's demand
for M I. The extent to which these shifts depress M I,
and thereby offset the expansionary effects of the
Super-NOW account, depends partly on the pricing
policies institutions adopt for the two accounts.
That is, it depends on the parameters in the depositrate setting Equation 3. If yields on MMDAs are
considerably more attractive than those on SuperNOWs (because of a liquidity premium and the
difference in reserve requirements), there could be a
net outflow of M I funds into MMDAs. It is also
possible that Super-NOWs are priced attractively
enough to offset the outflow from M I, or to cause
a net inflow. For these reasons, theory cannot tell us
very much about the direction of the transitory effects. MI demand could have shifted upward, making policy tighter than it appeared in 1983, or the
opposite could have occurred. Similarly, theory
cannot tell whether deregulation contaminated Ml
by attracting savings balances into Super-NOWs, or
purified MI by attracting savings balances already
in MI into MMDAs.

Super-NOWs from March through September 1983
has been below that of MMDAs by from 1.07 to
1.41 percentage points (see Chart 2). Using the
one-month commercial paper rate as the interest
rate, reserve requirement costs can be seen to
account for between one and I ]/s percentage point of
this spread in March through September 1983, so
there does appear to be a small additional spread due
to other factors.
The explicit rates of interest quoted here may not
give a very accurate indication of the true yields
available on these instruments for certain deposits,
the reason being that many institutions have attached various fees, including fixed monthly
charges that are larger for smaller deposits,7 to the
instruments. However, these fees are not likely to
affect a consumer's decision at the margin to add an
additional dollar of savings balances to a SuperNOW versus an MMDA since the fixed charges that
must be paid are unaffected by the decision. Thus,
the interest rate spreads shown in Chart 2 probably
give a good indication of the spread of yields (at the
margin) that help determine where savings balances
end up.
Although it is clear that consumers can earn more
on their savings balances if they put them into
MMDAs than in Super-NOWs, it is still possible
that the premium on MMDAs is not large enough to
prevent substantial mixing. This could be the case,
for example, if explicit or implicit transaction costs
between the two accounts were large enough to
overcome the yield advantage associated with
MMDAs. Unfortunately, it is extremely difficult, if
not impossible, to obtain reliable estimates of these
transaction costs, especially since they necessarily
include the value consumers place on the time and
"trouble" associated with managing liquid funds.
This paper employs two other methods of estimating how much Ml has been distorted by recent
deregulation: work done by the Staff of the Board of
Governors of the Federal Reserve System using
surveys of depositors and cross-sectional econometric techniques to estimate the magnitudes of the
various flows of liquid funds following the recent
deregulation,8 and econometric estimates and simulations of a demand-for-transaction-deposits equation to see if there is evidence of a "shift" in the
function.

Empirical Evidence in 1983
As noted earlier, there is good reason to expect
that MMDA yields should exceed yields on SuperNOWs. This expectation has been borne out by
subsequent events. The average interest paid on

As of September 1983, MMDAs had reached
$367 billion (about 17 percent ofM2), while SuperNOWs reached $35 billion (about 6 1/2 percent of
MI).9 The survey and econometric cross-section
evidence suggests that the net distorting effect of
this growth in Super-NOWs and MMDAs on Ml
was small. With respect to MMDAs, the major
sources of huge increases appear to be passbook
savings accounts, small denomination time deposits, large denomination time deposits and money
market mutual funds. Small amounts of funds are
estimated to have been transferred from Treasury
securities, other market instruments, demand deposits and regular NOW accounts. The last two
categories are the only ones that would affect Ml
growth, and they would apparently have contributed to a small downward shift in MI.
This same evidence indicates that the bulk of
dollars placed in Super-NOWs came from other
transaction accounts in Ml, including demand deposits and regular NOWs. A small amount of funds
probably came from non-Ml sources, including
passbook savings and small time deposits. These
latter movements would contribute a small upward
shift in M1 demand that would tend to offset the
small downward shift caused by funds transferred
from transaction accounts to MMDAs.
Our own method of analysis consists of examining temporal econometric evidence on the behavior
of the public's demand for transaction balances in
the period after the dergulation of deposit rates-in
December 1982 and January 1983. We employed
conventional equations for the public's demand for
transaction deposits. The equations specify Ml as a
function of the six-month commercial paper rate,
the personal consumption expenditure price deflator, and real personal income. Two alternative
variations of this equation were used, one which
restricted the interest elasticity to be constant, and
another which allowed that elasticity to vary positively with the level of interest rates.
These equations were used to determine if growth
in Ml after November 1982 was consistent with the
historical demand relationship. We estimated the
equations over the January 1970 through November
1982 period (see Table I) and (dynamically)
simulated them over the period December 1982August 1983. We then compared the simulated Ml-

Table 1
Transaction Deposit Demand Equations
A. Variable Interest Elasticity Specification
LTRD,

0.091
(0.86)

+ LPCE,

0.0021 CPR1',
(7.11)

+ 0.069 (LYPERS,

LPCE,)

(5.20)
0.()(1161',
(4.83)

+ 0.‫סס‬OO37 T;
(3.04)

+ 0.90 (LTRD t_1 - LPCE t )
(45.51)

0.16U, - 0.08U'_1
(2.00)
(1.00)

Estimation Period: 1970.01 - 1982.11

R- 0.999
SEE = 0.0050
DW
1.96

B. Constant Interest Elasticity Specification
LTRD,

0.071
(064)

0.014 LCPRT,
(5.82)

+ LPCE,

+ 0.054 (LYPERS, - LPCE,) - 0.00131',
(4.10)

(3.77)

+ 0.0000291';
(2.29)

+ 0.92 (L1'RD t_1 - LPCE,) + 0.18U t -0. lOUt_I
(47.7)

(2.23)

(1.24)

Estimation Period: 1970.01 - 1982.11

R- 0.999
SEE = 0.0052
DW = 1.97
Variables:
L1'RD
LCPR1'
CPR1'
LPCE
LYPERS =
l'

log of (MI minus eurrency).
log of 4-6 month commercial paper rate
4-6 month commereial paper rate
log of personal consumption expenditure deflator.
log of nominal personal income.
1.2 .... 24 in 1974.07-1976,(16: zero prior to
1974.07; 24 after 1976.06.
U = error term.

growth rates to actual growth. If the demand for M I
shifted with the introduction of the new accounts,
this should show up as large cumulative under-forecasts by the end of the period.
The results of our experiment are presented in
Table 2. They show that the variable interest elasticity Ml demand equation over-forecasted Ml
growth by a small amount. This result is inconsistent with the hypothesis that Ml-demand shifted up

tion of household savings and transaction balances,
the same may also be true of corporate balances.
Corporations, even small ones, are likely to manage
their liquid balances more closely than do most
households, and they have a wider variety of liquid
investment alternatives available to them than
do households.
Second, at least since the mid-1970s, deposit rate
ceilings have effectively been circumvented by
many large corporations. Banks often pay implicit
returns On demand deposit balances through arrangements whereby the balances that corporations
wish to hold are counted as payment for operational
and credit services. For example, business customers can pay for loan commitments with dollars held
in demand deposit accounts. In the case of operational services, dollars held in the checking account
are multiplied by the implicit rate of return to be
paid on the account, and the result of this calculation is counted as payment for services. Services not
paid for by these deposits often can be covered
Prospects for the Future
through explicit fees. 1J
The preceding analysis and evidence pertain only
With regard to operational services, interviews
to deposits held by households. Although housewith corporate treasurers and bankers suggest that
hold deposits have been largely deregulated, corpo(implicit) returns on checking account balances
rations still are prohibited from holding any interestgenerally have been set at some open market rate
bearing account that is fully checkable. This leaves
(for example, the three-month Treasury bill rate)
open the possibility that MI could be adversely
minus the cost to the bank of reserve requirements,
affected by the deregulation of corporate demand
and usually have been adjusted according to market
deposits at some time in the future. There are,
rates on a monthly or quarterly basis. Thus, many
corporations appear to have earned (marginal)
however, two reasons to believe that the effects of
this deregulation on MI may not be large. First, the
returns roughly at the competitive rate, presumably
evidence presented earlier suggests that the introclose to the rate they would have eamed under
duction of Super-NOWs has not caused a major
deregulated deposit rates. The interviews also suginflow of savings balances into MI. If the yield
gest that these competitive yield spreads were large
enough to induce most of the corporations to minispread between MMDAs and Super-NOWs has
been large enough to preserve a reasonable separamize their checking account balances for a given
Table 2
Growth in M1 minus Currency
(at Annual Rates)
with recent deregulation. The constant elasticity
equation under-forecast MI growth by 0.9 percent
(at an annual rate), but this is a very small error
compared with the standard error of the regression.
These results therefore tend to confirm the survey
and cross-sectional results which failed to find
evidence of a shift in the public's demand-fortransaction-deposit equation following the recent
deregulation. 1O
This evidence has two implications. First, instability in M I demand does not appear to have significantly distorted monetary policy in 1983. 11 Second,
if MI were to be permanently contaminated by an
inflow of savings balances, this would most likely
have shown up as an upward shift in MI demand
during the transition period following deregulation.
By not finding such a shift, this paper supports the
view that the recent important round of deposit
deregulation has not materially changed the transaction nature ofMIY

Period

Actual

A. Variable Interest Elasticity Specification:
December 1982
through
12.8 percent
August 1983
B. Constant Interest Elasticity Specification:
December 1982
through
August 1983
12.8 percent

Dynamic
Simulation

Actual minus
Simulated

13.6 percent

-0.8 percent

II .9 percent

+0.9 percent

corporate transaction balances that is unlikely to
be significantly affected by future deposit-rate deregulation because it has already been" deregulated
de facto."

volume of transactions. Liquid funds in excess
of this transaction demand were put into higher
yielding savings-type instruments. In this way, the
transaction and investment funds are effectively
separated. There is thus a sizable component of

III. Effects of Deregulation-Responsiveness of Money Demand
to Market Interest Rates
The second aspect of concern over interest rate
deregulation is related to the potential for permanent changes in the responsiveness of the demand
for M I to movements in market rates of interest, and
how these changes will affect the money-to-income
relationship. A key question in this regard is how
sensitive depository institutions will be to movements in market yields when they adjust their offer
rates on checkable deposits. Since the opportunity
cost of holding Ml is the spread between the market
rate and the deposit rate, adjusting deposit rates to
closely follow market rates would make the opportunity cost ofMI vary much less than market rates.
Thus, changes of a given size in the demand for Ml
would correspond to large changes in market interest rates: that is, the elasticity of Ml with respect to
market rates would be smaller.
This point is illustrated by Equations 2 and 3.
Equation 2, the money demand function, states that
the public's demand for money varies inversely
with the opportunity cost of holding money (i - z).
Equation 3, the bank deposit-rate setting equation,
defines how this opportunity cost varies with market rates. When deposit-rate ceilings are fully effective, deposit rates do not vary with market rates. In
such a case, changes in the opportunity cost of
holding money would be equal to changes in market
interest rates, and the LM-curve would have a positive slope as shown in Chart I. At the other extreme,
banks might vary deposit rates in tandem with market rates. In this case, the opportunity cost of holding money would be invariant with changes in market rates, and the opportunity cost variable (i ~ z)
would drop-out of the money demand equation. In
this situation, the LM-curve in Chart I would be
completely vertical.
As noted earlier, these assumptions obviously are
overstatements of the regulated and deregulated
worlds, respectively, since regulations on rates of
return paid on transaction deposits have not been
fully effective. Implicit returns on (large) corporate

checking accounts apparently have responded fairly
sensitively to market rates. However, it does appear
reasonable to conclude that rates on consumer deposits will be more flexible and move significantly
more closely with market rates after full deregulation than before .14
Implicit returns paid to households prior to the
authorization of Super-NOWs appeared to have responded quite sluggishly to movements in market
rates. Since part of that sluggishness presumably
reflected the costs of adjusting implicit compensation, Super-NOW rates for consumers should be
more variable than implicit returns. This expectation has been borne out so far by the experience with
yields on Super-NOWs. As shown in Chart 2,
Super-NOW rates appear to have moved fairly flexibly along with MMDA rates. However, this evidence is not conclusive because market rates have
not changed very much since Super-NOWs were
introduced.

Chart 2

Rates on MMDA's
and Super NOW Accounts
Percent
10.5
10.0

9.5
9.0
8.5
8.0

...

MMDAs

7.5
7.0

6.5
0'"
D

1982
35

'-..~"""'7T"""'--Super-NOWs
,

M
1983

as the deposit rate moves more closely with the
market rate, the LM-curve becomes more vertical.
Instability in money demand causes the LM-curve
to shift for given levels of the money supply. With a
more vertical LM-curve under deregulation, these
shifts have larger effects on interest rates and
income.

There has not been a real test of how quickly
banks will change Super-NOW rates in response to
a sizeable change in market rates. Possibly more
convincing is the evidence that banks have quite
flexibly varied rates on other consumer deposits that
were deregulated in recent years. A good example is
the money market certificate authorized in mid1978, Rates on these instruments have moved virtually in tandem with the six-month Treasury bill
rate., Corresponding to this regulatory change, the
responsiveness of M2 demand to changes in market
rates fell sharply in mid-1978 (the elasticity is estimated to have dropped from -0.28 in 1960/Q41978/Q2 to -0.06 in 1978/Q3-l98I/Q4.)15
Of course, it is unlikely that the opportunity cost
of holding MI will be totally invariant in relation to
the market rate even when deposit rate ceilings are
completely removed. The l2-percent reserve requirement on transaction deposits will be sufficient
to impart a small positive movement in the opportunity cost as market rates change. But this positive
movement is likely to be significantly smaller than
it was prior to full deregulation.

Fiscal Policy
Another effect of interest rate deregulation is that
it reduces the impact of fiscal policy on income. As
a result, fiscal policy actions would not have to be
correctly anticipated by the Federal Reserve for it to
achieve its income goals. This should enhance the
chance that the Fed will be able to correctly forecast
the monetary targets that are consistent with its
macroeconomic goals.
The reason that fiscal policy would have less
effect on income for given levels ofMl is that there
would be more financial crowding-out in the shortrun with flexible deposit rates. 16 When the high
employment deficit increases, the first round effect
is that real GNP rises. However, if the Fed holds to
its money target, interest rates will rise as the higher
GNP causes money demand to increase in excess of
the fixed money supply. With higher interest rates,
part of the initial increase in GNP is crowded-out as
firms and households cut back on their spending for
durable goods. This crowding out is greater with
flexible deposit rates because market interest rates
rise by more, that is, higher market rates feed back
on deposit rates which, in tum, induce further increases in market rates. As a consequence, the link
between money and income would be less responsive to changes in fiscal policy with flexible deposit
rates. In terms of the IS-LM diagram, a more expansionary fiscal policy causes the IS-curve to shift to
the right. The more vertical is the LM-curve, the
smaller is the effect of the IS-shift on income.

Money Demand Stability
It is important to recognize that deposit-rate deregulation not only raises the possibility that money
demand will become less stable, it also increases the
importance of having a stable demand function for
money. One possible effect of deregulation, then, is
that when deposit rates are flexible, unanticipated
"shifts" in the demand curve for money, at given
levels of money supplied, are likely to have larger
effects on income.
To illustrate this point, assume that the public's
demand for money shifts up, and that the Fed holds
the money supply constant. With more money demand and the same money supply, interest rates rise
and income falls. When deposit rates are inflexible,
the increase in nominal market interest rates lowers
the quantity of money demanded somewhat, and
thus causes income to drop by less than if deposit
rates rose along with market rates. This partial offset is not as large when deposit rates are flexible,
since in that case the increase in market rates has
only a small effect on the opportunity cost of holding money, and thus does not affect money demand significantly. This point can be illustrated
with the IS-LM diagram in Chart 1. As noted earlier,

Inflation Expectations
Interest rate deregulation can also improve the
money-to-income relationship by insulating income
from changes in inflation expectations. For example, a decrease in inflation expectations (all
else being equal) reduces nominal interest rates and
thus raises the, demand for money when deposit
rates are not flexible. With higher money demand
and the same money supply, income must fall.
36

These changes in income can be a major problem at
various times because expected inflation is inherently uncertain and difficult to estimate. This potential problem is less serious with flexible deposit
rates because the opportunity cost of holding money
does not vary as much with changes in market
interest rates.
The effect on the opportunity cost of holding
money would come into play, for example, when
inflation falls as the result of past tight monetary
policy. With fixed deposit rates, this will necessitate temporarily higher growth rates in the money
supply to accommodate the increased money demand associated with lower nominal interest rates.
Otherwise, the drop in inflation would lead to a
monetary policy that is more contractionary than
originally intended. Since it is often difficult to
forecast in advance when and by how much inflation will respond to money growth in any given
year, potentially large problems can occur as a result of the impact of inflation on velocity. This
problem was dramatically illustrated in 1982 and
early in 1983, when an unexpectedly sharp decline
in inflation led to a decline in nominal interest rates
and a surge in the quantity of money demanded. '7
The Fed responded to the continuing weakness in
the economy, and to the unusual behavior of MI by
allowing MI growth to exceed the upper boundary
of its 1982 target range by a wide margin. These
problems would have been smaller if deposit rates
had been flexible, since the drop in market rates
would have induced a smaller increase in the demand for money.

forecasted value for given levels of M I.

New Relationships
The preceding analysis suggests the following
conclusions regarding the impact of deposit rate
deregulation. First, deregulation insulates income
from a number of factors that otherwise could cause
it to change unexpectedly. These factors include
fiscal policy actions, changes in inflation expectations, and instability in the public's demand for
goods and services. The price paid for these benefits
is an increase in the destabilizing effects on income
of instability in the demand for money. It is therefore crucial in an assessment of the effectiveness of
monetary targeting under flexible deposit rates to
gauge the impact on money demand stability.
The empirical evidence examined in Section II
suggests that problems with unstable money demand may be small. However, it is important to
recognize that even if the LM-relationship were
more stable and predictable after deregulation than
before, deregulation still may temporarily raise uncertainties for monetary targeting by quantitatively
altering the responses of changes in income and
interest rates to changes in money. This would
occur if deregulation made the LM-curve significantly more vertical. In such a case, a given change
in the money supply would have a larger effect on
income and interest rates, at least in the intermediate run when income adjusts to monetary policy but
prices do not.
In the context of stabilization policy, a more
vertical LM-curve means that smaller changes in
money would be required to achievea given change
in income. As long as the LM-curve remained
stable and predictable, a more vertical LM-curve
would not permanently cause problems for monetary targeting. But, the Fed could face considerable
uncertainty during the period in which it was learning the new (reduced form) relationships. Of course,
these statements apply to stabilization policy only.
Deregulation would not affect the important longrun (or steady-state) properties of the macro-economy. Money would still be neutral in the long-run,
affecting inflation but not real GNP.

Consumption and Capital Investment
A final result to deposit rate deregulation is that it
would reduce the effect of unexpected shifts in the
IS-curve (due to changes in the public's demand for
goods and services) on the money-income relationship. With fixed deposit rates, swings in investment
and consumption spending that are not forecasted
by the Fed can have sizeable unexpected effects on
income, for given levels of Ml. Under flexible
deposit rates, changes in market interest rates lead
to only small changes in the opportunity cost of
holding money, and thus, income stays closer to its

IV. Monetary Control
The successful use of monetary aggregates targets requires that two basic conditions be satisfied:
that the money-to-income relationship be relatively
stable in the sense of being predictable, and that the
Federal Reserve be able to achieve its monetary
aggregates targets. In the analysis thus far, we have
focused on how money affects income and assumed
that monetary control was not a problem. In this
section, we analyze the monetary control issue.
Monetary control generally is viewed as occurring in the short-run environment in which income
and prices are fixed: that is, when the IS-curve is
vertical. Analysis of this monetary control environment shows that even if the demand for money were
stable under flexible deposit rates, there would be
additional reasons to be concerned about the effectiveness of M I targeting after deposit-rate deregulation. Some observers argue that with flexible deposit rates, MI will no longer be a leading indicator
of the pace of economic activity and inflation; it
will merely be a contemporaneous reflection of
economic conditions .18 Moreover, they argue that
deposit rate deregulation will make it difficult and
undesirable for the Federal Reserve to control MI in
the short-run of, say, a calendar quarter because
such control could induce disruptive volatility in
interest rates.
These points can be illustrated by describing the
conventional view of how monetary control works
and how this process fits into a full macroeconomic
model. Suppose the Fed wants to lower the total
spending on goods and services in the economy. If it
followed an intermediate targeting procedure, it
would lower the target for money. According to the
conventional view of monetary control, in the shortrun (in which income is exogenous), the Fed would
attempt to achieve this lower target by reducing its
reserve operating instrument and thereby raising
market interest rates. With deposit-rate ceilings in
place, "bonds" would become more attractive to
the public than the non- or low-interest bearing
checkable deposits in money. The public would
then demand smaller quantities of money-balances
at given levels of income and prices, and the money
stock would decline.
By raising the cost of credit, the increase in
interest rates also would eventually (over a longer

time period) reduce the public's spending on goods
and services. Since according to empirical research,
the lags from interest rates to M I are shorter than
those from interest rates to the economy, the decline
in money occurs before the decline in economic
ac~ivity. This timing pattern means that money is a
leading indicator of the economy, and, as a result,
has value as an intermediate target.
This view of the M I-targeting process places
great emphasis on deposit-rate ceilings. These ceilings ensure that money is a less attractive asset to
the public at high money-market rates than at low
rates. Thus, "tight" monetary policies, which
eventually reduce economic activity, show up first
in reductions in money via money demand. Without
deposit-rate ceilings, this result is far less certain. If
banks raise rates on MI deposits in tandem with
money market rates, higher rates would have little
effect on the relative attractiveness of securities
versus money and there would be little effect on the
quantity of money demanded. Put more formally,
there is no equilibrium between the vertical shortrun IS-curve and a vertical LM-curve that may be
created by deregulation. This would make monetary control difficult at best, and attempts at such
control would lead to extreme fluctuations in interest rates in the short-run.
Without. the ability to influence the spread between yields' on securities and money (and thus
money demand), the Fed would not be able to
control MI through that mechanism. Higher interest
rates (induced by lower reserves) would still lower
economic activity with a lag, and this in turn would
reduce the public's demand for MI, but Ml would
merely be a contemporaneous indicator of the economy. Since movements in Ml would no longer
foreshadow movements in GNP, M I would no
longer be as useful as an intermediate target.
Put differently, the Fed would be forced to formulate short-run policy in terms of the direct linkage between market rates of interest and income;
that is, it would need to create an equilibrium between the IS and LM curves by making the LM
horizontal through interest rate targeting. Since
income affects money demand, it would be possible
under such interest rate operating procedures to
control money through income. However, there

sistent with the widely accepted inventory theory of
the transaction demand for money, which emphasizes the role of transaction costs in determining
how closely balances are managed. Sudden inflows
or outflows of funds cause inventories of money to
be pushed away from their underlying desired \<.wels
in the short-run because it is costly for some money
holders to make the frequent adjustments needed to
bring money balances quickly back to desired levels.
The relationship between the transaction theory
and the buffer stock function of money can be
il!ustratedby analysis of the Miller-Orr model of
money demand?1 This model expands the classic
inventory-theory of money demand developed by
Baumol and Tobin 22 to include a cash flow that is
not known with certainty by the moneyholder. More
specifically, the Miller-Orr (M-O) model shows
how a cost minimizing money holder manages
transaction balances in the face of an uncertain cash
flow by balancing two competing costs. First, there
is the opportunity cost of holding transaction balances (the spread of yields on near money over
those on money), which tends to reduce the quantity
of money demanded. Second, there is the fixed per
transaction fee of raising or lowering money balances by selling or buying securities, which tends to
raise the quantity of money demanded.
M-O show that a cost minimizing solution to this
problem is to establish what is called a two-param-

would be no advantage in formulating policy in this
way, since income is the ultimate target of policy.
Thus, the relationship between money and income
could be perfectly stable, and yet be of little use to
policymakers because Ml would not be subject to
their control in the short run. 19
The preceding example is obviously an extreme
case. It is unlikely that the Fed would have no
control of Ml through interest rates under flexible
deposit rates. However, it is likely that the responsiveness of MI to changes in the overall level of
money market rates would decline significantly.
This, therefore, raises an empirical question: how
much will the interest-responsiveness ofMI decline
in practice? A cut in half, for example, would not
seem to present a significant problem. The Fed
could achieve a given reduction in aggregate
demand simply by lowering MI by half as much
as would have been required prior to deposit-rate
deregulation. However, if the interest-responsiveness were to come close to zero, the conventional
view of monetary control implies that the value of
M I as an intermediate target could be damaged
significantly.
Buffer Stocks and the Inventory Theory
Even if deregulation caused the interest-responsiveness of Ml demand to become very low, this
might not interfere significantly with the Fed's ability to control MI. There is an alternative view of
how monetary control works which at least partially
neutralizes the potential monetary control problems
associated with deposit rate deregulation. This view
holds that in addition to the interest rate channels
noted above, monetary control operates directly
through the supply of money provided by the actions of the Fed and the deposit-creating banking
system. The rationale for this view is that money
acts as a "shock absorber" or buffer stock between
the receipts and spending of the public. Short-run
variations in the observed stock of money, therefore, would not have to be induced by changes in
people's underlying demand for money; they could
result from independent changes in the quantity of
money supplied that are unrelated to underlying
demand factors such as interest rates and income?O
In this view, money demand is partly passive in
the short-run, accommodating itself to changes in
the supply of money. This view appears to be con-

Chart 3
Cash Balance Under Miller-Orr
Money Demand Model
Q)

u
C

«S
«S

co
.c H
~

!lIB

a
Time

eter control policy. Under this policy, individuals
establish a maximum cash balance (h) and a minimum cash balance (0). The width of this range
depends positively on the transaction cost and the
variance of the daily cash flow, and negatively on
the opportunity cost of holding money. Balances are
allowed to wander freely within the h-O range (see
Chart 3). It is only when too cash balance reaches h
that a security is purchased, and when it reaches 0
that a security is sold. In both cases, the size of the
transaction is chosen to bring the cash balance to
some level H, which lies in the h-O range. In the
long run, the average cash balance varies with the
opportunity cost of holding money and the other
underlying variables noted above. In the short-run,
the cash balance can differ from its average, or
underlying level of demand, depending on cash
flows that are uncertain to the individual. This
model can be regarded as a formal representation of
the buffer stock role of money. Within the h-O
range, money is simply the residual item in
the individual's balance sheet, and changes in
money do not reflect changes in the underlying
demand for money. Rather, within the h-O range,
changes in money are the side-effects of changes in
the demands for goods and services, and real and
financial assets.
The implications of this money demand model
can be seen by imagining a world of Miller-Orr cash
managers in which deposit rates move in tandem
with market rates, making the opportunity cost of
money constant. Now assume that the Federal Reserve makes the money supply exogenous through
precise short-run monetary control. In an effort to
achieve its money target, the Fed buys a Treasury
bill from the public. This requires a very small
decrease in Treasury bill rates, just enough to make
the sale attractive in this highly competitive market.
As a by-product of this transaction, the outstanding
quanti ty of transactions money is raised. If the cash
balance of the seller of the T-bill is still inside the
h-O range after the transaction, the newly created
money resides there for a time. Thus, in the shortrun, the quantity of money observed changes in
accordance with the money supply, with a very
small change in interest rates, and with no change in
the underlying demand for money.
Even if the T-bill seller's h-O range is pierced, the
new money may not disappear from the economy.

Instead, it may trigger the purchase of a security
from another money holder. This string of transactions continues until the money ends up within
someone's h-O range. Each time a transaction is
made to rid a portfolio of the newly acquired
money, interest rates are affected a little more according to demands and supplies in the securities
markets. If, for example, all money holders had
very wide ranges, it might take a long time for the
new money to be passed around enough for a large
interest rate effect. If ranges were small, this might
occur quickly. In either case, with the spread between market and deposit rates fixed, the money
must continue to be passed around until income
increases to the point where the new money is
demanded. In other words, the underlying money
demand eventually rises enough to absorb the increase in supply.
The conventional view of monetary control can
be viewed as being based on the empirical judgment
that h-O ranges are very small on average. Thus,
injections of new money are passed around so rapidly that they almost immediately cause large declines
in interest rates. With fixed deposit ceilings, these
declines translate into a lower opportunity cost of
holding money and thus a higher underlying demand. Over a period short enough that income and
prices cannot adjust, all of the increase in money
supply must be abosrbed through such interest rate
declines. In this circumstance, deposit rate deregulation would cause serious problems for monetary
aggregates targeting if deregulation made the opportunity cost of holding money insensitive to Fed
open-market operations. Attempts at short-run
monetary control in this environment could have
destabilizing effects on interest rates, or, at least,
cause wild gyrations in them.
The buffer-stock view of monetary control argues that h-O ranges are wide enough (on average)
that, even with fully flexible deposit rates, changes
in the money supply would induce only gradual
changes in interest rates that ultimately affect income and prices with a lag. 23 Ml can, therefore, be
controlled in the short-run even if the demand for it
is not very responsive to the overall level of interest
rates. Moreover, because ofMI's buffer-stock role,
changes in M I will continue to be a useful leading
indicator of future movements in income and prices.
The purpose of the preceding discussion was to

establish that (I) the size of buffer-stock effects is an
issue of great importance for monetary policy in an
era of flexible deposit rates, and that (2) the existence of these effects is primarily an empircal issue.
The theory behind buffer-stock demand appears to
be consistent with the inventory theory of the demand for the medium of exchange that has come to
be widely accepted by the economics profession.
That is why this issue should be decided on the basis
of empirical evidence.
A number of studies have used quarterly data to
estimate LM-equations under the assumption that
the money supply is exogenous. These equations
implicitly or explicitly employ buffer-stock specifications?4 Unfortunately, these equations do not
shed much light on the question being raised here:
in the short run (for example, weeks or months),
would buffer-stock effects significantly moderate
the interest rate fluctuations that otherwise might be
caused by close monetary control with flexible deposit rates? One problem in obtaining evidence on
this question is that the buffer-effects in question
would not come into play unless the Fed actually
exogenized money in the short-run. There is ample
evidence that the Fed has done so only sporadically.25 Substantial direct evidence is therefore not
likely to be available because the Federal Reserve
did not systematically "shock" the public's portfolio in an attempt to control money.
There is, however, a source of indirect evidence
having to do with "shocks" from the credit markets
that can occur when the Fed pursues a policy that
stabilizes interest rates. In a world in which there
are distinct markets for bonds (credit) as well as for
money and commodities, it is possible to have exogenous changes in the supply of money even when
the monetary authority pegs interest rates?6 Suppose, for example, that firms decide to spend more
on plant and equipment. They may finance this
desired increase in spending by issuing new debt.
Their increased demand for commodities (investment goods) is thus matched by an increased supply
of debt (demand for credit). Nevertheless, the increased demand for credit puts pressure on interest
rates to rise. To prevent the rise, the monetary
authority increases bank reserves, allowing the

banking system to purchase the new debt through
the creation of new deposits (i.e., an increase
in money supply). The firms' demand for money
therefore has not increased except in a temporary
sense: they have borrowed the money to spend, not
to hold.
At this point, there is an increase in the supply of
money that is not matched by any increase in the
demand for money. That is, the change in money
supply is exogenous. The firms borrowing the
money will spend it. And the recipients of that
expenditure will find themselves with excess
money balances, at which time, the issue of the size
of buffer stock effects comes into play.
If buffer-stock effects initiated by changes in
bank lending were found to be significant during
periods when the Fed used a short-term interest rate
as its instrument, it would be reasonable to expect
that buffer-stock effects also would be observed if
the Fed actually exogenized money in the short-run.
For this reason, evidence of a link between bank
lending and the demand for money in the short-run
would provide-indirect evidence of the buffer-stock
effects discussed above. The only available evidence on this point (to the author's knowledge) is in
a money market model developed and used at the
Federal Reserve Bank of San Francisco. 27 In this
model, the short-run (monthly) demand for transaction deposits equation specifies the (log) level of
transaction deposits as a function of the (log) levels
of prices, real income, a short-term interest rates,
and the (log) change in bank loans. For reasons
stated above, the bank loan variable is intended to
capture exogenous increases in the money SUpply at
given levels of the short-term interest rate. It was
found to be highly significant, both statistically and
economically, when monthly data for the 1976-82
period was used. This result is consistent with the
view that exogenous changes in the money supply
cause transitory increases in observed money relative to the underlying demand for it. While this
evidence is not proof in itself, it is sufficient to
establish a working hypothesis that buffer-stock
effects are significant and to demonstrate that further research in this area is warranted.

V. Conclusions and Policy Implications
This paper has analyzed how the effectiveness of
M I-targeting is likely to be affected by the removal
of regulatory ceilings on the interest banks are permitted to pay on deposits. A major conclusion is
that theory is silent on the issue. There are plausible
theoretical arguments both that deregulation will
make Ml a less reliable intermediate target and that
it will make MI more reliable. Therefore, substantial empirical evidence is needed. The evidence that
is available supports the view that deregulation has
not greatly reduced the reliability of Ml, but given
that deregulation is not complete, policymakers
face uncertainty about how Ml will behave in the
future, when deposit-rates are further deregulated.
However, uncertainty about the behavior of MI
under deregulation does not by itself justify a deemphasis of MI in favor of other monetary aggregates, such as M2. A decision to stress other aggregates should be based upon an evaluation of their

reliability relative to MI. Although studies of MI
have been extensive, the behavior of the broader
monetary aggregates in recent years under depositrate deregulation have not received the same attention. The deregulation of yields on M2, for
example, began in earnest in mid-I978 with the
introduction of money-market certificates. The
available evidence on M2 suggests that the relationship between it and income has deteriorated significantly si l1 ce mid-1978, and that M2 has become less
controllable."H This evidence, together with the
evidence presented in this paper on the stability of
Ml in the 1980s, suggests that M2 has been more
adversely affected by deregulation than Ml. Thus,
unless solid evidence of a major problem with Ml
develops, the Federal Reserve would be welladvised to place more weight on MI than the
broader aggregates as intermediate targets of monetary policy in the future.

FOOTNOTES
1. The theoretical foundations for this viewpoint were developed by James Tobin in a number of articles, including "A
General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, February 1969. For
discussions of these problems in the current institutional
setting, see Stephen A. Axilrod, "Monetary Aggregates and
Monetary Policy in a Deregulated Financial World," and
Richard G. Davis, "Monetary Targeting in a 'Zero Balance'
World," both in Interest Rate Deregulation and Monetary
Policy, Federal Reserve Bank of San Francisco Conference, Asilomar Conference Center, Monterey, California,
November 28-30, pp. 1-12, and 20-60.

5. John P. Judd and John L. Scadding, "Financial Change
and Monetary Targeting in the United States," in Interest
Rate DeregUlation and Monetary Policy, pp. 78-106.
6. See Ibid, pp. 90-91.
7. Bank Rate Monitor, Advertising News Service Incorporated, Miami Beach, Florida.
8. See Frederick T. Furlong, "New Deposit Instruments,"
Federal Reserve Bulletin, May 1983, pp. 319-326 for a
discussion of this work.
9. These increases appear to represent the bulk of the stock
adjustment into the new accounts. While these stock adjustmentsare taking place, the ratio of Super-NOWs to M1
and the ratio of MMDAs to M2 shold increase sharply,
whereas these ratios should be trendless once the stock
adjustment is over. These ratios did rise sharply shortly
after deregulation (until April 1983), but the rate of increase
in them has slowed markedly since then. This observation
suggests that we apparently have enough information to do
a fairly complete analysis of the response of the public to
the new instruments.

2. See Benjamin Klein, "Competitive Interest Payments on
Bank Deposits and the Long-Run Demand for Money,"
American Economic Review, December 1974, pp. 931949, and Stephen M. Miller, "A Theory of the Banking Firm:"
Comment, Journal of Monetary Economics, January
1975, PrJ. 123-128.
3. See William Poole, "Discussion of 'Monetary Targeting'
in a Zero Balance World," in Interest Rate Deregulation
and Monetary Policy, pp. 61-69, and James C. Van
Horne, Financial Market Rates and Flows, Prentice-Hall,
Englewood Cliffs, New Jersey, 1978, pp.6-11.

10. Qualitatively similar results were obtained from the San
Francisco Money Market Model. The transaction deposit
demand equation in the model differs from the one used in
this paper in that the model's equation includes as an
argument changes in bank loans. For a description of the
model, see John P. Judd and John L. Scadding, "What Do
Money Market Models Tell Us About How to Conduct
Monetary Policy?-Reply," Journal of Money, Credit and

4. See Van Horne, Ibid, pp. 86-112 for a review of the
theory and evidence on liquidity premiums in the term structure of interest rates. Some authors have argued that these
premiums vary systematically with market rates. However,
the theory and evidence on this point are inconclusive.

Journal of Monetary Economics, 1975,pp. 443-473. In
this context, an IS-LM model (expanded to include a money
supply function), would be solved in terms of nonborrowed
reserves as the exogenous policy instrument. Money would
be one among a potentially large number of exogenous
information variables, and would not be assigned any special role.

Banking, November 1982, pp. 868-873, and John P. Judd,
"A Monthly Model of the Money and Bank Loan Markets,"
Working Papers in Applied Economic Theory and Econometrics, Number 83-01, Federal Reserve Bank of San
Francisco, May 1983, p. 7.
11. For' an analysis of other factors that may have distorted
monetary policy in 1982 through 1983, see the articles cited
in footnote 17.

20. For an excellent description of the buffer stock concept,
and a. bibliography of· other papers on the subject, see
David Laidler, "The Buffer Stock Notion in Monetary Economics," Research Report 8313, The University of Western
Ontario, London, Canada, May 1983.

12. It might be argued that M1 Was contaminated despite
the lack of a shift in M1 demand. This could occur if active
cash managers transfered transaction balances out of M1
into MMDAs, while less active managers transfered savings balances into Super-NOWs. Although this is possible,
it seems unplausible.· First,the survey and cross-section
evidence contradicts this view, finding small flows from M1
to MMDAs and from non-M1 sources to Super-NOWs. Second, it is difficult to imagine why anyone would move funds
that were already acting as savings balances from, say, a
passbook savings to a Super-NOW account, when (1)
MMDAs have a higher yield than passbook accounts, and
(2) when MMDAs have lower transfer costs with checkable
deposits than passbook savings.

21. Merton H. Miller and Daniel Orr, "A Model of the DerrHirid forMorieyby Firms," Quarterly Journal of Economics, August 1966, pp. 413-35.
22. See William J. Baumol, "The Transactions Demand for
Cash: An Inventory Theoretic Approach," Quarterly Journal of Economics, November 1952, pp. 545-56,and
James Tobin, "The Interest-Elasticity of the Transactions
Demand for Cash," Review of Economics and Statistics,
August 1956, pp.421-47
23. The view that buffer-stock effects are empirically important does not deny the emergence of sophisticated money
management techniques and new instruments (like repurchase agreements) that have lowered transaction costs
and reduced the variance of cash flow for certain money
holders, especially large corporations. The demand for M1
by these firms fell sharply in 1975-76. (See John P. Judd
and John L. Scadding, "The Search for a Stable Money
Demand Function: A Survey of the Post-1973 Literature,"
Journal of Economic Literature, September 1982, pp.
994-1023.) This showed up clearly in a sizable downward
shift in money demand. However, there is no indication that
corporations' demand for money fell so low in that episode
that their buffer stock demand disappeared. Moreover,
since the mid-1970s, innovations appear to have been introduced at a markedly slower rate. Finally, smaller or less
sophisticated corporations and households are likely to
hold more or less than their desired level of money for an
extended period of time. Most households and small corporations have relatively low money balances on average,
and actions to adjust those balances to desired levels may
be costly relative to any resulting benefit. If money finds its
way into these "loosely" managed portfolios it may stay
there for awhile.
24. For reviews and evaluation ofthis evidence, as well as a
bibliography of the original articles, see David Laidler, "The
Buffer Stock Notion in Monetary Economics," and "The
Demand for Money-Yet Again," Carnegie-Rochester
Conference on Public Policy, On the State of MacroEconomics, Eds.: Karl Brunner and Alan H. Meltzer.
Amsterdam, North Holland, 1980, pp. 219-71; and John P.
Judd and John L. Scadding, 'The Search for a Stable
Money Demand Function: A Review of the Post-1973 literature," Journal of Economic Literature, September 1982,
pp. 994-1023, and "Dynamic Adjustment in the Demand for
Money: Tests of Alternative Hypotheses," Economic

13. See Thomas D. Simpson, "The Market for Federal
Funds and Repurchase Agreements," Staff Studies
106, Board of Governors of the Federal Reserve System,
July 1979.
14. Judd and Scadding, "Financial Change and Monetary
Targeting in the United States," p. 87.
15. Ibid, p. 97.
16. This discussion abstracts from the possible effects of
fiscal policy on the economy through changes in net wealth.
For a discussion of this issue see Benjamin M. Friedman,
"Crowding Out or Crowding In? The Economic Consequences of Financing Government Deficits," Brookings
Papers on Economic ActiVity, 1978:3, pp. 593-641.
17. See Michael W Keran, "Velocity and Monetary Policy in
1982" Weekly Letter, Federal Reserve Bank of San Francisco, March 18, 1983; John P. Judd, "The Recent Decline
in Velocity: Instability in Money Demand or Inflation?," Economic Review, Federal Reserve Bank of San Francisco,
Spring 1983, pp. 12-19; John P. Judd and Rose McElhattan, "The Behavior of Money and the Economy in 198283," Economic ReView, Federal Reserve Bank of San
Francisco, Summer 1983, pp. 46-51, Brian Motley,
"Money, Inflation and Interest Rates," Weekly Letter,
August 5, 1983, and John P. Judd and Brian Motley, "M1
Versus M2: Which is More Reliable," Working Papers
in Applied Economic Theory and Econometrics, No.
83-04, Federal Reserve Bank of San Francisco, October
1983.
18. Richard G. Davis, "Monetary Targeting in a Zero Balance World," in Interest Rate Deregulation and Monetary
Policy.
19. Money could still be used as an information variable in
an optimal control framework-see Benjamin M. Friedman,
"Targets, Instruments and Indicators of Monetary Policy,"

Review, Federal Reserve Bank of San Francisco, Fall
1982, pp. 19~30.

27. John P. Judd and John l. Scadding, "What Do Money
Market Models Tell Us About How to Conduct Monetary
Policy?-Reply," and John P. Judd, "A Monthly Model of
the Money and Bank Loan Markets."

25. This statement is obviously true for the pre-October
1979 period, when the Fed used the Federalfunds rate or
free reserves as operating instruments. It also can be argued that a great deal of interest rate smoothing (in the
short-run) also occurred under the reserve operating procedures initiated in October 1979. See various articles on
these control procedures in New Monetary Control Procedures, Volumes I and II, Board of Governors of the
Federal HeserveSystem, February 1981. Especially, see
papers by Stephen Axilrod, Fred Levin.andPauIMeek, and
Peter TinsleY and others. Also, see John P. Judd, "An
EXamination (jfthe FederaLReserve's Strategy for Controlling the Monetary Aggregates," Federal Reserve Bank of
San Francisco, EconomicReview, Fall, 1982, pp. 7-18.

28. For research in the early 1970s evaluating alternative
intermediate targets of monetary policy see the series of
articles by· Michael Hamburger, Frederick Schadrack and
Fred Levin under the heading ''The Choice of Intermediate
Targets," in Monetary Aggregates and Monetary Policy,
Federal Reserve Bank of New York, 1974. For recent analysissee, Dallas S. Batten and Daniel L. Thornton, "Mlor
M2: Which is the ..Better Monetary Target?" Review,
Federal Reserve Bank of St.Louis, June/July 1983, and
John P. Judd and Brian Motley,"M1 ver$us M2: Which
Is More Reliable?" Working Papers in Applied Economic
Theory and Econometrics, Federal Reserve Bank of San
Francisco, No. 83-04, October 1983.

26. Karl Brunner and Allan H. Meltzer, "An Aggregative
Theory for a Closed Economy, in Monetarism, edited by J.
Stein. Amsterdam: North Holland, 1976., pp. 69-103.

Full text of Economic Review (Federal Reserve Bank of San Francisco) : Fall 1983, Number 4 : Challenges to Monetary Policy

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