The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FEDERAL RESERVE BANK
OF SAN FRANCISCO
ECONOMIC REVIEW
;
The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
Bank’s Research and Public Information Department under the supervision of Michael W. Keran,
Senior Vice President. The publication is edited by William Burke, with the assistance of Karen
Rusk (editorial) and William Rosenthal (graphics). Opinions expressed in the Economic Review
do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, nor of the Board of Governors of the Federal Reserve System.
For free copies of this and other Federal Reserve publications, write or phone the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco,
California 94120. Phone (415) 544-2184.
Aspects of Inflation
I.
Introduction and Summary
5
II. Effects of Monetary Disturbances on Exchange
Rates, Inflation and Interest Rates
Michael Keran and Stephen Zeldes
7
. . . The inflation differential between countries—and the exchange
rate—are significantly affected by the relative growth of those
countries’ “excess money” supplies.
III.
30
Expectations, Money, and the Forecasting
of Inflation
Charles Pigott
Expectations about future economic conditions crucially influence
the lags in economic relations—and quickly adapt themselves to
changing conditions.
IV.
50
Money, Inflation and Causality in the
United States, 1959-79
Michael Bazdarich
Little evidence can be found to support the argument that costpush or government-spending pressures have led to monetary ex
pansion, and hence to inflation.
Editorial committee for this issue:
Adrian Throop, Joseph Bisignano, and Herbert Runyon
Inflation has become perhaps the most serious problem affecting the industrial world over
the past decade or more, and thus it has also
become the most important topic of research
for the world's economists. For example,
roughly half of all the issues of the Economic
Review during the past half-decade have concerned various aspects of the inflation problem.
This issue contains several articles on the subject, as the search continues for viable solutions to this severe and long-continuing problem. These articles explore such questions as
the relationship between monetary disturbances and exchange rates, the factors determining the lagged relation between money and
prices, and the influence of cost-push and government-spending pressures on money-supply
growth and inflation.
Michael Keran and Stephen Zeldes, in the
first article, investigate the link which exists
between money and exchange rates through
the goods and asset markets. Most analysts
agree that the fundamental influence on the exchange rate is the need to maintain "purchasing power parity"-the parity of national price
levels between countries. Because national
price levels change slowly over time, it could
be assumed that exchange rates also would
change slowly over time. But exchange rates
have shown much greater variance than underlying price levels since 1973, so that analysts have come to question the validity of the
purchasing-power-parity approach to exchange-rate determination.
Keran and Zeldes therefore find it necessary
to develop an alternative model to explain
short-run exchange-rate movements--one which
links monetary disturbances to short-run adjustments in the bond market. In their analysis, they argue that the exchange rate in the
long run is determined solely by purchasingpower-parity considerations, while long-run
interest-rate differentials across countries reflect differences in inflation expectations. In
contrast, short-run exchange-rate movements
depend on assumptions about 1) adjustments
of various markets and 2) expectations concerning the path of future money growth.
To test their model, Keran and Zeldes utilize
four sets of equations which compare the U.S.
bilaterally with five other major countries. On
the basis of those tests, they conclude that the
inflation differential is significantly affected,
with long lags, by the growth in the "excess"
money supply in the U.S. relative to each of
the other countries-and that the exchange
rate is similarly affected, although with much
shorter lags. They find also that long-term interest-rate differentials are significantly related
to the relationship between U. S. and foreign
excess-money growth rates. On the other
hand, short-term interest rates are influenced
by both a liquidity effect and an inflation-expectation effect of a change in excess money.
Charles Pigott, in a second article, examines
the lag between money and prices, and the
way that that lag is affected by expectations
about monetary policy. Until fairly recently,
most lags in economic behavior were regarded
as mechanistically determined by institutional
rigidities, adjustment costs, and other factors
which supposedly do not vary with government
policies. Empirical relations derived from past
data were commonly used to simulate the effects of policy changes, and also to predict
economic conditions under policy regimes very
different from those prevailing in the sample
period. But as Pigott notes, with the accelerating inflation of recent decades, relations that
used to be regarded as stable have shifted,
often dramatically.
Consequently, he concludes that expectations about future economic conditions, including monetary policies, crucially influence
5
the lags in economic relations-and that these
expectations become more quickly adapted to
changing conditions than once was thought. In
his analysis, he considers the lags in a relation
which is crucial for forecasting and policy analysis- the relation between inflation and current
and past money growth.
Pigott argues that the lag in money's effect
upon prices can be substantially affected by
individuals' expectations about future money
growth. This implies that money-inflation forecasting relations will change, at least eventually, when government policy alters the relation between current (and past) money growth
and future money growth-as he finds in measuring the experience of several industrial
countries. In fact, the long-run impact of
money on price:> implied by this relation appears to have shifted substantially between the
fixed rate period of the 1960's and the floatingrate period of the 1970's. Further, he argues
that prices will react more to money changes
perceived as permanent than to transient
changes. If true, this could provide at least a
rough indication of how inflation-forecasting relations can be adapted to altered policies.
Michael Bazdarich, in a final paper, examines the causality of U.S. inflation over the past
two decades. Most economists, in his view,
would agree that nonmonetary factors can
have a sustained effect on the inflation rate only
if they are accommodated or "validated" by
increases in the money supply. Thus, the debate on the causes of inflation and the proper
anti-inflation policy revolves around the issue:
what factors have typically caused movements
in the rate of money-supply growth?
Bazdarich develops his argument by conducting tests of cost-push and government-
spending theories of inflation. According to the
cost-push approach, central banks are forced
to expand money and credit in response to
large cost increases in various industries, in
order to avoid the output losses and unemployment that would normally follow such
phenomena. According to the governmentspending argument, central banks must monetize large government deficits in order to
avoid such alternative financing approaches as
tax increases or government-debt issues (with
rising interest rates). Bazdarich applies the
Granger causality-test technique to determine
whether these several"causes" of inflation have
systematically caused, or been caused by,
money-supply growth. The results provide evidence regarding the causal relationship between the individual variables and recent U.S.
inflation.
Bazdarich tested seventeen indicators of
cost-push or "supply shock" pressures with respect to four measures of the money supply,
but found virtually no evidence of monetary
accommodation. In the vast majority of cases,
the results indicate "one-way causality" from
several or all of the money-supply measures to
the respective price or cost indicator. The results were less conclusive for government
spending or deficit measures. But although
some of the latter indicators displayeq causal
effects on the money supply, the results were
either unsatisfactory in some way or were subject to conceptual problems involving the
forms of the equations. Additionally, in examining the 1974-75 and 1978-79 inflationary
episodes, he found that previous and/or concurrent money-supply growth provided a reasonable explanation of most of the inflation in
each case.
6
Michael Keran and Stephen Zeldes*
It has long been recognized that inflation is
primarily a monetary phenomenon. However,
some important implications of that relationship have become widely recognized only in
recent years. We now realize, for example,
that the link between the quantity of money
and the price of goods also has implications
for the value of financial assets-and further,
that the effects of monetary disturbances on
the prices of goods and assets have implications for international currency values in the
foreign-exchange market.
The purpose of this article is to shed additionallight on the relationship between a monetary disturbance and exchange rates by investigating the link through the goods and asset
markets. Most analysts agree that the fundamental influence on the exchange rate is the
need to maintain "purchasing power parity"that is, parity of national price levels between
countries. Because these national price levels
change slowly over time, it had been assumed
that the exchange rate would also change
slowly over time. This has not occurred; since
the move to flexible exchange rates in 1973, exchange rates have showed much greater variance than the underlying price changes.
This phenomenon has called into question
the validity of the purchasing-power-parity approach to exchange-rate determination, at
least in the short run. Analysts thus have developed a series of alternative models to ex-
plain short-run exchange-rate movements on
the basis of factors other than purchasing
power parity. 1
This article presents one such model-one
which links monetary disturbances to short-run
adjustments in the bond market. In Section I,
we present the long-run equilibrium effects of
a monetary disturbance on inflation rates, interest rates, and exchange rates. We note there
that the exchange rate in the long run is determined solely by purchasing-power-parity
considerations, while long-run interest-rate
differentials across countries reflect differences
in inflation expectations. In Section II, we concentrate on short-run movements in the system. In this section, we question the standard
assumption of continuous money-market equilibrium, and demonstrate that short-term exchange-rate movements depend on the shortrun response of interest rates to a monetary
disturbance. For example, a monetary disturbance can affect interest rates in two opposite
ways, because it can have both a liquidity effect and an inflation-expectations effect. The
adjustment path of the exchange rate toward
long-run purchasing-power parity will depend
on the relative magnitude of those two opposing influences. We note that profit opportunities
in the bond market can induce short-term capital flows, which cause the exchange rate to
move more than it would under conditions of
short-run purchasing-power parity.
Section III translates the propositions of
Sections I and II into testable hypotheses, and
Section IV presents the evidence which tests
'Mr. Keran is Senior Vice President and Director of Research, and Mr. Zeldes is Research Associate, Federal
Reserve Bank of San Francisco.
7
ance, while in the fifth country (France), the
adjustments occur at about the same speed.
The results also suggest that for only one country (Switzerland), the exchange rate tends temporarily to overshoot its long-run value (the
value consistent with long-run purchasingpower parity) following a monetary disturbance.
these theoretical conjectures. To test the
model, we utilize 4 sets of equations, each of
which compares the U.S. bilaterally with five
other major countries. The results suggest that
in four of those countries (Germany, Italy, Japan, and Switzerland), the exchange rate
changes more rapidly than the ratio of national
price levels in response to a monetary disturb-
I. Theoretical Framework (Long Run)
idents of a country will demand money denominated in that currency. This money-demand
assumption is based on the unique role of the
national money stock as a means of payment.
One cannot purchase goods in one country
with the currency of another country. There is
a strong preferred habitat in the demand for
money which is not necessarily observed in the
demand for goods or non-money assets. An
excess supply of money in one country cannot
be used directly to satisfy the excess demand
for money in another country, i.e. there is no
currency substitution. 2 However, an increase
in excess money in one country will induce an
excess demand for goods and financial assets
in that country which, in turn, can affect the
goods and assets markets in another country.
The exchange rate acts as a conduit to link the
goods and asset markets of the two separate
countries.
The next step in the analysis involves the
formation of inflation expectations. We assume
that price expectations are formed rationally.
The rational-expectations view of market behavior says that market participants form forecasts of future events based on the relevant
economic model and all available information.
We can therefore use price equations 1 and 2
to generate the following price-expectation
equations:
The monetary approach to exchange-rate
determination provides a conceptual basis for
simultaneously analyzing the interactions
among the major markets of the economy. We
can begin with the determination of the longrun equilibrium price level. (All variables, except interest rates, are to be interpreted in log
form.)
Home-country price level:
P = M
md == ME
(1)
Foreign-country price level:
P* = M*
md * == ME*
(2)
where:
*denotes foreign country
P = log of price level
M = log of nominal money supply
md = log of real-money demand (assumed
to depend on the nominal interest
rate and real permanent income)
ME
log of "excess money" (defined as
the difference between the log of
nominal money supply and the log
of real money demand)
Equations 1 and 2 specify that, in the long
run, the price level in each country is equal to
that country's excess supply of money. These
equations are based on the notion of long-run
equality between real money supply and real
money demand. They tell us that a rise in the
level of the nominal money supply will, given
constant real money demand, be matched by
a proportional rise in the price level.
We assume here that only the domestic central bank can supply money and that only res-
pe = MEe
or in change form
Ape = AMEe
(3)
(4)
where 3) and 4) are long-run equilibrium conditions which hold for each country. Superscript e denotes expectations, and AP and AME
8
reasonable to assume that expected changes
over time are zero. Equation 6 tells us that the
equilibrium bilateral exchange rate is a function of the ratio of excess money supplies of
the two countries. Equation 7 tells us that the
long-run expected change in the exchange rate
depends on the long-run expected growth in
the excess money supply of each country.
Because of the possibility of substitution between real assets of different countries and
because of long run PPP, we can also assume
that over the long run, real interest-rate parity
will hold: 4
refer to the first differences of logs of the price
level and excess money, respectively. Equation
3 says that if excess money determines the
actual price level, then expected excess money
will determine the expected price level. Similarly, current long-run inflation expectations in
each country are determined by long-run expected excess-money growth.
Our next equations deal with the determination of the long-term nominal interest rate.
We assume that the real interest rate-that is,
the nominal rate minus the expected inflation
rate-in the long run will be independent of
monetary factors. This assumption is based on
the presumed existence of "real assets", whose
nominal yields automatically adjust by the
same amount as the inflation rate. The inflationadjusted yield on these "real assets" is therefore determined solely by technological factors, which are presumably independent of
monetary factors. Because of the possibility of
substitution over the long run between financial assets and these real assets, nominal rates
on financial assets also will fully incorporate
any change in long-run inflation expectations.
Combining this concept with equation 4, we
arrive at the following equation:
R
LiP" + r = LiME" + r
r = r*
From equations 5 through 8 we can derive
the nominal interest-rate parity condition:'
R
(5)
Our next equations explain the equilibrium
exchange rate. Equation 6 expresses the purchasing-power-parity (PPP) condition which
equates the exchange rate (S) to the difference
of the log of the price levels in each country
(P*-P), adjusted for terms of trade (T).3
(6)
and
LiS" = LiP*"
R*
(9)
This equation tells us that the domestic nominal interest rate should be equal to the foreign
nominal interest rate minus the expected annual rate of appreciation of the domestic currency over the term of the asset.
All of these equilibrium relationships can be
expected to hold over the long run, with certain short-run deviations. Also, all of the equations are valid under both fixed- and flexiblerate regimes, although with different directions of causality under the two structures. (, In
this paper we deal only with adjustments under
a flexible-rate regime. The general equilibrium
nature of the model can best be illustrated by
an analysis of the long-run effects of some
monetary disturbances, which then provides a
point of reference for an analysis of short-run
adjustments.
Consider first the long-run effects of a onetime contemporaneous increase in the level of
a country's money stock, with no change in its
expected future growth. The resulting increase
in the supply of money relative to the demand
for money will be matched by an equal excess
demand for the sum of goods and non-monetary assets. Equilibrium will be restored in this
case via a price adjustment, i.e. a rise in the
domestic price level and a depreciation of the
exchange rate. Equations 1 and 2 determine
where:
R = long-term market interest rate
Lip e
expected long-run inflation rate
LiME" = expected excess money-growth rate
r = real interest rate.
S=P*-P+T=ME*-ME+T
(8)
LiP" = LiME*e - LiME" (7)
Equation 7 assumes that expected changes in
terms of trade (LiT') are zero. As these changes
generally take the form of real shocks, it seems
9
just equal the expected inflation differential. In
a steady-state condition, the money supply, the
price level, and the exchange rate will all
change at the same rate (equal to the expected
rate), and the level of the long-term interest
rate will be permanently higher. There will be
no incentive to switch between securities of
different countries, because higher domestic
interest rates will fully compensate holders of
domestic financial assets for the expected depreciation of the currency.
The usefulness of the long-run model depends on one key empirical regularity-purchasing-power-parity, or the equality between
bilateral exchange rates and the ratio of national price levels. In the long run, a close
association of this type has been apparent for
the United States with respect to five other
countries: France, Germany, Italy, Japan, and
Switzerland (Chart 1). However, for reasons
discussed in the next section the relationship
is not particularly close in the short run. 7
the home and foreign price levels, and equation 3 determines the exchange rate. The neutrality of money and PPP conditions requires
that the changes in the price level and the
exchange rate be proportional to the initial
increase in the money stock. The rise in the
price level will reduce the real money supply
to its initial level, restoring equilibrium in the
money market, and the depreciation of the
exchange rate will maintain the purchasingpower-parity condition. Interest rates will not
be affected by this one-time change in money,
because there will be no change in its expected
future growth rate, and thus no change in inflation expectations.
Next consider the long-run effects under a
flexible-rate regime of a second type of monetary disturbance-a permanent increase in the
growth rate of the domestic money supply.
Again, equilibrium will be restored via a price
adjustment. An expected higher money growth
rate leads to a higher expected inflation rate,
which means a comparable increase in the
long-term interest rate; the interest-rate differential between two countries will therefore
II. Theoretical Framework (Short Run Adjustments)
Our analysis of the nature of the long-run
equilibrium does not describe the mechanism
by which equilibrium is achieved, nor does it
describe the movements of the economic variables between equilibria. The short-run movements of the system depend on assumptions
about the nature of the adjustment process in
different markets. As seen below, real interestrate parity (equation 8) need not hold in the
short run, but nominal interest-rate parity
(equation 9) is a short-run condition which
must hold at all times. On the basis of these
relationships-along with assumptions about
adjustment in the goods, financial assets, and
money markets-we can determine the shortrun movements of the exchange rate in response to a monetary disturbance. The link
between the long run and short run, for the
purpose of analyzing exchange-rate movements, can be operationally defined by the
bond-market yield curve, which describes the
yield on bonds of different terms to maturity.
The underlying economic forces are fundamentally determined by liquidity considerations and market expectations about future
money growth and inflation. To understand why
exchange rates adjust differently in the short
run than in the long run, we must understand
why the yield curve varies in response to the
forces noted here.
If the yield curve remains unchanged in response to a monetary change, then short-run
and long-run exchange-rate adjustments would
be indistinguishable. A change in excess
money would lead to an immediate exchangerate response, bringing the exchange rate immediately to its long-run equilibrium valuethat value consistent with long-run purchasingpower parity. This response occurs even
though adjustment in the goods market is not
instantaneous, i.e., is lagged over a few years.
If the yield curve changes, however, then
III
1975
= 100
Italy
140
Chart 1
130
A Comparison of
Exchange Rates
and Prices
1975
100
130
120
110
100
Switzerland
90
120
1975
110
110
100
100
90
90
80
80
70
70
60 ..................
1974
1975
...
1974
100
110
1976
1978
100
1975
= 100
130
120
90
110
80
100
...
1976
1978
1980
1974
II
1980
Japan
...
1974
100
1974
1978
60
1980
Germany
70
=
1976
1976
1978
France
1980
short-run and long-run exchange-rate adjustments would be different, as is explained in
detail below.
To analyze the short-run movements of the
system in response to a change in money supply, we must 1) distinguish between different
types of changes in the money supply, and 2)
make assumptions (based on observations)
about the nature of the adjustment process in
certain markets.
either of two possible paths. 1) Actual excess
money could move to D in the next time period, at which point it would be back on the
previous expected path (AB). In this case, the
deviation is only transitory, and the monetary
disturbance would have no economic consequences for prices, interest rates or exchange
rates. 2) Alternatively, actual excess money
could proceed towards point F in succeeding
time periods. This permanent change in the
level of excess money, which was unexpected
at the beginning of the planning period, could
have definite effects on the economy. The price
level would eventually be higher because point
F is higher than point B. Also, short-run inflation expectations would be higher because the
slope AF is greater than slope AB. However,
long-run inflation expectations would remain
unchanged. Such expectations are based on
long-run excess money-growth expectations.
With line CF extended into the "long run"
(e.g., to point H), the slope of AH (long-run
excess money growth) approaches the slope of
AB (the previously expected long-run money
growth). There would therefore be no change
in expected long-run excess money growth or
in long-run inflation expectations.
We assume that if actual money changes are
expected and seen to be permanent (along line
AB), there will be no lag between excess
money and prices. In this specific case, contracts and other impediments to adjustment
would be arranged to ensure that price changes
occur when the money supply is expected to
support the price change. Fully anticipated,
permanent changes in the money supply thus
lead to contemporaneous price increases, and
the system therefore moves immediately to its
new long-run equilibrium. In this case there
are no short-run adjustments. In sum, because
transitory money-supply changes have no effect on the economy, and because fully anticipated permanent changes result in an immediate move to the long-run equilibrium, we
should concentrate on the results of a permanent, unanticipated change in the money stock
(A-C-F). (To avoid awkward phrasing, the rest
of the text will assume that all money changes
Money-supply Changes
There are two types of distinctions which
should be made regarding money supply
changes: a) permanent/transitory, and b) expected/ unexpected (Figure 1). The permanent
(as opposed to transitory) change in the level
of the money stock is that part which it is
believed will not be reversed in the short run,
i.e., the part that will result in a permanent
change in the level of the money supply. Only
the permanent part of the money-supply
change is generally believed to affect economic
behavior. This occurs because transactions are
not costless, and if the public believes that
money supply changes will shortly be reversed,
they will avoid taking action and will temporarily absorb these balances in their holdings
of money.8 The expected money-supply change
is the part which market participants anticipated in advance (by the length of the planning
horizon), while the unexpected money-supply
change is the difference between the actual
and expected money-supply change. Thus, if
individuals two years ago expected the money
stock to rise by 5 percent this year, when in
fact it rose by 15 percent, then 5 percent would
represent the expected part, and 10 percent the
unexpected part, of the change.
The line AB in Figure 1 is the expected path
of excess money over some relevant planning
horizon. MEe is the level of excess money
which is currently expected to exist at various
points in the future. a(ME)" is the expected
growth in excess money. A movement from A
to C represents a deviation of excess money
from its expected growth path. Following such
a move, excess money could proceed along
12
are permanent, unless otherwise indicated.)
In this situation, the difference between the
long run and the short run becomes important.
In the goods market, prices will adjust only
with a lag, and in the bond market there may
be a shift in the term structure of interest rates
(yield curve). These adjustment lags from an
unanticipated money change could lead to
short-run exchange-rate changes which are different from those resulting from an anticipated
change in excess money~and which can cause
purchasing-power parity not to hold in the
short run. In the following discussion we will
consider the different adjustment lags in the
goods, money and bond markets, and further,
consider their implications for exchange-rate
adjustments.
Goods Market. The lags in the adjustment
of goods prices in response to unanticipated
money-supply changes have been well documented. 9 Two different types of lags can be
differentiated. First, there is recognition lag:
the time the market takes to recognize a
change in the level of excess money and to
differentiate between the permanent and the
purely transitory part of that change. Given
transaction and decision costs, individuals will
delay changing their behavior until they are
reasonably sure that a money change is permanent~that is, a move to F instead of to D
in Figure 1. Secondly, there is market-adjust-
Figure 1
ME
F
ment lag: the time that goods-market prices
take to adjust to recognized changes in excess
money. Because of imperfect markets and information flows, there are lags between demand-and-supply shifts and changes in product
prices. 10
The existence of an organized secondary
market in a product serves to eliminate the
market-adjustment lag from the adjustment
process. II These markets are organized so that
changes in demand immediately become reflected in the price, i.e., the dealer or "auctioneer" moves the price immediately to equilibrate supply and demand, effectively eliminating
any information problems. In addition, the
factors which encourage the formation of organized markets also make these markets well
suited for the activities of speculators and arbitrageurs. Once the recognition lag has
passed, individuals realize that a price change
is going to occur. Knowing this, market participants will buy or sell as soon as possible in
anticipation of the price change, and this speculation causes the price change to occur right
away. Because of these two factors, organized
secondary markets do not exhibit a marketadjl,lstment lag, but only a recognition lag, between the occurrence of a monetary disturbance and a resultant price change. I2 In contrast, products which are non-homogenous
and/or expensive to store and transport, generally are not traded in organized secondary
markets. As a consequence, we experience imperfect information flows, a lack of speculation
and arbitrage, and therefore delays in price
changes. Prices in most goods markets thus
exhibit both recognition lags and market-adjustment lags in response to unanticipated
money growth.
Money Market. To understand money-market adjustments, it is useful to review the
money-price relationships of equations 1 and
2. These equations are based on an equality
between the real supply and the real demand
for money. In the present context, the relationship may be stated as follows:
m = md (y,R)
where m and mel are the real supply and real
A
S
S
a
1
234
time
13
must be out of equilibrium. It is reasonable to
assume that the market interest rate moves to
maintain equilibrium in the bond market, for
which (unlike the money market) there are
real-world primary and secondary markets. In
that case, the goods market and the money
market would be left out of equilibrium. 14 Such
a result would occur if money were considered
a "buffer stock", in much the same way that
inventories may be out of equilibrium because
of sudden shocks in either the supply or the
demand side of the goods market.
demand for money respectively, and the real
demand for money is a function of permanent
realincome (y) and the market interest rate
(R). As seen above, an anticipated and permanent rise in the nominal supply of money
will bring about a rise in goods prices contemporaneous with the rise in money supply, so
that there will be no change in the real supply
of money. In this case, there is no disturbance
to the real demand for money-the only effect
is a rise in prices. In contrast, an unanticipated
butpermanent rise in nominal money supply
will lead to a lag in the adjustment of prices.
In this case, the real supply of money will rise
temporarily and require an adjustment in the
real demand for money, thus affecting developments in the real economy, at least temporarily. Dornbusch (1976) in his article on exchange-rate overshooting, makes the standard
assumption that the money market is always
in equilibrium, i.e., that real money supply
and real money demand are equal at all moments in time. If this is the case, then an increase in nominal money supply must be accompanied by an increase in the price level,
an increase in real output, and/or a decrease
in the nominal interest rate. 13 An increase in
the price level would reduce real money supply, while an increase in real output or a fall
in nominal interest rates would increase real
money demand.
Given the slow adjustments of prices and
output, continuous money-market equilibrium
implies that the nominal interest rate must
move immediately in order to equilibrate the
real supply and real demand for money. Thus,
a rise in the real money supply would lead to
a fall in the market interest rate (liquidity effect). Once the goods-market adjustment is
complete-initially through higher real income
and eventually through higher prices-the interest rate in the bond market will return to
its previous equilibrium value.
Our model does not differ in any fundamental way from this analysis, except that we allow
for circumstances where the money market is
in disequilibrium. Given goods-market disequilibrium, Walras' Law tells us that either the
money market or the bond market, or both,
Bond Market. As we have seen, the long-run
effects of excess money on the bond market
are purely expectational. Expected excessmoney growth determines inflation expectations, and with the real interest rate given,
determines the market interest rate. In the
short run, an unanticipated increase in excess
money can depress real market interest rates
through a liquidity effect. But furthermore. it
can tend to raise short-term interest rates
through a rise in short-run inflation expectations. How is it possible to raise inflation expectations without a rise in long-run expected
excess-money growth? Because a rise in excess
money implies higher price levels once the
goods-market adjustment is complete. This
can raise short-run inflation expectations-the
slope of AF is greater than the slope of ABwhile leaving long-run inflation expectations unchanged.
A monetary disturbance can have offsetting
liquidity and inflation-expectation effects on
short-term interest rates. A rise in inflation expectations will shift the demand and supply of
bonds so as to create upward pressure on the
nominal interest rate. Thus, with interest rates
determined by short-run equilibrium in the
bond market, an unanticipated increase in excess money need not lead to a decline in market interest rates. Three conditions are possible, depending on the relative strengths of the
two effects. 1) The liquidity effect is less than
the short-run inflation expectation effect, pushing up short rates, leaving long rates unchanged, and thus causing a shift toward a
more negative sloping yield curve. 2) The liq14
uidity effect is greater than the expectation
effect, causing a decline in short-run market
rates and a shift toward a more positively sloping yield curve. 3) The liquidity effect is equal
to the inflation-expectation effect, leaving market interest rates and thus the yield curve unchanged. Thus, short-run equilibrium in the
bond market is consistent with different shifts
in the slope of the yield curve, which means
consistent with different exchange-rate adjustments.
grally related to movements in short-run interest rates.
Short-run movements of the exchange- rate
can .be better understood by examining the
effects of three different types of monetary
changes.
The first situation involves a one-time unanticipated but permanent increase in the level
of excess money (Figure 2). Assume that there
is a 5-percent increase in domestic excess
money (top line in Figure 2), that prices take
one year to fully adjust to this disturbance,
and that both the interest rate and expected
inflation rate are one-year rates. In the long
run, the effects of this disturbance will be a 5percent rise in the domestic price level and a
5-percent fall in the exchange rate, with no
change in the level of interest rates. In the
short run, prices (P) would be expected to rise
gradually over the course of a year and remain
stable thereafter, at a level 5 percent higher
than before the disturbance. Therefore, oneyear inflation expectations (ilp will initially risc
by 5 percent and then gradually return to their
initial level. Long-run inflation expectations will
be unchanged. The possible short-run adjustment paths are outlined in panels 1-3, corresponding to the three bond-market conditions
cited above.
Panel 1). An extreme case where short-term
interest rates increase to fully incorporate the
expected price inflation, i.e. an initial 5-percentage-point rise in the short-term interest
rate. This implies no liquidity-induced decline
in the real rate of interest. (Recall that given
slow adjustment of output, this rise in nominal
rates also implies money-market disequilibrium). Under these circumstances the exchange rate should move toward its long-run
value only gradually, at the same speed as the
price level, i.e., the spot exchange rate moves
so that purchasing-power parity is maintained
at all times. The expected short-run depreciation of the exchange rate equals the expected
short-run price increase (both 5 percent over
one year). The compensating rise in short-term
interest rates relative to long-term rates leads
to a gradual depreciation of the currency.
Exchange Adjustments
Now that we have considered the short-run
equilibrium conditions in domestic markets for
money, goods and bonds, we can proceed to
analyze the developments between countries
which operate through foreign-exchange rates.
The key assumption linking goods markets between countries is purchasing-power parity
(equation 6), and the key assumption linking
bond markets between countries is nominal
interest-rate parity (equation 9). Because of
the relatively long adjustment lags in the goods
market, movements in the bond market will
determine short-run movements in the exchange rate.
Under the assumption of perfect capital mobility, equation 9 represents a short-run condition which holds at all times. IS The condition
states that asset holders will be fully compensated for the expected depreciation of the currency in which their assets are denominated,
i.e., that the nominal interest rate in one country will exceed the nominal interest rate of the
foreign country by the amount of the expected
depreciation of the domestic currency. If this
condition did not hold, asset holders would be
induced to shift out of the assets of one country
into foreign assets in order to preserve the real
purchasing power of their bonds. This would
put immediate pressure on the exchange rate
and/or the nominal interest rate, and drive the
system back to the condition of nominal interest-rate parity. Thus, short-run profit possibilities create incipient capital flows which serve
to maintain this condition. Short-run exchange-rate movements are therefore inte-
C
)
15
Figure 2
Alternative Adjustments to a Monetary Disturbance
Note: For expositional purposes, we assume a one-year adjustment period between money and prices, and interpret the interest rate
and expected inflation rate as one-year rates.
16
Given our assumptions about goods prices and
capital mobility, the existence of a liquidity
effect ensures that the exchange rate will adjust more rapidly than prices in response to a
monetary disturbance.
We can deal with the other types of monetarychanges rather quickly. The second example of a monetary change involves a fully
antidpated and permanent increase in the level
of excess money movement along AB (in Figure 1). Because of the expected nature of this
increase, inflation expectations and therefore
nominal interest rates of all maturities have
already adjusted-that is, domestic bond holders are being compensated for the higher
(short-run) inflation. Both prices and the exchange rate should rise contemporaneously
with the money increase, with no effect therefore on real money balances, the real interest
rate, inflation expectations, or the market interest rate.
A final example involves an increase in the
permanent growth rate of excess-money-that
is, a change in the slope of the expected excessmoney path. This represents a combination of
two previous disturbances-an unanticipated
increase in the level of money, followed by
further anticipated increases, which are larger
than previously anticipated. The short-term
effects will therefore be similar to those in the
first situation described above. The long-run
effects will be similar to those in the second
situation, although with increased long-run inflation expectations as well as short, reflecting
the permanent alteration in the money-growth
rate. 16 The higher level of inflation expectations
will therefore lead to higher market-interest
rates (long and short). The currency will depreciate gradually over time, coincident with
and equal in size to the increase in the price
level. But no profit opportunities will emerge
in the bond market, because interest differentials will adjust to compensate fully for the
expected inflation and for the exchange-rate depreciation.
The key, therefore, to understanding shortrun movements in the exchange rate is to understand the effects of unanticipated excess
Panel 2). An opposite extreme where shortrun market interest rates decline by the full
amount necessary to maintain continuous
money-market equilibrium. In this case, the
short-run inflation-expectations effect is completely dominated by the liquidity effect. Not
only are asset holders uncompensated for a
decline in the real purchasing power of their
security, they are also forced to accept a lower
market-interest rate than they did before the
unanticipated rise in excess money. This combination of circumstances will induce market
participants to attempt to switch out of domestic assets into foreign assets, which will
cause an immediate depreciation of currency
by more than the 5-percent increase in excess
money. Thus, given a decline in both real and
nominal short-term interest rates, the exchange rate must depreciate to a level below
its expected long-run value. This overshooting
of the exchange rate (as described by Dornbusch), leads to an expected appreciation of
the exchange rate over time. The expected
appreciation of the domestic currency compensates for the lower domestic interest rate, and
the interest-rate parity condition (equation 9)
is maintained. In general, as long as the liquidity effect is greater than the inflation-expectation effect, there will be a shift toward a
more positive-sloping yield curve as well as a
temporary overshooting of the exchange rate.
Panel 3). An intermediate case, where the
inflation-expectation effect exactly offsets the
liquidity effect. In this panel, as in panel 2,
asset holders are not compensated for the expected depreciation (a decline in the real purchasing power of their bonds), so that they
attempt to shift out of domestic assets into
foreign assets. This immediately depreciates
the exchange rate. With no change occurring
in the nominal interest-rate differential, the
exchange rate must depreciate immediately by
5 percent to its long-run equilibrium value.
The long-run effects under each of the above
assumptions are equivalent. However, the
choice of assumption about the adjustment in
the money and bond markets is critical in explaining short-run exchange-rate movements.
17
an appeal to the evidence is needed to resolve
the question.
money on the bond market. Theoretically, the
effects are ambiguous in the short run, so that
III. Testing the Hypothesis
We are now in a position to write the equations which will be estimated. These estimates
will be used to test our theoretical conjectures
and make inferences about both the long- and
short-run adjustments of prices and exchange
rates.
Ll(P* - P)t = ao ' + taj Ll (ME*
ME)t_j
(10)
or not excess money changes affect exchange
rates more rapidly than they affect price-level
ratios.
The unexpected/ expected distinction is easy
to make conceptually, but difficult to make
empirically. 17 Thus, we do not attempt to break
down actual changes in excess money supply
into expected and unexpected components.
Money-supply changes over time undoubtedly
have contained both of these components, so
that we should see some combination of instantaneous and lagged adjustments in goods
prices and foreign-exchange rates. All else
equal, the greater the unexpected component
relative to the expected component, the longer
should be the lags between money and prices. 18
Next, we estimate the long-run interest-differential equation. Differentials across countries (R L *-R L ) are a function of differences in
long-run inflation expectations, and thus are due
to differences in expected excess-money
growth. The latter is determined not only by
past excess-money growth, but also by other
factors which market participants have found
to be good indicators of future money growth,
such as government budget deficits. Non-monetary factors are not directly included in our
estimating equation, but any systematic movement in these variables could be captured
through a Cochrane-Orcutt correction. Thus
we obtain the following:
LlS t = bo ' + ~obi Ll (ME*
ME)t_j
(11)
where m represents the length of the adjustment period between excess money and prices,
and n represents the length of the adjustment
period between excess money and exchange
rates.
First we ask whether we can confirm the
long-run relationship between excess money
and prices, and between excess money and
exchange rates. Further, we ask whether we
can confirm that the long-run coefficients in
the excess money/price relationships are equal
to those in the excess money/exchange-rate relationships (i.e. ~bj = ~aJor each country). For
these tests, the distinction between expected
and unexpected is not relevant, because the
long-run effects of a money change on prices
and exchange rates are the same in either case.
This is not so in the short run, however,
because as we have seen, short-run adjustments of the system depend on whether the
monetary change is expected or unexpected.
In particular, if all money changes were expected, both prices and exchange rates should
adjust contemporaneously with money, (i.e.,
m and n would equal zero). In contrast, if all
money changes were unexpected, the money/
price lag (m) should be long, while the
money/exchange-rate lag (n) should depend on
the short-term interest rate. In this connection,
the existence of the liquidity effect on shortterm interest rates ensures that adjustment will
occur more quickly in exchange rates than in
prices. This then raises the question whether
The role of relative excess money growth in
equation 12 is fundamentally different from
that in equations 10 and 11. Equation 12, unlike equations 10 and 11, is designed to capture
the effect of past actual money growth on expectations of money, providing evidence
whether government authorities have changed
the long-run target of future money growth.
This is therefore a form of a central-bank reaction function. Past money growth's only role
[8
in this equation is as a generator of changes in
inflation expectations. It has no role in either
the state of the business cycle or the state of
liquidity in the economy.
Next, we estimate short-run interest-rate
differences across countries (R,*-RJ, which
have a more complex relationship than longrun differences to current and past excessmoney growth. This is because short rates are
influenced by both liquidity and inflation expectations.
Although we cannot make any a priori statements about the relationship between shortterm interest rate differentials and excess
money growth differentials, we can say the
following: a) If liquidity effects have any influence on short-term interest rates, then the
exchange rate will adjust more rapidly than
prices i.e., the difference between the
money/price mean lags and the money/exchange
rate mean lags should be relatively large. b) If
liquidity effects initially dominate short-term
interest-rate movements, then the exchange
rate should overshoot the long-run equilibrium
value, i.e., the short-run effects of excess
money on the exchange rate should be greater
than the long-run effects. c) If the liquidity
effect has no influence on short-term interest
rates and inflation expectations effects dominate
initially, then the exchange rate should move
more in line with prices-i.e., the difference
between the money/price lags and the
money/exchange rate lags should be relatively
small.
(R s * - RJ, = do' + ~pjll(ME* - ME),.j (13)
The relationship between excess money and
short-term interest-rate differentials may be
positive if short-run inflation expectations dominate the relationship (Ldj>O); it may be negative
if liquidity effects dominate (Ld j<0); and it may
be approximately zero if the two effects offset
one another. In addition, the sign of the djs
may vary between negative and positive if the
liquidity effect dominates in the early months,
and if the inflation-expectations effect dominates thereafter.
IV. Empirical Estimation
To test the theory, we chose empirical measures which were as simple as possible, consistent with the variables in the theory. We
measured the exchange rate in all cases as the
monthly average of the bilateral rate between
the U.S. dollar and the foreign currency
(measured as foreign currency per dollar). For
a money-supply measure, we chose the broad
measure of money plus quasi-money from the
IMF's International Financial Statistics, seasonally adjusted using an X-ll routine. The
broad measure was used here because it was
found to be generally superior to the narrow
money-supply measure in earlier work of one
of the authors (Keran, 1979), although both
measures provided significant results with respect to exchange rates. For prices, we chose
the wholesale-price indexes from International
Financial Statistics, and again used an X-II
routine for seasonal adjustment. For interest
rates, we chose 3-4 month representative
money-market rates and long-term domestic
government bond yields from Morgan Guaranty's World Financial Markets.
As a proxy for real money demand, we constructed a 36-month moving average of actual
real money balances. This procedure is consistent with the assumption of noncontinuous
equilibrium in the money market, and it reduces the complexity of both the model specifications and the statistical estimates. In using
this proxy, we assume that purely transitory
changes in real money demand have no effect
on prices or exchange rates because they are
expected to be reversed. We also assume that
real money demand and real money supply are
equal over the long run, which is defined as
that time period in which prices adjust to a
monetary disturbance. This period of adjustment may vary between countries, but presumably in each case is completed within three
years-hence our choice of a 36-month moving
average. 19
All of the equations were estimated using
19
of lag coefficients are all a good deal greater
than 2 (averaging 5.0), which confirms that the
monetary variable is significant in explaining
the inflation differential between countries.
The values of the Durbin-Watson statistics
allo\V us to reject the possibility .of .autocorrelation in the errors. The lack of systematic
errors in these equations is consistent With the
notion that we have not left out any significant
systematic explanatory variables. The total lag
lengths ranged from 12 months for Italy to 36
months for France and Switzerlcl.lld, with an
average across countries of about 24 months.
Lags longer than these only decreased the explanatory power of the equation. The time required for 75 percent of the total effect to
occur ranged from 10 months for Italy to 30 1/2
months for France.
the Almon polynominal distributed-lag (PDL)
technique, which helps us distinguish between
the permanentand transitory changes in excess
money. Each equation .was mna number of
times, with different lag lengths ranging from
oto 36 months and up •to 4th. degreepolynomials. In all cases the far . ends were· constrained equal to zero. The I'best" totaFnumber of lags and degree were chosen based on
the criterion of lowest standard error of the
regression .• All of the equations were estimated with monthly data for the period January 1975-December 1978. 20
We present the results from the "best"
money/price equations for each country in Table 1, and the results from the "best"
money/exchange-rate equations in Table 2. Tables 5 and 6 show the long- and short-term
interest-rate results. In presenting the statistical results, we analyze a number of statistical
measures which are briefly discussed in Appendix 1.
Money and Exchange Rates
As with money and prices, the evidence
clearly supports a significant link between
money and exchange rates (Table 2). The sum
of the coefficients on the monetary variable
are significant for all five bilateral exchange
rates. While the R2s may seem low, all of the
variables in the exchange-rate and price equations are measured in monthly percentagechange form, so that there is a great deal of
unsystematic and random "noise" in the series
Money and Prices
Our results (Table 1) clearly support the theoretical belief in a significant relation between
an increase in excess money and a rise in the
price of goods, with the price lags reflecting a
host of contractual, informational, and inventory adjustments. The t-statistics on the sum
Table 1
Relationship of Changes in Wholesale Price Ratios and Excess Money, 1975-78
~(P*
Country
Total
No. Lags
75% Effect
Lag
- P)t = ao'
+
Jt a ~
j
(ME* - ME)t.j
Constant
~ Lagged
Coefficients
Fl'
S.E.R.
3.74
(4.94)
.338
.0066
1.66
Rho
D.W.
France
36
30.5
-.0021
( -1.81)
Germany
18
14.5
.0012
( 1.10)
1.33
(4.12)
.263
.0037
1.67
Italy
12
10.0
.0196
( -5.26)
3.07
(6.58)
.760
.0052
1.63
Japan
18
15.0
-.0031
( -5.26)
1.36
(6.64)
.511
.0039
1.71
Switzerland
36
30.0
.0005
(.22)
2.30
(3.30)
.183
.0048
1.82
t-statistics in parenthesis
20
which is not explained by the independent variable. 21
Table 3 presents the sum of the lag coefficients for the price and exchange rate equations, the difference between the coefficients,
and the t-statistics on each. 22 The exchangerate coefficients are larger than the price coefficients for all countries except France, but in
no case is there a statistically significant difference between the long-run price and exchangerate coefficients. This is consistent with our
theoretical argument that the long-run coefficients in the two sets of equations would be
equal.
Next, consider the cumulative effects of excess-money changes on price ratios and exchange rates (Chart 2). This chart shows the
total effect of an initial one percent change in
excess money for any month in the adjustment
period. Because the adjustment period is
never longer than 36 months, the value plotted
at lag 36 will be equal to the sum of the lag
coefficients estimated in equations 10 and II.
Exchange-rate overshooting, which occlirs
when excess money depresses short-term interest rates via the liquidity effect, should be
indicated by a distributed lag in the exchangerate equation consisting of positive coefficients
followed by negative coefficients, with the sum
equal to that in the price equation. Such ov-
ershooting was evident only in the case of
Switzerland, for it was the only country showing significant negative coefficients in the lag
patterns of the exchange-rate equations. This
can be clearly seen in the pattern of exchangerate lagged coefficients, where the cumulative
effect first rises above the long-run value. The
evidence in the short-term interest-rate equations is also consistent with this liquidity/
overshooting explanation.
Table 3
long-run Coefficients of Exchange Rate and
Price Equations
(1)
Exchange
Rate
Equation
(2)
Price
Equation
Difference
France
3.44
(2.94)
3.74
(4.94)
-.29
(- .27)
Germany
3.09
(2.37)
1.33
(4.12)
1.76
(1.33)
Italy
3.31
(3.15)
3.07
(6.58)
.24
(.22)
Japan
1.89
(2.79)
1.36
(6.64)
.53
(.82)
Switzerland
3.17
(2.97)
2.30
(3.30)
.87
(.76)
Country
(1)-(2)
(t-statistics in parenthesis).
Table 2
Relationship of Changes in Exchange Rates and Excess Money, 1975-78
n
.lSt = bo' + ~obj.l (ME* - ME)t_j
Country
Total
No. Lags
75% Effect
Lag
Constant
2: Lagged
Coefficients
Fl2
S.E.R.
3.44
(2.94)
124
.0184
2.00
Rho
D.W.
30
25.0
-.0008
(- .25)
Germany
9
7.5
.0044
(.91)
3.09
(2.37)
.118
.0196
1.88
Italy
9
5.75
-.0252
( -3.(2)
3.31
(3.15)
.675
.0l3l
1.58
Japan
6
4.5
.0037
2.37)
1.89
(2.79)
.168
.0204
1.67
Switzerland
6
1.0
3.17
(2.97)
.335
.0229
1.50
France
(
.0057
(.98)
t-statistics in parenthesis
21
Chart 2
Coefficients
Lag Patterns for
Exchange Rates
and·Prices
Coefficients
5
.....
:
..•
3
"..111.. 111.. 1.. 1......1•
.
2
Switzerland
4
Italy
4
1
0
Exchange
~ rate
o
...
6
12
18
24
30
Lags
3
Coefficients
2
2
1
1
Japan
o
o
-1
Coefficients
0
6
12
18
24
30
Germany
4
3
4
2
3
..,
~'''1''1''111I1''"1
1
36
Lags
Coefficients
France
2
~.
~.,
\\\~
o
-1
36
1
o
6
12
18
24
30
0
36
0
6
12
18
24
30
36
Lags
Lags
*The coefficients charted above show the cumulative effects of a monetary disturbance on the exchange rate and the WPI ratio, an<'
are derived by cumulatively adding the lag coefficients estimated in equations 10 and 11.
22
The exchange-rate equations are notable for
the shortness of the lags between money and
exchange rates (Table 4). For all countries except France, the total lag ranged between 3
and 9 months, and averaged about 7 months;
for France, the lag was 30 months. Similarly,
the 75-percent effect-the time required for 75
percent of the exchange-rate impact to occurranged below 8 months for all countries except
France (25 months). We may conclude that
money affects exchange rates more rapidly
than it does prices, judging from the evidence
that both the total and 75 percent-effect lags
were substantially less in the exchange-rate
equations than in the price equations. According to our theoretical model, these shorter lags
are consistent with monetary disturbances resulting in changes in real interest rates (liquidity effects). We will see that the evidence
from the short-term interest-rate equations is
consistent with this theory.
Our model is incomplete because it captures
the real terms-of-trade effect on the exchange
rate only in the constant term. Admittedly, this
is unrealistic. For example, one of the authors
(Keran, 1980) has shown that the yen/dollar
Table 4
Money-Exchange Rate and Money-Price Lags
(in months)
Country
Exchange Rate Equation
(1 )
(2)
Total lag
75% Effect lag
Price Equation
(4)
(3)
Total lag
75% Effect lag
(4)-(2)
Difference
30
25
36
30.5
5.5
Germany
9
7.5
18
14.5
7.0
Italy
9
5.75
12
10.0
4.25
Japan
6
4.5
18
15.0
10.5
Switzerland
6
1.0
36
30.0
29.0
France
Table 5
Relationship of Long-term Interest Differential and Changes in Excess Money, 1975-78*"
p
(R L* - RL)t
Country
Total
No. lags
=
co'
+ J2;Pi Ll (ME* - ME)t'i
Constant
L lagged
Coefficients
.07
( 1.84)
France
36
1.88
(14.88)
Germany
21
.06
(.15)
Italy
18
Japan
24
Switzerland
30
Fl2
S.E.R.
Rho
D.W.
.909
.2127
.71
(6.93)
2.05
.45
(463)
.968
.2425
.88
(1265)
2.26
(
1.83
2.(4)
.52
(6.11)
.843
.5074
.59
(5.05)
1.89
(
-0.50
3.07)
.29
(8.03)
972
.2044
.82
(7.68)
2.48
(
-2.88
5.93)
.38
(4.47)
.973
.2153
89
(13.26)
2.61
Lag Pattern'
'Shaded areas indicate not significantly different from zero.
t-statistics in parenthesis
**In order to better interpret the coefficients of these equations. annualized percentage changes in exCeSS money are usl'd
instead of the difference of logs.
23
Before adjustment for autocorrelation, the
DW statistics were extremely low, suggesting
that important variables were omitted from the
equation-and indeed, we excluded from our
equation other data which individuals might
use to forecast future money growth and future
inflation. Nonetheless, these results and the
money-price results confirm the relationship
between excess money-growth differentials on
the one hand, and current and expected future
inflation differentials on the other.
exchange rate is significantly affected by the
real price of oil. Real terms-of-trade factors
are beyond the scope of this paper, but they
still remain important.
Money and Long-Term Interest Rates
We obtain quite strong results from the
equations estimating the relationship between
long-term interest rates and the growth in excess money (Table 5). Relative to the U.S., all
countries show a significant positive relationship between the level of the interest-rate differential and the growth rate in excess
money.23
The link reflects the fact that changes in longterm interest rates are due primarily to
changes in long-run inflation expectations,
which in turn are based on expected future
excess-money growth. Forecasts of future
money growth often depend on the pattern
and size of current and past money-growth
rates. Therefore we obtain a significant statistical correlation between the level of the longterm interest differential and current and past
growth rates of excess money. The t-statistics
on the sum of lag coefficients ranged from just
under 2 for France to more than 8 for Japan.
Money and Short-Term Interest Rates
Our empirical results reflect the ambiguity of
our theoretical argument, that an increase in
excess money can simultaneously have a liquidity effect which reduces short-term rates
and an inflation expectations effect which increases short-term rates (Table 6). In the cases
of France and Switzerland, the liquidity effects
dominate initially; in the cases of Germany
and Japan, the results are not significant, reflecting offsetting effects; and in the case of Italy, the inflation-expectation effect dominates
initially. The evidence (except for France) also
supports our theory that countries with the
greatest liquidity effects would show the larg-
Table 6
Relationship of Short-term Interest Differential and Changes in Excess Money, 1975-78**
(R s* - Rs)t
Country
Total
No. Lags
Constant
,35
,16)
=
do' + J~~j~(ME* - ME)t_i
L: Lagged
Coefficients
-0,13
( ,61)
R2
S.E.R.
Rho
D.W.
,881
,7847
,95
(20,18)
1.98
France
15
Germany
15
-692.82
( - 1.43)
- ,30
(- 1.53)
,903
,5464
1.00
(381.63)
1.82
Italy
21
12,61
( -3,54)
1.87
(5.49)
,913
1.2385
,74
(7,73)
1.72
Japan
24
5,08
( -1.72)
,25
(1.22)
,958
,6729
,97
(28,35)
1.24
Switzerland
24
2,74
6.32)
,64
(7.32)
,894
,7270
,58
(4,90)
2,17
(
'Shaded areas indicate not significantly different from zero,
t-statistics in parenthesis
'*In order to better interpret the coefficients of these equations. annualized percentage changes in excess money are used
instead of the difference of logs,
24
tion-expectation and liquidity effects, with differences in these lags falling between those of
Switzerland and Italy. Switzerland shows asignificant initial liquidity effect which is accompanied by an overshooting of the exchange
rate. France also shows a significant liquidity
effect, but does not show a rapid adjustment
of the exchange rate. This may perhaps be
explained by France's pervasive system of capital controls. 24 Again, before adjustment for
autocorrelation. the DW statistics were extremely low in these equations, indicating the
probable omission of systematic explanatory
variables.
est differences between the lags in the price
and exchange-rate equations, and that countries with large inflation-expectation effects
would show the lags in the exchange rate
closely corresponding with the lags in goods
prices. With the exception of France, the evidence is consistent with this theory. Switzerland has a significant initial liquidity effect,
overshooting in the exchange rate, and the
largest difference between the price and exchange rate 75-percent-effect lags; Italy has a
significant initial inflation-expectation effect
and the smallest difference in these lags; and
Germany and Japan have insignificant infla-
V. Summary and Conclusions
It has long been believed and is now widely
accepted that exchange rates in the long run
will be determined by purchasing power parity.
That is, the exchange rate will be largely determined by equilibrium conditions in the
goods market. Because of the slow adjustment
of this market to economic disturbances, it was
generally assumed that the exchange rate
would also adjust relatively slowly. In fact,
however, variations in the exchange rate have
been considerably greater than variations in
prices across countries.
These facts have not shaken most analysts'
views about the long run validity of purchasing-power parity. As Figure 1 indicates, exchange rates do, in fact, move in line with the
ratio of national price levels over the long run.
However, the relatively large short-run deviations from purchasing-power parity require an
explanation. In analyzing short-run movements in exchange rates, most analysts focus
on the role of interest-rate parity. Interest-rate
differentials across countries can influence capital flows and thus exchange rates.
Research in this area has focused on the use
of money-market equilibrium models for interest-rate determination (see, for example,
Dornbusch 1976). Given lags in the adjustment of the goods market, an increase in the
supply of money, in these models, will neces-
sarily lead to a decrease in interest rates (socalled liquidity effect) and thus to a temporary
decline of the exchange rate below its long-run
equilibrium value. Later, as the goods market
responds to this monetary disturbance, interest
rates will gradually rise and the exchange rate
will appreciate back to its long-run value. This
temporary overshooting leads to greater variat.ion in exchange rates than in the ratio of
national price levels.
In this article, we evaluate the short-run relationship between interest rates and exchange
rates. In our short-run model, interest rates
are determined in the bond market, rather
than in the money market. This circumstance
permits a wider range of interest-rate responses to a monetary disturbance.
An increase in the money supply can have
both a short-run liquidity effect and a shortrun inflation-expectation effect (Figure 2).
These effects have opposite implications for
interest rates. 1) If the liquidity effect is dominant, then short-run interest rates will decline
and there will be exchange-rate over-shooting.
2) If the inflation-expectation effect is dominant, then interest rates will rise and the exchange rate will move slowly to its long-run
equilibrium value. 3) If the liquidity and inflation-expectation effects are equal, there will
be no change in short-term interest rates and
25
the exchange rate will move immediately to its
long-run value.
A comparison of the U.S. experience, vis-avis five major industrial countries, shows that:
1) For all countries, there is a statistically significant relationship between the monetary disturbance on the one hand, and exchange rates
and the ratio of national price levels on the
other.
2) There is no statistically significant difference between the long-term effects of a monetary disturbance on the ratio of national price
levels and on exchange rates.
3) The exchange rate responds on the average much more quickly than the ratio of
national prices to a monetary disturbance.
4) In only one country (Switzerland), is
there evidence of exchange-rate overshooting
in the short run. In three countries (Germany,
Japan, Italy), the exchange rate moves quickly
to its equilibrium value without overshooting,
and in one country (France), exchange-rate
movements were roughly in line with price
movements.
The analysis and research in this paper show
that interest rates do, in fact, play an important role in short-run exchange-rate movements. However, it is the equilibrium conditions in the bond market (not the money
market) which determine short-term interest
rates and thus exchange rates. These interestrate movements are the source of greater
short-run variations in exchange rates than in
the ratio of national price levels.
APPENDIX
Description of Statistics
t-statistic on the coefficients: The t-statistic,
which is equal to the ratio of the coefficient to
its estimated standard error, is a key determinant of the statistical significance of the independent variable in explaining movement of
the dependent variable. In our equations, a tstatistic greater than about 2 in absolute value
indicates that the corresponding coefficient is
significantly different from zero at the 95-percent coefficient level. t-statistics are calculated
on each lagged coefficient and also on the sum
of all lagged coefficients. The t-statistic on the
sum, which is reported in the tables, tells us
whether or not the long-run effect of the independent variable is significant in explaining
movement in the dependent variable.
Adjusted R 2(tP): The R2 tells us how much
of the variance in the dependent variable can
be explained by the variance in the independent variables, after adjusting for the number
of observations and the number of independent variables. The R2 can be a misleading measure of goodness of fit if it is used to compare
equations estimated in different dimensions,
such as level and percent-change form. The R2
will usually be much lower in the change form
than the level form, because of greater random
variation relative to the systematic variation in
the change form than in the level form. In this
case, a better measure of goodness of fit is the
standard error of the regression.
Standard error of the regression (SER): This
is another measure of the explanatory power
of the equation. It measures the degree to
which the estimated values of the dependent
variable differ from the actual values. Given
a normal distribution of errors, we would expect that the fitted value of the dependent variable would be within one standard error (plus
or minus) of the actual value 66 percent of the
time.
Durbin-Watson statistic (DW): This statistic
tests for first-order autocorrelation, i.e. systematic errors in the estimated equation. A
common cause of systematic error is the omissian from the equation of at least one significant explanatory variable. For our particular
equations, DWs of greater than 1.6 indicate,
with 95-percent confidence, a lack of positive
autocorrelation. In testing for negative autocorrelation, DWs of less than 2.4 indicate, with
95-percent confidence, a lack of negative correlated errors. If the DWs fall between 1.2 and
1.6 or between 2.4 and 2.8, then the respective
26
tests of
that is,
whether
DWs of
autocorrelation are indeterminatewe cannot conclude from the tests
or not systematic errors are present.
less than 1.2 indicate significant posi-
tive first-order autocorrelation, and DWs
greater than 2.8 indicate significant negative
first-order autocorrelation of the errors.
FOOTNOTES
1. These models usually have involved analyses of the
effects of changes in inflation expectations. In the monetary
approach, a rise in inflation expectations will reduce the real
demand for money, putting additional upward pressure on
prices which is initially observed in the foreign-exchange
rate. In the portfolio approach, a change in inflation expectations, operating through the bond market, will reduce the
desired holdings of assets in the inflating currency and thus
affect the exchange rate. The monetary approach assumes
prompt adjustment in the goods market to a monetary disturbance which is observed in the exchange rate but (because of measurement error) not observed in price indexes.
In the portfolio approach, goods markets presumably adjust
with a lag, but the bond market responds immediately and
thus affects the exchange rate. Either of these approaches
could explain a short-run exchange-rate change which is
greater than observed changes in the ratio of national price
levels; Both approaches accept implicitly or explicitly the
assumption of long-run purchasing-power parity.
2. For an opposing viewpoint on currency substitution and
a discussion of the effects on the exchange rate, see Wallace (1978, 1979).
3. The terms of trade measure the long run value of one
country's goods in terms of the value of another country's
goods, e.g., how many bushels of U.S. wheat it takes to
"purchase" one Japanese TV set. A change in the terms of
trade could be caused by a change in technology, the discovery of new sources of raw materials, or a substantial
change in relative prices of important commodities, such as
a rise in the price of oil. We assume here that terms of trade
changes are independent of monetary factors.
4. Equation 8 assumes that risk premiums are equal across
countries. This is done for simplicity and is not necessary
for the model. All that we really need to assume for the
model to hold is that these risk premiums are constant
across time, i.e., r = r* + c. We are not attempting in this
paper to model the consequences of long run changes in
the real interest rate.
5. Equation 9 can be derived as follows:
R
=
L1pe + r
R* = L1P*e + r*
L1S e
=
L1P*e - L1pe
r = r*
Sa)
5b)
7)
8)
Substituting Sa) and Sb) into 8 we get:
or R
L1pe = R* - L1pe
or R = R* - (L1pe - L1pe)
Substituting equation 7 into this, we arrive at equation 9:
R = R*
L1S e
9)
6. This topic is discussed in Bilson (1979).
27
7. Even in the long run, the relationship will not be exact,
because price indexes in two different countries will not
necessarily have the same weights. That is, even if individual goods are priced the same in two countries, the price
indexes may not necessarily have the same value in the
two currencies because of differences in the composition of
the indexes. To minimize these cross-country measurement
problems, wholesale rather than consumer prices are used
here. Furthermore, the existence of long-run purchasingpower parity does not imply anything about the direction of
causality, the theory only requires that prices and exchange
rates move together. Not only will prices affect exchange
rates, but exchange rates will also affect prices. The crucial
factor determining' both prices and exchange rates is the
difference in excess money growth between countries.
8. See Carr and Darby (1977) and Tucker (1971).
9. Charles Pigott discusses these lags in his article in this
issue, "Expectations, Money and the Forecasting of Inflation."
10. The market-adjustment lag also includes the time it
takes for a monetary disturbance, once recognized, to alter
individuals' behavior. This lag arises because each individual tends to economize on decisions and transactions, and
thus changes his behavior only periodically, even after the
monetary change is considered permanent. On the aggregate level, this implies a gradual change in demand and
supply.
11. A large number of organized, auction-type markets exist, where a large number of buyers and sellers trade a
single homogeneous product, and where the costs of holding inventories and transporting the product are not prohibitively high. (The importance of these conditions is illustrated
by the case of GNMA vs. regular mortgages. The creation
of GNMA mortgages served to homogenize the product and
enable the establishment of both spot and future markets.
See Froewiss, 1978.) These requirements are most applicable to financial assets. A large number of secondary markets have been organized for trading in stocks and bonds,
and there are also organized markets-foreign exchange
markets-for the buying and selling of national currencies.
There are also auction-type markets for certain goods, primarily raw commodities such as wheat and soy beans. In
general, however, most assets are :;aded on organized
auction-type markets while most goods and services are
not.
12. Adjustment lags for most goods prices are frequently
attributed to the existence of fixed purchase-and-sale contracts. The existence of contracts per se does not cause
these adjustment lags; after all, bonds represent fixed contracts also. Rather, the lags are due to the fact that these
contracts are non-negotiable, i.e., no organized market exists for the purchase and sale of contracts for such goods.
13. Actually, a large enough change in one or two of these
factors could reverse the sign(s), of the effects on the other
factor(s), while still maintaining money-market equilibrium.
Mar./April 1976, and zero elsewhere) and in the Italian exchange-rate equation (equal to 1 in February-April 1976 and
zero elsewhere).
14. See Tucker (1971).
21. In the text we focus on whether or not the coefficients
in the price and exchange-rate equations are different from
each other. While the two sum coefficients for each country
are. not statistically different from each other, a number of
them are significantly different from one. Given the fundamental postulate of neutrality of money, how is it possible
for monetary disturbances to have more than a proportionate effect (i.e., coefficients greater than one) on prices and
eXchange rates? Changes in the excess-money supply may
perhaps be measured improperly, either because of an inappropriate definition of nominal money supply or because
of an inappropriate measure of real money demand. Since
money-supply data are available from standard statistical
sources, and since money demand here is derived artificially as a 36-month moving average of the real money
stock, the most likely source of error probably arises from
the demand side. For example, current increases in money
growth may generate expectations of similar future increases, and may therefore raise inflation expectations. This
would cause people to economize on cash balances, i.e.,
reduce the quantity of money demanded. We have tried to
account for this by using "excess money" instead of actual
money, but our variable probably did not totally capture this
effect. Consequently, we would expect the coefficients to
be larger than one in both the exchange-rate and price
equations. Pig011, in his article in this issue, discusses other
reasons why these coefficients may be greater than one.
15. Equation 9 is a covered arbitrage condition only if ~Se
is interpreted as log F - log S, where F is the forward
exchange rate. Equation 9 then represents covered or
closed interest parity. For this paper, we only assume that
~Se is the expected appreciation, log Se - log S. If the
forward rate is equal to the expected future spot rate then
this will be a covered arbitrage condition, and if not equation
9 represents uncovered or open interest parity. See Frankel
(1979) for a further discussion.
16. One additional short-run effect is not mentioned explicitly in the text. The permanent increase in the long-run
expected inflation rate, and thus in the long-run interest rate,
will cause a one-time reduction in the level of real money
demand (due to movement along the money-demand
curve). Thus, a permanent increase in the rate of growth
of money will result in an additional one-time increase in
the level of prices and a one-time decrease in the level of
the exchange rate. To our knowledge, the quantitative importance of this effect has not been estimated.
17. For an example of an allempt to distinguish between
anticipated and unanticipated money-supply changes see
Barro (1978).
18. The relative magnitudes of expected and unexpected
money changes for each country may be estimated roughly
by examining the ranking of the means and variances of
changes in excess-money ratios. The means give us an
approximation of average expected excess-money growth
over the estimation period, and the variances around the
mean give us an approximation of unexpected excess
money. We discovered, however, that the rankings of the
means were approximately the same as the rankings of the
variances-i. e., those countries with higher means also
had higher variances of excess-money growth. Thus, the
ranking of the unexpected relative to the unexpected remained indeterminate.
19. We calculated the change in excess-money supply in
any month as equal to the change in nominal money supply
in that month minus the change in the 36-month moving
average in real balances. We used averages between 60
and 24 months for estimating the Japan/U.S. equations and
the results were not sensitive to the length of the moving
average, except at the short end.
20. Because of the lack of earlier data, the estimation period for the Japanese long-run interest equation was 75.02
to 78.12. Because of the closing of the Italian foreignexchange market in February-March 1976, a dummy variable was used in the Italian price equation (equal to 1 in
28
22. It was assumed for the t-test on the difference of the
long run coefficients that this difference was normally distributed with variance estimated by the sum of the estimated
variances of the coefficients minus twice their covariance.
Their covariance was estimated by the correlation between
the errors of the equations times the product of the estimated standard errors of the coefficients.
23. The French coefficient is significant only at the 90 percent confidence level.
24. Capital flows from France are subject to exchange-control approval, and are generally restricted. In the long run,
most of the controls may be circumvented, but a complex
system of administrative regulations still makes capital
transactions very cumbersome. (See IMF, 1979.) This implies that adjustment of the exchange rate must occur
through pressures which develop in the goods market rather
than in the asset market. This is probably the reason why
the French exchange rate adjusts at virtually the same
speed as prices to a monetary disturbance, despite the
existence of a liquidity effect in the short-term interest-rate
equation.
REFERENCES
Annual Report of Exchange Arrangements and Exchange Restrictions, International Monetary Fund,
1979.
Johnson, Harry G. "The Monetary Approach to Balance of
Payments Theory" in Jacob Frenkel and Harry G.
Johnson (eds.), The Monetary Approach to the Balance of Payments, University of Toronto Press, 1976.
Barro, Robert. "Unanticipated Money, Output, and the Price
Level in the United States," Journal of Political Economy, August 1978, pp. 549-580.
Karaken, John and Wallace, Neil. "International Monetary
Reform: The Feasible Alternatives," Federal Reserve
Bank of Minneapolis Quarterly Review, Summer
1978, pp. 2-7.
Bilson, John F. "The Monetary Approach to the Exchange
Rate: Some Empirical Evidence," IMF Staff Papers,
March 1978, pp.48-75.
Keran, Michael. "Money and Exchange Rates: 1974-79,"
Federal Reserve Bank of San Francisco Economic
Review, Spring 1979, pp. 19-34.
- - . "Recent Developments in Monetary Models of Exchange Rate Determination," IMF Staff Papers, June
1979, pp. 201-223.
Carr, Jack and Darby, Michael. "The Role of Money Supply
Shocks in the Short Run Demand for Money," UCLA
Department of Economics, Discussion Paper No. 98,
August 1977.
Dornbusch, Rudiger. "Expectations and Exchange Rate
Dynamics," Journal of Political Economy, December
1976, pp.1161-1176.
Frankel, Jeffrey. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials,"
American Economic Review, September 1979, pp.
610-622.
Schadler, Susan. "Sources of Exchange Rate Variability:
Theory and Empirical Evidence," IMF Staff Papers,
July 1977, pp. 253-296.
- - "International Monetary Reform: The Feasible Alternatives," Federal Reserve Bank of Minneapolis
Quarterly Review, Summer 1978, pp.2-7.
Sweeney, Richard J. "Risk, Inflation, and Exchange Rates,"
in the Proceedings of the West Coast
Academic/Federal Reserve Economic Research
Seminar, Federal Reserve Bank of San Francisco,
November 1978.
Tucker, Donald. "Macroeconomic Models and the Demand
for Money Under Market Disequilibrium," Journal of
Money, Credit, and Banking, February 1971, pp. 5783.
Frenkel, Jacob A. "The Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence," in Jacob Frenkel and Harry G. Johnson (eds.),
The Economics of Exchange Rates, AddisonWesley, 1978.
Wallace, Neil. "Why Markets in Foreign Exchange Are Different from Other Markets," Federal Reserve Bank of
Minneapolis Quarterly Review, Fall 1979, pp. 1-7.
Girton, Lance and Roper, Don. "A Monetary Model of Exchange Market Pressure Applied to Postwar Canadian
Experience," American Economic Review, September 1977, pp. 537-548.
29
Charles Pigott*
Economists continue to debate whether
money is the only or even the primary cause
of inflation. Few, however, would deny that
money affects inflation with a lag. This proposition has been confirmed by studies of a variety of countries and historical periods. In
most cases, money's effect upon prices has
been found to continue for several years' time,
although the precise lag often seems to vary
substantially. 1
Partly as a result of these studies, estimates
of the lagged relation between money and
prices are widely used for such purposes as
forecasting inflation. But this lagged relation
has implications that go well beyond the prediction of inflation. If money changes are not
immediately and fully reflected in prices, they
will lead in the short run to variations in real
balances and real liquidity, which in turn may
affect interest rates and real aggregate demand. Indeed, it is widely believed that money
affects real economic activity in the short run
because its impact upon prices is delayed. 2 This
view is reflected in many of the formal econometric models used in business and government, where the timing of money's impact
upon prices is critical in determining short-run
effects of monetary policy on the real sector.
But despite its widespread application, little
is known empirically about the factors determining the money-inflation lag. Indeed, the
very reasons for its existence are controversial.
A common and traditional view is that the lag
stems from institutional and technical factors--
e.g., contracts and adjustment costs- that
prevent prices from adjusting immediately to
money changes. Also, according to this view,
such factors presumably are unaffected by
monetary policy. This proposition, if true,
greatly simplifies the task of policy analysts,
since it implies that estimates of the moneyinflation relation derived under one type of policy will remain valid under another. Past behavior, that is, provides a relatively unambiguous guide to the future in this case.
In recent years, with the growing understanding of the influence of individuals' expectations upon behavior, such mechanistic views
of the lags in economic relations have been
challenged. Few would deny that institutional
and technical "frictions" such as contracts, adjustment costs, and imperfect information are
partly responsible for the lag between money
and prices. Nonetheless, basic economic theory suggests that the decisions individuals
make when faced with such factors often depend critically upon their anticipations about
the future. In some industries, for example,
contractual arrangements prevent prices from
adjusting immediately to a change in money.
It could be supposed that anticipations have
little or no influence upon the length and general form of such contracts, since these features often are largely determined by custom,
law, and industry characteristics. But the price
specified in any contract will depend upon firm
perceptions of future costs and demand, and
hence implicitly upon judgments about future
inflation and (thus) monetary policy.
This suggests that the lags in money-inflation as well as other economic relations result
from the interaction of two basic sets of fac-
'Economist, Federal Reserve Bank of San Francisco.
Kirk McAllister and Christopher Dunn provided research
assistance for this article.
30
tors. On the one hand, there are various "frictions" and "imperfections"-factors that are
determined largely by technology, precedent,
law, and other institutional characteristics that
change very slowly with anticipations, and
then only if these depart fairly radically from
past experience. But interacting with these factors are individuals' expectations, particularly
their perceptions as to how current and past
conditions relate to those in the future. Given
that interaction, the lag between money and
prices (and analogous lags in other economic
relations) is likely to change when government
policies are altered, because then individuals'
expectations can be expected to change.
Plainly then, the extent to which expectations influence the money-inflation lag has
potentially far-reaching practical implications
for policy formulation. If expectations are important, the relations used to predict inflation
and real-output responses to money are apt to
shift when basic policy is altered. To assess the
effects of alternative policies realistically, we
are likely to need an explicit identification of
the role of expectations in determining the
money-inflation lag, because only in this way
will we be able to predict shifts in the relation.
If expectations are as important as some economists believe, policy analysts will have to consider them more explicitly than they generally
have in the past.
This paper discusses how expectations about
monetary policy may affect the lag between
money and prices. Basically, we argue that
price decisions made now are likely to be
based upon individuals' anticipations about the
level of money in the future. If true, the consequences are very important for the forecasting of inflation, the evaluation of prospective
policies, and the testing of alternative theories
of inflation. Normally, inflation forecasts are
based upon data on current and past money
growth and, in some cases, other variables; the
same relations are usually employed in predicting the impact of prospective policies. If
prices are actually based upon forecasts of future money, such relations will reflect the way
in which predictions of future money are calculated from current and past data. For this
reason, basic changes in monetary policy are
likely to alter the lag between money and
prices, because such changes are likely to lead
individuals (at least eventually) to revise their
forecasting methods. Following Lucas (1970)
and Sargent and Wallace (1976), our arguments
criticize those procedures which use economic
relations observed under one set of policies to
predict the consequences of different policies.
Section I of the paper summarizes explanations that have been offered for the lag between money and prices. Nearly all of these
explanations suggest that prices will be based,
directly or indirectly, upon forecasts of future
money (see appendix for technical details).
Estimates presented for several countries suggest, tentatively, that expectations may have
significantly influenced money-inflation lags. For
policy purposes, however, we must identify the
way in which expectations affect such empirical relations between money and prices; only
then can we determine how inflation-forecasting
methods must be revised when policy is altered.
In Section II we discuss the implications of
a relatively simple but potentially powerful hypothesis-that prices respond more to money
changes that are perceived as permanent or
persistent than to those seen as transient, with
that response itself being relatively unaffected
by policy. This suggests that the empirical relation between inflation and actual money will
depend crucially upon how individuals view
the future sustainability of such changes in
money. The (crude) evidence cited here provides only mixed support for this view, but the
hypothesis merits further research.
31
I. Lags Between Money and Prices
In the long-run, it is widely believed, sustained changes in money merely lead to variations in all prices in the same proportion without affecting real output, interest rates, or
relative prices. ("Sustained" changes are those
that are neither augmented nor diminished in
the future.) This proposition, which is known
as the (long-run) neutrality of money, is based
intuitively on the fact that a rise in money and
all prices in the same proportion leaves the
"typical" individual's real balances, real
wealth, and real income unaffected; since that
individual's consumption, savings, work, and
leisure opportunities are unaltered by the
money change, his decisions similarly should
not be affected. 3 A substantial amount of evidence suggests, at least for the U.S., that
money is at least approximately neutral in this
sense. 4 Of course the neutrality of money does
not imply that money changes are the only
sources of change in the aggregate price level;
it is also affected by changes in real income,
interest rates, oil prices and other variables
which influence the demand for money. However, historical studies, particularly the monumental Monetary History of the United States
by Friedman and Schwartz (1963), have established that variations in money growth account
for most variations in long-term inflation rates.
This long-run relation suggests the use of
money to predict inflation in the short-run.
However, even casual observation reveals that
money changes do not lead immediately to
proportional changes in the price level, but
that they are associated initially with changes
in real output and interest rates. Most economists would agree that this short-run departure
from neutrality originates in factors that prevent prices from responding immediately and
proportionately to money changes, and that
the subsequent change in real balances leads
to interest-rate and real-output changes that
further influence the "transmission" of money
to prices.
More formally, we can distinguish between
long-run and short-run effects. In the long-run,
32
prices vary proportionately with nominal aggregate demand, which itself changes in the
same proportion as money. In the short-run,
however, money is not fully reflected in prices,
but "spills over" into real income and interest
rates, which in turn influence aggregate demand
and prices. This series of adjustments of prices
to money, direct as well as via money's effect
on output and interest rates, is reflected in relations used to predict prices and inflation from
rrioI1ey~gfowth data. Such relations are commonly written in the form,
p(t) = aom(t) + a]m(t-l) +
... anm(t-n) + z(t)
(1)
or more commonly in change-form as
6.p(t)
a o6.m(t) + a}6.m(t-1) +
... an6.m(t-n) + 6.z(t)
(1')
where p is the log of aggregate prices, m is the
log of the money stock, and z(t) stands for all
other non-monetary variables affecting prices,
such as long-run trends in real output and
money velocity; here 6.p(t) refers to the change
in pO, that is p(t)-p(t-l) and similarly for
6.m(t).5 Again, the lags reflect not only money's
direct effect upon prices but also its indirect
effects operating via short-run changes in real
output and interest rates. 6 What is the source
of these lags, and how may they be influenced
by individuals' expectations about monetary
policy?
Reasons for Lags
Until recently, lags between money and
prices were commonly explained as reflections
of disequilibria in commodity and labor markets. According to this essentially Keynesian
approach, prices and quantities in a market
generally differ from their equilibrium values
as determined by the intersection of market
supply-and-demand schedules. In this view,
prices and quantities adjust gradually and
fairly mechanically toward their equilibria in
response to excess demand-the gap between
demand and supply at current prices. Money
monetary impact emphasizes lags in the response of aggregate demand itself. Specifically,
individuals may shift their demands more in
response to changes in money that are viewed
as persistent than to transient changes. This
suggests that aggregate demand will vary proportionately with the average of current and
past money growth- the best reflection of permanent money changes-rather than only to
changes in the current money stock. Furthermore, aggregate demand may be influenced by
interest rates, which respond to expectations
of future inflation. This means that current aggregate demand will depend upon expectations
of future money growth-the likely basis of
expectations of future inflation-and thus indirectly upon observed current and past money
changes (to the extent they indicate future
money changes).9 In either case, there may be
a lag between money and prices, even when
prices respond immediately and fully to current aggregate demand.
Neither of these explanations involves any
impediments to the adjustment of prices to
aggregate demand. In practice, however, such
impediments almost surely exist. In some industries, for example, prices and wages are set
for protracted periods by contracts which contain only limited indexing provisions. In many
activities, furthermore, prices are constrained
by implicit agreements that limit the frequency
of price changes. For example, when a department-store chain mails out a catalogue it
makes a tacit agreement to honor the listed
prices-even when it is not legally bound to
do so. Why do firms voluntarily limit their
price responsiveness to current demand conditions? One important motivation may be the
customer loyalty that firms gain by offering a
more stable and predictable price than they
would offer if they responded-to every shift in
demand. lO In any case, firms that set fixed
prices over a certain period are likely to forecast the level of demand for that period, which
means that they will (at least implicitly) make
judgments about future levels of the money
stock.
thus affects aggregate demand initially, with
prices responding only later and gradually to
the resulting excess demands in commodity
and labor markets. This adjustment process
was (at least implicitly) supposed to depend
upon institutional features of the market, and
not upon monetary policy or expectations
about it. However, economists have become
increasingly skeptical of this view, since it implies that producers deliberately prolong a
state of excess demand even when they are
free to vary prices. 7
More "modern" explanations of the moneyinflation lag suggest the potentially crucial nature of individuals' expectations about policy.
According to one argument, prices fail to respond immediately and fully to money changes
because of an information lag between the
time a change in aggregate money occurs and
the time individuals find out about it. Under
this view, money changes that are perceived
by individuals are immediately and fully incorporated in prices, with no effect upon real output; perceived money changes, that is, are
neutral even in the short-run. However, because of lags in the publication and dissemination of government statistics, individuals
generally do not know the level of the current
money stock, but must estimate its value based
upon their knowledge of current and past economic conditions. When their estimates are
"incorrect," actual aggregate demand will differ from the level perceived by consumers and
firms. For example, when money rises by more
than is anticipated, a typical firm experiences
an increase in demand for its product that is
apparently greater than the increase it perceives in aggregate demand. Consequently,
firms generally raise real output in response.
But because of the adjustment costs involved
in varying output and employment levels,
firms usually will need a considerable amount
of time to return to their original levels of
output, even after they find out the true level
of the money stock. These output changes in
turn may account for the protracted response
of observed money-price effects. s
Another explanation of the delay in the
33
Also, according to this view, information on
variables that do not directly affect prices but
which aid individuals in predicting money
should be useful in predicting current as well
as future inflation. Sunspot activity is unlikely
of itself to affect aggregate prices-but if sunspots are useful in predicting future money,
analysts must take them into account in assessing current and future inflation developments. In other words, knowledge of the factors that directly cause price changes is only a
partial guide to their prediction. l3
Expectations and Inflation Prediction
All except the first of our explanations of
the money-price lag imply that current prices
depend, directly or indirectly, upon firms' and
individuals' forecasts of money over some
(generally considerable) future interval. This
is perhaps most obvious when prices are fixed
by explicit or implicit contracts, because price
setters then will have to assess the probable
level of demand prevailing over the contract
life. But producers' judgments about the division of current money into transient or permanent components also involve predictions
about future money. Furthermore, producers'
strategies about changes in future output levels, in the interval before prices respond fully
to money, are likely to depend upon their projections of future money. II
The implications of this money-price relation for predictions of inflation depend crucially
upon how the forecasts of future money are
made. Let us assume that predictions of future
money are based entirely upon past observations of money growth. Then, the above analysis suggests, the timing of money's effect
upon prices depends upon two sets of factors:
a) Rigidities and imperfections that are largely
determined by institutional structures, precedent or law, and/or technical factors that are
largely unaffected by all but drastic changes in
expectations and policy. (Examples are contracts, costs of adjusting output and employment, and factors generating incomplete information about conditions relevant to individuals'
decisions); and b) The relation used by individuals to forecast future money, in particular
the relation they perceive between already observed money changes and those they anticipate in the future.
It follows that money-price relations, such
as (1), are likely to remain unaffected by monetary-policy changes only if individuals do not
change the way they forecast future money.
But this is unlikely to be the case in the event
of major policy changes; however crude their
forecasting techniques, individuals are likely
to adapt their forecasts eventually to changing
conditions. 12
Some Evidence
Analysts normally develop inflation forecasts
from relations similar to (1) without explicitly
accounting for individuals' expectations. Frequently they estimate the forecasting relation
on the basis of data for all or most of the postWorld War II period; the result then reflects
some "average" of the monetary policies prevailing over the entire period. But as our analysis suggests, this procedure may lead to seriously biased inflation forecasts if monetary
policy has changed substantially and if individuals' expectations have changed to reflect this
fact. The appropriate relation for forecasting
inflation may be unstable, that is, may vary over
time.
How important a practical problem this presents is an empirical question. The lag between
money and inflation may primarily reflect institutional factors and adjustment costs, rather
than expectations, in which case the lag should
not vary perceptibly with policy. Alternatively,
policies themselves may not vary substantially
over time; or expectations about policy may
change only very gradually. If any of these
statements are true, relations such as (1) may
not be very different now from what they were
twenty years ago.
A direct, although crude, way to measure
the role of expectations is to see how moneyinflation relations vary from period to period.
This we have done with the relation between
quarterly consumer-price changes and current
and past money growth for several industrial
countries, including the U.S., for the 1961-78
34
period as well as two sub-periods, 1961-70 and
1971-78 (Table 1). We used the "narrow" (M1) definition of money, partly because data for
the entire period were available only on that
basis. 14 In deriving these estimates, we included an additional variable -an average of
the current and eleven previous quarters'
growth in real balances-to help correct for
variations in the trend of real money demand
arising, for example, from financial innovations. (A similar correction is used in the
Keran-Zeldes article in this Review). Also, to
help correct for the effects of oil-price increases on real income growth, we included a
dummy variable for the period 1974-78. 15
The choice of sub-periods reflects the different international monetary arrangements in
force during those two periods. From 1961
through 1970, foreign countries' monetary policies were constrained by the need to maintain
a fixed value of their currency in terms of the
dollar. Under the then-prevailing dollar standard, foreign inflation rates could not differ
from U.S. inflation rates over the long run.
After 1970, however, U.S. and foreign inflation rates increasingly diverged, leading by
1973 to a complete breakdown of the fixedexchange-rate system. Thus monetary poliCies
abroad (at least) may now be less constrained
than they were in the earlier period, which
raises the question whether this shift is reflected in the money-inflation relation for these
countries. The crudeness of our estimates reflects the use of several simplifying assumptions.
In particular, we assume that non-money factors affecting inflation (not captured by the
money-demand correction) varied at a constant average rate during the estimation period, and that deviations from this rate were
unrelated to money growth. 16 This and other
simplifying assumptions may account for some
of the anomalies of the results.
Our results suggest that the long-run impact
of money on prices frequently is significantly
different from unity. This might appear to contradict the proposition of money neutrality,
which implies that an increase in money that
is sustained will eventually raise all prices in
Table 1
Relationship of Inflation and Money Growth 1961-78
Belg.
Can. France
Ger.
It.
Japan
1961.1-1970.4
Money Demand Trend'
Long-run Money Impact
Adjusted R'
.57
.63'
.25
.13
.15 '
.55
.07
- .39 '
.23
1971.1-1978.4
Money Demand TrendS
1974-78 Shift Term6
Long-run Money Impact
Adjusted R'
.009
- .012 3
3.15'
.69
.16
NI
.26 '
.55
.48'
- .020'
2.11'
.79
.78' -1.23'
- .006'
NI
1.493
2.58 21
.60
.50
1.283
.023'
2.39'
.55
1961.1-1978.4
Money Demand TrendS
1974-78 Shift Term6
Long-run Money Impact
Adjusted R'
F Test for Homogeneity
.06
.20
- .009 3 NI
.22'
1.003
.50
.80
5.65' 1.61
-.04
.002
.01'
.67
5.41'
- .73'
- .005'
1.21'
.52
3.79'
.41
.020'
1.38'
.40
2.08
-1.16
1.17'
.23
- .55
1.343
.21
.50'
NI
2.06'
.68
1.94
-.97
.59
- .03
Neth.
-2.51
-.07 '
.28
Switz.
U.K.
U.S.
.19
- .17
.01
-1.26'
1.16'
.37
1.10'
1.2621
.88
1.08'
-.009'
2.90 3
.51
-1.19'
NI
1.18'
.77
- .71'
NI
- .14
'
.65
.66'
NI
4.99 21
.75
-1.04'
- .008 3
.73 3
.29
3.68'
- .62'
NI
1.16'
.58
2.52'
.45'
NI
.04 '
.73
3.48'
-.04
NI
1.56'
.82
5.46'
NI: Not included (see note 6).
'Significantly different from unity at the 5% level.
'Significantly different from zero at the 5% level.
3Significantly different from zero at the 10% level.
'Indicates that the null hypothesis that all the slope coefficients are the same in the two periods can be rejected at (at
least) the 5% level.
'Defined as the average long-run growth of real balances over the current and previous 11 quarters.
6Included in the reported results only if its value was significantly different from zero at the 10% level; otherwise the
equation excludes the variable.
35
expected, however, because we may suppose
that foreign countries' money growth was substantially constrained by V.S. growth during
the period of fixed exchange rates.
The evidence in Table 1 is thus consistent
with the proposition that expectations influence the money-inflation lag. The relation appears to shift between the two subperiods, possibly reflecting the difference in constraints on
foreigners' monetary policy. In addition, the
long-run impact of money on prices often does
not equal unity, as. would be the case if the
relation were valid under any monetary policy.
This evidence is far from conclusive, however,
particularly as there are other possible explanations of the apparent shift between the subperiods. In particular, autonomous domestic
price changes themselves may have served to
reduce domestic money via international reserve changes during the fixed-rate period; and
such feedback from domestic prices to money
could bias our estimates downward. Preliminary tests indicate that such an influence may
have been important for Germany, Japan, and
the V.K. during this period, although it was
less significant (if at all) for the other countries
considered.!7
proportion. Of course, such sustained increases would be typical only under certain
monetary policies; current money increases
often will be followed by offsetting or reinforcing money growth in the future. But if the
money-inflation relation is the same regardless
of the choice of monetary policy, and if money
is neutral, the long-run impact of money on
prices should be unity-since it should be the
same under one policy as under any other. Yet
as shown below, this impact will generally not
be unity if the lag between money and prices
is influenced by anticipations about future
money growth. Our finding thus provides indirect evidence that anticipations help determine the timing of money's effect upon prices.
Further evidence (again indirect) is provided
by the apparent significant shift in the moneyinflation relation between the two subperiods;
the hypothesis that the relation is the same for
both is nearly rejected for Italy and Japan, and
is easily rejected for all other countries except
Canada. This finding is particularly striking in
view of the fact that the long-run impact of
money on prices generally increased from the
first subperiod to the second. (However, this
is not true of the V .K., where the later-period
results are rather implausible). This might be
II. Response to Permanent and Transient Money Changes
money changes perceived as persistent or permanent. In this view, prices respond more to
the permanent than to the transient part of
money variations. Even if only approximately
correct, this view provides some useful guidelines as to how inflation forecasting relations
should be altered when policy is substantially
changed. This approach and its implications
are described in detail below, with a more technical development left to the appendix.
The mere observation that expectations can
cause money-inflation relations to vary is of little use for practical policy analysis. To improve
inflation forecasts, we must know precisely how
expectations affect the timing of money's impact upon prices, as well as how these expectations are determined. This is potentially a
very difficult task, especially as anticipations
may interact with other sources of the moneyinflation lag in complex ways.
Nonetheless, our arguments suggest a simple but potentially powerful explanation of the
lagged relation between prices and money.
This explanation is based upon the hypothesis
of a stable relation --one unaffected by monetary policy-not between prices and actual
money, but between prices and that part of
Prices and Permanent Money
An earlier argument suggested that prices in
individual industries are based upon an average of the level of money expected to prevail
over some future horizon. Consider, for example, the situation confronting a firm which
36
money over their future planning horizon. 19
It follows that prices in industry "i" will vary
proportionately with permanent money, or,
must fix its price by contract for several periods. The demand for the firm's product over
the life of the contract may be primarily determined by the level of aggregate demand
which (to simplify matters) we may assume
varies proportionately with the money stock.
Now if the firm sets too high a price relative
to expected demand, it will be unable to sell
all it produces and thus must carry inventories
at some cost; if it sets too Iowa price, it will
have to delay deliveries, speed up production
schedules, and/or draw down inventories from
desired levels, all of which entail additional
costs. Hence the firm may try to set an average
price that would ensure that sales equal output
over the contract period. IS This average will
then depend upon the expected level of aggregate demand over the contract period, so that
in setting its price the firm must forecast some
average of the money stock over its planning
horizon. Alternatively, suppose that all prices
vary simultaneously with aggregate demand,
but that (nominal) demand depends upon individuals' expected "permanent" level of
money-that is, upon an average of the money
balances they expect to have now and in the
future. It should be clear, at least intuitively,
that prices again will depend upon an average
of money levels expected in the future. (The
appendix demonstrates this point, and also
demonstrates that the dependence of aggregate demand upon interest rates is likely to
lead to a similar conclusion).
Suppose then that prices in industry "i" vary
proportionately with an average of the level of
money expected now and in the future. This
average (permanent money) can be written
without any essential loss of generality as,
m*(t)
=
(3)
where. Pi(t) is the log of industry i's price. (To
simplify the discussion, we may neglect all
other factors affecting the demand for and supply of firm products. )20 Since the aggregate
price level is simply an average of industry
prices, •it too will vary proportionately with
permanent money; more precisely, if all.anticipated future money stocks rise by a given
proportion, the aggregate price level will eventually increase by that proportion. However,
when prices are set by contracts, the response
of the aggregate price level to a change in
permanent money is likely to be substantially
slower than that for an individual industry. In
a contract situation, some prices composing
the current aggregate price index, having been
set earlier, will be based upon past permanent
money; thus the aggregate price level will respond to an average of current and past permanent-money levels. 21
The pricing strategy outlined above tends to
diminish the impact of perceived transient
money changes on inflation. That is, monetary
variations which individuals view as transient
~ave little or no effect upon their estimates of
permanent money, and thus little effect upon
prices. In principle, this general strategy is sensible whatever policy is followed by the monetary authorities. Of course, the exact relation
between aggregate prices and permanent
money depends upon firms' forecasting horizons, which influences their calculation of permanent money, and depends also upon contract durations and the timing of renewals-all
of which could be affected by monetary-policy
decisions. However, these characteristics are
based upon industrial-organization patterns
and other institutional features that generally
change slowly and that generally remain unaffected by all but the most dramatic policy
shifts. Thus, at least upon examination we may
view relation (2) as invariant to expectations
about policy.
~I
[m(t) + ,mC(t + I) +
n+
,mC(t+ 1) + ... ,mC(t+n)J
(2)
where m*(t) is the logarithm of permanent
money, m(t) is the log of the current aggregate
money stock, and ,me(t + j) is the log of money
currently (at t) anticipated j periods in the
future. In other words, m*(t) is individuals'
current anticipation of the average level of
37
Forecasting Inflation
What are the consequences of our permanent money-price relation for the prediction of
inflation? Normally analysts use current and
past data in forecasting future prices and thus
inflation-because, after all, expectations are
not directly observable. In our view, however,
prices do not respond directly to actual money,
but only to individuals' perceptions of permanent money.
Nonetheless, current and past money data
may be useful in predicting inflation, because
individuals normally use such data in forecasting future money and thus in assessing permanent money. Relations between inflation and
current and past money growth, such as (1'),
then reflect individuals' perceptions of how observed money changes relate to future, and
therefore permanent, money. In other words,
an inflation forecaster must "predict" individuals' perceptions of permanent money, and in
particular determine how individuals use current and past money in anticipating future
money.
In practice, we are not likely to know exactly
how individuals calculate permanent money.
However, individuals are likely to learn, by
observation, how a particular monetary policy
operates-provided it has been followed for a
long-enough period of time-and thus their
forecasts of future money will tend to reflect the
way money has actually behaved. Analysts can
follow the same thought processes, and thus
can estimate what individuals' expectations
will be in the context of any specific monetary
policy.
The impact of past money on inflation accordingly reflects the way in which permanent
money is calculated. This conclusion has important consequences for the relations we have
used to forecast prices. If our view is correct,
the long-run impact of money on prices apparent from these relations will not generally be
unity (even assuming that money is neutral);
rather the measured impact will be that of
current money on permanent mQney.22 Imposing the constraint of unity could lead to misleading inflation .forecasts. except under certain
limited policy conqitions. In contrast, our approach could provide a possible explanation of
the changes in the impact of money on prices
observed between the 1960's and 1970's (Table
1).
Consider, for example, a situation where individuals know that the monetary authorities
have adopted a certain target path for money,
and also know that the authorities will correct
for deviations from the target path in the period following any such misses (Figure 1, Case
1). Changes in money that bring its level above
or below the target path are then transient;
that is, they exert virtually no impact on permanent money. Indeed, individuals in any period will expect that money will be on target
by next period. Apart from this path, current
inflation will be unrelated to past money
growth-since this provides no additional information about future money and thus very
little about permanent money-and the measured long-run impact of money on the price
level will be essentially zero.
Now consider a policy situation where
money changes are purely random. Imagine,
for example, that money growth is determined
by the spin of a roulette wheel, with money
growing by the winning number when it is red
Figure 1
Effects of a One-Percent Increase in Money
(Above Its Long-Run Average Rate)
Effect on:
Forecasts of Future
Money
Permanent Money
Case 1
(Money Change
Viewed As Transient)
Case 2
(Money Change
Expected to be
Sustained)
Case 3
(Money Change Expected
to be Followect by Further
Changes)
Do not rise
Rise by one percent
Increases by (much)
less than one percent
Increases hy one percent
Rise hy more than one
percent
Increases hy more than one
percent
38
and declining when it is black. Average money
changes will then be zero, but at any given
time the level of money expected in the future
will be the same as what is now prevailing
(Case 2). The level of expected future money,
and thus permanent money, will then shift up
and down with current money growth. That is,
a rise in current money will signal an increase
in permanent money and thus a proportional
increase in prices. Inflation and current money
growth will certainly be related- and inflation
may also be related to past money growth if
contracts prevent some industries from adjusting immediately-and the long-run impact of
current money growth on prices will be unity.
Finally, consider the case where money
growth exceeds its long-run average and remains above target in succeeding periods. Individuals perceiving this pattern will then raise
their estimates of permanent money more than
proportionally whenever they observe money
growth rising (Case 3). Such accelerations
generally will lead eventually to more-thanproportionate increases in the price level, so
that the measured impact of money on prices
in this case will be greater than one.
To summarize, we argue that a money-price
forecasting relation reflects the way in which
individuals predict future money, not primarily
the causal links between money and prices. 23
If true, this has several important implications
for the forecasting of future prices, and hence
inflation. First, the total effect of money on
prices measured from such relations generally
will not be unity, and should not be constrained
to be so. The more persistent the current
money changes, the more they will ultimately
affect prices. Second, when other variables,
such as government deficits, provide information about both past and future money, they
should be used in the forecasting of inflation.
Even if money were the only direct cause of
inflation, accurate predictions of prices generally will also involve other variables; in other
words, because of the complex social and political nature of inflation, individuals should rely
on more than the past history of money in
predicting its future. 24
flow important are these considerations in
practice? Consider the case where the monetaryauthorities switch from a policy of offsetting monetary deviations to one of constant
accelerated growth. So long as individuals continue to predict future money as before, inflationforecasters utilizing data based on the initial policy will continue to be reasonably
successful. But once individuals learn of the
new policy, the old forecasting relation will
seriously underpredict inflation. This relation
wiUpredict relatively small price responses because iUs based upon a period in which money
changes were normally transient; once individuals learn that new money changes are more
permanent, actual price responses will be
much greater.
Evidence Reconsidered
Our arguments help explain certain features
of the money-inflation relation summarized in
Table 1. As we saw, the long-run impact of
money on prices was greatest for the U.S. Furthermore, the long-run impact was generally
higher during the 1970's than during the
1960's; the impact generally was below one
during the 1960's, but equal to or above one
during the 1970's. However, our permanent
money-inflation theory suggests an explanation
for this shift, based on the different international monetary arrangements prevailing during the two decades.
During the 1960's, foreign nations attempted to maintain a fixed value for their
currencies in terms of the dollar. Such a policy
required that foreign prices rise at the same
rate as those in the U.S., at least on average.
This in turn meant that foreign money growth
was effectively constrained by U.S. growth. If
foreign money growth was too high, for example, prices of traded goods produced abroad
would tend to rise faster than those in the
U.S., eroding the competitiveness of foreign
industries. The resulting trade and balance-ofpayments deficits then would render such a
policy incompatible with maintenance of a
fixed exchange rate. In effect, foreign money
39
growth had to follow a path determined by
U.S. money, at least in the long-run. U.S.
monetary policy, on the other hand, was much
less constrained by its balance of payments, in
part because our economy was much less open
than abroad, and in part because U.S. dollars
were the primary reserves held by foreign central banks.
Under these circumstances, foreign money
changes that diverged from U.S. money
growth could not persist indefinitely. Perhaps
a significant portion of money growth abroad
was viewed as transitory; if so, this could explain why the long-run effect of money on
prices abroad was generally below unity (and
below the U.S. figure) during this period.
Also, perhaps U.S. money growth provided
information about the future direction of foreign money growth, in which case it should
have been useful in forecasting foreign inflation as well. Logue and Sweeney provide indirect evidence of this, by finding that foreign
nominal income changes were frequently explained much better by foreign and U.S.
money growth than by foreign money changes
alone. 25
During most of the 1970's, in contrast, countries were not officially committed to maintaining fixed exchange rates, so that in principle, foreign nations were able to vary their
money supply independently of any U. S. actions. A higher proportion of foreign money
changes thus could be viewed as permanent,
which might help account for the fact that the
long-run effect of money now appears generally to be higher than before. 26 On the other
hand, all countries do not exploit their monetary independence; some have adapted their
policies to others in an attempt to limit fluctuations in the value of their currency. Canada's policy, for example, has been designed
in part to limit variations in the value of its
currency in terms of the U.S. dollar, even during the 1970's. Not surprisingly, then, the longrun impact of money on prices apparently remains below one, and although higher than
the 1960's, is not substantially so.
Our explanation assumes that money changes
now are generally regarded as more persistent-that is, with greater impact upon permanent money-than they were in earlier periods. But is this really the case? To answer
this question would, ideally, require the identification of the exact relation used by individualsto estimate permanent money. This is a
formidable task, because the process determining money growth depends upon a variety
of factors, and also involves an unknown time
horizon.
Nonetheless, we can make crude approximations by estimating the extent to which a
money change typically is offset or reinforced
in subsequent periods; this can be estimated
from the pattern of money growth observed
over the period in question. Specifically, what
is the cumulative total of future money
changes that typically follows a rise in current
money above its long-run average-that is,
how much would we expect the money stock
to rise ultimately as the result of an initial
increase? This long-run impact should be relatively small when money changes are largely
transient (i.e., offset in the future). Hence, in
our view, the impact might be larger during
the floating-rate period than during the fixedrate period; it might also be higher for the
U.S. than for other countries during the earlier
(fixed-rate) period.
Admittedly, this is a crude measure of the
effects of past upon permanent money. In particular, a pattern where a current increase is
followed by further changes, but ultimately is
completely offset, could substantially affect
permanent money if price-setters' horizons are
sufficiently short. For this reason, it will also
be useful to examine how the level of the
morey stock varies in the quarters following
the initial shock.
To measure these impacts, we have fitted a
simple (univariate) time-series model of
money-supply changes for each country for
two periods, 1958-67 and 1968-78, again using
quarterly (seasonally adjusted) data. Note that
each of these periods begins several years before the corresponding intervals used to estimate the results reported in Table 1. This was
40
the current value only of o( ).27 In this, o( )
stands for money changes in excess of those
already anticipated on the basis of past money
changes.. Its meaning can be seen from the
computation of the impact of money growth
on the l~vel of money in the long-run (Table
2). Assume· that money, after growing steadily
at its long-run average rate, rises by one percent more in the current period; then o( ) is
equal to one percent. The long-run effect of
this increase on the level of money then equals
the sum of the current and future money
changes generated by this "blip" in money
growth; it equals (1 + b i + b2 + b4 )/(1 - a i
- a 2). Of course this ultimate impact will take
some time for completion, and indeed this in-
done because of the assumption that individuals would require some time to observe the
behavior of money before arriving at a final
notion of how to predict it; thus the relations
estimated over these earlier periods may better
reflect individuals' expectations than relations
estimated for later periods. We then have the
following:
~m(t)
c
+
al~m(t-l)
a2~m(t-2)
+
+ o(t-l) +
b20(t-2) + b4 0(t-4)
(4)
where ~m(t) is the quarter-to-quarter change
in the logarithm of money. This relation can
also be written in a form where current money
growth depends upon past money changes and
Table 2
Summary of Univariate Time-Series Estimates for Changes
in Log Values of the Money Supply'
1958.1-1967.4
Long-run
Effects'
1968.1-1978.4
F2
Adjusted R2
Long-run
Effects'
F2
Adjusted R2
Belgium
.59
2.1
.12
6.8
2.8
.17
Canada
.53
4.6
30
26.4
3.1
.20
France
8.0
7.4
.43
3.3
3.5
.22
Germany
1.9
2.3
.13
3.3
2.3
.13
Italy
1.2
5.0
.32
2.4
3.4
.22
Japan
1.1
8.5
.47
14.8
4.1
.27
Netherlands
1.2
2.3
.13
3.2
2.9
.18
Switzerland
5.3
1.3
.04
5.0
2.2
.12
United Kingdom
1.5
5.0
.32
2.4
2.2
.13
United States
.33
4.3
.28
2.3
4.9
.31
'Ultimate effect upon future money of a I-percent unanticipated change in current money.
2Test of the significance of the entire set of parameters. A value above 2.3 is significant at the 5-percent level.
'The model contains moving average parameters at lags 1,2 and 4 and autoregressive parameters at lags one and two. Thus
the model can be written as,
Llm(t)
=
a"Llm(t-l) + a,Llm(t-2) + o(t) + b, o(t-l) + b20(t-2) + b4 0(t-4)
where Llm(t) is the quarterly first difference of the log of Ml, and the 00 are white-noise errors.
'For Canada for the first period, the estimated model is (barely) unstable in the sense that the changes in money following
the initial increase persistently grow in absolute value (however, the estimates are fairly 'close' to being stable). When the
model is reestimated dropping the second autoregressive term (a, assumed to equal zero), the response becomes stable.
The revised model implies a negative long-run impact for the earlier period ( .62), that is, an initial rise in money leads
ultimately to a fall in its level. For the second period, the long-run impact calculated from the revised model is 13.2;
however, the fit compared with the original model is substantially worse in this case.
41
terval may encompass many quarters, depending upon the parameters of the above relation.
Table 2 summarizes the results of these estimations of relation (4): the first column lists
the ultimate impact of an (unanticipated) increase of one percent in current money upon
future money, while the second and third columns give measures of the significance and
goodness of fit of the time-series models. In
addition, Appendix Table A.l gives the estimated impact of this increase upon the expected level of the money stock after four,
eight, twelve, and sixteen quarters. Again note
that the horizon over which permanent money
is calculated is unknown and may vary across
countries, so that the ultimate impacts listed
in Table 2 are only approximations of their
perceived impacts upon permanent money as
defined earlier. 28 Also, the magnitudes of the
estimates are often quite sensitive to the precise specification of the relation between current and past money growth used to estimate
the long-run impacts. For both these reasons,
our results are most meaningful for what they
indicate about the relative persistence of
money changes for a given country over the
two time periods. Conclusions based upon the
absolute magnitudes of the impacts, and to a
lesser extent cross-country comparisons, are
probably less meaningful.
In view of our earlier hypotheses, the results
reported here are at best very mixed. For most
countries, the long-run impact of a change in
current money upon the level of future money
increased between the earlier and later periods. The increase was quite sharp for Belgium, Germany, Italy, Japan, and the U.S.countries which also showed an increase for
the measured impact of money upon prices.
However, the current money-future money impacts actually fell for France and Switzerland,
although they showed an increase for the longrun effect of money on prices. Canada's results
also were not consistent, and indeed those for
the first period were dynamically unstable; see
note 4 to Table 2. (With a slightly modified
version of the Canadian model, the long-run
impact for the first period was negative, im-
plying that an initial rise in money leads ultimately to a fall in its level, while the impact
was positive and well above unity in the second
period.) Again, some of our results seemed
implausible. For example, the long-run impact
reported for the U.S. in Table 2 was below
that found for most foreign nations, while the
Table 1 results would suggest that the opposite
pattern should hold, at least for the earlier
period. The lack of clear-cut results perhaps
should not be surprising, since stringent conditions would have to apply if the results of
the money-inflation relation and current moneyfuture money relation were to correspond.
One plausible explanation may be that individuals use variables other than the money supply
itself to forecast future money. In any event,
the results suggest that either the theory developed earlier is over-simplified,29 or at least
that the monetary authorities' reactions to
other economic variables must be accounted
for explicitly, both in modeling individuals'
forecasts of permanent money and in estimating the money-inflation relation (1).
Taken as a whole, our results reveal more
possibilities than answers. The fact that the
measured impact of money on prices is generally not unity is more consistent with the
hypothesis that expectations about permanent
money affect the relation between inflation and
current and past money growth, than it is with
the mechanistic view that the relation is the
same regardless of whatever policy is followed.
Furthermore, these long-run impacts generally
shift between fixed-and floating-rate periodsand shift in a fashion that is compatible with
our arguments as well as with widely-held
views about exchange-rate implications for national monetary policies. Finally, our arguments are consistent with the Keran-Zeldes
finding that money's impact upon prices is generally above unity under a floating-rate regime.
However, our actual measurements of the persistence of money changes do not accord very
well with the theory outlined here. In view of
the crudeness of these estimates, further development and testing of models relating
money forecasts to prices seems warranted.
42
III. Summary and Conclusions
It has long been noted that most economic
variables react to past as well as current conditions. Except in a few cases, the sources of
these lags in economic behavior are not precisely known. Until fairly recently, most lags
were regarded as mechanistically determined
by institutional rigidities, adjustment costs,
and other factors which supposedly do not vary
with government policies. Empirical relations
derived from past data were commonly used
to simulate the effects of policy changes and
to predict economic conditions under policy
regimes very different from those prevailing
during the sample period. However, relations
that used to be regarded as stable have shifted,
often dramatically, with the accelerating inflation of recent decades, and this shift has considerably complicated the task of prediction
and policy analysis. Many analysts have concluded from this experience that expectations
about future economic conditions, including
monetary policies, crucially influence the lags in
economic relations-and that these expectations become more quickly adapted to changing conditions than once was thought.
This paper has considered the lags in a crucial relation for forecasting and policy analysis-the relation between inflation and current
and past money growth. We argue that the lag
in money's effect upon prices can be substantially affected by individuals' expectations
about future money growth. This implies that
money-inflation forecasting relations will change,
at least eventually, when government policy
alters the relation between current and past
money growth and future money growth. The
estimates of the money-inflation relations for
several industrial countries seem quite consistent with this conjecture. In particular, the
long-run impact of money on prices appears to
have shifted substantially between the fixedand floating-rate periods, and in .a plausible
fashion given the nature of those regimes. Furthermore, those relations often do not show
the characteristics that would be expected if
they were invariant to government policies. In
particular, the long-run impact of money on
prices frequently does not equal unity, as
would be expected if those relations were invariant to policy.
Finally, we argue that the relative impact on
inflation of the (permanent versus transitory)
components of money growth may be stable
across policy regimes, or at least more stable
than under the standard forecasting relation.
In particular, we argue that prices will react
more to permanent money changes than to
transient changes. If true, this hypothesis provides at least a rough indication of how inflation-forecasting relations can be adapted to
altered policies. Although the crude evidence
cited here does not confirm this hypothesis, it
could prove useful in further research as we
learn more about the money-supply process
and the expectations surrounding that process.
APPENDIX
This appendix sketches several approaches
to price determination that lead to price-permanent money relations similar to those discussed in Section II. Implications of this relation for the forecasting of inflation are also
developed. In the following-as in the textp(t) refers to the log of the price level, e(t) to
the log of aggregate demand, and m(t) to the
log of money.
Three Simple Models
p(t) = e(t)
A. Interest rates, inflation expectations, and
prices
Suppose that prices vary immediately and
proportionately with aggregate demand as in,
(1)
Assume as well that aggregate demand varies
proportionately with the current money stock
and the (short-term) nominal interest rate, as
43
c.• Contracts and Pricing
indeed is implied by the usual money-demand
relation. Then,
e(t) = met) - ai(t) , a > 0
(2)
A still simple but somewhat richer model of
permanent money and prices is based upon
contracts. Suppose in a given industry that
prices are set .for several periods, say i, at a
time. Imagine also that the supply of output is
given exogenously, so that the task of the price
setter is essentially to forecast demand over
the life of the contract. *** Assume finally that
the value of industry sales in a given period is
a •fixed fraction of aggregate expenditure,
which in turn varies proportionately with curmet) ).
rent money (i.e., e(t)
Now in each period, there will be a single
price which will allow the firms in the industry
to sell just the amount available, no more nor
less; define this as the "desired" price, since
if firms were not constrained by contract this
would be the price they would actually set. It
seems reasonable to suppose, then, that contract prices will be set at some average of expected "desired" prices over the life of the
contract. Let p(t) now refer to the log of the
industry price. Then since "desired" prices
vary proportionately with money,
where i(t) is the one-period interest rate. Finally suppose that i(t) is equal to a fixed real
rate, taken here as zero, plus an inflation premium:
pet)
(3)
i(t) = tpe(t + 1)
Now if bond-market participants are aware
ofthe relations (1) and (2), their price expectations, and therefore interest rates, will be
based upon their forecasts of future money.
Substituting (1) into (2), that is,
pet) = met) - aCpe(t+l) - pet))
(4)
Taking the pet) on the right over to the left
and repeatedly substituting then gives, *
1 00 ( a
p(t) = 1 + a
1+ a
+
2:
)i
)""·0
,me(t+j); where ,meet)
=
met)
(4)
Defining permanent money as the discounted
value of present and future money in the above
gives an infinite-horizon analog to the relation
in the text. In arriving at this, rational expectations in its strictest sense need not be invoked: (4') will be valid regardless of how
"rationally" future money is forecast. The relation (4') effectively reflects a "Fisher" interest-rate impact upon prices; the implications
of this for inflation were described in detail in
Cagan's classic article on hyperinflation. **
Pi(t)
...,m (t+i-l)] == m*(t)
C
=
1
n
[met) + ,meet + 1) +
... tme (t+n-l)]
(5)
where the price is newly set at the beginning
of period t (and fixed through the next i-I
periods), and where we assume met) is known
althat point (this is not essential). The money
forecasts might also be discounted. ****
In relating aggregate prices to money, we
must take account of the fact that contracts are
likely to be staggered (i.e. expire at different
times) and to be of different lengths. Suppose
first that all contracts are of the same length
but are staggered evenly in the following manner: in each period, industries whose contracts
are being renegotiated account for the same
fraction (Vi) of aggregate expenditure. Defining the aggregate price index (in logs) as a
simple average of industry prices then gives,
B. "Permanent" Money Demand
Suppose that (1) is valid but that now,
e(t)
= ~
[met) + ,meet + 1) +
1
(2)
That is, current expenditure depends not only
upon current money but upon an average of
current and expected future money. Evidently
pet) then will respond proportionately to permanent money, as defined by the right-handside of the above expression.
44
p( t) =
Exchange rates are apt to respond immediately
to permanent money-i.e., transient money
changes will tend to be speculated out-while
the price response can be delayed because of
contracts.
Finally, the existence of different contract
lengths does not greatly alter conclusions
based upon (6). To each contract length there
corresponds a particular horizon for the calculation of permanent money. When there are
different contract lengths, the current aggregate price level will be a weighted average of
current and past values of these alternative
permanent-money aggregates.
~
[m *(t - i + 1) +
I
m*(t-i+2) + ... m*(t)]
(6)
Here the first term represents prices set in the
oldest non-expired contract. Thus, in contrast
to the earlier models, the contract model allows for a lag between prices and permanent
money-as we will see below, a lag between
prices and actual money will be observed even
if this is not the case. This offers a potential
explanation of the Keran-Zeldes finding of an
apparently shorter lag between money and exchange rates than between money and prices.
Implications of Models
and current and past money given in the text.
Notice that the long-run impact of money on
prices measured from this-which is
V2(I- a l - a z ... )-depends upon the coefficients of the process (7) generating money, and
generally will not be equal to unity.
To see this more specifically, suppose first
that money is known and expected to follow
a given path with random but temporary deviations:
When prices depend upon forecasts of future
money, as in the above, the usual forecasting
relation between pet) and current and past mO
depends upon how individuals use current information to predict money. To see this, suppose that the price-permanent money relation
is as shown in (6). Assume first that money
follows a (invertable) stationary processknown to individuals and used by them to forecast-described by,
A(L)m(t)
=
u(t) , A(L) ==
1 + aiL + azL2 + . . .
met)
2[(1 al)m(t) - a 2m(t - 1)
- a,m(t-2) + ... ]
pet)
=
=
(lO-a)
m + V4[(m(t)
(m(t
1)
m) +
m)]
(ll-a)
so that the long-run impact of money upon
prices is V2; this will be smaller of course for
longer forecasting horizons. In contrast, suppose that money changes are purely random,
that is "base-drift" is not corrected,
1/
(8)
met)
sincem(t+I) = u(t+I) - alm(t) - azm(t1) ... , so ,me(t+I)
-alm(t)
azm(t-I) .... Then substituting in (6)
pet)
m + u(t)
where u(t) is a white noise. In effect the authorities are expected to correct any "basedrift" in the next period, since ,meet + 1) = m.
Then the price-money relation is,
(7)
where u(t) is a white-noise disturbance and
A(L) is a polynomial in the lag operator L. To
simplify matters, suppose that the horizon over
which permanent money is forecast is two periods (i = 2). If individuals use only the past
history of money in forecasting its future-that
is, if they employ (7)-permanent money can
be written as,
m*(t)
=
=
met-I) + u (t)
(lO-b)
Then at any time the forecast of future money
is simply today's observed level: thus m*(t)
= met) and,
V2[m*(t) + m*(t 1)]
V4[(I- at)m(t) + (I-at - az)m(t -1)
-(a2 +a 3 )m(t 2)+ ... ]
(9)
pet)
V2(m(t) + m(t-l)).
(ll-b)
The long-run effect here is unity. It is easy to
show that when current money changes are
Relation (9) is the standard relation of prices
45
when prices respond to permanent money as
defined here:
i) The long-run impact of money on prices
measured from inflation-forecasting equations
will depend upon how future money is forecasted, and generally will not be unity.
ii) When current money changes are typically viewed as transient, the long-run impact
of money on prices will generally be less than
unity, and less than when such changes are
expected to be permanent or reinforced.
iii) Inflation-forecasting equations should include all variables used to forecast future
money, and not simply current and past money.
As these indicate, it generally will not be possible to test propositions about the causal links
between money and prices using only the empirical relation between prices and current and
past money; the same point was made in a
slightly different context by Lucas (1970).
expected to be reinforced in the future, this
long-run impact can be greater than unity.
Hence the more persistent that money changes
are expected to be, generally the larger will be
the apparent long-run impact of money on
prices measured from money-inflation forecasting relations.
More generally, future money may be predicted from information other than its past;
letting z(t) stand for such additional information (which will usually include past data), we
might then have,
m*(t)
=
B(L)m(t) + z(t).
(12)
Plainly, the relation used to forecast prices
then must include z(t). Conversely, the fact
that non-monetary variables are useful in "explaining" or predicting inflation in standard relations does not necessarily mean that they can
directly affect prices, independently of money.
To summarize the implications of this view,
Table A.1
Impact of a One-percent Increase in Current Money Growth
on the Expected Future Level of the Money Stock*
1957-1969
1970-1979
Percent Increase in Money Stock Level
Expected After:
Percent Increase in Money Stock Level
Expected After:
4
Qtrs
8
12
16
12
16
Qtrs
Qtrs
Qtrs
4
Qtrs
8
Country
Qtrs
Qtrs
Qtrs
Belgium
.22
.56
.58
58
2.32
4.79
5.90
6.41
Canada'
.40
.35
.33
.30
3.53
8.06
11.62
14.47
2.23
4.30
5.60
6.44
2.47
3.33
3.32
3.32
Germany
.85
1.46
1.70
1.80
2.54
3.30
3.30
3.30
Italy
.34
1.I6
1.22
1.22
.81
2.09
2.31
2.36
Japan'
.26
1.10
1.01
.99
3. ]()
7.22
9.83
11.53
Netherlands
.62
1.23
1.23
1.23
1.50
2.81
3.09
3.16
Switzerland
2.38
4.02
4.73
5.07
5.41
513
4.94
4.97
V.K.
88
1.48
1.48
1.48
4.16
1.97
2.60
2.43
U.S.'
.27
2.26
-1.53
28
2.03
2.77
2.78
2.78
France
*Results are based upon a simulation of the estimates summarized in Table II in the text.
'The results for Canada for the first period are unstable in that the absolute value of money changes (although not their
cumulative sum) increases over time. When the model is reestimated suppressing the second autoregressive term. the longrun impact for the first period is negative and virtually complete after six quarters.
'The Japan results for the first period show considerable "cycling" in the first four quarters: after two quarters the expected
money stock level is up 1.8%, while it is up only .55% aftcr five quarters.
'The V.S. results for the first period again show substantial "cycling."
46
FOOTNOTES
1. The "long and variable lag" for nominal income and
money was first documented for the U.S. by Milton Friedman, in "The Lag in the Effect of Monetary Policy," in his
The Optimum Quantity of Money and Other Essays. See
also the article on "Inflation and Monetary Accommodation
in the Pacific Basin" by Michael Bazdarich in the Summer
1978 issue of this Economic Review, as well as the article
by Michael Keran and Stephen Zeldes in this issue.
2. See, for example Gordon (1976), pp. 201-02.
3. The conditions for money neutrality are fairly stringent.
First, transfers of wealth among individuals resulting from
price-level changes must not affect aggregate demand and
supplies. Second, open-market exchanges of money for
government bonds will not be neutral unless individuals
discount future tax liabilities in calculating their wealth, so
that for the "typical" individual, government bonds are not
net wealth. Furthermore, the proposition does not apply to
money-supply changes accompanied by variations in real
government expenditure or taxes. Finally, money neutrality
refers to changes in the level of money with its long-run
growth rate held constant; if anything, there is a consensus
that changes in the long-run money-growth rate are not
neutral.
4. Specifically, most economists would now agree that
money changes have negligible long-run impacts on real
output and unemployment, that is, the "Phillips" curve is
vertical in the long-run. This factor,combined with empirical
estimates of money-demand relations (where real balances
are generally a function of real output and interest rates)
suggests that a rise in money (with no change in its expected growth rate) will raise the price level proportionally.
5. Trends in real output and velocity enter because they
influence the real demand for money. This real demand can
be permanently affected by factors, such as financial innovations, that are not easily summarized quantitatively-and
indeed are not always observable, and thus cannot be accounted for explicitly. Since these factors then enter the
disturbance term in the empirical relation, the relation (1 'j
relating price and money changes is most often used; these
factors would cause the constant term relating the level of
prices and money to shift about during the sample period.
Consequently, this relation is less practical as a form for
estimation. For this reason, the empirical results referred to
later will be of the second form, and we will normally refer
to the money-growth inflation relation in the text.
6. In other words, we can imagine a system where prices,
output, and interest rates are simultaneously determined
as, for example,
Lip(t) )
Liq(t)
(
i(t)
=A
' Lip(t) )'
Liq(t)
+ CLim(t)
(
i(t)
where i(t) is the interest rate, A is a matrix of lag polynomials, and C is a vector of such polynomials, The lagged
relation between money and prices referred to in the text is
defined as the "reduced form" solution of this system where
prices depend only upon money: This is obtained by solving
47
the above system to obtain an equation relating price and
money changes only, This is the text relation (1) and it
includes all indirect effects upon prices of output and interest rate responses to money, This fact makes it often difficult
to interpret the empirical counterparts of (1),
7. See Rutledge (1979) and (1977) for a more detailed
discussion.
8. This is the rationale implicit in Barro (1979).
9. Indeed, nearly all rational-expectations models imply that
economic decisions depend upon expectations of future
policy variables. Some concrete illustrations of this are described in the Appendix.
10. Arthur Okun ("Inflation; its Mechanics and Welfare
Costs," Brookings Papers on Economic Activity:2, 1975)
discusses the reasons why price fluctuations may be limited
by tacit agreement in what he describes as "customer markets." See especially pp. 358-73.
11. That is, decisions about inventory levels, work schedules, etc" are all likely to depend upon firm anticipations of
"typical" patterns of behavior of variables affecting firm
costs and profits.
12. This is, of course, implied by the hypothesis of "rational
expectations"-but it is more general. Individuals may not
make use of all information potentially available, but they
are likely to adapt whatever forecasting techniques they do
use to changed policies, at least given enough time.
13. This observation is relevant to tests of the influence of,
(say) government deficits on prices. Suppose that the deficit
is found to be a significant variable, in addition to current
and past money, in a regression "explaining" inflation. Does
this imply that the deficit affects inflation independently of
money growth? The arguments in the text suggest that this
is not necessarily the case if the monetary authorities react
to deficits so that deficits provide a "signal" of future money
growth. As will become clearer in the next section, tests
about the causes of inflation cannot generally be based upon
relations such as (1) alone. This point has been emphasized
by Lucas (1970).
14. In Britain, for example, the authorities define monetary
objectives for M-3, while in Japan targets are set for M-2.
See the OECD's Monetary Targets and Inflation (p. 27) for
an assessment of the stability of money-demand relations
using alternative aggregates. This finds M-2 inferior to M-1
for Germany, while M-2 is at best marginally "preferable" to
M-1 for Japan. The choice also does not seem clear-cut in
the U.K.; see also Goodhart and Crockett (1970).
15. Another reason for including this dummy variable is the
possible shift in the perceived long-run growth rate of
money-that is its unconditional mean-in several countries. If so, the models developed in the Appendix also imply
a shift in the constant term in a regression of price changes
on current and past money growth. This change does not
necessarily arise from the resulting change in interest rates
(although it may, at least in part). For example, in the simple
contracting model in the Appendix, there is no interest rate
impact on prices. However, a rise in the long-run moneygrowth rate will lead to an increase in the "shift" parameter
used by rational forecasters to predict permanent money,
and this "shift" parameter is included in the constant of a
standard inflation money growth relation.
The real balance correction (similar to the one used by
Keran and Zeldes for their article in this Review) is taken
over 12 quarters, in order to 'smooth out' any businesscycle fluctuations in the real demand for money that might
be induced by variations in nominal money growth. Basically, this correction is designed to adjust for shifts in real
money demand that are unrelated to actual nominal money
changes but which tend to add 'noise' to the money-inflation
regression. An example of such a shift would be changes
in the real demand for various currencies as a result of the
switch from fixed to flexible rates, or changes due to financial
innovations that influence velocity. It should be noted that
this correction often affects the results substantially. Frequently, the inclusion of this term substantially reduces the
regression standard error for the second period. Moreover,
the correction often substantially raises the estimate of
money's long-run impact upon prices for the second period.
Finally, in three cases the comparisons of the long-run impacts between the two periods are affected by the correction: for Canada, the long-run impact declines from the first
to the second period when the correction is not included,
although again the change is fairly small and both impacts
remain well below unity; and for both Germany and the
Netherlands, the long-run impacts are negative in the second period when the correction is not included (for Germany,
the dummy variable also substantially affects the results).
The results obtained by omitting the real money-demand
correction and dummy variable will be supplied upon request.
16. For example, suppose that an acceleration in money
growth is associated not only with an expectation of higher
future inflation but also with an increased risk of holding that
money. This increased risk may then reduce the real demand for money in a way not captured by the interest rate
(i.e. it induces a shift in the real money-demand function).
17. Michael Darby ("Sterilization and Monetary Control under Pegged Exchange Rates: Theory and Evidence," NBER
Working Paper #449, February 1980) also finds that foreign
countries had very considerable short-run control over their
domestic money stocks during the adjustable-peg regime.
This suggests a general lack of bias in the Table I results
resulting from "feedback" from prices to money operating
via reserve flows. It is important to note that this argument
refers to the short-run; in the long-run, foreign money stocks
probably would have had to conform to the trend in U.S.
money. Rudimentary tests for a causal relation from prices
to money were also run for the two periods. Some feedback
from prices to money was detected for Japan and the U.K.,
and possibly Germany, for the earlier period. Interestingly,
there was some evidence of a feedback for Italy and Japan
for the later period. These results will also be supplied upon
request.
18. This, admittedly, is something of an oversimplification,
in that firms will also have to estimate costs over the contract period in setting prices. The simple model in the Appendix assumes that firm supply is essentially exogenous
and fixed, so that the firm's task is to estimate future demand only. Taylor (1980) considers a more complex model
in which wages and price setting "interact," but one which
yields similar results to those developed here. In still more
complex models, decisions regarding prices, investment,
inventory, and output are all interdependent. In these cases,
the dependence of prices on expected future money is not
likely to be as simple as the relation described in the Appendix.
19. This horizon need not, of course, be the same for all
agents. As indicated in the Appendix, when prices are set
by contracts, the horizon for permanent-money calculations
may depend upon the contract length. This horizon may
also be infinite, as in the case where aggregate demand
depends upon interest rates. Finally, the calculation of permanent money might involve discounting of expected future
m( ).
20. In particular, output responses to money and their effects upon aggregate demand are ignored. Taylor (1980)
considers wage-price interactions.
21. See the Appendix for further details. Contracts provide
one possible explanation for the Keran-Zeldes finding (in
their article in this Review) that the lag between money and
exchange rates is shorter than that between money and
prices. Specifically, exchange rates are free to adjust immediately to permanent money changes, while price responses may be delayed by contracts.
22. See the Appendix for further details. It should be noted
that this does not require that interest rates significantly
affect aggregate demand. Bilson (1978) has noted that the
long-run effect of money on exchange rates will depend
upon the characteristics of the money-supply process.
23. Lucas' (1970) statement applies here: "...the natural
rate hypothesis restricts the relationship of policy parameters to behavioral parameters. It cannot be tested on a
behavioral relationship (Phillips curve, supply function, and
so on) alone." (p. 57) Indeed, this is an elegant and succinct
statement of the basic arguments in the text about the
money-inflation relation. But there is also wide acceptance
of the opposing view-see for example Gittings (1979)that causal restrictions should be imposed on moneyinflation relations.
24. Evidence that money has "accommodated" domestic
variables, such as government deficits and wage increases,
can be found in Gordon (1977).
25. See Logue and Sweeney (1978), pp. 153-55.
26. In practice, countries may have occasionally varied
money growth so as to limit exchange-rate fluctuations.
Something like this occurred in 1978, when large intervention in support of the dollar was partly responsible for substantial overshooting of money-growth targets in Germany
and Switzerland. There is also evidence for Japan (see my
"Rational Expectations and Countercyclical Monetary Policy: The Japanese Experience" in the Summer 1978 issue
of this Review) that the monetary authorities reacted to
Japanese-U.S. price shifts after 1971. In short, money
abroad may still be somewhat constrained by exchangerate considerations, so that the current floating-rate regime
differs only in degree from the former fixed-rate regime.
27. The model included moving-average terms at lags one,
two, and four (see the notes to Table II) as well as two
autoregressive parameters at lags one and two. The third
lag was omitted, as it generally was not statistically significant. The long-run effects reported in the table are of-
ten quite sensitive to variations in the number of movingaverage or autoregressive terms; for this reason they should
be interpreted with considerable caution.
28. As indicated in the Appendix (see Section II), the measured long-run impact of money on prices will generally vary
with the horizon over which permanent money is forecasted.
Indeed, in the first example given there, an increase in
current money has no effect upon the long-run money
stock-but the long-run effect of money on prices as measured from the standard relation is positive, although below
unity.
29. Two possibly significant effects that I have largely ignored are the influence of unanticipated money changes and
the interaction of output adjustments and price changes. In
the rational-expectations model of Barro (1979) and others,
prices are supposed to react immediately and proportionately to money changes that are expected (perceived). Unanticipated changes, however, push real output away from
its "natural" rate, and hence influence aggregate demand. In
this case, prices will react not only to forecasts of future
money but also to past errors in predicting money. This is
likely to lead to price-money relations that are more complex
than implied by the hypothesis developed in the text.
APPENDIX FOOTNOTES
but the implications of his model are very similar to those
considered here.
""For example suppose that there is a loss from deviations from the desired price that is proportional to the
difference of (the logs of) the actual and desired price.
Then the firm is apt to seek to minimize the discounted
value of such losses, which would lead to discounting of
money forecasts in the calculation of m'( ).
'This is not the only technically admissable solution, although it is economically the most sensible.
"Phillip Cagan, "The Monetary Dynamics of Hyperinflation," in Milton Friedman (editor) Studies in the Quantity
Theory of Money, pp. 25-117.
"'Thus the influence of fluctuations in wages and other
costs on output supply is ignored. Taylor ( ) considers
pricing based upon both wage and demand projections,
REFERENCES
Barro, Robert. "Unanticipated Money, Output, and the Price
Level in the United States," Journal of Political Economy, Volume 86, No.4, pp. 549-580.
Logue, Dennis E. and Sweeney, Richard J. "Aspects of
International Finance," Journal of Financial and
Quantitative Analysis, March 1978, pp. 143-156.
Bilson, John F. "Rational Expectations and the Exchange
Rate," in Jacob Frankel and Harry G. Johnson (eds.),
The Economics of Exchange Rates, (1978), pp. 7880.
Lucas, Robert E. Jr. "Econometric Testing of the Natural
Rate Hypothesis," in Otto Eckstein (ed.), The Econometrics of Price Determination, Proceedings of a
Conference sponsored by the Board of Governors of
the Federal Reserve System and the Social Science
f3esearch Council, October 30-31, 1970.
Darby, Michael R. "Sterilization and Monetary Control Under
Pegged Exchange Rates: Theory and Evidence,"
NBER Working Paper No. 449, February 1980.
Gittings, Thomas A. "A Linear Model of the Long-Run Neutrality of Money," Staff Memorandum 79-6 of the Federal Reserve Bank of Chicago.
Goodhart, Charles A.E. and Crockett, Andrew. "The Importance of Money," Bank of England Quarterly Review,
Volume 11, No.2 (June 1970), pp. 159-198.
Gordon, Robert J. "Recent Developments in the Theory of
Inflation and Unemployment," Journal of Monetary
Economics, Volume 2 (1976), pp. 205-210.
- - . "World Inflation and Monetary Accommodation in
Eight Industrial Countries," Brookings Papers, No.
2/1977, pp. 409-468.
49
Rutledge, John. "A Neoclassical Model of Wage and Price
Dynamics," Proceedings of the West Coast-Academic Federal Reserve Economic Research Seminar, Federal Reserve Bank of San Francisco, November 1977.
- - . "The Effect of Money on Output and Prices," Proceedings of the West Coast Academic/Federal Reserve Economic Research Seminar, Federal Reserve Bank of San Francisco, November 1979.
Taylor, John B. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, Volume 88,
NO.1 (February 1980), pp. 1-23.
I
Michael Bazdarich*
After more than twenty years of work on
what has been called a "monetarist counterrevolution" to Keynesian economic thought,'
the economics profession again has come to
acknowledge the importance of the money
supply in determining inflation and changes in
nominal GNP. Most economists would agree
that, in the long run, the level of the money
supply has no sustained effects on output, but
solely affects prices. Furthermore, most would
also agree that non-monetary (cost-push) factors can have a sustained effect on the inflation
rate only if they are accommodated or "validated" by increases in the money supply.
Given the widespread agreement on these
points, the debate on the causes of inflation and
the proper anti-inflation policy then revolves
around the following issue: what factors have
typically caused movements in the rate of
money-supply growth. Inflation has continued
and accelerated over the last fifteen to twenty
years, as has growth in the money supply.
What's more, it is generally agreed-and confirmed by existing evidence-that inflation
could not have continued for this long without
accompanying money-supply growth. It follows, then, that the underlying causes of inflation are fhose which can be convincingly shown
to have caused money-supply growth-either
directly or indirectly-over this period.
The present paper follows this argument by
conducting tests of cost-push and government-
spending theories of inflation. It applies the
Granger causality-test technique to determine
whether various "causes" of inflation have systematically caused, or been caused by, moneysupply growth. These results then provide evidence as to whether the respective variables
have indeed systematically caused recent U. S.
inflation. Furthermore, we argue that this technique is indeed more powerful than those commonly applied to such theories.
The arguments for the possible effects of
various inflation indicators on the money supply
take many forms. With respect to the costpush theory of inflation, many analysts argue
that central banks are forced to expand money
and credit in response to large cost increases
in various industries in order to avoid the output losses and unemployment that would normally follow such phenomena. By "accommodating" such increases through monetary
expansion, a slump is avoided, but at the cost
of eventually higher inflation. These cost increases thus cause sustained inflation through
their effect on the money supply. In the absence of accommodation, such increases primarily would cause changes in relative prices
and temporary losses in output, but at most
only temporary increases in the general price
level.
As for the effects of government spending
(deficits) on the money supply, analysts frequently argue that central banks monetize (accommodate) large government deficits rather
than financing through tax increases or through
government-debt issues which would raise interest rates. Though the monetization eventually leads to inflation, those favoring such an
approach argue that this is politically prefera-
'Vice President and Deputy Director of Research and
Planning, United California Bank (Los Angeles). The author completed this study while on the staff of the Federal
Reserve Bank of San Francisco. Kirk McAllister, Benny
Yu and Renee La Bran provided research assistance for
this study.
50
ble to the alternatives, at least in the shortrun.
The next section of this paper presents a
short analysis of the theory underlying our approach. It discusses the necessity of accompanying money-supply growth in order to have
continuing inflation, and therefore uses the "accommodation" hypothesis to substantiate costpush theories of inflation. Section II applies the
Granger causality test technique to U. S. data
for the 1959-79 period, as a means of testing
these accommodation hypotheses for various
measures of cost-push or government-spending-based inflationary pressure. Section III analyzes the episodic evidence on the money-inflation relationship for two particularly prominent
inflation periods: the post-oil-crisis period of
1974-75, and the recent 1978-79 period. Section IV concludes with a discussion of the implications of these results.
To summarize the results, we find virtually
no evidence of monetary accommodation of
cost-push or "supply shock" variables, despite
testing over seventeen indicators of such pressures with respect to four measures of the
money supply. In the majority of cases, the
result indicates "one-way causality" emanating
from several or all of the money-supply measures to the respective price or cost indicator.
These results are especially prevalent with respect to wage and unit-labor-cost indicators.
On the other hand, the results are less conclusive for government spending and deficit measures. Some of these indicators display causal
effects on the money supply, but these results
are either unsatisfactory in some way or are
subject to conceptual problems involving the
form of the equations themselves. The general
tenor of these results remains the same when
the estimation form for the respective relations
is altered in different ways. In addition, previous and/or concurrent money-supply growth
is found to provide a reasonable explanation
of most of the inflation occurring in both 197475 and 1978-79.
I. Conceptual Issues Behind the Money-Price Interrelationship
To reiterate, most economists would agree
that inflation cannot continue without an accompanying increase in the money supply. Inflation is essentially a tendency for all prices to
continue to rise, with little or no attendant
movements in workers, capital, or goods
among industries. And only a change in monetary conditions, viz. an increase in the money
supply, can plausibly generate such an increase
in all prices with little or no side-effects on the
real economy. Any other disturbance would
change the prices of some goods relative to
others-raising some, lowering others-and
would therefore induce movements of resources among industries, but not necessarily
any increase in prices in general. However,
because .economic actors can be expected to
base their decisions on real conditions and on
relative prices among goods, rather than solely
on money prices, an increase in the supply of
money (and thence in all money prices) leaves
these real conditions and relative prices unchanged, and so results in a pure inflation. 2
Many detailed discussions of this approach
can be found in early post-war inflation surveys
and early discussions of various types of costpush or supply-side inflation theories-e.g.,
Schlesinger (1957), Haberler (1959), and
Bronfenbrenner and Holzman (1963), the last
of which lists many more such examples. This
literature generally recognizes that in and of
themselves, supply-side shocks are sources of
only temporary inflationary pressure, and become sources of ongoing inflation only when
they are accommodated by the monetary system.
This being the case, it's surprising that most
empirical tests of supply-side inflation theories
have completely ignored what Schlesinger calls
"the monetary environment," and have instead attempted to identify statistical relations
between the price level and the particular
"causal" factor under consideration-e .g.,
Means (1935, 1972) and Wachtel and Adelsheim (1976). The problem with such tests is that
positive results are then equally consistent with
a wide variety of conflicting inflation theories.
For example, suppose a wage-push study
51
rise, would soon bring any inflation to a sudden
halt. Therefore, identifying some factor as a
systematic cause of monetary expansion is the
one reliable way to mark that factor as a cause
of the inflation.
Yet very few studies have taken this approach in discussing the causes of inflation.
Even monetary analyses have made little attempt to document the causes of monetary expansion as rigorously as they document the
effects of money on prices. There are some
exceptions, such as Gordon (1977), Bazdarich
(1978), and various studies of Federal Reserve
reaction functions, such as Barro (1979). Of
these, only Gordon and Bazdarich attempt to
identify causes of inflation, and then only with
a very small number of variables for a number
of countries.
The present study, in contrast, considers an
exhaustive list of possible indicators of U.S.
inflation. We perform Granger causality tests
for these indicators to determine whether they
can be identified as systematic causes of monetary expansion, and thence inflation. Now one
might contend that monetary accommodation
is typically an episodic process- that monetary authorities react to different factors at
different times-and that tests for systematic
effects are therefore likely to miss important
effects. Yet we argue at length that systematic
effects are necessary if we are to obtain objectively meaningful results, although we also
analyze two major inflation episodes to illustrate the predictive power of various inflation
theories over shorter periods of time.
finds a relation between wage increases and
inflation. This might signify the existence of
wage-push. However, even in a monetary theory of inflation, increasing money supplies are
considered to raise demand for goods and factors, and so to raise prices and wages. In such
a theory, wages might be said to respond to
money before prices, or the labor market
might be considered part of the transmission
mechanism whereby higher money supplies
lead to higher goods prices. Either development then could imply a statistical relation between wages and prices. Thus, a relationship
between wages and prices could exist under a
number of theories, and so in and of itself, it
provides no compelling evidence of the existence of wage-push pressure. Similarly for
other indicators, without evidence regarding
the effect of various factors on the "monetary
environment," it's impossible to tell whether
the existence of a statistical relation between
inflation and a given indicator represents cause
or effect: whether the indicator causes inflation, or whether money-supply growth causes
both the indicator and the price level to rise.
Consequently, evidence on monetary accommodation is crucially important in identifying inflation's causes. Again, an increasing
money supply is the one absolutely necessary
symptom, the sine qua non, of any inflation.
Holding milk prices frozen, or clothing prices,
or even oil or auto prices, while allowing other
inflationary phenomena to continue, would not
materially change the nature of the inflation
process. However, holding the money supply
fixed, though letting other factors continue to
II. Evidence of Systematic Accommodation
The Granger causality method, which we
use here to test the various inflation theories,
asserts that a variable x "Granger causes" a
variable y if fluctuations in x can be used to
predict subsequent movements in y, that is, if
fluctuations in x are systematically transmitted
to y. For example, consider the equation
where x, and y, are values of x and y at time t,
and where E it is a random disturbance term.
If the C'Y1' 'Yz' ... 'Ym) vector is non-zero, then
past x values can be used to predict current y
values (even when the past history of y is considered as well through the ~iYI-j terms), so that
x "Granger causes" y. Similarly, if, in the equation
(1)
x,
52
= 3
+ ~nl.x'_·1 + ~1fJ...·IYI-.·1 +
J-·l,.
1-"
EZI'
(2)
ture of the results. To avoid this problem, all
tests were performed with a standard equation
form using eight lags of each variable in equations (1) and (2).5 The eight lags were considered sufficient to pick up the lagged effects of
money on prices and wages, and vice versa.
Following the initial tests, alternative estimation forms were also used.
Theoretical discussions of the Granger causality technique suggest the use of non-seasonally adjusted data, since seasonal-adjustment
techniques can perhaps distort the statistical
interrelation between two variables. We followed this approach as much as possible, adding seasonal dummies to pick up deterministic
seasonality, while relying on the lagged dependent variables to prevent stochastic seasonality common to both variables from showing
up as statistical causality.6
We performed our tests with quarterly data
for the period 1957.1-1979.2, but dropped the
first nine quarters from our sample period to
generate lagged values and rates of change. 7
We used rates-of-change data to induce stationarity in the series, as well as for analytical
reasons mentioned earlier. H We chose costpush indicators which could represent specific
effects, but still be general enough to be recognized-and perhaps reacted to-by the
monetary authorities. We utilized four monetary aggregates-M-l (currency plus bank demand deposits), M-2 (currency plus all bank
deposits except large time certificates), the
source base (sources of the monetary base as
defined by the Federal Reserve Board of Governors), and the St. Louis base (the monetary
base, adjusted for reserve requirement changes,
as defined by the Federal Reserve Bank of St.
Louis).9 We calculated F-statistics to test the
significance of each explanatory variable in
"Granger causing" the respective dependent
variable. A significant F-statistic indicates evidence of Granger causality for the explanatory
variable in question- that is, it implies that
the )I-vector in forms of equation (1), or the
f.L-vector in equation (2), is significantly different from a zero vector.
In testing our money-price relation, the Fstatistic of 2.9 represents an effect of M-l on
the (f.Lp f.Lz' ... , f.LJ vector is non-zero, y is
said to "Granger cause" x. When x "Granger
causes" y, and y "Granger causes" x, two-way
"feedback" exists between the variables.
When x "Granger causes" y, but the converse
doesn't hold, x is said to be econometrically
exogenous to y-and similarly for the reverse.
On philosophical grounds, one would be
hard pressed to assert that empirical evidence
could be used to identify as metaphysical a
concept as causality.3 Thus the phrase "Granger cause" is substituted for "cause" in order
to emphasize the philosophical shortcomings
as well as the particular statistical phenomenon
(that of predictive power) which is being identified. Still, it can be argued that the Grangercausality concept is quite relevant to our
"causes of inflation" issues. In discussing the
monetary accommodation issue, we cannot
easily determine in what sense disturbances
such as large wage settlements or oil-price increases truly cause the monetary system to expand credit. Rather, the issue is whether this
process can systematically explain observed increases in the money supply, and the Granger
technique would seem to be well suited for this
purpose.
The existence of significant, positive causal
effects from money-supply measures to inflation measures would tend to confirm the standard monetary analyses of inflation. 4 The existence of significant, positive causal effects from
cost-push or government-spending indicators
to money-supply indicators would indicate the
existence of systematic monetary accommodation of these variables, so that they could
indeed be deemed basic causes of inflation.
These effects would have to be generally positive in order to show that the monetary authorities typically react to accommodate these
factors, rather than perhaps countering them,
which negative coefficients would suggest.
To estimate equations of the form in (1) and
(2), one must choose finite values for the laglengths n, m, r, and s. Clearly, experimentation
would allow one to find the values in each
equation that best fit the data. However, such
a procedure inevitably involves "peeking" at
the data, and would inevitably affect the na-
53
price variables. Most of the monetary indicators have significant effects on consumer food
prices and the CPI excluding food. Significant
reverse effects are shown only for the CPI
excluding food on M-1. In this case, as seen
already with the entire CPI on M-1 and M-2,
the effects at the shorter lags are negative,
with the estimated equation showing no real
sign of accommodative tendencies by the Fed.
For the GNP price deflators-for both total
GNP and personal consumption-the results
generally display strong one-way causality
from the money-supply variables to the price
indices, with no sign of systematic monetary
accommodation.
The wholesale (producer) price variables
similarly show no sign of accommodation. Virtually all are significantly affected by M-l and
various other monetary indicators. Yet, significant reverse effects are shown only from steel
and metals prices onto M-2. Here again, the
long-run effects of these variables on M-2 are
small and likely insignificant. Also, these variables show no significant effects on M-I,
which in the past two decades has surely been
a more prominent indicator of Fed policy than
M-2. In fact, the effects of steel and metals
prices on M-2-in the absence of effects on M1- may reflect business-cycle factors. Metals
and steel prices are very cyclically sensitive.
Similarly, because disintermediation in times
of cyclically high interest rates normally affects
M-2 more than M-1, it would appear that a
large portion of disparate movements between
M-I and M-2 would reflect cyclical factors.
Thus, the estimated relationship between M-2
and steel and metals prices (and the lack of
such a relation for M-l) may reflect the existence of similar cyclical behavior in these variables.
As for labor-market indicators, we see absolutely no sign of accommodation effects on
any of the monetary indicators of movements
in either wages or unit labor costs (Table I).
Unit-labar-cost data are available only in seasonally adjusted form, so that those particular
results should be interpreted with caution, but
the results are completely consistent with those
for the wage data. The general result indicates
the consumer-price index that is significant at
the I-percent level (Table I, line I). The longrun effect of 1.6 indicates that any sustained
one-percentage-point change in the M-l
growth rate would generally eventually result
in a 1.6-percentage-point change in the CPI
inflation rate in the same direction. III The Fstatistic of 2.6 indicates an effect of CPI inflation on M-I growth that is significant at the 5percent level, while the long-run effect of 0.1
indicates that a one-percentage-point change
in the CPI inflation rate would eventually result
in a O.l-percentage-point change in the M-l
growth rate. The results for the other monetary indicators and the CPI can be equivalently
interpreted.
All four monetary indicators have effects on
the CPI with some degree of significance, as
monetary theories would lead one to expect.
On the other hand, the CPI has significant
effects only on M-I and M-2. This by itself
need not be damaging to an accommodation
hypothesis, since it could be argued that accommodation should show up in the Federal
Reserve's traditional policy variables, M-I and
M-2, rather than in variables which the Fed
targets only indirectly, such as the monetarybase indicators. (Even so, such accommodation, if significant, should be expected to show
up to some extent in the base indicators, which
are certainly affected by Fed open-market operations). Nevertheless, a more serious problem with interpreting the significant effect of
the CPI on M-1 and M-2 as evidence of accommodation is that the signs of the significant
coefficients for the CPI effects are negative at
the shorter lags, and become positive only at
the longer lags. In other words, the equations
suggest that given a disturbance to CPI inflation, the Fed initially acts to counter rather
than accommodate this disturbance, while its
estimated reaction becomes and stays positive
only after a substantial lag (twenty-five quarters!), and even then only at an insignificant
level. Thus, despite the significant effects of
the CPI on M-I and M-2, the tests involving
that variable do not show much sign of systematic accommodation by the Fed.
Much the same is true for other consumer54
Table 1
Causality Results Between Various Economic Indicators and the Monetary Aggregates
Eight Lags for all Variables, 1959.2-1979.2*
M-1
C onsum er Prices
All Items
Food
Excluding food
W holesale Prices
All Items
Non-Farm
Farm
Metals
Steel
Fuel
Petroleum
M-2
F'
2.4“
1.6
1.5
LR0.4
0.2
0.4
F1
1.7*
2.4**
1.8*
2.2“
1.6
1.5
1.4
1.0
1.6
1.1
1.9
1.9
2.0
1.9
1.7
3.1
2.0
0.9
1.5
0.7
2.3“
2.8“
1.0
1.0
0.2
0.2
0.1
0.1
0.1
0.1
0.1
0.4
0.5
2.4“
2.3“
0.4
1.5
0.6
1.1
1.6 0.8
1.6 0.4
1.6 0.4
0.3
0.1
0.3
1.7
1.4
1.7
1.3
1.1
1.3
1.3 0.6
0.7 0.4
0.2
0.0
1.4
2.1“
0.5
0.4
LR0.9
0.9
0.9
F1
1.2
1.1
1.3
LR0.0
0.0
- 0 .2
2.2“
3.0***
1.8*
2.5“
2.0*
1.7
1.4
1.1
1.2
0.9
1.4
1.4
2.7
1.9
0.8
0.7
0.7
0.7
0.6
0.9
0.6
- 0 .2
- 0 .4
0.1
-0 .5
- 0 .5
- 0 .2
- 0 .4
0.7
0.1
3.9*“
3.7***
- 1.4
1.1
0.7
1.0
0.5
0.2
0.7
0.9
0.9
0.3
0.1
0.2
2.4**
1.8*
2.0*
1.0
0.9
0.9
0.2
0.6
0.3
- 0 .7
- 0 .7
- 0 .7
0.6
-0 .2
1.9
0.9
0.3
0.2
0.8
0.2
0.4
0.0
0.4
0.8
-
1.0
1.0
1.0
0.8
0.4
0.3
1.6
2.2“
0.9
0.8
2.0* - 0 .6
0.9 - 1.0
1.2
0.1
1.8*
F1*
0.9
1.0
0.9
LR0.1
-0.1
-0 .2
1.1
0.9
1.4
1.9*
1.5
1.9*
1.1
1.5
1.4
1.5
1.5
1.6
2.7
1.9
0.3
0.4
0.3
1.6
0.9
0.7
0.4
0.0
0.0
0.0
0.0
0.0
0.1
0.1
0.2
0.5
3.8*“
3 9“ *
0.5
1.1
1.0
0.9
1.0
0.8
0.7
0.5
0.2
0.4
1.4
1.3
1.8*
1.1
0.8
1.1
- 0 .3
- 0 .7
1.2
1.3
0.2
0.1
1.5
1.8*
2.3“
2.6“
1.1
1.2
1.1
1.2
0.6
0.5
2.7“
1.7
.0.2
0.7
F'
2.1**
2.2“
1.2
2
0.6
0.8
0.5
0.9
i .6
0.7
0.8
-0 .3
-0.1
-0 .4
-0.1
0.1
0.0
-0.1
2.5“
1.2
0.5 0.7
1.5 0.7
2.7”
1.7
2.7“
3.2*“
3.5*“
** 2.3
2.2
2.4
2.4
2.4
3.8
3.1
Source Base
LR1.1
1.2
1.2
LR0.1
-0.1
0.3
1.9*
2.4“
2.4“
1.2
2.3“
2.1“
St. Louis Base
LR1.4
1.5
1.7
F'
LR- F>
2 (^*** 1.6 2.6“
2.6“
1.9 1.6
1.7
1.7 3.3***
F1
2.2**
1.5
2.1**
W ages for
Nonagricultural
Workers1
Manufacturing
Unit Labor C osts
Private Business
Manufacturing
Non-farm
U nem ploym ent Rates
All Workers4
Males 25-444
0.1
0.1
Im plicit Deflators
GNP
Personal
Consumption
Expenditures
3.2“ * 1.3
2.4“
1.3
1.1
1.0
G overnm ent
Deficit5
1.7*
5.0 2.3“
0.1
0.5
2.2
1.8*
D eficit/GN P
R atio4"
0.8
0.1
0.6
0.4
1.1
0.4
0.6
0.2
0.7
0.8
0.6
0.1
1.1
0.8
0.7
1.4
0.1
0.5
0.6
2.5“
0.2
1.0
0.7
0.7
-0 .2
1.0
G overnm ent
Spending"
16.6
2.0*
0.1
0.7
1.1
0.5
0.7
0.9
0.4
15.0
‘ First column of each set shows F-statistic for effect of respective monetary aggregate on "cost" variable; second column shows long-run effect for this
relation; third column shows F-statistic for effect of "cost" variable on respective monetary aggregate; fourth column shows long-run effect for this
relation.
‘ Significant at 10 percent level.
“ Significant at 5 percent level.
“ ‘ Significant at 1 percent level.
'F-Statistic for hypothesis that explanatory variable has no effect.
:Long-run effect of a permanent one-percentage-point change in explanatory variable on dependent variables; see Appendix 1.
’Sample period: 1966.2-1979.2.
’"Cost" variable is in level form.
'Level of deficit vs. first difference of supply.
"Sample period: 1959:2-1978:4.
55
variables, and could be expected to yield statistically meaningful results.
However, we should not expect the same for
various government spending or deficit variables . .The government deficit, in its raw form,
is measured in dollars, and so should have an
increasing trend over time, both because of
inflation and economic growth. Therefore it
should be non-stationary. The percentage rate
of change of the deficit is not a reliable indicator either, since a change from a $1 deficit
to a $2 deficit need not elicit the same moneysupply change as a shift from a $lO-billion to
a $20-billion deficit, and since any change from
a balanced budget indicates an infinite percentage change.
One alternative is to run the test between
the level of the deficit and the first difference
in the particular money-supply variable. This
equation form implies that a given dollar
amount of deficit requires a given dollar
amount of monetization by the Fed, and so a
given dollar amount of change in the moneysupply indicator. This form, although consistent with government-deficit theories of inflation, has poor statistical properties because
both of the variables are non-stationary. Despite these reservations, we ran causality tests
using this equation form, 12 and found significant effects of the deficit on money growth,
with significant positive coefficients at the
shorter but not at the longer lags. 13 But again,
given the suspect nature of the variables, these
results must be interpreted carefully.
Another alternative would be to induce stationarity in the deficit series by dividing it by
another series with similar trend, such as nominal GNP. Such a ratio does not have dollar
dimensions, and so will not be non-stationary
on this count. However, the resultant equation
form does not have clear theoretical validitythus, a one-point change in the deficit as a
percentage of nominal GNP need not generally elicit a fixed change in the money-supply
growth rate. When we performed causality
tests between the deficit/nominal GNP ratio
and various money-supply growth rates, we
found no significant effects in either direction.
one-way causality from the monetary indicators to the labor-market indicators.
Haberler has suggested that central banks
typically react more to unemployment rates
than wages, and that wage increases exert sustained effects on inflation by initially raising unemployment, which the authorities then
counter by monetary expansion. II Thus, he
postulates a causal chain-from wages or labor
costs to unemployment to monetary expansion
to inflation. If this were in fact the case, one
would still expect wages or labor costs to affect
monetary expansion, although at perhaps long
lags because of the two-step process. However,
we have seen that this is not the case. We also
tested this hypothesis directly by running causality tests between labor-cost variables and unemployment, and between unemployment
rates and the money-supply indicators. Though
two-way causality or feedback was found between the labor-cost variables and unemployment rates, one-way causality from moneysupply growth to the unemployment rates was
generally found, with no sign of "accommodation" of unemployment forthcoming. Thus,
the feedback between wages (or labor costs)
and unemployment is consistent with the apparent one-way causal effects of money-supply
movements on all of these variables. Although
wages or labor costs are usually cited prominently in cost-push analyses of inflation, our
analysis found no sign of systematic effects of
these variables on the "monetary environment," and so no compelling evidence for
these variables as causes of sustained inflation.
Most of the tests for cost-push indicators
involved price indices vis-a-vis money-stock
variables, so that the percentage rate of change
of each of the variables in a particular set could
be readily related in theoretical terms as well
as providing reasonably stationary time series.
That is, a change in the percentage rate of
growth of say, M-l could be expected to elicit
essentially the same percentage-point change
in, say, the CPI inflation rate, and vice versano matter how high or low these rates were.
Thus, equations (1) and (2) could reasonably
be expected to be stable over time for these
56
Table 2
Causality Results Between Various Economic Indicators and the Monetary Aggregates
Four Lags for all Variables, 1959.2-1979.2
M-1
Consumer Prices
All Items
Food
Excluding Food
f'
2,5"
3.6***
1.6
LR'
0,3
0,1
0,3
f'
1.9
F'
1.9
1.0
1.2
F'
1.7
1.3
1.3
LR'
0,2
0,1
0,3
F'
1.3
l.8
Source Base
St. louis Base
M-2
LR'
L7
1.3
1.5
LR'
1.9
1.8
1.6
1.8
2,0*
3,3"
LR2
1.3
1.3
1.3
1.0
0.4
0,5
0,2
0,2
f'
LR2
OJ
f'
LR'
F'
2,8"
1.4
3,9" ,
l.l
0,8
1.3
1.0
1.3
0,3
1.8
1.5
1.2
2.5"
2.5"
1.4
1.3
1.2
1.2
0,9
1.3
1.5
2.5
2.2
0.4
0,3
1.0
0,8
1.0
D.6
0.4
0.1
-D,I
0.2
-0.2
-0.2
-0.1
-0.1
LR'
0,3
OJ
0.0
Wholesale Prices
All Items
Non-farm
Farm
Metals
Steel
Fuel
Petroleum
2.7"
1.7
2,7"
2.D'
1.6
1.4
1.2
2.2
1.8
2.2
1.9
L7
1.8
1.3
0.1
0.4
D.2
1.5
0,7
0.1
D,8
0.0
0.0
O.D
0,1
0.1
O.D
0.1
1.5
1.1
1.2
1.8
2,2'
0.9
D.4
1.7
1.4
1.4
1.4
1.3
1.0
0.1
0.2
D.3
0.5
2.9"
1.8
0.5
1.4
0.1
D.l
0,0
0.1
D.I
D.I
D,I
1.4
1.3
1.5
3.9***
2.1 '
1.5
D,2
1.5
1.4
1.5
1.4
1.5
2.4
I.D
0.2
D.3
0.2
1.3
0,6
O.S
D,6
0.1
-0,1
O,D
0.1
0.1
D.I
D,I
Wages for
Nonagricultural
Workers J
Manufacturing
4.1 '**
1.6
0,5 0,3
0,9 D,9
0,3
D,S
3,7"
3.6***
D,2
D,8
0.3
1.6
D.D
D.4
6.2***
4.8***
D,S
0,9
0,2
1.0
D.4
0.4
1.4
3,2"
D.2
0.7
0,1
1.2
0,2
D.2
Unit Labor Costs
Private Business
Manufacturing
Non-farm
4.1 ***
2,3'
3.6***
1.5 0.4
1.2 D,3
1.5 D,3
D,2
0,1
0.2
2.D
1.7
1.8
1.0
0.5
1.0
0,8
D,7
0,9
D,3
D,2
D,3
2,2'
1.5
1.9
1.0
D,7
I.D
D.6
D,8
D.8
D,2
D,2
D,3
3.6***
2,7"
2,9"
D.9
0.9
I.D
0,3
0,7
0,7
-0,1
-0.2
-0,1
Unemployment Rates
All workers'
Males 25-444
0.9
2,8"
-0,9 0,5
-0,8 0,3
0.1
-0.1
1.4
-1.2
1.2
2.0
0,2
D.D
0.4
0,5
-0,1
-D.5
l.l
0.5
0.2
0,0
0.1
D.4
0.4
0,1
0.4
1.2
0.1
-0,1
GNP
3.2"
1.3 1.0
D,3
1.8
I.D
1.4
0.4
3.1"
1.0
1.2
OJ
3.2"
0,9
3.3"
0.2
Personal
Consumption
Expenditures
2.7"
1.2 0.4
D.3
1.6
1.0
1.2
0.4
2,9"
1.0
D,S
D,3
3,6"
0,3
0,7
0,0
1.0
D,D
2,5"
11.9
2.4'
D,D
1.4
2.8**
Implicit Dellators
Government
Deficit'
0.\
-2,7
1.9
0.\
0,2
1.5
2.3'
0.2
0,9
Deficit/
GNP Ratio'"
1.2
-D,7 D,7
D,2
1.1
0,2
D,6
0,2
1.6
D,9
0,3
0,2
1.6
0.5
1.0
0,5
Government
Spending'
0.2
D,O 0,6
D.2
0,2
D,3
2.7"
0.3
1.1
0,5
0.6
0,2
0,9
0.7
0.9
0,3
12.4
'First column of each set shows F-statistic for effect of respective monetary aggregate on "cost" variable; second column shows long-run effect for this
relation; third column shows F-statistic for effect of "cost" variable on respective monetary aggregate; fourth column shows long-run effect for this
relation,
'Significant at 10 percent level.
"Significant at 5 percent level.
"'Significant at 1 percent level.
'F-Statistic for hypothesis that explanatory variable has no effect.
'Long-run effect of a permanent one-percentage-point change in explanatory variable on dependent variables; see Appendix I,
JSample period: 1966,2-1979,2.
'''Cost'' variable is in level form.
'Level of deficit vs, first difference of supply.
'Sample period: 1959:2-1978:4,
57
One other alternative would be to consider
the percentage rate of change in government
debt, since the deficit presumably represents
the first difference in the debt. But there is no
reason why a stable relation should exist between the rates of change in debt and money
stock. Additionally, several measures of the
government debt, including on- and off-budget
items and various agency-debt issues, do not
provide first differences comparable to the deficit. We found no significant results when running tests using some of these variables.
Finally, we might consider government
spending as a cause of inflation and money
growth, since it represents the government's
actual drain of goods and services from the
economy-and since spending changes should
correspond to deficit changes, given the largely
inflexible (short-term) nature of the tax codes.
Also, the percentage rate of change of government spending makes statistical sense and is
likely to be stationary. However, our tests indicate that none of the money-supply variables
have significant effects on government expenditures. Expenditures have a significant effect
on M-2, and also have a significant effect on
M-l when data for an earlier time period are
included. Even for these results, however, the
coefficients of expenditures at shorter lags are
negative, which would suggest that accelerations in spending are initially followed by decelerations in money growth. Obviously this
finding is counter to what government spending-inflation theories normally suggest.
One might argue that our eight-quarter lag
structures are not conducive to measuring accommodation effectively, that perhaps shorter
lags would be better for that purpose, since if
the Fed acts to accommodate inflationary disturbances, it might do so quickly in order to
avoid near-term losses in output and employment. We tested this thesis by re-estimating
our Table 1 equations using four-quarter lag
structures (i .e., n = m
r = s
4 in equations [1] and [2]), with the results shown in
Table 2.
However, there is even less evidence of accommodation with these shorter lag structures.
The significant effects of the CPI on M-l and
M-2 disappear, as do the effects of steel prices
on M-2. The only significant "feedback" onto
monetary indicators occurs for metals prices
on M-2, the GNP deflator on the source base,
and the deficit on M-2 and the source base. In
view of the isolated nature of these results,
and in view of the mitigating factors discussed
for similar results in Table 1, the feedback
shown in these three cases can probably be
dismissed as evidence of accommodation.
With our re-estimated equations, the signiflcance of the effects of money on prices and
wages also declines slightly, but the general
result is still that of one-way causality from
money to inflation indicators. There is certainly
nothing in these results that gives any stronger
signal of accommodation than the very weak
evidence found with longer lag structures. We
also obtained similar results with tests involving Almon polynomial-lag structures, and with
tests involving smaller sample periods (see
Appendix).
Conceivably we could keep dropping or adding coefficients and re-estimating equations
until we found "significant" positive effects of
some inflation indicator on some money-supply
indicator. But after mining the data in this
fashion, it would be impossible to determine
whether the significance of the results actually
lay in the data or in the prior beliefs of the
experimenter.
For the present results, we used generalequation forms to minimize the amount of
prior information that might affect the results.
These tests were generally able to verify the
existence of a strong effect of monetary expansion on a wide range of inflation indicators,
but found no reliable accommodative effects
of these indicators on the money-supply process. Thus the evidence suggests that cost-push
factors do not provide a convincing explanation of continuing inflation in recent U.S. history. Much the same could be said of government-spending theories of inflation, although
our equation forms were not as well suited to
these types of theories as they were to costpush theories. Also, these indicators showed
more positive results, although their reliability
was suspect.
58
m.
Episodic Evidence on Inflation
Our tests found no reliable sign of systematic accommodation by the monetary authorities of cost-push or supply-side inflationary pressures. It might be argued that the tests were
run over too long a time period to obtain
meaningful results-that thc Fed's "reaction
function" for these disturbances varies or
evolves over time, and/or that the Fed reacts
to different factors at different times, so that
a test involving one such factor over a twentyyear period is doomed to failure. However,
these arguments for shifting, evanescent effects hamper the measurement of such phenomena, and also diminish the usefulness of
the theory which they are intended to support.
If a theory is to be objectively testable and
useful for practical purposes, it must hold over
an extended period of time. To see this, recall
that in our tests, we estimated a common equation form, and avoided the temptation to "doctor" the equations to improve the results. We
did this not because of an unshakable belief in
the equation form we used, but in order to
make the data speak directly to us and thus to
avoid making any subsequent changes that
would inevitably bring subjective judgment
into the final results.
By the same token, to argue that monetary
policy reacted to, say, wages in 1957-5R, and
then to use 1957-5R data to "verify" this argument, inevitably involves prior knowledge
of the data. This argument also effectively ignores prior historical events (perhaps inflationary money growth in 1955-56) that might better explain 1957-58 developments. We would
be dealing with a sample of one period, i.e.
the 1957-5R period, which was drawn from the
whole set of historical data in a non-random
way. It is difficult to determine the reliability
of any such demonstration unless the evidence
holds over an extended period of time. Also,
tests over such a narrowly specified period
could provide evidence of an effect only for
that period. Knowing that money growth and
inflation, say, in 1957-58 were caused by wage
increases would not necessarily tell us anything
about the causes of inflation in other periods.
A verifiable, useful hypothesis about mon-
etary accommodation and inflation therefore
should be supported by evidence of a systematic link between the particular variable and
the money supply over a period of time long
enough to allow statistical identification. Although we were unable to find that type of
evidence in our earlier analysis, it is nevertheless interesting to examine the explanatory
power of the competing theories in certain specific periods.
Consider first the 1973-75 inflation. This burst
of inflation followed three possible causative
factors: the removal of mandatory wage and
price controls, largely completed by late 1973;
the oil crisis in late 1973, which resulted in a
quadrupling of crude oil prices; and a worldwide acceleration in money-supply growth
starting in late 1970. 14 The removal of wage
and price controls could be expected to precipitate a temporary acceleration in inflation in
1973-74 to make up for the 1971-73 suppression of inflation, therefore transfering it to the
period immediately following the removal of
controls. The oil-price shock, on the other
hand, could have caused a temporary acceleration in inflation for reasons discussed earlier.
In any event, monetary accommodation was
not evident in 1973-74, because money-supply
growth was decelerated sharply both before
and after these several developments (Figure
1) .15 The Federal Reserve apparently moved
to counter-rather than accommodate-inflationary forces following the removal of controls and the oil-price shock. Therefore, on the
basis of our earlier analysis, none of these factors could be regarded as sources of continuing
inflation even in this subperiod.
This leaves the question: how important are
these factors as causes of transitory inflation
over the period at hand? We can address this
question by determining how much inflation can
be explained by monetary forces alone, attributing any remaining inflation to the non-monetary factors mentioned. Because the existence
of controls probably shifted monetary inflation
to the post-controls period, the simulations
were performed starting in third-quarter 1971,
the date of imposition of the controls. Because
59
mated from two other sample periods: 1959.21971.2, designated the "short" sample period,
and 1959.2-1971.2 /1976.1-1979.2, designated
the "bracketed" sample.
As would be expected, the simulations
yielded generally positive "forecast" errors
over the early part of the period, when controls should have suppressed inflation below the
level implied by previous money-supply
growth, and generally negative "forecast"errors over the latter period, when the renlOval
of controls should have pushed inflation above
levels predicted by previous money-supply
growth. Yet the monetary aggregates do a
the suppressed inflation presumably took two
years to work through the economy, the simulation period was terminated in fourthquarter 1975, two years after the end of the
controls period. 16
Thus,the inflation-money version of equation
(1) was simulated over 1971.3-1975.4 for four
general measures of inflation (CPI, WPI, GNP
deflator, and GNP deflator for personal consumption goods) and for the four basic moneysupply measures. 17 Because the results could
be biased by using an equation form estimated
from a sample period including 1971.3-1975.4,
we performed simulations for equations esti-
Chart 1
Inflation and Money Growth
Change (%)
12
10
8
Money growth (M 1 ) *
"
6
4
2
\.
Consumer prices
++-------------------
0 ......
2
1959
1963
1971
1967
* Adjusted for automatic transfer accounts (ATS)
60
1975
1979
fairly good job of explaining cumulative inflation over the entire period (Table 3). M-1
growth can explain all but 6 percentage points
of the 37.9-percent cumulative increase in the
CPI in the short-sample simulation, and actually overpredicts inflation in the other simulations. Similar results hold for the deflator simulations. In contrast, simulation errors are
larger by as much as 31 percentage points for
the 56.2-percent cumulative increase in the
WPI. The disparity can be explained in part
by the fact that the WPI involves goods at all
stages of the production process, and so probably over-counts the effects of an increase in
the price of a factor (like oil) which is prominently used in a number of products. Also, as
our earlier analysis suggests, a supply shock
should primarily affect relative prices. In the
case of the oil shock, one would expect the
relative returns to other productive factors,
such as labor and capital, to fall relative to
that for energy. This would then increase the
level of wholesale prices relative to consumer
(retail) prices, since the latter has a higher
service and labor content, while the former is
more sensitive to fuels and primary products.
In any case, previous movements in money-
supply growth (along with the transferring effects of controls) are able to explain most of
the 1973-75 inflation, with the divergent movements between the WPI and the other measures apparently due to higher relative prices
for oil and energy inputs. These results, and
the apparent lack of monetary accommodation
of various price shocks, suggest that this period
was not demonstrably different from other periods in terms of the interrelation between
monetary policy and inflation.
In similar fashion to the earlier debate, some
analysts today describe the 1978-80 inflation as
being a new strain of the inflationary "virus,"
contracted from different "germs," and so
somehow immune to traditional anti-inflation
policy prescriptions. They tend to blame the
current inflation on large food-price increases in
early 1978, and oil-price increases in 1979,
spread through the economy by workers seeking to index their wages to the cost of living.
Some argue that this widespread trend to indexing makes inflation more immune to restrictive monetary policy. Still, the arguments propounded today resemble those made in 197375, although perhaps on a smaller scale.
We can gain some insight into the nature of
Table 3
Simulation of Money-Inflation Effect, 1971.3-1975.4
Inflation
Indicator
Actual Inflation
Over Period
Inflation Forecasted (and Forecast Error) By
M-1
M·2
St. louis Base
Source Base
26.1
(8.5)
23.4 (26.6)
40.6 (-3.4)
25.5 (7.0)
21.0(13.1)
17.3 (33.2)
35.9 ( 0.0)
23.4 ( 8.9)
36.6
35.6
35.3
33.2
( 0.2)
(15.2)
( 0.5)
( 0.8)
33.6
31.0
31.2
28.5
( 2.5)
(19.3)
( 3.6)
( 4.5)
34.8
41.1
33.1
31.2
( 1.6)
(10.7)
( 2.2)
( 2.4)
31.0
32.8
32.0
27.7
( 4.4)
(17.6)
( 3.0)
( 5.2)
Short Sample
Consumer Price Index
Wholesale Price Index
GNP Deflator
Personal Consumption
Deflator
36.9
56.2
35.9
34.3
29.2 (5.9)
19.3 (31.0)
38.2 (1.6)
26.6 (6.1)
Consumer Price Index
Wholesale Price Index
GNP Deflator
Personal Consumption
Deflator
36.9
56.2
35.9
34.3
38.8 (1.4)
34.5 (16.1)
33.8 (1.6)
32.4 (1.5)
Consumer Price Index
Wholesale Price Index
GNP Deflator
Personal Consumption
Deflator
36.9
56.2
35.9
34.3
38.5 (- 1.2)
44.8 (7.9)
35.6 (0.3)
33.2 (0.9)
33.8 (2.3)
24.4 (25.5)
56.1 ( 14.8)
34.3 (0.1)
Bracketed Sample
41.8 (-3.6)
37.4 (13.7)
39.6 ( 2.7)
40.8 (- 4.8)
long Sample
61
37.4 (-0.4)
43.6 (8.8)
34.8 (0.8)
32.0 (1.7)
tion, significant amounts of inflation clearly appeared to· be outside •the explanation of previous money-supply <growth (Table 4). For
example, CPI inflation was two percentage
points higher in .1978 and four percentage
points higher in 1979 than would be suggested
by conditional forecasts ba.sedon·M-l.growth. 19
These results would seem to reflect the impact
of the 1978 food-price shock and the 1979 oilprice shock. Even so, the first simulation results are still able to explain a large part of the
recent inflation acceleration.
To the extentthat large, recognizable .shocks
to food and oil prices explain the rest, this
argument is consistent with the previous analysis, where such shocks were said to have possibly permanent effects on the price level (independently of the money supply) and so
temporary effects on the inflation rate. However, this can be true only to the extent that
the simulation errors evidenced in Table 4 represent the effects of unforseeable shocks. If
these errors could be attributed instead to the
systematic effects of factors predictable on
non-monetary grounds, the power of the
money-price relation might be diminished. To
analyze such questions, we should consider
what forecasters were predicting about 197879 inflation in 1977-78. These analysts, especially those employing large econometric
this inflation by analyzing it in terms of the
money-price relations developed earlier. Moneysupply growth started to accelerate in late 1975
or early 1976, following two years of declining
growth rates. (Figure 1). This development
would suggest an acceleration in inflation starting in late 1976 or early 1977, and becoming
very strong by about early 1978, as actually
occurred. However, there were no signs of an
acceleration in labor costs, nor any identifiable
supply shocks, at the time of the monetary
acceleration. It seems unlikely, then, that the
monetary acceleration of 1976-77 was generated by accommodative Federal Reserve behavior, at least attributable to cost-push pressures.
To measure these factors more precisely, we
again simulated the inflation-money supply
equations for various indicators. To avoid biasing the results, we again re-estimated the equations over sample periods not including the
respective simulation period. Thus, the equations were estimated over the 1959.2-1977.4
period, and simulated over 1978.1-1981.4 (first
simulation), then estimated over 1959.2-1978.4
and simulated over 1979.1-1981.4 (second simulation), and finally estimated over 1959.21979.4 and simulated over 1980.1-1981.4. IH
Despite the correct "phasing" evidenced in
recent years between money growth and infla-
Table 4
Simulations of M-1 Inflation Equation (1978-81)
Compared to Forecasts By Major Analysts
Forecasts
Consumer
Price Index
Actual
1978
1979
1980
1981
9.0
13.3
Simulation Results
Over Sample Period
59.2-77.4
59.2-78.4
59.2-79.4
7.0
8.0
7.9
6.4
9.0
8.1
6.1
6.5
7.7
7.8
6.8
8.8
8.3
7.1
Wharton Econometrics
Data Resources Inc.
12/31/77 12/1/78 12/3/79 12/21/77 12/27/78 12/20/79
5.5
6.3
7.1
6.3
11.8
7.9
11.3
8.7
5.8
5.3
5.7
7.8
6.9
6.8
10.4
9.1
7.4
7.1
6.9
9.4
9.2
GNP Deflator
1978
1979
1980
1981
8.2
8.9
5.6
5.7
6.6
6.1
8.8
7.2
'This rate is the December over previous December increase.
62
9.4
7.8
6.0
5.4
6.1
MagaZine
Board of
Economists
6.2'
7.5 1
9.1'
models, presumably utilized a wide range of
available information in their forecasts. If our
simulations compare favorably to their forecasts, it would suggest that recent "nonmonetary" inflation was in fact due to large unforseeable shocks to oil and food prices rather
than to systematic defects in the money-price
relation. 20
As it turns out, most analysts experienced
forecast errors larger-and in some cases much
larger- than the errors for the money-price
simulations shown in Table 4. Most late-I978
forecasts showed inflation slowing to below 8
percent in 1979. The simulations-using
money-supply information through 1979 but
price information through only 1977 or 1978showed inflation remaining steady or even accelerating in 1979. Despite underpredicting
1979 CPI inflation by four percentage points,
the simulation predictions were certainly more
accurate than those of the major forecasters.
This does not necessarily mean that the
money-price equation is a superior forecasting
tool, because the simulations utilized information not available to the forecasters: actualmoney-supply growth over the respective simulation periods. 21 However, it does suggest
three important points: a) actual money-supply growth is indeed helpful for predicting inflation in the present period; b) the large errors,
apparent in both the simulations and outside
forecasts, represent the effects of random, unpredictable shocks, rather than systematic defects in the money-price relation; and c) M-l
does a creditable job of explaining inflation in
1978-79, accounting for an acceleration in the
underlying rate of inflation to the 8-to-1O percent range.
The remaining CPI inflation in 1979 is clearly
due to the short-term effects of large oil-price
increases, given the larger errors experienced
by forecasters using more structural information-and given the lack of large simulation
errors for the GNP deflator, which does not
directly include import prices, and thus fails to
reflect the full impact of OPEC price actions.
Such a random shock to prices can temporarily
pull measured inflation rates away from rates
predicted by the money supply. However, the
expansion in money-supply growth and the acceleration in inflation clearly occurred well before oil prices surged, so that the recent inflation could not be attributed to monetary
accommodation of oil-price increases.
In summary, the 1973-75 and 1978-79 episodes of inflation did not show any greater sign
of accommodation than did the 1959-79 period
as a whole. In each case, the acceleration in
inflation was preceded by an acceleration in
money-supply growth. The money-supply behavior then was able to explain a predominant
portion of actual measured inflation, with the
remaining part clearly attributable to the temporary effects of oil- and food-price shocks. As
for 1980, the money-price relation suggests
that inflation, though declining, will remain
quite high through the year, even if M-1 grows
no faster than the 5-percent rate assumed in
the simulations.
IV. Summary and Conclusions
In this article, we have examined the direction of Granger (econometric) causality between the U.S. money supply-as measured
by four prominent monetary aggregates-and
a number of variables considered representative of cost-push and government-deficit inflationary pressures. We found widespread and
significant "causal" effects from the moneysupply measures to the price or cost variables,
but found no reverse effects, at least not of a
nature that would suggest monetary-accommodation. Thus, we found little if any evidence
of the systematic existence of cost-push infla-
tion in the last twenty years. Furthermore,
even in two recent episodes of inflation acceleration, the behavior of the money-supply
measures alone was capable of explaining
these experiences reasonably well, with little
evidence of accommodation. Though some
signs of systematic effects of governmentspending variables on the money supply existed, these effects were not particularly convincing.
These result!i therefore fail to support the
commonly-held theory of a wage-price spiral:
the idea that increasing labor costs cause in-
creasing prices, which cause workers to seek
still higher wages, with the process continuing
indefinitely on its own momentum. Such a
"perpetual motion inflation machine" could not
not continue on its own without continuous
"refueling" in the form of an accommodative
monetary policy. Yet, there is no convincing
evidence that the Federal Reserve has conducted monetary policy in such an accommodative manner. Rather, the increases in the
money supply have more typically acted as an
underlying cause of the increases in wages and
prices. More than providing the fuel to keep
the engine running, an increasing money supply has apparently provided the initial spark
igniting the engine.
Some might contend that at root the various
theories of inflation all say much the same thing.
Cost-push theorists might see income-share
struggles as first affecting wages and prices,
and thence forcing accommodation by monetary authorities who seek to avoid disruptions
to output and employment. At the same time,
monetary theorists might emphasize government efforts to achieve unattainable economic
goals (or to avoid painful explicit tax increases)
in order to appease impatient electorates,
thereby leading to autonomous monetary expansion and thence inflation. At this level, both
sides ultimately seem to blame inflation on socio-political pressures, and disagree mainly
about the mechanisms which transmit these
pressures.
Yet, it can be argued that the two approaches actually give rise to quite different
insights and policy implications. If nothing
else, the monetary approach emphasizes the
importance of the money supply in continuing
the inflation process, whereas this role is often
left implicit in the cost-push formulation. More
importantly, identifying the actual channels
through which inflationary forces operate suggests different policy strategies for slowing inflation. It is true that if socio-political struggles
underlie any inflation, then any effective antiinflation policy must educate the public about
the futility of attempting to resolve struggles
in this way, and must devise political reforms
to keep these struggles from being translated
into inflation. But it is also true that if cost-push
channels cannot be identified as crucial in the
transmission of these struggles to inflation, as
we suggest, then policy reforms should start
with channels that can be identified. Thus, reform should possibly begin with the operations
of monetary policy and related policy influences. from the executive and legislative
branches-rather than with income policies
designed to control industrial sectors which
have typically reacted to rather than instigated
inflationary pressures. Of course alternative
channels of inflationary pressures operating on
the money supply (such as government spending or "finetuning" tendencies) may be just as
hard to identify as cost-push pressures are.
Indeed, our study suggests that while we can
easily identify money-supply expansion as a
cause of inflation, we cannot easily explain why
the money supply grows. Neither major set of
theories--cost-push or government-spendingprovides convincing evidence on this point.
Fluctuations in interest rates (actually, credit
market conditions) may be able to explain
money-supply growth in relation to former
(pre-October 1979) Federal Reserve operating
procedures, but a definitive answer to this issue awaits further research.
In closing, we may note a few other implications of our results. First, the two monetary
base measures exerted significant effects on
many of the cost variables, and in some cases
actually outperformed the broader moneystock measures. This suggests that monetary·
base information can be useful in judging the
inflationary impact of monetary factors when
financial innovations (e.g., automatic trans·
fers) blur the meaningfulness of the money·
stock data. Thus, monetary policymaking need
not be totally at a loss in times of financial
innovation. Also, M-1 generally outperformed
the .broader M-2 measure, both in terms of the
statistical reliability of its effect on various cost
variables and in terms of its independence of
such variables. This observation will not resolve the long-standing M·l vs. M-2 controversy, but it should provide a useful piece of
evidence on that subject.
64
REFERENCES
Anderson, Leonall and Jordan, Jerry. "The Monetary
Base-Explanation and Analytical Use," Federal Reserve Bank of St. Louis, August 1968, pp. 7-11.
Jacobs, Rodney, Leamer, E. and Ward, M.P. "Difficulties
With Testing for Causation," Dept. of Economics, University of California at Los Angeles, manuscript, 1978.
Barro, Robert J. "Are Government Bonds Net Wealth?"
Journal of Political Economy, November 1974 pp.
1095-1117.
Johnson, Harry G. "The Keynesian Revolution and the Monetarist Counter-Revolution." American Economic
Review. May 1971, pp. 1-14.
- - . "Unanticipated Money Growth and Unemployment
in the U.S." American Economic Review, March
1979, pp. 101-115.
Means, Gardner. "Industrial Prices and Their Relative Inflexibility." A Report to the Secretary of Agriculture. Senate Document 13, 74th Congress, 1935.
- - and Grossman, H.1. Money, Employment, and Inflation. Cambridge University Press, 1976.
Bazdarich, Michael J. "inflation and Monetary Accommodation in the Pacific Basin," Federal Reserve Bank of
San Francisco Economic Review, Summer 1978, pp.
23-26.
Bronfenbrenner, Martin and Holzman, F.D. "Survey of Inflation Theory." American Economic Review, September 1963, pp. 593-661.
Business Week. "An Uneasy Balance for the U.S. Economy," Dec. 26, 1977, p. 52.
- - . "A Year of Slowdown and Inflation," Dec. 25,1979,
pp.70-74.
Euromoney. "What the Forecasters Expect for the World
Economy." October 1978, pp. 161-178.
- - . "The World Economy in 1980," October 1979, pp.
185-216.
Friedman, Milton. "The Quantity Theory of Money: A Restatement," in Studies in the Quantity Theory of
Money. University of Chicago Press, 1956.
- - - and Modigliani, Franco. "The Monetarist Controversy: Discussion." Federal Reserve Bank of San
Francisco Economic Review, Spring 1977 Supplement.
Gordon, Robert J. "World Inflation and Monetary Accommodation in Eight Countries." Brookings Papers on
Economic Activity, 1977, pp. 409-477.
Haberler, Gottfried. "Wage Policy and Inflation," in P. Bradley
(ed.), The Public Stake in Union Power, 1959, pp.
63-85.
65
- - . "The Administered Price Thesis Reconfirmed."
American Economic Review. June 1972, pp. 292306.
Metzler, Lloyd G. "Wealth, Savings, and the Rate of Interest." Journal of Political Economy, 1951, pp. 93116.
Niskanen, William. "Deficits, Government Spending, and
Inflation: What is the Evidence?" Journal of Monetary
Economics, August 1978, pp. 591-602.
Patinkin, Don. Money, Interest, and Prices, 2nd Edition,
Harper and Row, 1963.
Plosser, Charles. "Time Series Analysis, Seasonality, and
Econometric Models," H.G.B. Alexander Research
Foundation, Graduate School of Business, University
of Chicago, manuscript, 1975.
Sargent, Thomas. "Notes on Stochastic Equations," Working Paper #66, Federal Reserve Bank of Minneapolis,
1976.
Schlesinger, James R. "The Role of the Monetary Environment in Cost Inflation." Southern Economic Journal,
July 1957, pp. 12-27.
Wachtel, H.M., and P.D. Adelsheim. "The Inflationary Impact
of Unemployment: Price Markups during Postwar
Recessions, 1947-70." Study Paper # 1, Achieving the
Goals of the Employment Act of 1946-Thirtieth
Anniversary Review. Study Prepared for the Joint
Economic Committee, 94th Congress, 1976.
APPENDIX
Alternative Estimation Forms
This Appendix discusses the results of estimations of alternative equation forms for
equations (1) and (2), for the variables listed
in Table 2. Once again, Table 2 showed the
results of estimating the equations:
8
8
y,
ex
+ L[3y,_j + L1' jX,_j +
1
X, =
I)
+
8
Lnjx _i
1 '
2 were re-estimated, first under a specification
of second-degree PDL for all lag sets, and then
under a specification of third-degree PDL for
all sets. No further constraints were imposed
on the lag structure. The results of these estimations are shown in Tables A-I and A-2 respectively. Also, by comparing the results of
the PDL with that of the OLS estimation of
the same equation, the suitability of the POL
specification can be tested. An F-test can be
derived, a significant value of which would indicate that the data are inconsistent with the
POL specification. These F-statistics are
shown in Tables A.I and A.2, along with the
F-statistics for the hypothesis that the explanatory variable does not "cause" the dependent
variable.
For example, consider the first set of results
in Table A.I. The first F-statistic of 6.2 indicates that the effect of M-Ion the CPI is significant at the I-percent level. The 0.8 "POL"
F-statistic (not significant) indicates that the
second degree POL assumptions for this
regression are not inconsistent with the data.
The 0.3 F-statistic shows that the effect of the
CPI on M-I is statistically insignificant. The
3.9 "PDL" F-statistic indicates that the POL
assumption for this regression is inconsistent
with the data, i.e. that the equation regressing
M-I growth on lagged M-I growth and CPI
inflation has coefficients which do not obey a
second-degree polynominal specification.
The results of Tables A.I and A.2 are clearly
similar to those of Tables' 1 and 2. While the
F-statistics suggest that POL assumptions are
generally inappropriate for regressions using
money-supply growth-especially M-l growthas the dependent variable, this generally mirrors the inappropriateness of the POL for the
time-series behavior of the money supply itself. Generally, the feedback effects on inflation indicators themselves on the money supply are too weak or non-existent to be
materially distorted by POL assumptions.
Finally, Niskanen (1978) has referred to an
obvious change in the conduct of monetary
policy starting in the late 1960's. If policy re-
E lt ,
(1)
1
8
+ LlLjY'_i +
E ZI '
1
(2)
The estimations of the equations (1) and (2),
as documented so far, were done through ordinary least-squares estimation (OLS), with no
constraints imposed on the structure of the lag
coefficients, other than the lag-length assumption.
While this technique is common in time-series analyses and causality studies, the reader
may object to the existence of multicollinearity
among the regressor variables, because of the
number of lagged regressors involved. A technique designed to minimize this multicollinearity and preserve degrees of freedom in
estimation is that of polynomial distributed
lags (PDL). This technique assumes that the
coefficients of a given distributed lag are related to each other through a polynomial function. For example, in equation (1), for the lag
set 1'10 ... , 1's, a second-degree PDL specification would assert that
1'j = af + bj + c,
j = 1, ... , 8
where a, b, and c are the coefficients of the
polynomial. This specification would necessitate estimation of only three parameters, a, b,
and c, rather than eight, 1'1' ... ,1'w Also, the
technique for estimating this equation would
use three variables, Sit ' Sz, ' and S3' which are
linear combinations of X'_I' . . . , x,_s' and allegedly the multicollinearity among these three
variables would be less of a problem than that
among the eight lagged values of X, .
Without speculating on the validity of this
technique, the equations summarized in Table
66
Table A.1.
Causality Tests Using an Unconstrained Second Degree
Polynomial Lag Structure (Eight Quarters Long) for All Variables·
M-l
Consumer Prices
All Items
Food
Excluding Food
F-PDl' F'
F'
0.3
6.2*** 0.8
004
5.9*** 0.7
M-2
F·PDl' F'
F-PDl' F'
0.9
3.9*"'* 4.2*** 0.7
St. Louis Base
F·PDl' F'
F-PDl' F'
3.0**
2.6**
2.1 **
3.1**
2.9**
1.9
0.7
1.7
3.0**
2.6*
0.3
104
2.9***
4.2***
4.1 "'*'"
2.3*
0.8
0.9
0.3
1.4
[A
0.7
0.7
0.8
0.9
0.7
0.9
4.9***
104
2.7***
4.5***
5.4***
3.1 **
4.1 ***
2.3*
3.0**
0.7
0.3
0.1
0.2
0.5
1.9*
2.2**
1.8*
2.3**
10***
2.1 **
2.0**
1.3
3.0***
1.3
3.5***
1.7
1.6
Wages For
Nonagricultural
Workers'
Manufacturing
2.4*
3.1 **
2.0*
0.8
0.7
0.6
0.9
2.0*
1.3
2.2**
104
0.1
0.6
0.8
1.9*
1.9
4.3***
3.2***
3.7**
Unit Labor Costs
Private Business
Manufacturing
Non-Farm
6.6***
4.5***
6.6***
0.6
104
0.7
0.7
0.3
0.5
3.2**
3.5**
3.3**
0.7
1.5
0.7
l.l
[A
004
004
1.5
1.0
1.3
Unemployment Rates
All Workers'
Males 25-44'
6.4*** 9.2***
4.4*** 6.0***
1.2
0.7
0.3
0.3
3.7**
304**
7.8***
4.9***
1.8
1.6
Wholesale Prices
All Items
Non-Farm
Farm
Metals
Steel
Fuel
Petroleum
Implicit Deflators
GNP
Personal
Consumption
Expenditures
4.6***
0.7
1.0
5.8***
6.2***
4.1***
4.7***
3.6**
5.0***
0.8
1.2
1.2
2.0**
0.2
0.1
1.5
004
0.6
0.4
1.2
0.8
104
1.7
1.3
1.5
Source Base
F-PDl' F'
1.2
1.2 1.0
0.3 0.7
0.2
2.8**
1.3
F-PDl' F' F-PD[
1.1
0.3 1.6
1.0
0.8
1.4
0.6
1.2
2.5*
1.4
2.8*
2.7**
2.9**
1.5
1.6
3.3***
1.5
2.6***
2.5**
1.5
3.2***
0.5
0.5
1.2
1.1
1.1
1.1
0.9
1.0
0.8
0.3
0.3
1.3
1.1
5.5***
1.3
1.2
0.1
0.3
0.5
0.5
0.2
0.2
0.2
0.7
0.8
0.7
1.8*
1.2
1.0
0.8
0.5
004
0.9
1.2
6.0***
5.7***
1.9*
1.9*
0.9
0.2
1.2
204**
3.5**
2.2*
3.8**
0.5
1.7*
0.7
0.8
0.6
0.8
1.6
1.8*
1.7*
4.4***
2.6*
3.9**
0.9
2.1 **
0.8
0.3
0.3
0.3
0.6
0.9
0.6
2.1
1.6
8.9***
5.3***
1.6
1.0
2.3**
1.6*
1.5
8.1 *** 0.1
0.8
1.6
1.0
3.6***
004
1.1
2.2**
1.7*
3.0***
104
1.7
1.1
2.8**
2.5*
2.7**
2.1 **
2.1 **
1.8*
3.0***
1.1
0.9
104
4.5***
1.3
1.6
0.6
2.7*
1.1
1.7
104
4.7***
0.9
0.8
1.8*
2.9**
0.5
0.8
1.9*
5.6***
0.6
0.5
0.8
4.3***
1.2
1.1
1.7*
3.8**
0.7
0.2
1.8*
3.9**
1.0
1.1
0.9
Government Deficit'
1.2
2.9* '" '"
3.5** 1.3
0.9
1.9*
3.1** 1.8*
1.6
1.8*
1.6
104
4.0**
2.0**
2.1 * 1.8*
Deficit/GNP Ratio'
1.4
1.8*
0.9
1.3
0.1
2.6**
0.5
104
0.9
1.8*
0.5
0.8
1.3
2.1 **
0.3
1.5*
Government
Spending
1.0
2.6***
0.1
2.2**
004
2.5**
0.3
3.2***
0.7
2.9* '" '"
0.1
1.0
1.2
2.8***
0.7
1.3
'The first column in each set shows the F-statistic for the effect of the respective monetary aggregate on the "cost" variable; second column shows thl
F-statistic for the hypothesis that a second degree PDL fits this relation; third column shows the F-statistic for the effect of the "cost" variable on tht
monetary aggregate; fourth column shows the F·statistic for the PDL for this relation.
'Significant at 10% level.
"Significant at 5% level.
"'Significant at 1% level.
IF-statistic tests the hypothesis that the explanatory variable has no effect on the dependent variables. 'F-statistic tests the hypothesis that the PDt
constraint is consistent with the data. 'Sample period: 1966.2-1979.2. '''Cost'' variables are in level form. sThis result is between the deficit and
difference in the respective monetary aggregate.
fi",
67
of freedom. Also, some of the results were rerun over the 1959.2-1979.2 period in OLS form
with a dummy variable for the last ten years,
in an attempt to pick up obvious shifts in the
money-supply accommodation equations. These
estimations did not show any substantive
changes in the causality results, nor were any
signs of a shift in policy behavior apparent.
action did indeed shift starting in the late
1960's, one might expect the causality results
between the money supply and various cost
indicators to be different in the last ten years
than in the previous ten. As a first attempt to
allow for such changes,somepf the results in
Table 2 were re-run with a sample period consisting of 1969.2-1979.2, and a third degree
PDL specification imposed to preserve degrees
Table A.2
Causality Tests Using an Unconstrained Third Degree Polynomial Lag Structure
(Eight Quarters Long) for all Variables·
M·l
M·2
St. Louis Base
Consumer Prices
All Items
Food
Excluding Food
F-PDL'
5.0*** 0.8
4.9*** 0.6
3.3"
0.8
Wholesale Prices
All Items
Non-Farm
Farm
Metais
Steel
Fuel
Petroleum
5.0'" 0.7
3.8**'" 1.0
3.9*** 1.0
3.8"* 1.6
3.0" 0.6
3.8*** I.I
4.0*** 2.8"
0.2
0.4
0.3
0.5
0.5
0.2
1.7
2.1'
2.3"
2.0'
2.3"
3.1 ***
2.3"
1.5
Wages For
Nonagricultural
Workers'
Manufacturing
1.8
2.2*
2.3"
1.0
0.5
0.7
10
2.0*
1.1
2.6'*
2.7'*
1.8
0.2
0.5
0.8
0.2
1.6
5.3*** 0.4
0.6
0.4
0.5
0.6
0.3
0.2
3.3*'
2.8"
3.2'*
0.3
4.9***
3.7***
3.6***
3.1 ***
l.l
0.7
0.2
0.1
Unit Labor Costs
Private Business
Manufacturing
Non-farm
Unemployment Rates
All Workers'
Males 25-44'
F'
5.6***
3.5"
F'
F-PDL' F'
0.2
1.1
2.0'
4.5***
2.8**
3.3**
3.8***
4.1 ***
1.8
F-PDL'
0.8
0.6
1.0
F'
0.7
0.3
2.8'*
0.7
1.0
0.8
1.2
1.0
1.2
1.3
1.8
0.2
2.2*
1.2
1.0
3.3** '" 1.9
F-PDL' F'
3.7***
2.6'*
3.1'*
3.1 ***
1.7
1.6
F-PDL'
0.8
0.7
1.6
Source Base
F'
F-PDL'
0.4 1.2
1.2 0.9
0.3 0.7
0.7
0.8
0.5
2.1 **
1.3
0.8
0.8
F-PDL'
1.4
1.3
0.9
F-PDL
F'
0.7 1.3
1.1 l.l
1.1 0.8
2.1 '
2.2'
1.6
3.1**
2.8*'
2.0
1.4
0.3
0.8
1.1
1.4
0.9
1.6
2.3**
19
3.5'*
3.6***
2.8***
1.0 0.9
0.3 1.3
5.0'"
4.1 ***
2.1 *
2.4'*
1.0 0.9
0.8 1.1
0.4
1.1
05
1.0
1.0
l.l
07
2.7"
2.0
3.5**
0.3
1.9
0.4
0.6 1.8
0.4 2.1"
0.7 1.6
3.4**
2.0
1.5*'
0.8
2.5**
0.5
0.2 0.5
0.9 0.6
0.2 0.5
2.2'
2.4*
3.1 ***
2.4**
1.7
0.9
1.1
1.4
1.8
3.7** '"
2.3**
1.3 2.7*'
0.9 1.8
0.2
0.5
3.6***
1.6
1.2
0.3 0.7
0.4 1.0
3.8***
3.3'*
2.6'*
2.5**
1.7
2.0
1.0
1.7
1.7
2.1 *
2.1 '
2.8*'
3.8***
1.9*
15
0.2
0.2
0.6
0.5
0.7
0.7
3.0*** 0.2
F'
2.2*
0.9
4.0'*'
1.6
1.6
0.5 1.0
1.9*
0.6 0.9
1.1
1.7
1.0 0.7
4.0* *' 1.5
0.9 0.8
3.9*** 0.9
0.8 0.7
3.0** 0.9
0.3 1.3
II
3.6*** 0.4 0.9
4.1 ***
Implicit Deflators
GNP
Personal
Consumption
Expenditures
3.8***
14
1.3
0.5
2.5"
II
1.5
10
3.6***
10
0.5 2.2"
2.7'
0.5
0.5
2.2**
4.2***
0.6
0.4
0.9
3.0"
1.4
08
1.4
2.8**
0.7
0.3 2.1 .,
3.4'*
0.9
0.7
10
Government
Deficit'
0.7
2.6"
2.7"
15
0.7
1.4
2.4'
2.0'
1.4
1.2
1.8
2.8**
1.6
2.9'* 1.2
Deficit/GNP
Rati04
0.9
2.3"
0.7
1.3
0.1
3.2***
08
15
0.7
2.2'*
0.9 06
1.3
2.4**
1.5 0.9
Government
Spending
0.8
2.1**
0.3
2.3**
0.3
2.1 **
1.2
3.3***
06
2.4'*
0.7 0.8
110
2.3'*
0.4
1.4
1.2
'First column in each set shows the F-statistic for the effect of the respective monetary aggregate on the "cost" variable; second column shows the Fstatistic for the hypothesis that a third degree PDL fits this relation; third column shows the F-statistic for the effect of the "cost" variable on the
monetary aggregate; fourth column shows the F-statistic for the PDL for this relation.
'Significant at 10 percent level.
"Significant at 5 percent level.
.. 'Significant at 1 percent level.
'F-statistic tests the hypothesis that the explanatory variable has no effect on the dependent variables.
'F-statistic tests the hypothesis that the PDL constraint is consistent with the data.
'Sample period: 1966.2-1979.2.
'''Cost'' variables are in level form.
'This result is between the deficit and first difference in the respective monetary aggregate.
68
FOOTNOTES
mies do in the regressions done here. Stochastic seasonality must be handled in other ways, such as through the
fourth- and eighth-order autoregressive coefficients in the
equations in the text.
1. Johnson's (1971) is the best known use of this phrase.
Earlier users are cited by him as well.
2. This is obviously a very capsule treatment of the neutrality-of-money hypothesis. Among other things, it implicitly
assumes 1) that economic actors do not have "money illusion," and so will not feel better (worse) off if nominal wealth
and all money prices increase (decrease) by an equal proportion; 2) that government bonds do not represent net
wealth to the private sector (that is, the interest payments
forthcoming from them are offset by future tax revenues
needed to service the debt-see Barro (1974) for a discussion of this, and Metzler (1951) for a model where the net
wealth status of bonds prevents neutrality); and 3) that the
distribution of wealth in an economy is not irretrievably altered by the process of convergence to equilibrium following
an increase in the money supply. See Patinkin (1963), Friedman (1956), or Barro and Grossman (1976) for extended
treatments of these issues.
Plosser (1975) provides a more complete discussion of
these issues. Also, Sargent (1976) discusses how the use
of seasonal filters to "pre-whiten" data can distort the results
in Granger causality tests.
7. Also, the quarterly level observations used are end-ofperiod observations for the quarter rather than quarterly
averages. Computing rates of change for averaged data
can be shown to introduce spurious effects, and so this
practice was avoided.
8. That is, the levels of the variables used here generally
have increasing time trends, and so are very likely nonstationary. Therefore, percent changes were computed to attempt to induce stationarity. While inflation rates would also
seem to have shown some trend over the last twenty years,
these are, in any case, clearly more stationary than price
levels. For the equations summarized in Table 1, the sum
of the coefficients for the lagged dependent variable, while
large, were uniformly below 1, in the .5-.7 range, suggesting
that the implicit stationarity assumptions behind these equations hold at least approximately.
The neutrality hypothesis does not rule out grow1h in output
or employment over time, but only specifies that these will
eventually be unaffected by the level of the money supply.
Nor does neutrality imply that real variables are independent
of the rate of change of the money supply, this latter concept being commonly known as "super neutrality."
The reader should note that these neutrality concepts, while
convenient for showing the effects of money on prices, are
not necessary conditions for the inflationary effects of an
increase in the money supply.
9. The St. Louis base is adjusted for shifts in deposits
between large (high reserve requirement) banks and small
(low reserve requirement) banks, as well as for shifts in
general reserve requirements, in order to capture the "deposit-creating" power of a given stock of currency and reserves. For a detailed explanation of this series, see Anderson and Jordan (1968).
3. This point is discussed in Jacobs et al. (1978).
4. Monetary discussions of inflation state that sustained
changes in the rate of money-supply growth, relative to
previous trends, will lead to changes in the trend rates of
change in prices and wages. This description allows for the
possibility that a positive rate of money-supply growth (usually estimated at about 1% per year for M-1 in the U.S.) will
allow a zero inflation rate. Even in this case, it is still true
that sustained changes in money grow1h above this rate will
lead to sustained inflation.
10. Using the variables in equation (1), if x were held at a
stationary value x, y would approach the stationary value y,
where
y
y
a
=
+
~f3iY
+
~'Yix, so that
a/(1
Therefore, in the long-run, y responds to sustained changes
in x by a factor of ~'Yi/(1 - ~f3j), which is how the long-run
effects in Table 1 are computed.
5. Because lagged dependent variables are included in
equations (1) and (2), the eight-quarter lag structure does
not constrain the total lag from the explanatory to independent variables to be eight quarters or less. That is, in
(1), Ytdepends on Yt.l, ..., Yt.B, but since YI·Bdepends on Xt·1B,
Ytwill then indirectly depend on xl.1B, and a very long lag can
be estimated by the equation form described in the text.
It is important to keep in mind that the significance of the Fstatistic does not necessarily say anything about the significance of the long-run effects also shown in Table 1 (and in
Table 2 below). This is because the F-statistic is for the
hypothesis that the whole vector bl,"" 'YB) in (1) (or
(f.Lj, ..• , f.LB) in (2)) is equal to a zero vector, while a test of
the long-run effect would concern whether ~'Yj in (1) (or ~
f.Lj in (2) was equal to zero. Thus it could well be that the 'Yvector differs significantly from zero, but that the individual
coefficients vary in sign so that their sum is negligibly different from zero. Indeed, this is the case for the regressions
of M-1- and M-2-growth rates on CPI inflation, as discussed
in the text.
6. Deterministic seasonality refers to the perfectly predictable seasonal variation in a variable, while stochastic seasonality refers to seasonal fluctuation that varies randomly,
perhaps in correlation with other seasonal variables. For
example, suppose M-1 's growth rate was on average 6
percentage points higher in the fourth quarter, due to Christmas financing needs, than in the first quarter. Then M-1
would have a deterministic seasonal component of 6 percent in the fourth quarter relative to the first. However,
fluctuations in this seasonal difference would still exist due
to random seasonal factors, and these would represent
stochastic seasonality.
On the other hand, it should be clear that if the 'Y-vector (f.Lvector) is not significantly different from zero, the sum of its
coefficients cannot be significantly different from zero.
Therefore, significance of the F-statistic is a necessary but
not a sufficient condition for the significance of the long-run
effect.
Deterministic seasonality can be handled by extracting seasonal means from the data, which is what seasonal dum-
69
Tests of the significance of the long-run effect could be
conducted by running another regression in which the longrun effect was constrained to zero, for (1) by imposing the
linear constraint ~'Yj = 0 on the data-just as the significance
of the "I-vector was tested by running another regression
with the 8 linear constraints 'Yj = 0, j = 1,...,8 imposed on the
equation, I.e. by dropping the Xt.j regressions from '(1). These
tests of the long-run effects were not conducted in order to
economize on computer time, especially in view of the general lack of significant F-statistics for the accommodation
equations initially.
CPI inflation rate in 1974-somewhat below the actual recorded rate of 12.2%, but nevertheless suggestive of a very
inflationary monetary climate.
17. That is, inflation was forecasted for 1971.3 using previous money-supply growth, and this forecast amount was
then used as the lagged dependent-variable value for
1971.3 in subsequent quarters, and so on. Thus, no actual
1971.3-1975.4 inflation information was used in generating
these simulations, although actual money-supply growth
was used.
18. Also, allowance was made for the effects of automatic
transfers (ATS) onM-1. Due to the emergence of ATS, it's
clear that M-1 demand would grow at a slower rate than
previously, and therefore that a given rate of M-1 growth
would be more inflationary immediately after the inception of
ATS than before its inception. The Federal Reserve Board
of Governors Staff estimates that ATS had about a 1.5%
effect on M-1 growth in late 1978 and early 1979, by which
time the effect was largely completed. Therefore, in these
simulations, the actual levels of M-1 were increased by
0.75% in 1978.4, and by 1.5% in 1979.1 and 1979.2, so
that M-1 growth rates in 1978.4 and 1979 were both increased by 0.75 percentage points. Other aggregates were
not altered.
11. This argument was attributed to Haberler by Milton
Friedman.
12. Since the deficit and first difference in the money-supply series already have a decided trend, the seasonal
means of. these variables also have a trend over time, so
that seasonal dummies would be expected to do a poor job
of removing even deterministic seasonality from the data.
Therefore, seasonally adjusted data were used for this test,
further clouding the meaningfulness of its results.
13. The long-run effects can be easily cOl.lputed from the
estimated equations. However, computing the significance
of differences in these long-run coefficients from zero or
unity, involves estimating another equation (one in which
the long-run effect is constrained to zero or one) and then
comparing the two equations. Since a substantial number
of equations had already been run in compiling Table 1,
tests of the significance of the long-run effects were not
generally conducted.
In order to continue the simulations through 1981.4, growth
rates for the aggregates in the 1980.1-1981.4 period were
assumed to be 5% for M-1, based on the current midpoint
of the Federal Reserve's long-run target ranges.
14. Gordon (1977) presents an interesting discussion of
these and other effects, and the various theories citing
them.
19. That is, these simulations use actual money-supply
growth through 1979.4. Since they are therefore conditioned
on this information, they are not true forecasts.
15. In considering these issues, Bazdarich (1978) found
that money-supply growth was actually significantly lower
in a number of Pacific Basin countries (including the U.S.)
than would be expected given inflation and previous money
growth. This also suggests a lack of accommodation in this
period.
16. A similar calculation was performed by Friedman in an
exchange between him and Modigliani (see Friedman and
Modigliani (1977)), with much the same results.
20. The simulations or "conditional forecasts" shown in
Table 4 represent the compounded sum of quarterly inflation
forecasts for the year in question. Thus, they represent
December/December or fourth-quarter/fourth-quarter measures of inflation. For this reason, lists of forecasts appearing
in Euromoney (1978, 1979) and Business Week (1977,
1978) are not included in Table 4, since those forecasts
were apparently on a year/year basis (using yearly average
price levels). Still, this exclusion weakens the present paper's results, if anything, since the excluded forecasts are
all much lower than the Table 4 results.
In a subsequent part of that discussion, Modigliani claims
that the Nixon Administration price controls "had no effect
whatever on wages ... (and) a small effect on prices, and
that it washed out fairly quickly." Yet the simulations discussed in the text showed a run of positive simulation errors
(over forecasts of inflation) during the controls period, and a
run of negative errors immediately following the controls
period. For example, the "bracketed sample" M-1 - CPI
simulation from 1971.3-1972.4 showed six straight positive
simulation errors generally larger than 2 percentage points
on an annualized basis, and summing to 4 percent over
"forecast" of the price level over the controls period. In
1973, when the controls were being phased out, two small
overforecasts were followed by one small underforecast.
Then, through 1974.4, five straight sizable under-forecasts
were found, with a cumulative underforecast inflation in the
post-controls period of 3.3%. This provides at least impressionisticevidence that the controls transferred price increases across periods.
The forecasts shown in Table 4 were all computed on a
fourth-quarter/fourth-quarter basis from published forecasts.
In passing, it can be shown that year/year inflation figures
inevitably involve heavy use of previously available figures,
so that the ability to forecast December/December inflation
rates is a better gauge of the predictive power of a given
forecasting technique.
21. Actually, in view of the eight-to-ten quarter lag that
occurs before money-supply expansion has had its full effect on inflation-implied by the equations estimated here
and found in many other studies-the use of actual moneysupply growth has little effect on predicted inflation rates in
the first year of each simulation. The effect is probably less
than half a percentage point, compared to simulations using, say, the midpoints of Federal Reserve target ranges or
other forecasts of money-supply growth. Thus, the simulation predictions are in fact probably close to money-supplybased forecasts that might have been made at the dates
shown.
Finally, even without any allowance for the possible delaying
effect of controls on inflation, this simulation predicted a 9.2%
]0
@FedFRASER