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2
I.
Consumer Experiences With Credit Insurance:
Some New E v id en ce............................................................... 5
Anthony W. Cyrnak and Glenn B. Canner
II.
Japanese Monetary Policy, Flow o f Funds,
and Domestic Financial Liberalization.........................
21
Thomas F. C argill
III.
Japan’s “Money Focused” Monetary P o lic y ..................... . 33
M ichael M. Hutchison
IV.
Deposit Rate Deregulation and
the Demand for Transactions M e d ia ..................................... 47
M ichael C. Keeley and Gary C. Zimmerman
V.
Financial Deregulation, Interest Rates,
and the Housing C y c le ............................................................. 63
Adrian W. Throop
Editorial Committee:
Brian Motley, Frederick Furlong and Reuven Glick.
3
4
ith
Anthony W. Cyrnak* and Glenn B. Canner**
Credit insurance is a product that has been steeped in controversy for
many years. This article examines several issues surrounding the marketing and sale of credit insurance through a recent survey on consumer
experiences with the product. Survey findings indicate that credit insurance is purchased frequently, that consumers generally do not feel
pressured into buying the product, and that consumers view credit
insurance quite favorably. Past abuses in the marketing and sale of credit
insurance therefore may have been overstated or have declined in recent
years.
some governmental authorities to take note once
again. Recently, the Federal Reserve's Consumer
Advisory Council, an advisory group consisting of
30 financial industry, regulatory, and consumer
representatives, expressed interest in credit insurance practices and the attitudes of borrowers toward
them. Also of late, mandatory competitive rate
bidding (for credit insurance) in Massachusetts has
been the object of intense scrutiny by industry
observers.! Pressures for greater banking deregulation and attempts by some banking organizations to
gain permission to conduct specific new insurance
activities, such as underwriting and selling home
mortgage insurance, also have called attention to
insurance practices. 2
Finally, considerable discussion has arisen concerning an amendment to the Federal Reserve System's Regulation Y. This amendment eliminates a
longstanding requirement that bank holding company subsidiaries proposing to engage in the underwriting of credit insurance demonstrate public benefits in the form of a rate reduction (see Box).
In view of the continuing interest in credit insurance, it seems worthwhile to examine the nature of
this product and to review some of the issues surrounding it. This paper also reports some new
evidence on the frequency of credit insurance pur-
The sale of credit insurance in connection with
extensions of consumer credit has been a controversial subject for many years. Sold by various types of
financial institutions and some retailers, credit
insurance is designed to repay a borrower's debt in
the event of his death or disability. Credit insurance
has been controversial because of its alleged high
cost in many states and because of allegations of
abusive marketing and sales practices. The credit
insurance industry has responded to such criticisms
by arguing that rates are reasonable in view of the
circumstances under which credit insurance is sold.
Also, while acknowledging the existence of some
abusive practices in the past, industry representatives argue that most abuses have been eliminated in
recent years.
Credit insurance will likely remain a controversial product. A strong rise in consumer debt during
the 1980s has caused both consumer advocates and
* Economist, Board of Governors of the Federal
Reserve System, and Visiting Economist, Federal
Reserve Bank of San Francisco.
** Economist, Board of Governors of the Federal
Reserve System.
5
6
chases, borrower perceptions about lender recommendations to buy credit insurance, and overall
borrower attitudes toward this product. Based upon
these survey results, some inferences are drawn as to
the likely validity of some of the criticisms levied at
the sale of this insurance product.
Section I describes the nature and primary types
of credit insurance. Section II focuses on various
marketing and sales abuses (including tie-in sales)
that have been alleged by some industry critics. The
third section presents an analysis of the results of the
1985 Federal Reserve Board survey of borrower
experiences with credit insurance. These results are
compared to those found in a similar Board-sponsored survey conducted in 1977.
Two important conclusions emerge from the
consumer surveys. First, consumers believe that
creditors base their decisions to grant credit on
factors other than consumer decisions whether to
purchase credit insurance. Second, consumers who
purchase credit insurance believe it is a valuable
product and would be inclined to purchase insurance in the future. The final portion of the paper
summarizes the findings.
I. Credit Insurance
insurance is designed to repay a borrower's debt in
the event of a loss of income due to illness or injury.
A&H credit insurance entails greater risk of loss to
the underwriter and is more difficult to administer
than credit life. Consequently, it is more costly to
offer than credit life insurance. Borrowers may be
required to be employed at the time that coverage is
extended and usually face restrictions concerning
pre-existing health conditions. Frequently, A&H
policies feature a "retroactive" clause that requires a
borrower to be disabled for a specified time before
insurance payments begin. Once this time requirement is met, however, insurance payments are made
retroactively to the first day of disability.
A third type of credit insurance is credit property
insurance, which provides coverage for personal
property purchased with a loan. It may also insure
collateral property.
Credit insurance policies are written by various
types of insurance companies. Those that deal primarily in credit policies are known as "specialty"
companies and are the largest issuers of credit
insurance policies. A second type of credit insurer is
a "captive" insurer - a firm that is owned by a
single creditor or group of creditors through a second company, usually a "reinsurer." A third type of
credit insurer is the general or full-line life insurance
company.
Credit insurance typically is sold to borrowers in
connection with the extension of credit by a lender,
usually a financial institution or retailer. It is
designed to ensure the repayment of a borrower's
debt in the event of death, disability or loss of
property. The types of credit extensions that are
usually covered include automobile loans, personal
loans, and installment purchases of appliances as
well as other consumer goods 3 . Generally, credit
insurance is sold to a lender by an insurance underwriter on a group basis. The lender holds the policy
and issues a certificate of insurance to any borrower
who purchases credit insurance. The lender is
named beneficiary and directly receives any payments made on submitted claims.
There are three basic types of credit insurance:
credit life, credit accident and health, and credit
property insurance. Credit life is the most commonly purchased type of credit insurance and
provides for the repayment of a loan in the event of
the borrower's death. Credit life insurance first
appeared in the early 1900s to insure automobile
loans. It typically is written as declining term insurance, that is, coverage decreases as the loan is
repaid. At the beginning of 1985, there were nearly
66 million credit life policies in existence in the
U.S. with in-force coverage of $190 billion. 4
Accident and health insurance (A&H) is also
known as credit disability insurance. A&H credit
7
II.
Credit Insurance - Consumer Issues
Credit insurance, particularly credit life insurance, has characteristics that distinguish it from
other types of insurance. For example, unlike regular life insurance, it is made available in small
amounts of coverage, and its premium rate does not
depend on the insured's age or health (although
credit life insurance is usually not made available to
borrowers over the age of 65). It is usually sold by
the creditor directly at a premium rate that is constant regardless of the size of the loan or its maturity.
Generally, no proof of insurability is required, and
credit insurance usually cannot be cancelled. As a
result of these characteristics, credit insurance may
offer important advantages to certain borrowers who
find it to be a convenient and economical way to
purchase protection against debt default.
Industry critics, however, contend that while
credit insurance offers borrowers some advantages,
its sale has often been associated with abusive and
even illegal practices. Their criticism has centered
on several issues including the cost of credit insurance and the manner in which credit insurance has
been marketed and sold. These issues present difficult questions, and they warrant further discussion.
sex, marital status, or different personal habits such
as smoking or nonsmoking.)
The cost issue does not lend itself to an easy
resolution. Most observers agree that credit insurance rates should be set at a level that will allow for
the payment of claims, provide reasonable lender
compensation, and ensure normal profits to insurance underwriters. To achieve these goals, the
National Association of Insurance Commissioners
recommends that states set prima facie maximum
rates at levels that will generate a target "loss ratio"
(ratio of premiums paid out to premiums collected)
of 60 percent. Maximum allowable rates for credit
life insurance (and actual loss ratios), however, vary
widely, ranging from as much as $1.00 per hundred
dollars of insurance in some states to as little as
$0.28 per hundred dollars in others.
Wide variations in maximum allowable credit
insurance rates among states, moreover, are not well
explained by what are believed to be only minor
differences in the costs of providing insurance in
different states. Rather, industry critics contend that
the allegedly high prima facie rates found in certain
states result from several factors, including a lack of
organized consumer pressure for lower rates, a low
level of concern by state insurance regulators,
strong industry lobbies that seek to maintain existing rate structures, and market conditions that are
perceived as conducive to noncompetitive pricing
behavior.
The level at which legal maximum rates are set is
a concern because in most states lenders tend to
charge the highest rate permitted. This practice
exists because lenders are typically compensated for
credit insurance sales by receiving a portion of the
collected premiums (up to 60 percent in some
states). Although state laws generally limit the size
of this commission and prohibit lenders from marking up the cost of insurance to borrowers, lenders
(by sharing in the premiums collected) as well as
insurers profit from charging higher premiums.
Lenders have the ability to charge maximum
allowable rates only when borrowers have an inelastic demand for credit insurance since revenue to the
lender would then increase as price rises to the state
Credit Insurance Rates
One important concern of industry critics is that
credit insurance is relatively expensive, particularly
in comparison with other types of insurance such as
term life insurance. Lenders and insurers have
responded by arguing that the circumstances in
which credit insurance is sold justify higher premium rates. They argue that the administrative costs
of providing credit insurance are high compared to
other forms of insurance. Indeed, the small average
size of credit insurance policies and the presence of
some fixed costs in administrating and servicing
policies suggests that there may be some validity to
this point. Also, they argue that credit insurance
sales are subject to an "adverse selection" process
that permits purchasers of varying ages to obtain
credit insurance at the same premium rate. Typical
term life policies account for variations in risk by
charging different rates to individuals with different
risk profiles (for example, different ages, health,
8
borrowers into purchasing credit insurance by
threatening, either explicitly or implicitly, to withhold credit unless the borrowers also buy credit
insurance? Eisenbeis and Schweitzer have argued
that such coercion is likely to be more successful in
markets where lenders enjoy some degree of
monopoly power in the granting of credit. 7 An
example of such a market might be one that
ex.hibited high concentration, had few lenders,
maintained restricted entry conditions, and presented high search costs for alternative sources of
credit. 8
ceiling rate. This demand inelasticity might derive
from several sources. Borrowers may be unaware of
alternative sources of credit insurance or of substitute products (such as increasing existing life
insurance coverage). Inelastic demand also could be
the result of a desire to minimize search costs for
alternative sources of credit insurance - especially
since the cost of credit insurance typically accounts
for a small proportion of total loan costs.
Tying Arrangements and Credit Insurance
A second major issue that surrounds credit insurance is that of "tie-in" sales between the granting of
credit and the sale of credit insurance. Tie-in sales or
"tying arrangements" occur when the purchaser of
some product (the tying good) agrees or is required
to purchase a second good (the tied good) from the
seller as a condition to the purchase of the first good.
Involuntary tie-ins through explicit contractual
arrangements are generally prohibited under
various federal laws including Section 3 of the
Clayton Act, Section 1 of the Sherman Antitrust
Act, and Section 106 of the Bank Holding Company
Act.
The economic rationale for tying arrangements
has been explored thoroughly in the antitrust literature by such authors as Singer, Scherer, and
Edwards. 5 This literature argues that tying arrangements may accomplish several objectives for the
seller. One, firms may realize sales economies by
distributing tied products together. Two, tying
arrangements have been used to protect the reputation of a firm's products by ensuring that compatible
joint inputs are used in production processes. Three,
tying arrangements have been used to circumvent
price controls such as usury restrictions on consumer finance rates. 6
In the case of credit insurance, much of the debate
over tie-ins centers on whether the tying of credit
and credit insurance is due to a lack of competition.
That is, under what conditions can lenders coerce
Other Consumer Issues
Some ind1lstry observers have criticized other
aspects of the marketing and sale of credit insurance. They argue that the extent of coverage has
frequently been misrepresented to consumers. In
addition, they allege that consumers have suffered
from fraudulent and deceptive claims practices
(such as not being provided a copy of the insurance
policy or being subject to an extremely narrow
definition of "disability"). They also argue that
credit insurance often is sold in excessive amounts,
such as when creditors base the amount of coverage
on the sum of monthly payments (" gross
coverage") rather than the outstanding principal
balance ("net coverage"). At present, few states
require coverage to be made on a net basis.
Critics also argue that coverage sometimes is sold
for periods that exceed the term of the loan and that
unearned premiums often are not refunded when
loans are prepaid or refinanced. These and other
abuses have been discussed more extensively in a
number of previous studies of credit insurance practices. 9 While the extent of these practices has always
been a matter of intense debate, examples from
several recent court cases provide some evidence
that they exist. 10
9
III. Studies of Credit Insurance
Credit insurance has been discussed widely but
has been the subject of relatively few empirical
studies. Important studies of credit insurance
include efforts by the National Association ofInsurance Commissioners (NAIC, 1970), Hubbard
(1973), Huber (1976), and Eisenbeis and
Schweitzer (1979).11 The NAIC study surveyed
state insurance regulators and reported on the frequency of consumer complaints arising from coercive selling practices. A more comprehensive study
conducted at Ohio University (Hubbard) attempted
to determine consumer attitudes toward credit insurance and the extent to which consumers may have
been pressured into buying it. A consumer survey
was used to identify consumer perceptions about
tie-in sales of credit insurance. Huber, in an examination of the sale of credit insurance by retailers,
focused on the demand for credit insurance and how
it varies by different groups of consumers.
The most comprehensive empirical study of
credit insurance tie-in sales was the 1979 study by
Eisenbeis and Schweitzer. Using the results of two
surveys - one of consumers and the other of bank
holding companies - the authors constructed an
analytical framework that enabled the existence of
tie-in insurance sales to be revealed by a high
proportion of joint purchases of credit and credit
insurance, by borrower perceptions of and resentment at being forced to make insurance purcnlasles,
and by creditor conduct that is thought to promote
tying arrangements.
The study found that a rel:ltivelv
of borrowers purchased credit insurance but that
these high penetration rates probably did not indicate coercion. Their conclusion was based upon
generally favorable consumer perceptions of credit
insurance and the low reported incidence of survey
responses that indicated that credit insurance had
been required or strongly recommended. In addition, an examination of insurance selling practil:es
by bank holding companies revealed procedures
that seemed to make coercive selling practices
unlikely.
10
The 1985 survey examined consumer experiences
with credit insurance and contains the responses of
652 representative U.S. families reporting at least
one nonmortgage closed-end loan. 12
This paper reports the resultsofthe 1985.s11rvey
and compares some of those results to those of the
1977 survey. The analytical approach used to investigate the seriousness of consumer abuses in the sale
of credit insurance· is the same as that developed in
the Eisenbeis-Schweitzer study. In this approach,
the presence of excessive costs or unfair or abusive
sales practices, including coercive tying arrangements, would be revealed by adverse consumer
experiences and attitudes of resentment toward
credit insurance.
Within the Eisenbeis-Schweitzer framework,
consumer surveys help to determine whether credit
insurance is purchased even though it is viewed
The 1985 Survey
The Eisenbeis-Schweitzer study (1979) was
based primarily on the results of the 1977 Consumer
Credit Survey. Sponsored by the Board of Governors of the Federal Reserve System, the Office of the
Comptroller of the Currency, and the Federal
Deposit Insurance Corporation, that survey collected detailed information on the credit insurance
experiences of approximately 2,500 families
selected to be representative of all families residing
in the United States.
In December 1985, the Federal Reserve Board, at
the request of the Consumer Advisory Council
(CAC), sponsored credit insurance questions on the
University of Michigan monthly Survey of Consumer Attitudes. The CAC request was based on a
perception that substantial changes may have taken
place in the credit insurance market in recent years.
11
12
insurance often is "buried" within loan documentation to such an extent that consumers do not know
that they are purchasing credit insurance. In 1985,
only 2.2 percent of all borrowing families reported
that<theydid not knbwwhether .they .had credit
insurance coverage on their outstanding loan. This
contrasts with nearly 6 percent of borrowers in
1977. The explanation for this statistically signifiCallt improvement in awareness is a matter ofspeculation, but it could be related to efforts by· consumeradvocacygroups •and state insurance
regulators to promote more open marketing practices. It could also be attributable to the effects of
Regulation Z which requires borrowers to sign a
statement indicating their desire to purchase credit
insurance. 15
An important issue regarding credit insurance has
been that of penetration rates - the percentage of
qualified borrowers who actually purchase credit
insurance. Concern has focused on the possibility
that high penetration rates may indicate successful
coercion. Both the 1977 and 1985 surveys collected
information on penetration rates by type of creditor,
and found· that the purchase of coverage was most
common for loans obtained from finance com-
unfavorably. Moreover, high sales penetration rates
among borrowers may be a signal that involuntary
tying is occurring if it is accompanied by consumer
perceptibns of coercion. The following, therefore,
specificallyexarmnes the frequency of credit insurance purchases, borrower perceptions of creditor
recommendations to buy insurance, and consumer
attitudes toward credit insurance.
Frequency of Credit Insurance in Consumer
Loan Transactions
The December 1985 survey indicates that slightly
less than two-thirds (64.7 percent) of all borrowers
purchased credit insurance to cover their most
recent closed-end consumer loan with regular
monthly payments of at least $25 (see Table 1).13
The percentage of credit insurance buyers compares
to a nearly equivalent 63.9 percent in 1977, and
indicates that consumers continue to be frequent
buyers of credit insurance. 14
As iJ)dicatedby the smaller proportion of "don't
know"responses, borrowers in the 1985 survey also
seemed to be more aware of whether they actually
purchased credit insurance than their 1977 counterparts. Critics frequently argue that the sale of credit
13
Recommendations to Buy Credit Insurance:
Borrower Perceptions
Credit insurance industry critics claim that the
strong tendency for borrowers to purchase credit
insurance from their lender is evidence of coercion.
To evaluate this claim, the 1985 survey collected
information on consumer perceptions of creditor
recommendations on the purchase of insurance.'
The 1985 survey (Table 4) indicates that 20.1
percent of borrowers with credit insurance have the
impression that credit insurance was either required
or strongly recommended by their creditor. In
marked contrast, 39.3 percent of credit insurance
purchasers in 1977 thought that the creditor either
required or strongly recommended the purchase of
credit insurance. I?
Requiring credit insurance, however, does not
necessarily indicate the existence of illegal
behavior. In many states, creditors may legally
require the purchase of credit insurance as a condition to receiving credit. They may not, however,
require that such insurance be purchased from a
particular source (especially the creditor). Furthermore, the cost of credit insurance must be reflected
in the calculation of the loan's annual percentage
rate. 18
Table 5 suggests that customers of finance companies more frequently believed credit insurance to
be required than borrowers obtaining credit
elsewhere. Comparison of these data with the 1977
survey indicates virtually no change in the proportion of finance company borrowers who reported
that the purchase of credit insurance was required
(data not shown in tables).
To gain further insight into the question of
whether borrowers are subjected to undue pressure
by creditors to purchase insurance, survey respondents were asked whether they felt their decision to
purchase credit insurance made a difference in
whether the creditor would grant the loan (borrowers who reported that credit insurance was
required were not asked this question). In 1985,
borrowers with credit insurance and those without
it, held similar views. Overwhelmingly (approximately 95 percent), borrowers expressed the belief
that their decision regarding the purchase of credit
panies. In 1985, for example, 69.7 percent of
finance company borrowers were covered by some
type of credit insurance. Penetration rates for commercial banks and savings institutions were nearly
as high at 67 percent. Credit insurance sales appear
to be less frequent for credit unions (61 percent) and
for retailers, dealers, and contractors (52.4 percent),
probably because fewer such lenders offer credit
insurance.
One of the more interesting aspects of credit
insurance is the tendency ofpenetration rates to vary
according to income class and education (Table 2).
The 1985 data indicate that higher income ($35,000
or more) and better educated (at least a high school
diploma) borrowers were less likely to have credit
insurance than other borrower groups. These findings seem reasonable given that individuals with
more education and higher annual incomes typically have greater net worth on which to rely in
emergencies and are more likely to have other forms
of insurance.
For example, information obtained from the 1983
Survey of Consumer Finances I6 indicates that only
55 percent of families with incomes below $15,000
in 1983 were covered by some type of life insurance
plan. In contrast, 94 percent of families with
incomes above $35,000 had such coverage in that
year. High income individuals may also be perceived as better credit risks, and thus may be subject
to less pressure to purchase credit insurance.
Mostborrowers who buy credit insurance obtain
it from their lender. In 1985, 90 percent of borrowers with credit insurance reported that they
obtained the insurance from the lender (Table 3).
Among such borrowers, the two most frequently
cited explanations for this selection were convenience and availability. Among borrowers who
obtained insurance from a source other than the
creditor, the principal reason cited for their choice
was familiarity (prior experience) with that insurer.
There was a small but statistically significant
increase fr6m 2 percent in 1977 to 10.1 percent in
1985 in the proportion of borrowers who reported
that they obtained credit insurance from someone
other than the creditor. This suggests that borrowers
have developed a greater awareness of alternative
sources of credit insurance.
14
15
Borrower Attitudes Toward Credit Insurance
insurance had no effect on the creditor's decision to
grant the loan (Table 6). These results strongly
suggest that most borrowers did not feel pressured
by .lenders into purchasing credit insurance as a
condition for obtaining credit. Moreover, comparisons between the two consumer surveys indicate
that significantly fewer borrowers in 1985 than in
1977 believed that the creditor's decision to grant
creditwl:lS affected by their choice of whether or not
to.purchasecredit insurance (Table 6).
As noted, survey findings that the purchase of
credit insurance was required by some creditors do
not provide direct evidence of the existence of
illegal tying practices. Nonetheless, survey information can be used to explore whether respondents
perceived that lenders exerted pressures to engage in
involuntary tying. Specifically, since coercive pressures are likely to generate resentment by borrowers
16
A cross-tabulation of consumer attitudes toward
credit insurance with selected family characteristics
indicates that few differences exist in responses
among different subgroups of families (Table 8). In
nearly all categories, 90 percent or more of the
respondents with credit insurance exhibited a favorable attitude toward the purchase of credit
insurance.
Finally, to evaluate further consumer perceptions
about the purchase of credit insurance, each borrower with credit insurance was askedwhether tiley
would be inclined to purchase credit insurance in the
future. Ninety-four percent of the respondents indicated that they would be inclined to purchase credit
insurance again (Table 9). The most frequently cited
reason (mentioned by 83 percent of respondents) for
such a preference was that credit insurance serves a
valuable purpose.
toward credit insurance, survey responses could
reveal such adverse reactions. Adverse reactions
also might be expected if borrowers felt that the cost
of credit insurance was excessive, or if lenders
engaged in any of the abusive sales practices cited
earlier.
Borrowers were questioned about their general
attitude toward the purchase of credit insurance in
both the 1985 and 1977 surveys. Both sets of
responses indicate that about 90 percent of all
borrowers who were covered by credit insurance
thought buying the insurance was a "good idea"
(Table 7). Only 5.2 percent of borrowers who had
credit insurance in 1985 thought that it was a "bad
idea" to purchase such insurance. Even among
borrowers without coverage, 56 percent in 1985
stated that its purchase was a "good idea."
17
IV..Summary and Conclusion
This study hasreviewed someoftheissues that
surround credit insurance, including· claims of
excessive • cost .• andabusivetnarketingand. sales
practices, such as tie-in sales. While the. study
provides no direct evidence on the validity of such
criticisms, it does provide evidence on recent borrower experiences with, and attitudes toward,credit
insurance. It is reasonable to .assulle •that the presence ofexcessive costs or abusive selling practices
would be reflected in borrower expressions of dissatisfaction with or resentment toward credit
insurance.
The study is based primarily on evidence from the
University of Michigan· Survey of Consumer Attitudes that was conducted in December 1985. This
survey provides information on the frequency of
borrower purchases of credit insurance, borrower
perceptions about lender recommendations to buy
credit insurance,and overall borrower attitudes
toward. credit insurance.• Results. frol11 this •. survey
were analyzed and compared to those of a similar
1977 survey sponsored by the Federal Reserve
Board.
The results ofthe 1985 survey indicate that nearly
two-thirds of families that borrow, • purchase credit
insurance; furthermore,mostpurchasers viewcredit
insurance favorably.•.The.survey reveals that about
one-fifth of borrowers who purchased creditinsurance .believed such coverage was required or
strongly recommended. by the creditor. However,
exclUding borrowers who saidtheywere required to
purchase cre<;lit insurance, few believed that their
decision to purchase or not to purchase credit insurance had any effect on the lender's decision to grant
credit.
The 1985 survey found that the large proportion
of borrowers who were aware that they had purchased credit insurance has not changed in recent
years. However, significantly fewer borrowers surveyed in 1985 were unaware of whether they actuaUypurchasedcredit insurance than were in 1927.
The decline in the number of such unaware borrowers may help alleviate concerns. about the
alleged sales practice of "burying" credit insurance
within the loan document.
The1985 survey a1sofound a significant decline
in the proportion of borrowers with credit insurance
who felt that the insurance was either required or
strongly recommended. Although this decline must
be interpreted with caution (some states permit
creditors to require the purchase of credit insurance), it may be evidence of fewer involuntary credit
insurance tie-in sales. This conclusion is supported
by additional survey results that indicate that in
1985, 94 percent of borrowers with credit insurance
felt that their decision to buy credit insurance had no
effect on the creditor's decision to grant credit. This
compares to 80 percent in 1977.
Finally, the 1985 survey revealed that nine-tenths
ofborrowers who bought credit insurance thought
the purchase was a "good idea, "and would buy it
again. Among borrowers who purchased credit
insurance, there was littIechange in attitudes to\Vard
the desirability of credit insurance between 1977
and 1985. These findings are consistent with the
view that creditors in general do not subjectborrowers to undue pressure
purchase a product
(credit insurance) that they do not want.
Overall, the 1985 survey results suggest thatthe
widespread.abuses alleged by industry critics <are
not perceived by most borrowers as important concerns.Thus, although this study does not contend
that all pastcriticisms of the .credit insurance indusof such abuses has declined or may have been
overstated.
18
FOOTNOTES
1. On May 10. 1984, the Massachusetts Banking Department implemented Regulation 209 CMR 2.00 (Mass. Reg.
No. 415). This regulation requires state-chartered savings
banks, cooperative banks, credit unions and trusts to seek
arl~ast three bids from insurers and to accepUhEilowest
qualified bid for the provision of credit insurance to loan
customers. Federally chartered banks, finance companies, and automobile dealers are exempt from this
regulation.
however, have not argued that lenders have used credit
insurance to price-discriminate among borrowers.)
The more likely situation that would be consistent with
the Eisenbeis-Schweitzer position is that the conditions
that lend themselves to a less competitive loan market also
result in some. degree of monopoly power for providers of
credit insurance. If this were the caSe, the provision of
credit and credit insurance by the same firm could. be
accounted for by cost advantages connected with the joint
production ofthetwo services. That is, it is cheaper for one
firm to provide credit and insurance to a customer than to
have the customer contract with two different firms.
To the extent that there are cost advantages to jointly
producing credit and certain insurance services (e.g.,
insurance brokerage services), they should apply regardless .of the degree of competition in a given mark~t. Thus,
even in highly competitive markets, credit and insurance
brokerage services cou.ld be supplied by individual firms.
Indeed, given these efficiencies, we would expect to
observe borrowers obtaining credit and insurance services from the same firms. Explicit or implicit enforcement
of tying arrangements would not be needed. The cost
advantages of joint production, however, do not rule out
the possibility that the market for credit insurance itself
necessarily will be competitive. Therefore, the earlier discussion suggesting higher-than-competitive rates on
credit insurance coverage is consistent with th~ existence
of efficiencies in the joint provision of credit and credit
insurance.
2. Application by Citicorp, NewYork, New York, pursuant
to section 4(c)(8) of the Bank Holding Company Act, to
engage in the underwriting of home mortgage redemption
insurance; approved by the Board of Governors of the
Federal Reserve System (March, 1986).
3. Credit insurance is available for virtually all kinds of
consumer credit. However, unlike credit insurance for
consumer installment loans, which usually is sold directly
by the loan officer or retail merchant, credit insurance for
home purchase loans and credit cards typically is solicited
by mail by parties unrelated to the creditor.
4. Credit life insurance is a relatively small segment of the
life insurance industry. At the beginning of 1985, credit life
insurance policies accounted for approximately 17 percent of the number of all life insurance policies (issued and
in force in the U.S.) but only three percent of the amount of
coverage in force. Similarly, premium receipts from cre.dit
life insurance policies accounted for only four percent of
total life insurance premiums.
5. See, for example, Eugene Singer, Antitrust Economics:
Selected Legal Cases and Economic Models (Englewood
Cliffs, N.J.: Prentice Hall, 1968); Frederick Scherer, Industrial Market Structure and Economic Performance (Chicago: Rand McNally, 1970); and Franklin R. Edwards,
"Economics of 'Tying' Arrangements: Some Proposed
Guidelines for Bank Holding Company Regulation," Antitrust Law and Economics Review, Vol. 6, 1973.
9. See, for example, National Association of Insurance
Commissioners, "A Background Study of the Regulation of
Credit Life and Disability Insurance," (Milwaukee: Executive Secretary of NAIC, 1970). Also, Joel Huber, "Credit
Insurance on Retail Purchases: What Does the Public
Feel?" Cambridge Reports, Second Quarter, 1976;
Charles L. Hubbard, ed., Consumer Credit Life and Disability Insurance (Ohio University, College of Business
Administration, 1973); Tracy Dobson, "Credit Insurance:
The Hidden Insurance," Michigan Bar Journal, February
1986.
6. See Scherer for a discussion of the advantages of tying
arrangements, pp. 505-507.
7. Robert A. Eisenbeis and PaUl R. Schweitzer, "Tie-Ins
Between the Granting of Credit and Sale of Insurance by
Bank Holding Companies and Other Lenders," StaffStudy,
101, Board of Governors of the Federal Reserve System
(February 1979).
10. Recent evidence of credit insurance abuses is
provided by a June 1985 settlement agreement between
Thorp Loan and Thrift Company and the state of Minnesota. The agreement required the finance company to
refund nearly $7 million in premiums to borrowers who
were subjected to abusive marketing practices in which
insurance coverages were added to consumers' loans
without their knowledge or consent.
8. It is not clear, however, that the monopoly extension
argument provides a satisfactory explanation for the
apparent tying of credit and insurance. In the case where a
lender has some degree of monopoly power in the market
for, say, consumer loans, it is questionable that the lender
could increase profits by "forcing" borrowers to pay an
above-market price for insurance which otherwise is supplied competitively. One reason is that such an arrangement would reduce the demand for loans and, thus, the
interest rate on loans would have to be lower. It is by no
means a straightforward proposition that the higher
income on credit insurance would more than offset the
reduced income from lending. (For a firm with monopoly
power, tying arrangements could comprise a convenient
means of price discrimination according to the difference
in demand for the monopolized good. In such a case, there
could be gains if the tied good is otherwise competitively
supplied. Critics of credit insurance tying arrangements,
11. See footnote 8.
12. The respondents were selected in a way that ensures
that they are representative of all U.S. families residing in
the 48 contiguous states. Telephone interviews were conducted with the family member determined to be most
financially knowledgeable.
13. The survey excludes mortgage loans, credit card
debts and other loans with irregular payment schedules. In
1985, 17.6 percent of borrowers reported they only had
credit life insurance coverage, 1.6 percent had only credit
accident or health insurance, and 43.4 percent of borrowers stated they had both types of coverage.
19
14. The small increase in the proportion of families with
credit insurance between 1977 and 1985 is within the
associated sampling error. Therefore, it cannot be concluded that the proportion of consumers with such insurance in 1985 is greater than the comparable proportion in
1977.
16. Robert B. Avery and others, 1983 Survey of Consumer
Finances, Board of Governors of the Federal Reserve
System: Washington, D.C., forthcoming.
15. Regulation Z of the Federal Reserve requires that a
borrower sign an affirmative written request whenever a
borrower purchases credit insurance from a lender who
does not require s.uch insurance (12 CFR S226.4d).
18. Title 1 of the Consumer Credit Protection Act of 1968;
also known as the Truth-in-Lending Act (15 USC 1605B).
17. Hubbard (see footnote 9) reported that 19.7 percent of
bqrro\Ners (who purchased credit insurance) surveyed. in
1970 state that its purchase was required by the creditor.
REFERENCES
American Council of Life Insurance. 1985 Life Insurance
Fact E300k Update, Washington, D.C., 1986.
Coapstick, Janet and Loren W. Geistfeld. "Retail Credit
Users' Awareness of their Credit Insurance
Coverage," Journal of Consumer Affairs, Vol. 13, No.
2, Winter, 1979.
Committee of the Judiciary, United States Senate. "Hearing Before the Subcommittee on Antitrust, Monopoly
and Business Rights: First Session on Credit Life
Insurance," Serial No. 96-44, Washington, D.C., 1980.
Dobson, Tracy. "Credit Insurance: The Hidden Insurance," Michigan Bar Journal, February 1986.
Edwards, Franklin R. "Economics of 'Tying' Arrangements:
Some Proposed Guidelines for Bank Holding Regulations," Antitrust Law and Economics Review, Vol. 6,
1973.
Eisenbeis, Robert A. and Paul R. Schweitzer. "Tie-Ins
Between the Granting of Creditand Sale of Insurance
by Bank Holding Companies and Other Lenders,"
Staff StUdy 101, Board of Governors of the Federal
Reserve System, February 1979.
Hubbard, Charles L., ed. Consumer Credit Life and Disability Insurance, Ohio University, 1973.
Huber, Joel. "Credit Insurance on Retail Purchases: What
Does the Public Feel?" Cambridge Reports, 2nd
Quarter, 1976.
National Association of Insurance Commissioners. "A
Background Study of the Regulation of Credit Life and
Disability Insurance," Milwaukee, 1970.
National Consumer Law Center, Inc. Limitation and Regulationof Credit Property Insurance, Boston, July
1978.
Scherer, F.M. Industrial Market Structure and Economic
Performance, Chicago, 1970.
Sheffey,John M. "Credit Life and Disability Insurance
Disclosures Under Truth-in-Lending: The Triumph of
Form over Substance," Florida State Law Review, Vol.
8, No. 463,1980.
Singer, Eugene. Antitrust Economics: Selected Legal
Cases and Economic Models, Englewood Cliffs, N.J.:
Prentice Hall 1968.
20
Thomas F. Cargill·
While financial liberalization has fundamentally altered Japan's financial institutions and markets, in particular, theflow offunds, it has not yet
had a dramatic effect on the instruments and strategy ofmonetary policy.
The framework in which the Bank of Japan conducts its policy is,
nevertheless, on the verge of a major change as Japan considers establishing a short-term market for government securities.
The liberalization of Japan's domestic financial system has been ongoing since the mid-1970s. Prior to
that time, the financial system was highly constrained by regulation and administrative guidance
by the Ministry of Finance (MOF) and the Bank of
Japan (BOJ). It was characterized by interest rate
ceilings on deposits and loans, limited portfolio
opportunities for market participants, undeveloped
securities markets, and restrictions on international
capital movements. This highly structured, segmented, and regulated system was designed to support export-led economic growth, industrialization,
and high personal savings, and to provide a simple
conduit for transferring the large surplus of the
personal sector to finance the large deficits of the
corporate sector.
The oil-price shock of 1973-74 and the associated
end of the "high growth period" were the primary
catalysts for financial liberalization. In particular,
the impact of reduced economic growth on the
established flow of funds pattems set the liberalization process in motion 1 •
Since then, specific reforms have been designed
to increase the role of market forces by relaxing
interest rate constraints, broadening portfolio
opportunities for market participants, expanding
existing securities markets and developing new ones
especially for government debt. To increase Japan's
role in the international financial system, other
reforms aimed at increasing capital flows in and out
of Japan, widening access by foreign financial
institutions to the domestic flow of funds, and
"internationalizing" the yen.
The changes in the flow of funds after 1973-74
and in the structure of the financial system as a result
of liberalization have fundamentally altered the
financial environment for Japanese monetary policy.
As a result, the BOJ has had to consider alternative
policy instruments, short-run tactics, and even
longer run strategies of monetary policy.
This paper focuses on the changing financial
environment for monetary policy in Japan and its
impact on the conduct and impact of monetary
policy. The subject is developed in four steps. First,
we outline the major features of the flow of funds
prior to liberalization and describe how the monetary policy of the BOJ relied on these flow of fund
patterns and the highly regulated nature of the
financial system. Second, we indicate the major
changes in the flow of funds that followed the first
oil-price shock of 1973-74 and that resulted from
liberalization. Third, we indicate how these
* Professor of Economics, University of Nevada,
Reno, and Visiting Scholar, Federal Reserve Bank
of San Francisco. He appreciates comments from
Hang-Sheng Cheng, Michael M. Hutchison, the
review committee of the Federal Reserve Bank of
San Francisco, and Toshihiko Fukui, Susumu
Katagi, and Masatake Kotani of the Bank of Japan,
but takes responsibility for this paper.
21
changes have altered the domestic financial environment facing the BoJ and review the response of BoJ
policy to these changes. The paper concludes with
some comments on a new policy instrument for the
BoJ.
Since the focus of the paper is on the changing
financial environment for monetary policy, we need
to date the emergence of the new environment. As
mentioned, the major catalyst for liberalization was
the downward shift in economic growth induced by
the oil-price shock of 1973 and the impact of slower
growth on the flow of funds. Nevertheless, 1976
often is regarded as the official start of liberalization
because that was the year the MoF officially recog-
I.
nizeda competitive money market for repurchase
agreements in government securities, known as the
gensaki market. Thus, the years from 1973 through
1976 may be regarded as the period over which the
new environment for BOJ policy emerged.
Financial liberalization in Japan, however, has
been a more continuous and less crisis-oriented
proGess than liberalization in the U. S. Hence, we do
not observe sharp and discrete changes in the conduct of monetary policy in response to changes in
Japan's financial environment (Cargill, 1985a and
1985b). Rather, the transition of BoJ policy is
reflected in new and slowly evolving tactics and
strategies of monetary policy.
The Financial Environment Prior to Liberalization
private and public financial institutions (see Box).
Such deposits and currency holdings accounted for
67 percent of the personal sector's uses of funds over
the 1965-72 period.
The corporate sector deficits were financed primarily by financial institutions as opposed to open
money and capital markets. Over the period
1965 c 72, loans from private and public financial
institutions accounted for 86.6 percent of the corporate sector's sources of funds. Financial institutions were designed to serve the borrowing needs of
the business sector in general, and the corporate
sector in particular3 .
Corporations relied on indirect rather than direct
financing for several reasons. Equities were not an
attractive funding source because of the tax advantages of debt over equity, because of the practice of
issuing stock at par value rather than market value,
and because of the existence of extensive regulations regarding new stock issues. Domestic money
and capital markets were undeveloped prior to liberalization and extensive regulation of capital flows
prevented Japan's corporations from using foreign
capital markets as a source of funding.
Private financial institutions acted as the primary
conduit for funds between the personal and corporate sectors, but were themselves linked through a
relatively free interbank market. This interbank
market is similar in function and structure to the
federal funds market in the U.S. and was one of only
two markets not subject to extensive regulation and
Two characteristics of the financial environment
prior to liberalization provided a foundation for BoJ
policy. First, there were well-established flow of
funds patterns between major nonfinancial and
financial sectors of the economy and, second, there
were extensive interest rate and portfolio constraints
on all major market participants. These characteristics ensured a close relationship between the
Bars policy instruments and final policy targets.
Table 1 reports the surplus and deficit position of
four major nonfinancial sectors in Japan as a percentage of GNP for the period 1965-842 •
Prior to 1973, the flow offunds was characterized
by large personal sector surpluses, large corporate
sector deficits, and comparatively small public sector deficits. The personal sector surplus averaged
9.2 percent of GNP over the period 1965-72,
whereas the corporate and public sector deficits
averaged 6.5 percent and 2.6 percent of GNP,
respectively.
The public sector deficits were concentrated in
public corporations and local government entities
rather than in the central government. In fact, the
central government ran small surpluses during most
of the 1965-72 period. Net financial flows between
Japan and the rest of the world were small, reflecting
Japan's tendency toward current account balance.
In addition, a variety of restrictions on capital flows
ensured Japan's international financial isolation.
The personal sector surpluses were held primarily
in the form of currency and of liabilities issued by
22
in the bill component of the market consisting
mainly of purchases of bills, and thus became a net
supplier of funds.
The net demand position of the city banks
resulted from their central role in serving the borrowing needs of the largest and fastest growing
corporations in Japan. Corporations depended on
city banks for a major part of their external funding
because the city banks were the largest and most
convenient of the private financial intermediaries
with offices throughout the country and.the world.
City banks also had access to BOJ direct credit on a
continual basis, while corporations did not. have
administrative guidance. The other market was an
unofficial gensaki market or repurchase market in
government securities that emerged in the late
I960s4 .
Table 2 reports the net interbank position of the
city banks, other banks, other private financial
institutions, and the Bank of Japan in terms of their
interbank financial assets less interbank liabilities
over the period 1969-84. The city banks were continual net demanders of funds from the interbank
market, while other private financial institutions
were continual net suppliers offunds. After 1971,
the BOJ initiated a form of open market operations
23
access to open money and capital markets. Most
importantly, city banks played a leadership role in
the large groupings of firms that continue to dominate the industrial structure of Japan5 .
The corporate sector's greater dependence on city
banks rather than other financial institutions for
external financing accounted for the continued net
demand position of the city banks in the interbank
market. Other banks and private financial institutions (see Box) were net suppliers of funds to the
interbank market. Thus, funds from these other
institutions flowed to the corporate sector both
directly and indirectly via the interbank market and
the city banks.
Prior to liberalization, almost 90 percent of the
BOJ's loans and discounts to financial institutions
were made to the city banks. The BOJ encouraged
city bank dependence on the discount window both
by restricting all financial institutions, including
city banks, to a small set of sources offunds subject
to interest rate controls and by keeping the discount
rate at a level significantly lower than the interbank
loan rate.
Prior to liberalization, virtually all interest rates
in Japan were regulated in one form or another with
the only significant exceptions being the interbank6
rate and the gensaki rate. Thus, interest rates were
not sensitive to market forces and were not used by
the BOJ in a systematic manner to influence spending during periods of tight or easy monetary policy.
The overall objective of interest rate control was to
achieve a "low interest rate" environment to stimulate corporate investment spending.
Within Japan's financial environment, a variety of
portfolio constraints sharply segmented financial
institutions and limited sources and use~offunds for
all market participants. Banks were not authorized
to issue market-sensitive large CDs, and were limited in the variety of deposit accounts they could use
to obtain funds. Corporations faced a variety of
regulations and administrative guidance that
provided strong disincentives to substitute direct for
indirect finance. Since banks were segmented
according to loan maturity, corporations were
restricted to obtaining short-term and long-term
funding from specific types of institutions. Both
banks and corporations were severely restricted
from obtaining funds in the foreign market.
24
By determining the amount of reserves available
to the banking system the BOJ was able to set the
ultimate constraint on credit creation. Reserves
were supplied through the discount window and a
type of open market operation in the interbank
market. To achieve the targeted path of bank
reserves, the BOJ varied the amount of direct credit
to the city banks and conducted operations in the bill
component of the interbank market. The BOJ used
the discount window not only as a means for determining the total reserve base but, just as importantly, to ration credit to the city banks.
Unlike other institutions, city banks had continuous access to BOJ credit and were always willing to
take as much credit as the BOJ was willing to
provide because the discount rate was maintained at
a level below the interbank rate. As a result, the BOJ
did not employ changes in the discount rate to affect
the costs and thereby the willingness of city banks to
Monetary Policy Prior to liberalization
The financial environment that existed in Japan
prior to liberalization supported a close relationship
between the BOrs policy instruments and final
policy targets and also defined a specific transmission process for BOJ policy. During this earlier
period, the major policy instruments of the BOJ
were credit rationing at the discount window, variations in the discount rate, purchases and sales of
commercial bills in the interbank market, and loan
limits on individual banks referred to as "window
guidance". These instruments were used to control
the volume of loans to the corporate sector by
financial institutions in general, and the banking
system in particular. Since the corporate sector had
limited access to securities markets to satisfy external funding requirements, the BOJ could thereby
influence corporate investment spending and,
hence, the overall level of economic activity.
25
The interbank market ensured that BOJ policy
spread beyond the city banks to institutions other
than the city banks9 . For example, regional banks
and other financial institutions were induced by
changes in the interbank rate to substitute interbank
assets for business loans. Regulated loan and
deposit rates ensured the existence of significant
substitution effects between interbank assets and
business loans in response to changes in the interbank rate.
As a policy indicator, the interbank rate reflected
the pressure placed on the city banks. Portfolio
restrictions on the sources of bank funds and interest
rate ceilings forced the city banks to use the interbank market as a source of funds whenever the BOJ
restricted funds at the discount window or through
slower purchases of bills.
Thus, the BOJ's policy instruments influenced
the ability of financial institutions to extend credit to
the corporate sector. And since corporations
depended heavily on intermediation finance, business investment also was sensitive to the BOJ's
policy instruments. The well-defined flow of funds
patterns ensured that BOJ influence over the city
banks would translate into influence over all major
financial institutions. The portfolio and interest rate
restrictions on the sources of funds limited the
ability of financial institutions to attract funds in
an effort to offset BOJ intentions. The limited
sources of funding available to the corporate sector
ensured that influence over private intermediation
credit would translate into influence over corporate
spending.
borrow and lend, but rather to achieve an
"announcement effect," that is, to signal its intentions with respect to credit expansion.
The BOJ imposed "window guidance" lending
limits on individual banks, including city banks,
regional banks, and other types of financial institutions. City banks were the primary focal point of
window guidance and their dependence on BOJ
direct credit increased the probability that the loan
limits would be respected. Also, the BOJ took into
account existing market shares among different segments of the market in setting the limits and thus
ensured that institutions not dependent on BOJ
direct credit also would adhere to the limits. The
BOJ fostered the attitude that adherence to the limits
by all institutions would be in their best interest
because it would allow them to maintain their market shares7 .
The interbank rate played an important role in the
transmission of BOJ policy and as a policy indicator.
In terms of the transmission process, the interbank rate influenced the cost of funds to city banks,
and this cost was passed on to the corporate borrowers in the form of higher deposit/loan ratios 8 .
Thus, even in the absence of a change in the corporate loan rate, increased interbank rates raised the
effective cost of borrowing. Increases in the official
discount rate would amplify this effect since loan
rates were tied to the discount rate. While this aspect
of the transmission process relied on an interest rateexpenditure effect, it was secondary to the credit
availability effect achieved by varying the reserve
base, administrative guidance imposed on city
banks at the discount window, and window-guidance on loan limits.
II.
Initiation of Financial Liberalization
The financial system that existed prior to the start
of liberalization (1973-76) served well the industrial
objectives of Japan. It supported a high rate of real
economic growth through the early 1970s and
provided a framework for BOJ policy that enabled
the Bank of Japan to support the rapid growth while
maintaining reasonable price stabiIltylO. However,
because this financial structure was incompatible
with the economic environment that emerged after
the oil-price shock of 1973, the process of liberalization began.
Reduced economic growth as a result of the oil
price shock in 1973 dramatically affected the flow
of funds patterns in Japan. Growth declined from a
10 percent level to a 3-5 percent level that continues
to the present. While the personal sector surplus
26
remained at about 10 percent ofGNP after 1973, the
relative positions of the corporate and central government deficits changed. The corporate sector deficit declined by almost 50 percent as a result of the
reduced need for external funding in a slower
growth environment, while the total public sector
deficit roughly doubled.
The changes in flow of funds created pressures
that could only be relieved by a less constrained
financial system. The detailed causes of this liberalization are beyond the scope of this paper l l .
Instead, we focus on the role of the increased
government sector deficit on the liberalization
process 12.
Government debt was not sold in an open market
but placed with a "captive" syndicate of banks and
security companies at below-market rates. Syndicate members did not object to this practice prior to
1973 because the amount of debt was small. In
addition, the BOJ was willing to purchase the debt
from the banks at prices that guaranteed no capital
loss and security companies were permitted to operate an unofficial gensaki market based on government debt.
After 1975, the increased government deficits
made the amount of debt placed annually large. This
influenced the liberalization process in two ways.
First, in 1978, the BOJ no longer guaranteed that
the debt would be purchased at favorable prices.
Increasing market resistance forced the MOF to
make a number of concessions, the most important
of which were the decisions to offer medium-term
debt at market prices and to reduce the holding
period for syndicate members.
Second, the rising volume ofgovernment debt led
to the emergence of a growing secondary market.
This market was not regulated and provided a market-determined rate of interest that made it difficult
to enforce deposit rate ceilings, especially for large
corporate depositors who were becoming less
dependent on the banking system and who wanted
to shift deposits to higher yielding assets. A number
of observers have judged the growth of the secondary bond market in government securities to be a
major force for liberalization by the time of the late
1970s (Bank of Japan, December 1982b).
The impact of government debt and other forces
therefore initiated financial liberalization in Japan.
Liberalization has been ongoing for more than a
decade now, and, combined with the changes in the
flow of funds, has fundamentally altered the financial environment for BOJ policy. While the Japanese
financial system remains highly regulated, market
forces now play a more important role in allocating
funds. Both money and capital markets have
expanded, and controls over international capital
flows have been relaxed.
Regulators have permitted financial institutions
to offer a wider range of deposits (including
deposits not subject to ceilings, such as large CDs),
and have adjusted deposit rate ceilings more frequently. They also have relaxed controls over loan
rates.
The volume of large CDs has expanded since
their authorization in 1979, as has the volume of
gensaki trade after official recognition in 1976. A
yen-dominated bankers' acceptance market has
recently been established, and regulators are considering establishing a short-term or T-bill market
for government debt. The long-term securities market has expanded greatly from the increase in outstanding government debt.
In 1980, Japan accepted as a general principle the
idea that international capital flows should not be
restricted. Since that date, there has been a significant increase in funds flowing into and out of Japan.
In addition, Japan has increased access by foreign
financial institutions, and taken other steps to make
the yen more acceptable as an international investment and reserve asset.
27
III. Changing Domestic Environment for Monetary Policy
for external funding by the corporate sector and
changes in the financial system as a resllit of liberalization lessened the dependfence . of the cOrporate
sector, especially large corporations, on the banking
system. Accompanying the absolute decline. in the
corporate sector's funding requirements has been a
shift, made possible by libemlizati()lJ" in its SOllrces
of funding. While the major increase. in securities
market activities is associated with the mounting
size of outstanding government debt, corporations
have taken advantage of the growing market as a
source of external funding. Issues of securities
accounted for 14.2 percent of the funds raised by the
corporate sector over the 1973-83 period, compared
to 10.8 percent over the 1965-72 period.
The declining dependence of the corporate sector
on bank credit has, in tum, been responsible for a
decline in the market share of city banks. In almost
every year since 1962, city banks have lost market
share to other private financial institutions. The
actual percentage of city bank assets to total assets
of private financial institutions dropped from 32.1
percent in 1969 to 26.1 percent in 1983.
In addition to the decline in city banks' market
share of private intermediation, a shift in flows away
from private to public intermediaries also may
impede BOJ policy. Government financial institutions accounted for 16.1 percent of the total flow of
funds to final borrowers (Table 3) in 1972, but by
1982, their contribution had increased to 29.2 percent. Funds transferred through public intermediaries are believed to be less sensitive to BOJ policy
than those transferred through private intermediaries.
The pre-liberalization transmission of monetary
policy in Japan can be summarized by Figure 1. This
transmission. process Was .based on a well-defined
flow of funds. pattern between financial and nonfinancial sectors and an extensive set of interest rate
and portfolio constraints on market participants.
Molletary policy. fOCllSfe(}. ()lJ, . credit.as the intermediate target and empl()yed credit allocation controls to achieve the desired targets for credit.
Although theBOl used the interbank rate as an
operating variable and policy indicator, it did not
emphasize the interest rate-expenditure channel of
monetary policy. Variations in the interbank rate
were designed to influence the portfolio decisions of
noncity banks with the overall objective of controlling the quantity rather than the price of intermediation credit.
Change in .the flow of funds patterns after 1973
along with the liberalization process reduced the
role of private intermediation credit as a determinant
of spending and weakened the ability of the BOJ to
control intermediation credit in general.
The most significant change for BOJ policy was a
gradual decline in the role of indirect finance (Table
3). The corporate sector, now a smaller deficit unit,
gained increased flexibility to obtain funds in open
markets. Money markets themselves expanded, as
did long-term security markets for government
debt. While Japan does not yet possess a set of open
money and capital markets matching the depth and
breadth of those in the U.S., direct financial transactions have steadily increased in importance.
A discrete shift in the deficit position of the
corporate and public sectors was associated with the
decline in intermediation finance. The reduced need
Figure 1
Monetary Policy Transmission Before Liberalization
Bank of Japan •
Policy
Instruments.
•
28
Quantity of
Intermediation Credit •
Corporate
Investment
Liberalization also has reduced the relative size of
the interbank market in the flow of funds,and
allowed city banks to reduce their dependence on
BOJ direct credit. Although the interbank loan
market rernmnscentral to the transIllissionofBOJ
policy, the rapid growth of new money market
instruments ~ in both yen and foreign currencies ~
has reduced its relative importance. Prior to liberalization, the interbank market represented approximately 70 percent of total money market transactions; by June 1985 (Toshihiko Fukui, 1986), it
represented only 27.4 percent.
The Bank of Japan 's pre~liberalization monetary
policy tactics were based on the strong incentive of
city banks to borrow from the BOJ. As city banks
now have the ability to offer financial assets that are
more market-sensitive, especially large CDs, they
have become less dependent on BOJ credit. The
Bank of Japan's loans and discounts to city banks
have consequently declined as a percentage of city
banks' liabilities during the past ten years. In addition, while city banks are still the major recipients of
BOJ credit, other institutions have become more
dependent on BOJ credit than in the past.
In sum, corporations now have sources of funding other than bank credit. Banks and other financial
institutions also have use of expanded •sources of
funding that have made them less dependent on both
the BOJfor direct creditandthe interbank market.
Liberalization has also increased both the role of
interest rates in portfolio management and the interest-sensitivity of private spending 13.
Implications for Monetary Policy
Together, •these developments have· forced the
BOJ to consider new operating tactics and even new
strategies for monetary policy. The BOJ has
responded in several ways, although the changes
have evolved slowly. One does not observe in Japan
the discrete changes in either tactics or strategies of
the kind exemplified by the Federal Reserve's
announced shift in policy in October 1979.
First, as liberalization has rendered interest rates
more responsive to market forces, the BOJ has
increasingly emphasized the interest rate-expenditure paradigm in the transmission of monetary policy to influence spending decisions. It has
increasingly used policy instruments that are cap-
29
believe that the BOrs conversion to monetarism is
less than complete (see Michael M. Hutchison in
this Economic Review).
Third, the BOJ has reduced the role of direct
credit allocation instruments such as windowguidance. Although window guidance limits are still
imposed, they are now part of a so-called voluntary
system in which individual banks take a leading role
in setting the limits 14 .
The BOrs shift from a credit-control paradigm
toward an interest rate-expenditure paradigm is, in
essence, a modification of its earlier policy framework. The BOJ has added another channel and
another policy instrument that emphasizes the relationship between the interbank rate and interest
rates in general. It continues to focus on the interbank rate, bank credit in general and city bank credit
in particular, and it still relies on various types of
administrative guidance to influence the portfolio
behavior of financial institutions.
The pre-liberalization transmission process has
not been replaced, but augmented. The BOrs policy instruments are still directed toward influencing
the flow of intennediation credit, but are now also
concerned with influencing the cost of credit and
interest rates in general, that is, with influencing
fund flows through primary or direct markets as well
as through intennediation markets. The new transmission process is sketched in Figure 2.
able of influencing interest rates within a market
environment.
Second, the BOJ has come to regard open market
operations as a more flexible instrument for influencing interest rates than either the discount window or window guidance. At this time, however, the
BOJ does not have a flexible open market operation
policy instrument because there is no competitive
short-tenn government securities market. Instead, it
has confined its open market operations to the
interbank market and,recently, conducted operations in large CDs.
The increasing emphasis on open market operations also has been a response to the declining role
of credit as an intennediate target. In 1972, loans
made by private financial institutions represented
27.2 percent of the financial assets of all sectors; by
1984, they had declined to 21.8 percent of all assets.
Claims on the rest of the world and the central
government increased in relative importance.
The de-emphasis .on credit control received official sanction in 1978 when the BOJ began to publish
projections of the money supply for each quarter.
The BOJ, at least officially, now regards the money
supply as the primary measure of liquidity in the
economy. This has led some observers such as
Milton Friedman (1983) to suggest that the BOJ is
now following a monetarist strategy of stable monetary growth. Despite the frequent reference in BOJ
publications to the role of money, there is reason to
Figure 2
Monetary Policy Transmission After Liberalization
Bank of Japan •
Policy
Instruments.
•
30
Corporate
Investment
IV. Conclusion
The effective monetary and credit policies of the
Bank of Japan are in transition as the Bank reevaluates~d adjusts them inresponse. to the new
financial environment of the 1980s. The BOJ has
increasingly expressed concern that familiar instruments such as the discount window and window
guidance cannot continueto provide the basis for an
effective policy in the new environment. In this
regard, BOJ has strongly advocated the establishment of an. open and competitive market in shortterm government securities. Such a market would
yield a flexible policy instrument for affecting interestrates directly as well as via the intermediaries'
access to reserves.
Japan's Ministry of Finance has not beenreceptive to establishing such a market in short-term
government securities. At present, • , theBOJ is
required to purchase and hold most of the short-term
government debt since the MOP prices ,the debt at
such low rates that syndicate members refuse to
purchase it. This state of affairs cannot continue.
At the time of this writing, the outcome of the
short-term govel1.lment securities market issue has
not been decided. But if the past is any indication,
the MOP will be required to make short-term government debt more responsive to market forces.
When this occurs, the BOJ will obtain a new and
major policy instrument that will further emphasize
interest rate effects.
FOOTNOTES
5. The firm groupings are often referred to as the "main
bank system." They form a unique Japanese structure of
financial and nonfinancial firms interrelated by service,
production,and financial relationships, and supported by
extensive reciprocal holdings of equities. The phrase
"main bank system" is derived from the fact that a city bank
stands at the center of the structure and provides financial
resources and financial services, and acts as a general
spokesperson for the firms in the grouping.
1. This is not to ignore a variety of other factors such as
binding interest rate ceilings, advances in computer technology, and financial innovations introduced by the private
market that have played a role in the liberalization process
but have not been dominant.
Authoritative discussions of the financial system in Japan
and the recent changes are provided by Yoshio Suzuki
(1980 and 1986). Other references include Thomas F.
Cargill (1985a, 1985b), Charles Pigott (1983), and Shoichi
Royama (1983-84). Raymond W. (3oldsmith (1983)
prOVides an overview of the development of Japan's financial system from 1868 through 1977.
The main bank system is discussed in more detail by C. D.
Elston (1981). Iwao Nakatani (1984) presents empirical
research on the behavioral characteristics of group and
nongroup firms.
2. The flow of funds accounts in Japan are published by
the BOJ and are similar in construction to those for the U.S.
They reflect the financial aspects of the real saving and
investment decisions of the major nonfinancial sectors of
the economy: public or government, corporate business,
personal, and rest of the world sectors.
6. BOJ administrative influence over the interbank rate
rendered it less sensitive to market forces than the gensaki
rate. See also footnote 4.
7. An interesting insight into the interaction between the
BOJ and the banks that form the basis of window guidance
is provided by Tadashi Yasuda (1981).
In the Japanese accounts, the business sector refers only
to incorporated businesses; the personal sector includes
both households and unincorporated businesses. The
practice of highlighting the corporate sector and deemphasizing unincorporated firms reflects the importance
of the corporate sector in the Japanese economy.
8. Japanese banks typically imposed large deposit/loan
ratios on their borrowers and adjusted these ratios according to the availability of fundS. Based on survey information
(Masahiko Takeda, 1985" p. 77), the deposit/loan ratio
averaged about 45 percent prior to liberalization.
3. The flow of funds accounts do not provide detailed
information on consumer and mortgage credit. However,
consumer and, mortgage credit comprised a relatively
small part of the lending activities of financial institutions.
9. Suzuki (1980) has developed a detailed theoretical and
empirical model of how the BOJ influenced the lending
decisions of financial institutions.
10. In fact, several researchers (Hamada and Hayashi,
1985 and Pigott, 1978) investigating the natural-rate
hypothesis in Japan have found that countercyclical monetary policy appears to have been effective at least
through the late 1970s. Their findings reject the naturalrate hypothesis and are inconsistent with some of the
empirical research for the U.S. Pigott suggests that the
explanation for the 'Japanese results may reside in the
4. The repurchase market for government securities, or
gensaki market, emerged in the late 1960s and was not
officially recognized until 1976. It was Japan's only competitive short-term money market. The interbank market
differed from the gensaki market in that transactions and
interest rates in the interbank market were subject to
administrative influence; participation in the market was
limited to financial institutions.
31
regulated and narrow flow-of-funds channels that dominated the Japanese financial system for much of the postwar period.
13.M. A. Akhtar (1983) estimated aggregate demand
functions for Japan over the period from 1962 through
1982, and found that the interest rate effect had become an
important determinant of total spending by the mid-1970s.
11. References to this subject can be found in footnote 1.
14. Robert A. Feldman (1983, p. 198), however, suggests
that it is difficult to determine empirically the extent to which
Window guidance is still effective.
12.• The role of government deficits asa catalyst for financial reform in Japan and a number of· countries in the
Pacific Basin regions is discussed by Michael M.
Hutchison (1985).
REFERENCES
Akhtar, M. A. Financial Innovation and Their Implications
for Monetary Policy: An International Perspective.
Bank for International Settlements, Basle, Switzerland,
December 1983.
Bank of Japan, Research and Statistics Department. Flow
of Funds Accounts in Japan, 1975-1981, September
1982a.
Bank of Japan, Research and Statistics Department.
Recent Developments in the Secondary Market for
Bonds." Special Paper No.1 03, December 1982b.
Bank of Japan, Research and Statistics Department. Flow
of Funds Accounts in Japan, 1965-1974, December
1982b.
Bank of Japan, Research and Statistics Department. Economic Statistics Monthly, issued on a monthly basis.
Bank of Japan, Research and Statistics Department. Economic Statistics Annual, issued on an annual basis.
Cargill, Thomas F. "A U.S. Perspective on Japanese Financial Liberalization," Monetary and Economic Studies.
The Bank of Japan, May 1985a.
Cargill, Thomas F. "Financial Reform in the U.S. and
Japan: A Comparative Overview," in Hang-Sheng
Cheng, ed., Financial Policy and Reform in Pacific
Basin Countries. Lexington: D. C. Heath and Company, 1985b.
Elston, CD. "The Financing of Japanese Industry," Quarterly Bulletin. Bank of England, December 1981.
Feldman, Robert A., Japanese Financial Markets: Innovation and Evolution. Unpublished PhD. Dissertation,
Massachusetts Institute of Technology, September
1983.
Friedman, Milton. "Monetarism in Rhetoric and in Practice," Monetary and Economic Studies. The Bank of
Japan, October 1983.
Fukui, Toshihiko. Recent Developments of the Short-term
Money Market in Japan and Changes in Monetary
Control Techniques and Procedures by the Bank of
Japan." Special Paper No. 130. Bank of Japan,
Research and Statistics Department, January 1986.
Goldsmith, Raymond W. The Financial Development of
Japan, 1868-1977. New Haven: Yale University Press,
1983.
Hamada, Koichi and Fumio Hayashi. "Monetary Policy in
Postwar Japan," in Monetary Policy in Our Times,
Albert Ando, Hidekazu Eguchi, Roger Farmer, and
Yoshio Suzuki, eds., Cambridge, MA: The MIT PreSS,
1985.
Nakatani, Iwao, "The Economic Role of Financial Corporate Grouping," in The Economic Analysis of the Japanese Firm, Masahiko Aoki, ed., Amsterdam: Elsevir
Science Publishers B.V., 1984.
Hutchson, Michael M. "Financial Effects of Budget Deficits
in the Pacific Basin," in Financial Policy and Reform in
Pacific Basin Countries, Hang-Sheng Cheng, ed. Lexington: D. C. Heath and Company, 1985.
Pigott, Charles. "Rational Expectations and Counter-Cyclical Monetary Policy: The Japanese Experience,"
Federal Reserve Bank of San Francisco, Economic
Review, Summer 1978.
Pigott, Charles. "Financial Reform in Japan," Federal
Reserve Bank of San Francisco, Economic Review,
Winter 1983.
Royama, Shoichi. "The Japanese Financial System; Past,
Present, and Future," Japanese Economic Studies,
Winter 1983-84.
Suzuki, Yoshio.Money and Banking in Contemporary
Japan. New Haven: Yale University Press, 1980.
----------. "Financial Innovation and Monetary Policy in
Japan," Monetary and Economic Studies. Bank of
Japan, June 1984.
----------. Money Finance, and Macroeconomics Performance in Japan. New Haven: Yale University Press,
1986.
Takeda, Masahiko. "A Theory of Loan Rate Determination
in Japan," Monetary and Economic Studies. Bank of
Japan, May 1985.
Yasuda, Tadashi. "A theoretical Interpretation of the Window Guidance: A Game-Theoretic Interpretation,"
The Bank of Japan, Special Economic Studies Department, February 1981 .
32
Japan's"
Focused"
Michael M. Hutchison*
This article studies the evolution of the Bank of Japan's methods of
implementing monetary policy since the move to floating exchange rates
in 1973. Analysis ofboth institutional changes and empirical data on the
central bank's behavior suggests that the Bank of Japan has followed a
flexible approach to monetary policy. Japan's move away from direct
credit controls toward moreflexible short-term interest rates over the past
decade does not represent a "money-focused" monetary policy in the
sense of a close adherence to a constant money growth rule.
money growth rule. An Executive Director of the
Bank of Japan has stated that ". . . even though the
Bank of Japan emphasizes the money supply, we are
not blind to other indicators. We consider money
supply movements in an overall framework that
includes prices, output, the balance of payments,
interest rates at home and abroad, and attitudes of
financial intermediaries to lending." 2
The objective of this paper is to investigate the
extent to which monetary policy in Japan has followed a "monetarist" strategy in practice, as
opposed to the publicly stated policy of an eclectic
approach. This article studies the constraints on
policy in Japan and the evolution of the Bank of
Japan's methods of implementing monetary policy
since the move to floating exchange rates in 1973.
(The pre-1973 obligation to fix the yen/dollar rate
closely tied Japanese monetary policy to foreign
influences and thereby limited the Bank of Japan's
discretion.) It analyses both institutional changes
and empirical data on the behavior of the Bank of
Japan.
Our approach does not attempt to answer the
broader questions of why inflation has been low and
output stable in Japan over the last decade. By
focusing on the Bank of Japan's behavior, however,
we are able to shed light on whether Japan's success
with managing inflation was occurring in tandem
with the implementation of a so-called monetarist
policy strategy.
The Bank of Japan's success in maintaining the
lowest rate of price inflation among the major industrial countries since the mid-1970s has been a
source of envy for many central bankers, especially
since low inflation was accomplished without a
major recession even after the second oil price shock
in 1979. There are many reasons for this success,
but the dominant view cites the gradual deceleration
of trend money growth over the last decade (Chart 1)
as the Bank of Japan moved to a so-called "money
focused" monetary policy (Suzuki, 1985).
A number of academic economists and others
have therefore pointed to monetary policy in Japan
as a potential model, at least in part, for the Federal
Reserve to emulate. Some of these economists have
interpreted the Bank of Japan's policy as following
classic "monetarist policy prescriptions" 1, even
though the Bank of Japan does not publicly state a
policy objective that suggests a traditional monetarist strategy of strict adherence to a pre-determined
* Assistant Professor of Economics at the University of California, Santa Cruz and Visiting Scholar,
Federal Reserve Bank of San Francisco. I wish to
thank· members of the editorial review committee,
participants of the FRBSF research workshop and
Tom Cargill for numerous helpful suggestions.
Research assistance by Laura Shoe and typing by
the FRBSF clerical staff is gratefully acknowledged.
33
The paper is divided into four sections. The first
presents a simple framework for understanding the
process of monetary policy and distinguishing
between monetarist policy and nonmonetarist policy. This section defines terms and draws out both
institutional factors and empirical regularities that
are likely to be associated with a monetarist policy
strategy. The second section investigates the institutional aspects of the evolution of the Bank of Japan's
I.
operating techniques and procedures over the last
decade. The institutional evidence is compared to
. thea priori predictions associated with a monetarist
strategy. The third section of the paper is empirical,
ang irtvestigates whether the Japanese experience
fits a number of implications and predictions of
traditional monetarism. The final section draws
some policy implications from the analysis.
Defining A "Monetarist" Policy: Tactics and Strategy
target ranges deemed necessary to obtain the
desired final policy goals. The tactics of policy
involve the choice of operating instrument variables
designed to control the intermediate targets.
The most important distinction between "monetarists" and "non-monetarists" in terms of policy
prescriptions involves the appropriate monetary
policy strategy, that is, the choice of intermediate
target and the stand on whether intermediate targets
should be varied to attempt to counteract business
cycle fluctuations. To be specific, a monetarist
strategy would choose a money aggregate as an
intermediate target (as opposed to market interest
rates or a broad measure of credit) and set it to grow
at a fairly steady rate - some would suggest a
constant rate (Friedman, 1960). Traditional monetarist policy strategy argues against varying the
intermediate target in counter-cyclical policy moves
designed to "fine tune" the economy. Its reasoning
is that such attempts usually lead to greater uncertainty in the economy, and exacerbate, rather than
dampen, swings in the business cycle.
The pursuit of a monetarist pplicy strategy is
likely to be associated with a particular institutional
framework and a number of empirical implications,
several of which are investigated below for Japan's
experience. The institutional framework must make
available policy instruments that are effective in
targeting money as an intermediate objective.
Enough variation in the operating instruments (for
example, interbank interest rates) must be allowed
within the framework to permit fairly precise monetary control if a monetary strategy is followed. That
is, the tactics of policy must be consistent with a
monetarist strategy.
In terms of empirical predictions, the transition
from a non-monetarist to a monetarist policy regime
Monetary policy may conceptually be divided
into several operational stages that help to distinguish a "monetarist" policy from a discretionary
counter-cyclical policy. Schematically, the basic
stages may be represented as (Cargill and Garcia,
1985):
Tactics
Instruments -
Strategy
Intermediate- Goals
The goals of monetary policy generally are set in
terms of growth of real GNP, employment, and
prices, with perhaps a balance of payments or
exchange rate objective or constraint. The instruments of policy are variables over which the central
bank has more or less direct control, such as the
level of borrowed and nonborrowed reserves, interbank interest rates, the discount rate, the level of
reserve requirements and, perhaps, the quantity of
bank lending.
In general, the policy instruments do not affect
the ultimate policy goals directly. Thus, in manipulating its instruments to achieve the ultimate goals
of policy, central banks generally set targets for
some intermediate variables. The intermediate variables, such as various money aggregates or market
interest rates, are assumed to exert an important
influence on the variables that have been selected as
the ultimate goals of policy. Presumably, the central
bank can exert greater direct control (less "slippage") over the intermediate variables than over the
ultimate policy goals through its manipulation of
operating instruments. In other words, the intermediate variables are used as links in the implementation of policy.
The strategy of monetary policy involves both the
choice of the intermediate target variables and the
34
A final point concerns the feedback relationship
between the central bank's operating instruments
and the intermediate target. Under a monetarist
policy regime, there would be two-way feedback
between the control instruments and theintermediate target: the operating instruments would be systematically set to move future money growth toward
the targeted range. Also, the central bank would
systematically consider past money growth (particularly swings outside the target range) when it
determines the current value of its operating instrument.
is expected to be associated with less money variability and, perhaps, greater interest rate variability
(to the extent that maintaining steady money growth
precludes the central bank from "smoothing" interest rate fluctuations). More generally, the stochastic
time series properties of the money stock normally
would be significantly different under the two regimes. In particular, one would expect stronger negative correlations between money growth in the present period and its past values under a monetarist
regime because any past deviations from constant
money growth would tend to be offset in current and
future periods.
II.
Monetary Policy in Japan: Institutional Features
The traditional tactics of monetary policy in
Japan have emphasized control of interbank interest
rates, direct credit controls on commercial bank
lending, and changes in both the official discount
rate and reserve requirement ratios.
Monetary policy by the Bank of Japan on a dayto~day basis has traditionally focused on control of
the interbank money market, which consists largely
of call loans and commercial bills traded among
financial institutions. Similar to the role of the
Federal Reserve in the federal funds market in the
United States, the Bank of Japan is able to exert
control over interbank interest rates by influencing
the level of aggregate reserves available to the
banking system. Japanese financial institutions are
required to maintain legal reserves on their deposit
liabilities with the Bank of Japan. By exerting
various degrees of aggregate "reserve restraint,"
the central bank can influence conditions in the
interbank market where banks trade reserves among
themselves and thereby affect the call money and
commercial bill interest rates.
The link between the Bank of Japan's restraint on
bank reserves and interbank interest rates has traditionally been rather direct. In particular, a large
percentage of total reserve assets posted at the Bank
of Japan by financial institutions are "borrowed
reserves" subject to recall at the discretion of the
monetary authorities. 3
The reserve requirements system in Japan
amounts to a mix between a contemporaneous and a
lagged reserve system. 4 Financial institutions affiliated with the system are required to place legal
reserves (vault cash is not included) with the Bank of
Japan, in an amount equal to the monthly average of
outstanding deposits (calculated from the first day to
the last day of the month) times the reserve ratio,
during a reserve maintenance period beginning
from the 16th day of the month through the 15th day
of the following month. Each institution can choose
its daily rate of reserve accumulation during a given
reserve maintenance period. The "reserve progress
ratio" on any day is the ratio for the current maintenance period of reserve deposits accumulated to
reserve deposits required for the period.
The Bank of Japan is able to raise interbank
interest rates by limiting overall credit provisions to
financial institutions, and thereby maintain a low
aggregate reserve progress ratio during the greater
part of the reserve maintenance period. As financial
institutions attempt to meet the required reserves
ratio by the end of the maintenance period and run
up against the Bank of Japan's greater reluctance to
extend more credit, they tum to the interbank market. Greater competition for funds in the interbank
market cause interbank interest rates to rise.
Although the Bank of Japan adjusts its credit to
financial institutions to allow financial institutions'
reserve deposits (eventually) to meet their legal
reserve requirements, interbank interest rates nevertheless tend to rise during periods of "reserve
restraint. " This is because the Bank of Japan's
"moral suasion" during periods of restraint causes
financial institutions to become reluctant to extend
their borrowed reserves credit lines, and to prefer to
purchase reserves from the interbank market.
35
In effect, the Bank of Japan's attitude toward
lending comprises an important, although supplementary, element in the Bank's control over interbank interest rates. It causes financial institutions to
distinguish between reserves obtained directly from
central bank credit and reserves obtained through
the interbank market. Moreover, the Bank ofJapan's
lending operations have an especially large influence over interbank rates because excess reserves
held by financial institutions are generally very
small.5
Another instrument of monetary control in Japan
that has been important as a supplementary measure
is the central bank's direct quantitative control over
commercial bank lending (so-called "window guidance"). Window guidance is also a form of "moral
suasion" that has been used at times of monetary
restraint when the Bank of Japan wanted to limit
deposits and money creation by limiting the
increase in the total loan volume of individual
banks.
Individual banks have apparently not resisted
"window guidance" partly because of their heavy
dependence on borrowed reserves from the Bank of
Japan, and partly because they perceive that longterm customer relations would not be adversely
affected by following credit controls during periods
of general credit restraint. Moreover, during periods
of monetary restraint (when interbank rates are
rising) the cost of funds to banks increases. Since
their loan rates are also subject to administrative
"guidance" and, as a consequence, are fairly rigid
(Suzuki, 1985; p. 6), this induces them to reduce
their lending. 6
Although monetary control in Japan has traditionally worked primarily through Bank of Japan's
credit adjustments and, as a supplementary measure, direct controls on bank lending, changes in the
official discount rate and reserve requirement ratios
also have been important instruments. 7 These latter
instruments are employed much less frequently, and
have served both to "signal" and to make responses
Chart 1
Money, Interest Rates, Output and Prices*
Percent
30
20
Money Growth (M2 + CDs)
~
10
0--
__
40
20
1981
*Growth rates are calculated against same
month of previous year.
36
1983
1985
Changes in Monetary Policy Tactics
to changing economic conditions and significant
changes in underlying policies.
The Bank of Japan has used a number of separate
instruments to accommodate seasonal fluctuations
in money demand, as opposed to implementillg
short and medium-term policy actions and accommodating longer term money demand growth.
Largely in response to seasonal "surplus" funds,
the Bank of Japan sells bills of exchange drawn on
itself to short-term money market dealers to tighten
money market conditions. Similarly, the Bank purchases private commercial bills possessed by financial institutions (again via short-term money market
dealers) in large part to provide credit to accommodate seasonal shortages in the interbank market.
These operations are analogous to Federal Reserve
repurchase agreements (repos) and matched salepurchases of securities designed to even out seasonal money market swings.
In contrast, the Bank of Japan supplies base
money growth over longer periods largely by purchasing government securities (IO-year government
bonds) directly from financial institutions. Prior to
1963, the Bank of Japan concentrated most credit
expansion in direct lendings to financial institutions. Analogous Federal Reserve operations are
outright purchases of government bills and coupon
securities.
The Bank of Japan's basic tactics for implementing monetary policy have Qhanged in two major
ways since the mid-1970s. The Bank has encouraged greater interest rate flexibility and de-emphasized credit controls, although adjusting reserves
and controlling interbank interest rates through its
lending to financial institutions remain the predominant instruments of short- and medium-term monetary policy.
Policymakers now attach greater emphasis on
daily movements in interest rates as an instrument of
policy. This new emphasis is reflected in Table 1
which shows increasingly frequent daily changes in
the interbank interest rate. 8 Since 1981, the Bank of
Japan has also spurred interest rate flexibility
through sales of short-term government Treasury
bills. These sales have facilitated interest rate
arbitrage between the interbank and open markets.
Moreover, the terms on whicWlhe Bank of Japan has
purchased government bonds from financial institutions since 1978 have also gradually come to reflect
market forces. 9
Policymakers also have de-emphasized direct
quantitative controls on bank lending. 10 In particular, they have removed "window guidance" as a
binding condition on bank lending and, therefore, as
a means of monetary control in recent years. 11
37
Japan's move to floating exchange rates, and consequent elimination of the formal obligation to pursue
a monetary policy strategy consistent with maintaining fixed exchange rate parities, the shift in
policy tactics is broadly consistent, or at least compatible, with the hypothesis that the Bank of Japan
has adopted a monetarist strategy.
Other institutional evidence also appears consistent with the view that the Bank of Japan is now
placing greater emphasis on the control of money
aggregates than in the past. This evidence includes
both the number of policy statements by the Bank of
Japan since the mid-1970s 12 and the announcement
since July 1978 of quarterly money "projections" as
a broad measure of money growth (M2 + CDs ).13
Moreover, while officials of the Bank of Japan
indicate that they are paying greater attention to the
growth of money aggregates in conducting policy,
they also stress that they are giving a smaller role to
lending by financial institutions as an intermediate
target (Fukui, 1986).
Changes in the relative emphasis of operating
instruments and greater flexibility in the interbank
interest rate operating target have occurred in tandem with the liberalization ofopen market interest
rates in Japan. Greater flexibility of open market
interest rates and development of secondary
securities markets have increased the importance of
the interest rate channel in transmitting monetary
policy to the economy (Suzuki 1985, Cargill 1986).
In this sense, a broader "opportunity set," or selection, of channels of transmission are now available
to the Bank of Japan in its pursuit of monetary
policy objectives.
Taken in this context, neither the relaxation of
controls on commercial bank lending nor greater
emphasis on interbank day-to-day interest rate flexibility necessarily represents a move to the monetarist strategy of targeting a money aggregate. The
switch in the Bank of Japan's tactics is equally
consistent with targeting open market interest rates
as an intermediate objective. However, in light of
III. Short-term Monetary Policy in Japan:
Empirical Regularities
Traditional monetarism makes extensive use of
money aggregates as an intermediate target. In this
section, we study the empirical evidence on the
extent to which the Japanese central bank's presumed "money focused" policy follows the traditional model. 14
Since interbank interest rates remain the Bank of
Japan's direct operating target, we look at the extent
to which the central bank attempts to maintain
money growth along a predetermined path by systematically changing the interbank interest rate. As
discussed, one would expect to observe significantly less money variability and significantly
greater interest rate variability under a money targeting regime.
exchange rate period 1973-1985. The post-1973
sample was chosen because it represents a fundamental departure from the money supply process
associated with a fixed exchange rate regime, and
also because empirical work by Okubo (1983) and
Hamada and Hayashi (1985) suggests that the
money supply process shifted in 1973 15 • Moreover,
work by Blundell-Wignall, et al. (1984) and
Hamada and Hayashi (1985) suggest structural
change in the money demand function in 1973 that
was potentially related to shifts in monetary regimes.
The focus on the post-1973 period is important. A
number of researchers (for example, Meltzer 1985
and Friedman 1985) have contrasted the fixed and
floating rate periods. They have emphasized the
switch in monetary regimes and the simultaneous
falling-off in the average rate of money (M2 + CD)
growth from 16.2 percent (s.a.a.r.) between the first
quarter of 1960 and the first quarter of 1973 to 10
percent between the second quarter of 1973 and the
Data Trends
Table 2 shows the means and standard deviations
of several key monthly economic statistics in Japan
(M2 + CDs, interest rates, industrial production
and consumer price inflation) for the floating
38
Also shown in Table 2 is a division of the sample
into periods before and after July 1978 - the date of
the first quarterly money supply "projection" in
Japan. Although it is difficult to pinpoint the date of
an abrupt shift in the Bank of Japan's policy regime,
most Japanese policymakers have indicated the latter 1970s as a time of gradual change and would
clearly include the post-1978 period as falling
within the new "money focused" regime.
Table 2 and Chart 1 clearly indicate that average
money growth and inflation in Japan have been
declining since the mid-1970s. Somewhat surprisingly, the month-to-month variance of money
around both its mean and (declining) trend growth
has increased since the introduction of money "forecasts" in July 1978. This is true whether money
growth is measured on a month-to-month, quarterto-quarter, or semi-annual basis. And even though
the interbank interest rate moves more frequently on
third quarter of 1985, and the decline in money
variability (the standard deviation fell from 12 percent to 3 percent the two periods).
The pre-1973 period, however, cannot be reasonably considered a discretionary policy regime and
used as a basis of comparison. Under the fixed
exchange rate system that prevailed before 1973, the
central bank was given only a limited degree of
discretion in its conduct of policy. The need to
maintain fixed exchange parities meant that domestic monetary policy was subject to foreign money
shocks. Moreover, as emphasized by Okina (1985),
structural change after the mid-1970s could be
associated with the first oil shock as well as a switch
in monetary policy rules or the shift to floating
exchange rates. Our analysis of the extent to which
the Bank of Japan has followed "monetarist" policy
prescriptions therefore focuses on the period since
1973.
39
toward a more monetarist regime (constant money
growth rule) would lead one to expect, a priori,
greater negative autocorrelations because any past
deviations from constant money growth (picked up
in the constant term) would presumably be offset in
current and future periods.
A comparison of the two periods, shown in Chart
2, indicates that the stochastic process generating
M2 + CDs in Japan was virtually unchanged
between the two periods, although the first two
autocorrelations increased slightly. Both series are
clearly dominated by seasonality factors, but all the
autocorrelations are nevertheless very close. There
is no evidence of a significant and systematic move
to a constant money growth rule.
a day-to-day basis than before (Table I), Table 2 and
Chart I clearly show that its monthly variability has
declined somewhat since July 1978. Put differently,
its monthly variability has not increased as one
might have expected if the Bank of Japan had
closely followed monetary targeting. 16 The variability of output growth, in contrast, is roughly the
same in both periods. Mean output growth,
however, rose sharply from 1.6 percent during the
period 1973-1978 to 4.4 during the period
1978-1985.
Another summary measure of interest is the autocorrelation function of money (expressed in monthto-month percent changes), which is the correlation
of money with its past values. The function is useful
in determining whether there is any particular pattern in the money time series. A sharp shift in the
autocorrelation functions between pre- and
post-1978 periods would indicate a major difference
in the time series pattern of money. The switch
Causality Tests
The discussion above emphasizes that one should
observe a systematic two-way feedback between the
operating control instrument and the intermediate
Chart 2
Autocorrelation Function of M2
+ CDs*
1.00
First Period: March 1973· JUly 1978
.75
.50
.25
.00
-.25
-.50
-.75 .....0........2........4.......6.......8.....1...0.....1...2.....1..4.....1...6......18.........2....0......22..........2411.00
Lag
.75
Second Period: August 1978· September 1985
.50
.25
.00
-.25
-.50
-.75
1..10.
o
2
4
6
8
10
_
12
Lag
14
16
*Shading indicates within two standard errors.
40
18
20
22
24
money target under a monetarist policy strategy. We
used the Granger causality method to investigate
this relationship for the Bank of Japan's policy
actions(Granger, 1969).
The Granger causality method asserts that a variable x "Granger causes" a variable y if fluctuations
in x can be used to predict subsequent movements in
y after taking into account other relevant information (such as past values of y and a third variable, z).
Similarly, y'''Granger causes" x if fluctuations in y
can be used to predict subsequent movements in x.
When x "Granger causes" y, and y "Granger
causes" x, two-way feedback exists between the
variables. The phrase "Granger causes" is substituted for "causes" in order to emphasize the
particular statistical definition used and its statistical shortcomings (such as the limited information
set, potential contemporaneous correlation between
the endogenous variables, lag length selection, and
sample period).
We investigated causality in the context of a
three-variable, reduced-form system for the process
generating money (M t), interest rates (it) and nominal retail sales (St) in Japan. Our main focus was the
relationship between money and interest rates.
Retail sales were included to control for the response
of money and interest rates to business cycle fluctuations. Nominal values were used to capture both
output and price movements and therefore to save
degrees of freedom. Retail sales rather than GNP
was used because only the former is available on a
monthly basis. Our maintained structure therefore is
a system where M t, it and St are jointly determined
endogenous variables. The reduced-form of the
model is:
= L(1Tll)G Mt - I + L(1T12)P it-I + L(1TI3)N St-I + J.L1t
it = L(1TZI)GM t _ 1 + L(1Tz2)P it-I + L(1TZ3)N St-I + J.LZt
St = L(1T31)GMt _ 1 + L(1T32)P it_I + L(1T33)N St-I + J.L3t
Mt
(1)
where
Mt = M2 + CDs (percent change)
it = call money rates (percent change)
St = nominal retail sales (percent change)
L(.)i
= the polynomial lag operator of order j, that is, L(1TII)IZ Mt money lagged one to twelve periods.
41
I represents the 12 coefficient values on
Japan's .policy statements and the preceding discussion that the primary operating instrument of monetarypolicy was the interbank interest rate, and that
interest rates are an important channel for transmitting monetary policy to the economy. Interest rates
clearly lead money in these results. However, the
results are not consistent with a practice of systematic changes to the interbank rate operating control
deviations of money. If
money were an intermediate target closely followed
by the Bank of Japan, then one would expect to find
two-way "feedback" between the money and interest rate series. 18
It is possible, however, that the Bank of Japan
placed less emphasis on money in the period before
the beginning of the announced money projections
in July 1978. Then one may suspect that the full
sample results could be contaminated by the inclusion of the earlier period. In particular, there is the
possibility that the August 1978-September 1985
period would show feedback causality running from
money to interest rates, whereas the earlier March
1973-July 1978 period would not. 19
Table 3 results do, in fact, suggest a discernible
shift in the causal relationships between money and
interest rates. In particular, they indicate no evidence to suggest that money "Granger causes"
interest rates or that interest rates "Granger cause"
money during the March 1973-July 1978 period. In
contrast, during the July 1978-September 1985
period following the beginning of money supply
"projections," there is clear causality running from
interest rates to money. Again, however, this
causality is unidirectional, and money growth was
found not to Granger cause interest rates even in the
more recent period. Thus, it appears that the
1978-85 period is dominating the full sample period
The 1TS are nonlinear functions of the parameters of
the maintained structure.
The equations in 1 are the standard equations for
the Granger variant of causality testing. To the
extentthat interest rates are the primary monetary
operating instrument in Japan, and rate changes
influence the money aggregates, L(1T d should be a
non-zero coefficient vector, that is, i "Granger
sense that
values of interest
rates add relevant information to predicting money.
Similarly, if the Bank of Japan were systematically
shifting its operating instrument - call money rates
- in response to a money aggregate intermediate
Objective, then the L(1TZI) coefficient vector would
be non-zero (M "Granger causes" i). If both the
L(1Tlz) = o hypothesis andtheL(1TzI) = Ohypothesis could be rejected, then there would be "feedback" between money and interest rates as the basic
money targeting model (with short-term interest
rates as the primary operating instruments) predicts.
Table 3 presents the F-statistic test results from
estimating the equation system 1. Money, interest
rates, and retail sales were expressed in monthly
percent changes to create stationary series. All
series were seasonally unadjusted, and seasonal
dummy variables were included in the regressions to
control for seasonal factors.
Lag length selection (parameters G, P and N in
system I) is potentially very important to the
causality test results. Twelve monthly lags were
chosen for all of the variables in the tests, but no pretesting of various lag lengths was conducted. The
twelve monthly lags were chosen based on various
policy statements by officials of the Bank of Japan
regarding the period of monetary targeting. I?
The full sample (March 1973-September 1985)
results suggest significant unidirectional causality
running from interest rates to money, but no feedback causality from money to interest rates. Evidence for the former lies in the highly significant (at
the one percent level of confidence) coefficient of
lagged interest rates in the money equation in Table
3 (given a 3.81 F-statistic). The full-sample results
indicate that money adds no additional explanatory
power to that imbedded in past interest rates and
retail sales in predicting interbank interest rates (the
F-statistic is 0.69).
These results are consistent with the Bank of
For the 1978-85 period, there is evidence that
changes in call money helped predict changes in
money growth but not that money growth systematically helps to predict the call money rate
policy instrument as would be the case if a precise
money target were followed by the Bank of Japan.
This. finding nonetheless is consistent with the
Bank's policy pronouncements that it has placed
greater emphasis in recent years on the control of
interbank interest rates as the primary operating
42
Japan, although the present interpretation of the
eviden<.;e is somewhat different. Okubo (1983) uses
the relative power contribution method to analyze
causal relations among money, income, prices, and
interest rates ill. Japan during .several sample periods. Similar to the results presented above,Okubo
finds strong unidirectional causality running from
the call money rate to money after 1974 and also
concludes that this evidence· '\ . . supports the
usual contention that monetary control in Japan is
effected not by changes in the (monetary)base, but
rather by adjustment of policy-influenced interest
rates" (p.• 129). With no additional evidence,
however, he also implies that these results are consistent with an "explicitly money-supply oriented"
Bank of Japan policy. The analysis above questions
Okubo's interpretation of the regime shift in the
early 1970s.
Okina (1985), in a somewhat different context,
also expresses some doubt on the significance of the
shift in the Bank of Japan's operating procedures.
He points to both the switch in exchange rate
regimes and the aftermath of the first oil price shock
as potential alternative candidates to explain lower
Japanese money and income variability between the
pre- and post-1973 periods.
variable in implementing monetary policy. It is also
consistent with the commonly accepted view that
interest rate fluctuations have grown in importance
asa channel of monetary policy transmission to the
economy.
Overall, these causality test results provide some
support for the view that, in recent years, the monetary authorities in Japan have placed a great deal
more •emphasis on interest rates, as opposed to
direct credit controls, as an operating target in
controlling the economy, including money fluctuations. There is, however, no evidence that the introduction of money "projections" in Japan in July
1978 was associated with a statistically significant
and stable policy feedback rule running from money
to interest rates. Hence, there is little evidence to
suggest that the Bank of Japan has closely adhered
to monetary targeting. It is noteworthy that this
conclusion also is consistent with the descriptive
statistics presented in Table 2. Those statistics show
that although average money growth has declined
steadily since the mid-1970s, its variance around
trend has remained largely unchanged since the
advent of floating exchange rates in 1973.
These results are consistent with other research
on the relations between interest rates and money in
IV.
Conclusion and Policy.lmplications
than before, and has virtually discontinued direct
controls over commercial bank lending.
The empirical results suggest that the move away
from direct credit controls ("window guidance")
toward more flexible short-term interest rates does
not represent a "money focused" monetary policy
in the sense of a close adherence to a constant
money. growth rule. In particular, money variability
has not declined in recent years in contrast to interest
rate variability.
Moreover, it does not appear that up to a year's
lagged values of money help to explain fluctuations
in the operating control variable of the central bank
(interbank interest rates). This indicates that the
Bank of Japan. has not systematically moved interbank interest rates in response to deviations of
money growth from its narrow targeted rlll1ge since
either the move to floating exchange rates in 1973 or
the announcement of money projections starting in
The environment in which monetary policy in
Japan is conducted has changed significantly since
the move to floating exchange rates in 1973. Along
with relaxation of a formal exchange rate objective,
the Bank of Japan's behavior has been modified by a
gradual liberalization of the Japanese financial system: interest rate decontrol, the development of new
financial instruments and financial markets, and
fewer constraints on the asset and liability choices of
investors, borrowers, and financial institutions.
These developments, in turn, have broadened the
"opportunity set" of monetary policy instruments
available to the Bank of Japan. In particular, the
transmission of interest rate changes to economic
activity is now more significant in the emerging
deregulated Japanese financial environment. Partly
in response to these changes, the Bank of Japan has
emphasized interbank interest rates as the primary
operating instrument of policy to a greater extent
43
have been responsible, but at least three other factors
may have lowered the trend rate of money demand
growth. First, lower average inflation, perhaps associated with the rapid increase in interest rates by the
Bank of Japan in response to the second oil shock,
may have created less nominal money demand
growth. Second, the sharp drop in the growth rate of
potential real GNP in Japan following the first oil
price shock in 1973 may have lowered the trend
groWtl1 of real money demand.
Third, and perhaps most intriguing, the decline in
trend money growth in Japan may simply be associated with the shift in the flows of funds away from
intermediary channels of finance toward direct
finance. 21 In particular, this shift has tended to slow
the growth of the banking sector and its liabilitiesa good part of which constitute broad money in
Japan.
The empirical evidence suggests that these
explanations, and other potential explanations as
well, serve as credible alternatives to the conventional wisdom that attributes slower Japanese
money growth to a conscious systematic shift in the
Bank of Japan's behavior since the latter 1970s.
1978. Nevertheless, we found clear causality running from interest rates to money in the later period
(1978-1985), indicating the greater importance of
the interest rate channel in transmitting monetary
policy changes to the economy in a deregulated
financial environment.
A cautious interpretation of these results is appropriate. No statistical evidence was found to suggest
asystematic "causal feedback" between money and
interest rates as even loose adherence to a money
supply rule would generate. Moreover, neither the
institutional nor the empirical evidence suggests
that the Bank of Japan controls its interbank interest
rate operating instrument in a systematic fashion
designed to maintain control (up to a year) of money
aggregates along a fixed or gradually evolving predetermined growth path. The evidence suggests that
a more flexible approach to policy is followed, and
that Japan's success at maintaining low and stable
inflation and stable output growth cannot be
attributed to its adoption of traditional monetarist
policy prescriptions. 20
The task remains to identify the source of the
Bank of Japan's success at slowing money growth.
Conscious policy action by the central bank may
FOOTNOTES
1. See Friedman (1985) and Greenwood (1985). Friedman, for example, recently stated that " ... the Bank of
Japan has been the least monetarist central bank in its
rhetoric, the most monetarist in its policy ... " of all the
major central banks.
6. The loan rates of deposit banks are less flexible than
interbank rates because prime lending rates are linked to
the •official discount rate, and the cost of funds is still
regulated except for CDs and money market certificates
(Suzuki, 1985; p. 6).
2. Shimamoto, 1982, p. 82. Similarly, Suzuki (1985)
recently stated that" ... the policy attitude of the Bank of
Japan over the past years ... is in my interpretation neither that of a post-Keynesian 'discretionary fine tuning' nor
that of an 'x percent rule.' It is discretionary in that it allows
for gradual tuning of monetary growth, and it conforms to a
rule in the sense that it stabilizes money growth as much as
possible and gives information to the public about policy in
the form of forecast announcements. An appropriate term
may be 'eclectic gradualism.'"
7. The Bank of Japan provides financial institutions with
loans at the official discount rate. Since the discount rate is
below the interbank call and bill money rates, there is
ordinarily an excess demand for the Bank's funds, which
the Bank manages by rationing credit at its own discretion
(Fukui, 1986; p. 5).
8. Fukui (1986, pp. 14-15) has identified three stages of
interbank market liberalization that have allowed greater
interest rate flexibility: (i) 1978-79, when the "quotation
system" for call and bill rates (in which money market
dealers operated as brokers and consulted with porrowers
and lenders to determine "quotations" according to a
formula based on a consensus between borrowers and
lenders, changes in rates were infrequent) was abolished,
and a diversification of maturities of instruments traded
was developed; (ii) 1980-1982, when a liberalization of
controls allowed arbitrage opportunities to develop to link
the interbank and open markets; (iii) 1983 onward, when
there was a further relaxation of controls on various transactions and introduction of new financial instruments.
3. Lendings to financial institutions by the Bank of Japan
may be withdrawn at any time at the option of the Bank
(Fukui, 1986; p. 5).
4. The following discussion draws heavily on Fukui (1986),
particularly pages 3-4.
5. The Bank of Japan's ability to control money and credit
is also helped by the fact that almost all financial institutions in Japan are required to join the reserve requirement
system. Moreover, all deposits by the general public at
financial institutions are reservable, with the exception of
"new money in trust," supplied by trust banks since the
end of 1985.
9. The Bank of Japan is eager to expand the role of
Treasury bills in its money market operations because the
44
bills are believed to offer the greatest degree of control.
That is, T-bill operations influence interest rates in open
markets directly whereas interbank rates are an indirect
means of influencing market rates. The T-bill market nonetheless remains undeveloped, and the Bank of Japan's
operatipnson these instruments are not conventional
"open market" operations. In particular, the Bank of Japan
is reluctant to repurchase Treasury bills sold .to absorb
funds because of its desire to see larger private holdings of
these instruments.
16. Melt,zer (1985) notes that, in his estimation .forecast
error, variances for output and prices were reduced followingtheBank of Japan's move to announce projections of
money growth. He suggests that these announcements, if
credible, increase information about money growth. and
reduce uncertaintY (p. 40). Seemingly atodds with this
interpretation, however, is that the variance of forecast
errors of the M1 money stock and money growth variability
generally increased after the move to announce projections (Meltzer, 1985; p. 15).
10. According to an Executive Director of the Bank of
Japan, " ... in money supply management, interbank rate
operations are the main tool, and window guidance is only
a supplementary or stopgap measure. With this attitude,
and in response to the growing monetary relaxation since
the middle of 1980, the Bank of Japan has permitted city
banks, long-term credit banks and all other financial intermediaries to lend as they wish." (Shimamoto, 1982; p. 83).
17. Fof<example, an Executive Director of the Bank of
Japan has stated that "... the Bank of Japan follows the
money supply not weekly, but rather monthly andquarterly" (Shimamoto, 1982; p. 81). The Director oftheBank of
Japan's Institute for Monetary and Economic Studies, in
contrast, recently stated that, "there are three principal
features of monetary targeting as practiced by the Bank of
Japan since 1975. First, broad money (M2 + CDs) is
chosen as the most important intermediate target. Second,
the period of targeting is not a week, a month, or a quarter,
but a year. Third, the target is not announced, but the
forecast is announced quarterly in terms of the percentage
increase over the previous year in the average money
stock of the quarter concerned" (SUZUki, 1985; p. 5).
11. The Bank of Japan has expressed its willingness to
reimpose credit controls on bank lending if controls seem
desirable, however.
12. Suzuki (1985), for example, notes that ... "Japan
also shifted to a money focus as its intermediate objective
in the last half of the 1970s" (p. 7-6). Moreover, Fukui
(1986) notes" ... As for intermediate objectives of monetary policy, emphasis has been placed on the control of
money supply instead of ceilings on increases in lending
by financial institutions to the non-banking sector"
(p.17).
18. It is important to emphasize that, strictly speaking,
feedback from actual money changes as deviations from
the target range is what should be "causing" changes in
the call money rate when money targeting is followed.
However, as long as the target is not moved frequently, the
Granger tests presented in the test should capture this
variability from the target ranges. As footnote 13 indicates,
changes in the Japanese ."monetary projections" have
been infrequent since 1978. Moreover, the Bank of Japan
emphasizes that money projections are not to be interpreted as money targets in the United States.
13. The Bank of Japan publishes projections of the rate of
increase in the average outstanding M2 + CDs each quarter over the corresponding quarter of the previous year.
These projections tend to move gradually over time. For
example, recent projection ranges were: 1978.3 - 1979.4,
11-12%; 1980.1 - 1981.2, 7-8%; 1981.4 - 1982,3, 9-10%;
and 1982.4 - 1983.4,8-9%.
19. Okubo (1983), for example, deletes the period immediately after 1973 "... to avoid the influence of the disorganized quarters at the time of the first oil crisis"
(p.117).
14. Various Japanese policymakers and government
economists have emphasized the introduction of broad
money (M2 + CDs) as an important intermediate indicator.
See, for example, Shimamoto, 1982; p. 82 and Suzuki,
1985; p. 5.
20. This interpretation also has been expressed by a
number of Bank of Japan officials. For example, ... "Thus, the attitude of Bank of Japan toward the
money supply is, in a word, pragmatic. Given uncertainty,
shifts in functions, and instabilities, we believe this stance
most appropriate to conditions at home and abroad."
(Shimamoto, 1982; p. 82).
15. Hamada and Hayashi (1985) estimate money supply
equations as functions of lagged money growth, lagged
inflation, lagged industrial production growth, and lagged
reserves to test Barro's anticipated money neutrality
hypothesis. They find a significant shift in the function with
the move to floating exchange rates in February 1973, but
not at other potential shift points (December 1970, December 1973 or December 1974). There is doubt, however,
whether the direct approach of estimating money equations as functions of ultimate policy variables to test for the
degree of "policy discretion can disentangle money supply from money demand influences. See DeRosa & Stern
(1977)
21. See Cargill (in this Economic Review) for a detailed
discussion of the shift in the flows of funds in Japan and its
importance for increasing the role of direct finance, as
opposed to indirect finance working through the banking
system, in channeling funds from the surplus (household)
sector to the deficit sectors (government and corporate
sector) since the mid-1970s.
45
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San Francisco, Summer 1986.
Real Output in the Japanese Economy" Survey on the
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EmpiricalTests olthe LSW Proposition"Bank of Japan
Monetary and Economic Studies, VoLA, No.1 ,April
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Okubo, Takashi. "Money, Interest, Income and Prices."
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""""""""""."The Fed's Monetarism Was Never Anything But
1,No.2, Oct. 1983.
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Suzuki, Yoshio. "Monetary Policy in Japan: Transmission
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Hypothesis in Disequilibrium Econometrics: An InterSuzuki, Yoshio. "Japan's Monetary Policy Overthe Past 10
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46
posit Rate
Demand
Michael C. Keeley and Gary C. Zimmerman*
The deregulation of deposit rates on personal checking accounts has
caused a large portion ofthe M1 monetary aggregate to become interestbearing and has raised the question ofwhether the demand for M 1 might
also have been affected. This article compares the behavior of deregulated components of Ml with that of the regulated components prior to
deregulation. We find that the short-run open-market interest rate elasticities of demand for the noninterest-bearing components prior to
deregulation are considerably lower than the elasticities of the deregulated interest-bearing deposits. Deposit rate deregulation, therefore,
appears to have made the demandfor M1 much more sensitive to interest
rate changes.
Many analysts argue that the traditional relationship between Ml and the economy no longer holds.
As supporting evidence, they cite the apparent contradiction between Ml's historically high annual
growth rate of approximately 11 percent between
September 1984 and September 1985 and the lack
of a resurgence of high inflation that would normally be associated with such rapid money growth.
Some have attributed this changed behavior to the
elimination of deposit rate ceilings, claiming that
the elimination has altered the relationship between
the demand for Ml and interest rates, income, or
both. In this article, we examine the behavior of
each of the components of Ml to see whether
deregulation can explain Ml's recent unusual
behavior.
Deposit rates on personal checking accounts have
been deregulated very rapidly during the past few
years through the authorization of NOW (Negotiable Order of Withdrawal) accounts nationwide on
December 31, 1980 and Super NOW accounts on
January 5, 1983. While the NOW account was
restricted to pay a maximum of 5Y4 percent interest,
the Super NOW was totally free of interest rate
ceilings. When introduced, the Super NOW had a
$2500 minimum balance requirement, but the
requirement was reduced to $1000 on January 1,
1985 and dropped entirely on January 1, 1986, thus
eliminating the regulatory distinction between
NOW and Super NOW accounts.
Personal interest-bearing checking accounts now
are free of all regulatory deposit rate or minimum
balance restrictions, although individual institutions are free to impose their own minimum balance
requirements. l Businesses, however, are still limited to holding noninterest-bearing demand
deposits.
This deregulation of personal checking accounts
raises a number of questions about how the monetary aggregates will behave because balances in the
new accounts are counted in the checkable deposit
component of Ml - the narrowly defined monetary
* Senior Economist and Economist. Maureen
O'Byrne, Joni Whitmore and Alice Jacobson
provided useful research and programming
assistance.
47
aggregate. 2 Some have suggested that these
accounts may have attracted funds from savingstype balances that were previously counted only in
the broader monetary aggregates, such as M2 or
M3. 3 If true, shifts into 1Jf1e new accounts may have
altered the behavior of M,l and changed the relationships between Ml and the economy.
Even if such portfolio shifts did not occur, deposit
rate deregulation has the potential to change the
income and interest rate elasticities of the demand
for checkable deposits and, perhaps, even of currency. This also would change the behavior of the
I.
monetary aggregates and prevent them from providing the signals for monetary policy they have in the
past.
In this paper, we explore these issues. Section I
provides a brief sketch of the deregulation of checkable deposits and the impact of those changes on the
composition of the monetary aggregates. In Section
II, we outline a microeconomic model of the
demand for various transactions media and discuss
the likely impact of deregulation on that demand.
Section III presents our empirical evidence. Finally,
Section IV contains a summary and conclusions.
The Changing Composition of the Monetary Aggregates
Over the last decade, the composition of Ml has
undergone a major shift (See Chart 1). The shift
began with the gradual adoption of NOW accounts,
which were first available on an experimental basis
in New England. NOWs and a number of like
accounts - ATS at banks and share drafts at credit
unions that will hereafter be referred to as NOWs raised the explicit interest paid on transaction balances from zero to a maximum of 51f4 percent. 4
Following their authorization nationwide on
December 31, 1980 for banks and thrifts, NOWs
grew very rapidly. As Chart 2 shows, even after the
initial large shift into NOWs was completed in
1981, interest-bearing checking accounts continued
to grow more rapidly than Ml 's other components.
At the beginning of 1980, only 5 percent of households had interest-bearing checking accounts; by
1985, over 35 percent had them. As of mid-1986,
Chart 1
Composition of M1
Percent
100
80
60
40
20
o
1977
1979
1981
48
1983
1985
interest-bearing checking account deposits
amounted to $200 billion; and they comprised over
30 percent of Ml, and over 70 percent of personal
transaction deposits.
During the introductory NOW period, surveys
and studies suggested that about 25 percent of the
new money shifted into NOWs came from nontran
saction sources.6These funds, generally believed to
have been shifted from savings accounts and time
certificates, may be more interest-sensitive than
demand deposits, and therefore may have made Ml
more interest-sensitive.
However, there undoubtedly also was a major
shift of demand deposits into NOWs during the
introductory period. Chart 3 shows, for example, a
sharp drop in demand deposits coinciding with the
initial sharp increase in NOW balances in early
1981. Our statistical estimates of that shift are
consistent with the earlier estimates — they show
that about 71 cents of each dollar moved into NOWs
came from demand deposits.7
NOWs, while apparently more attractive than
demand deposits for many consumers, were only
partially deregulated (since they had a ceiling rate of
5% percent) in contrast to the Super NOW, which
offered depositors a full transaction account free of
Sources of Interest-Bearing Checkable
Deposits
The source of funds moved to interest bearingcheckable deposit balances included in Ml may be
an indicator of how Ml will behave. If NOW
accounts attracted balances from savings or time
accounts, those balances may behave more like
savings balances than transaction balances and
impart a savings quality to Ml. One piece of evi
dence suggesting that NOWs and Super NOWs may
have attracted a sizable portion of funds from non
transaction balances is that the average balances in
these transaction accounts are substantially higher
(at approximately $5,000 and $13,000, respec
tively) than the average balance (of approximately
$1,500) in personal checking accounts prior to the
nationwide authorization of NOWs.5
Chart 2
Growth Rates of M1 and its Components
Percent
(Annual Rate of Change)
4 0 r35 H
30
M1
S
Currency
S I Demand!
25 20
□
Ill
Interest Checking
-
(‘Preliminary estimates using first 6 months of 1986)
49
In sum, deregulation has dramatically changed
the composition of M 1 by making a large portion of
it interest-bearing. A future sharp increase in interest rates could well induce flows from the remaining
noninterest-bearing demand deposits stiUheld by
households into interest-bearing accounts. To
understand better the impact of these actual and
potential changes, we present the theoretical effects
of deregulation and empirical estimates of their
magnitude in the following sections.
any interest ceilings. Thus, one might expect many
customers to prefer the Super NOW over the NOW.
In fact, the Super NOW was very popular and
caused a dramatic shift in the composition of MI.
By. year-end .1985, Sl1per NOWs represented over
10 percent of ML Chart 3 also suggests that a
majority of Super NOW deposits came from NOW
accounts 8 , although other explanations are possible.
The •growth in Super NOWs for example, is not
inconsistent with a significant inflow from such
nontransaction sources as passbook savings or time
accounts.
Chart 3
Transaction and Savings Deposits Over Time
Billions
of Dollars
600
NOW Accounts
authorized
nationwide
Super NOW
Accounts
authorized
500
400
300
200
100
NOWS + ATS
'4
0 1977
1979
1981
50
1983
II.
Theoretical Framework
from other accounts), and Super NOW accounts
attracted funds from NOWs. These large shifts
would not have occurred if depositories had been
able to circumvent the ceilings costlessly. Thus, in
the aggregate, depositors' returns on Super NOW
accounts likely exceeded returns on NOWs, and the
returns on NOWs likely exceeded the returns on
demand deposits. 9
The other, more commonly discussed (Santomero and Siegel, 1985), effect of deposit rate
deregulation is that deregulation may make deposit
rates vary more closely with open market interest
rates. 10 This effect is presumably due to the higher
cost of varying implicit rather than explicit interest
payments, at least in the short-run. However, as
Flannery (1982) has argued, explicit retail deposit
rates (adjusted for reserve requirements) are not
expected to vary one-for-one with open market rates
because there are adjustment costs to changing them
too. Thus, the importance of this effect is an empirical question.
Although the most important type of deregulation
of transaction accounts was the raising and then
removing of the deposit ceilings on them, ceilings
on term accounts and limited transactions accounts
such as the money market deposit account (MMDA)
also have been removed. Thus, rates on these other
accounts also may vary more than before. Since the
other accounts may be substitutes for transaction
accounts to a certain degree, the increased variation
in term accounts' interest rates also may affect the
demand for transaction accounts and currency.
The effects of removing interest rate ceilings on
deposit accounts depend on how easy it was for
depository institutions to circumvent the ceilings
through nonprice competition in the first place. A
profit~maximizing depository institution would
expend resources (both interest and noninterest) on
attracting and holding various kinds of deposits to
equate the marginal costs of different types of
deposits, including transaction deposits. However,
depositors' returns need not be equal to the marginal
costs of attracting deposits if nonpriced services are
not perfect substitutes for cash interest payments.
At one extreme, some economists (for example,
Klein, 1974) have argued that ceilings can be circumvented costlessly through nonprice competition. If this were correct, deposit rate deregulation
would have no effects. At the other extreme, much
of the traditional money demand literature (see Judd
and Scadding, 1982, for a review) assumes that the
ceilings were perfectly enforced so that deposits for
which the payment of interest is prohibited earn no
return, even in terms of nonpriced services.
An intermediate position is that binding deposit
rate ceilings drive a wedge between depositories'
marginal costs of deposits and depositors' marginal
returns because of the inefficiencies of nonprice
competition (see Keeley and Zimmerman, 1985).
That is, in general, depositors value the implicit
payments (of nonprice competition) at less than
their cost because people generally prefer cash to
payments in kind. In other words, barter is less
efficient than monetary exchange.
The view that nonprice competition is inefficient
implies that removing a deposit rate ceiling would
increase the return depositors receive without affecting depositories' marginal costs. Such an increase in
depositors' returns should lead to a one-time
increase in the quantity of deposits in the affected
account. In addition, as we discuss in more detail
later, the increase in the level of depositors' returns
may affect the interest elasticities of demand for
deposits as well.
There is strong evidence supporting the view that
nonprice competition is inefficient: NOW accounts
succeeded in attracting large quantities of deposits
previously held in demand deposits (as well as funds
Interest and Income Elasticities
In sum, deposit rate deregulation may have
increased the· return and/or the covariation of
deposit rates with respect to open market rates.
Below, we analyze these potential effects on the
sensitivity of the demand for transaction deposits to
changes in income or open market interest rates. We
begin by discussing the implications of a simple
inventory model of money demand, and then consider a more general model of asset demand.
An Inventory Model
Much of the literature on deregulation's effects
51
intermediate stage. If nonprice competition were
inefficient, then these varying degrees of regulation
would translate into own rates of interest (implicit
plus explicit) on transaction media with the following ranking:
has used the simple inventory model of money
demand. l l This model, developed by Baumol
(1952), assumes that persons minimize the inventory costs of holding transaction balances by holding most of their financial wealth in one asset, such
as a bond. This model implies that the demand for
real transaction balances D can be written as 12:
(3)
0= rcurrency < rdemanddeposits < rNOWs < rSuperNOWs
If the own rate of interest on each of these
accounts does not vary with open market rates, then
equation 2 implies that Super NOWs should be the
most interest-elastic (in absolute value) and currency the least, with demand deposits and NOWs in
between:
(1)
where
=
=
I' =
I'd =
a =
D
Y
131 =
132 =
real transaction balances
real income
open-market interest rate
rate on deposits
a parameter that depends on the
transactions costs of selling bonds
(assumed to be constant)
elasticity of demand with respect to
income
elasticity of demand with respect to
the opportunity cost of holding
deposits.
(4)
TJcurrency < TJdemanddeposits < TJNOWs < TJ Super NOWs
This ranking would still hold even if the covariation of I'd with 1', were not zero (which it is not for the
Super NOW, for example), as long as it is small
compared to the differences in the levels of I'd due to
the inefficiencies of nonprice competition. This
result, however, is due to the logarithmic form of the
demand function, which in tum comes from the
inventory-cost minimizing basis of the model. A
more general asset demand function would not
necessarily reproduce this implication about the
ranking of elasticities.
Differentiating IuD with respect to 1m gives:
dlnD
dIm
=
0
TJ r
= -13
(---!-\It -~\
2\f.-rct)' 81' J
(2)
The Short-Run Versus Long Run
Although the covariation of deposit rates with
open-market rates may be low in the short-run,
especially for implicit interest payments, in the
long-run, it is likely that competitive forces would
push (implicit plus explicit) deposit rates towards
open market rates until they equalled the open
market rate times one minus the reserve requirement. Thus, even though the ranking in equation 4
might hold in the short~run, it would seem much
less likely to hold in the long-run because in the
long-run, I'd would adjust fully to changes in r.
Thus, deregulation may have substantial effects
on the short-run interest elasticities yet not affect
long-run elasticities. In the empirical analysis, the
model we employ allows for differences between
long-run and short-run elasticities.
This equation shows that the elasticity of D with
respect to the market rate 1', TJg depends on two
factors with opposite effects: how close I'd is to I' and
the covariation of I'd with respect to r. The closer the
level of the rate on deposits to the open market rate
(that is, the closer I'd is to 1'), the greater the elasticity; but the greater the covariation of I'd with
respect to 1', the lower the elasticity.
This model can be used to analyze how the
interest elasticities of various transaction media,
which are deregulated to different degrees with
regard to interest payments, might compare with
one another. The most highly regulated transaction
medium in a sense is currency, on which the own
rate is zero. This model predicts, therefore, that the
interest elasticity of currency should be -132'
As mentioned previously, checkable deposits
were subject to varying degrees of regulation
regarding the payment of interest, with demand
deposits being the most highly regulated, Super
NOWs the least regulated, and ordinary NOWs at an
A Generalized Asset Demand Model
The simple inventory model has been criticized
on a number of grounds. For one, if reserve requirements were eliminated and deposit rates equalled
52
open market rates, the model would collapse. A
more general model, similar to that discussed in
Santomero and Siegal (1985), which does not suffer
from this drawback, views the demand for (real)
transaction balances as a generalized asset demand
that depends on the own rate of return, rates of
return on substitute assets (including the open market instrument), and income or wealth:
+
+
would be evaluated at a higher level of rd' Such an
increase in the level of r d would cause portfolio
shifts into transaction deposits, but without a
knowledge of the specific functional form of equation 5, it is not pOssible to judge what the effect
would be on interest and income elasticities.
It appears that, in general, theory cannot predict
the net effect of deregulation on the interest-sensitivity of checkable deposits with one exception.
The deregulation of checkable deposit rates as well
as the deregulation of other deposit rates should
increase the interest-sensitivity of the demand for
currency (since rd = 0), assuming that deposits are
substitutes for currency and that rates on checkable
and other deposits would vary more closely with
open market rates after deregulation.
(5)
D = f(rd' rsl' rs2 ' ... ,rsn ' r, Y)
where r8i is the rate of return on a substitute asset i,
and Y is real income (or wealth). Taking the derivative of equation 5 with respect to the open market
rate r gives:
dD =
dr
+
+
+
oD ~+~~
ord or
or81 or
Income Elasticity
Deregulation may also have altered the income
elasticity of demand for currency and bank transaction deposits. The simple inventory model implies
that the income elasticity of the demand for all types
of transaction media, including fully deregulated
accounts, would be unaffected by deregulation (and
equal to 131) as long as rd < r. In contrast, the more
general model of asset demand suggests that, as r d
approaches r with deregulation, more and more
investment funds may be held in bank transaction
deposits because there are costs to holding multiple
investments or switching funds from the openmarket instrument into bank deposits. If so, the
income elasticities of deregulated accounts may
differ from those of regulated accounts if the income
elasticity of demand for investment balances differs
from that for transaction balances.
+
+ ... + ~ ~ +
orsn
or
oD .
or
(6)
This formulation has several implications about
the effects of deposit rate deregulation - both
deregulation of own rates and rates on substitute
bank deposits - on the sensitivity of transactions
media to the open market rate, r. First, deregulation
of the own rate may increase ord!or. This alone
would lessen the interest-sensitivity (in absolute
terms) of checkable deposits. Second, deregulation
of substitute deposits would likely increase ors/or,
and thus increase the sensitivity of D with respect to
r (holding constant the own rate).
Third, by eliminating the inefficiency of nonprice
competition, deregulation would increase the level
of rd and thus the partial derivatives in equation 6
III. Empirical Results
The traditional approach to studying the effects of
deposit rate deregulation on the behavior of transactions media has been to try to determine if the
behavior of an aggregate, such as MI or M2,
changed with deregulation (see, for example, Judd,
1983 and Judd and Motley, 1984). This paper takes a
different approach, and tries to determine how
deregulation might have affected the behavior of
each component of the Ml monetary aggregate.
Our approach has several potential advantages.
First, it may be better able to determine whether
deregulation had an effect. Deregulation ofpersonal
checkable deposit accounts has been phased in
gradually along with deregulation of noncheckable
deposits and limited checking accounts and reductions in reserve requirements. Thus, it may be
difficult to detect an abrupt change resulting from
deregulation by examining an aggregate's behavior
53
at anyone time even though a deregulated account
may behave much differently from a regulated one.
Second, our approach may yield more information about deregulation's effects. In particular, only
an analysis ofthe behavior of the components of M I
can test the ranking of short-run interest elasticities
of demand implied by the inventory model of money
demand. The model implies, under certain assumptions, that the most deregulated media would be the
most interest-elastic. Our analysis allows us to test
this hypothesis directly by comparing the elasticities of currency, demand deposits, NOW, and
Super NOW accounts. By analyzing only the
behavior of an aggregate, one cannot compare the
demand elasticities of different transactions media
that have been deregulated to varying degrees.
Finally, our approach may yield more insight into
the future behavior of transactions deposits. Since
the final step of deregulation was completed just this
year, the behavior of the Super NOW account - a
prototype of a fully deregulated account - may
give a better indication of the future behavior of
transactions deposits than the past behavior of an
aggregate dominated by regulated and partially
deregulated deposit accounts.
Below, we present estimates of the interest and
income elasticities of various transactions media:
currency, demand deposits, NOWs, and Super
NOWs. We also present estimates for money market
deposit accounts (MMDAs) for purposes of comparison. However, before presenting estimates of
income and interest elasticities of demand, we present some evidence on how the own interest rates on
two deregulated accounts - MMDAs and.. Super
NOWs - have behaved to shed light on the hypothesis that deregulation will increase the covariation
of deposit rates with respect to the open market rate.
Covariation of Deposit Rates with
Open-Market Rates
The hypothesis that deposit rate deregulation will
increase the covariation of deposit rates with respect
to open-market rates cannot easily be tested directly
because there were no direct measures of (implicit)
deposit rates prior to deregulation. However, an
extreme version of this hypothesis - that deregulated deposit rates will equal the open-market rate
times one minus the reserve requirement - can be
tested. An alternative hypothesis suggested by Flannery (1982) is that deposit rates respond sluggishly
54
costs involved in opening Super NOW accounts,
which increase the associated adjustment costs.
Another reason may be that tax incentives make
implicit interest a larger part of the return from
holding Super NOWs.
In sum, deposit rates on retail deposit accounts do
not move one-for-one with open-market rates, at
least in the short-run. Even the MMDA, which is
not .sUbject to .a reserve requirement (on· personal
accounts),responds sluggishly in the .short-run· to
changes in open-market rates. The Super NOW
exhibits even more sluggish behavior. It seems
likely. that (before deregulation) implicit. rates on
checking deposits behaved at least as sluggishly and
perhaps even more so than Super NOW rates.
While not definitive evidence, the sluggish
behavior of the Super NOW rate suggests that the
main effect of deposit rate deregulation will be to
increase the short-run variation in the relative opportunity cost of transaction deposits. If the elasticity of
demand for transaction deposits with respect to that
cost were constant, the increased relative variation
would imply an increase in the responsiveness of the
transactions deposits to changes in the open-market
rate.
with respect to open-market rates because of adjustment costs. Tests of these hypotheses for Super
NOWsand MMDAs are presented in Table 1, which
contains regressions of MMDA and Super NOW
rates on the three-month T-biUrate using monthly
data. 13
The hypothesis that deposit rates should equal the
reserve-adjusted open market rate implies that, in a
linear regressionof a deregulated deposit rate onthe
open-market rate (which we measure as the continuous-time, annualized 3-month T-bill effective
yield), the constant term should be zero and the
slope equal to one minus the reserve requirement.
Estimates of the first set of regressions reject this
hypothesis. They both show positive and statistically significant constant terms and slopes of less
than one minus the reserve requirement (the reserve
requirements are zero for personal and .03 for
nonpersonal MMDAs, and .12 for Super NOWS).14
One interpretation of the type of deposit rate
behavior implied by these results is that there are
adjustment costs involved in varying the. rate on
deposits. In the long-run, bank deposits would be
priced competitively (after adjusting for reserve
requirements), but in the short-run, the rate on
deposits would vary less than one-for-one with
open-marktit rates.
To test d~ctly for sluggish adjustment of deposit
rates, we estimated a standard "adjustment" model
in which a fraction of the difference, 'A, between the
actual deposit rate and the equilibrium deposit rate
is assumed to be eliminated in each period. The
second set of regressions in Table 1 contain estimates of this model. For the MMDA, the estimated
adjustment coefficient '11. is about one-third and the
long-run effect of an increase in the T-bill rate on the
deposit rate is somewhat less than unity (.88). A one
percentage point increase
bill rate leads to
only a .30 point increase in the MMDA rate in one
month.
Super NOW rates behave even more sluggishly,
with an adjustment coefficient of .18 and a onemonth response of only .llpercentage point to a 1
point increase in the T-bill rate. Part of this greater
sluggishness may be due.to the much higher reserve
requirements on Super NOWs, but the large differences cannot be explained by reserve requirements alone. The explanation may lie in the greater
Effects of DeregUlation on Interest and
Income Elasticities
:perhaps the most direct way to determine the
effect of deposit rate deregulation on the interest and
income elasticities of demand for checkable
deposits is to compare the elasticities of demand of
fully and partially deregulated deposit accounts
with each other and with transactions media prohibitedfrompaying interest. Below, we present
such comparisons.
Estimates. of interest and income elasticities of
specific transactions media were obtained from the
following partial-adjustment form of the real money
dem~md function that has been widely used in past
studies:
In(Dit)
55
= <Y + (l
- '1I.)ln(DiH )
+ 'A131In(r) + 'A1321n(Y)
+ 133T l + ... +1313T ll
+1314 Trend
(7)
where:
Dit
=
=
r
Y
T l' . •
Trend
=
.,
T 11
=
=
which included the mortgage costs of housing. See
Huizinga and Mishkin, 1985.) The nominal openmarket interest rate is the 3-month T-bill rate (converted to a continuous-time yield from the bankdiscount basis), and real income is personal income.
In Table 2, estimated interest and income elasticities are presented for three at least partially
deregulated deposit accounts: the Super NOW,
NOW, and MMDA, and are compared with estimated interest and income elasticities for demand
deposits and currency held by the public both prior
to and after deregulation.
Estimates for the NOW account are presented
separately for the periods before and after the Super
NOW was introduced because of a possible change
in its interest elasticity. It appears that Super NOWs
were successful in attracting substantial deposits
real deposits at time t of type i
the nominal open-market interest rate
real income
monthly seasonal dummies
a linear time trend variable
Monthly data (not seasonally adjusted) from different subperiods within the time frame of January
1959 through February 1986 were used to estimate
the parameters of equation 7. The CPI-UXL series,
which uses the rental equivalence method of computing housing costs, was used to deflate all nominal variables. (This measure avoids the built-in
correlation between interest rates and housing cost,
and hence the price level, in the older CPI-U series
56
from NOWs. Since the most interest~sensitive funds
in NOWs likely shifted into Super NOWs, NOWs
might have become less interest-elastic after Super
NOWs became available.
Finally, the firstthree months after an account was
introduced were excluded from the sample periods
to allow for portfolio adjustment not related to the
explanatory variables. For similar reasons, the two
months prior to the· introduction •of· NOWs were
excluded from the sample· used to estimate· the
models for demand deposits and currency. 15
The estimated short-run (one-month) interest
elasticities presented in the first column of Table 2
are relatively high for both Super NOW accounts
and NOW accounts prior to the introduction of
Super NOWs, averaging around - .10. This compares to the interest elasticities of demand deposits
and currency of - .017 and - .005, respectively. In
fact, the estimated short-run interest elasticity of the
Super NOW is closer to the elasticity of the MMDA
__ an account used primarily for savings, not transactions - than the elasticity of either demand
deposits or currency prior to deregulation. The
NgW account appears to have become less interestel~stic after the introduction of Super NOWs, but it
still is much higher than the short-run interestelasticity of demand deposits or currency prior to
deregulation.
The results for demand deposits during the postderegulation period suggest that their short-run
interest elasticity increased over time. For example,
the e.stimated short-run interest elasticity was
- .044 during the 1981.04"1986.02 post-NOW
period and - .064 during the 1983.04-1986.02
post-Super NOW period, compared to .an estimated
elasticity of only
.017 during the
1959.01-1980.10 pre-NOW period. Nevertheless,
these higher·elasticities.are still far below those of
Super NOWsand even conventional NOWs during
the pre-Super NOW period.
The estimated short"run interest elasticities of
demand for currency for all periods are considerably
lower (in absolute value) than. the •elasticities of
SuperNOWs, NOWs or demand deposits astheory
predicts. However,there is some indication that.the
interest elasticity of currency may be higher inthe
post-NOW period.
For the Super NOW and NOW, the estimated
long-run elasticities appear to be larger than that of
demand deposits prior to the introduction of NOWs.
In addition, the speed of adjustment,A, for the
Super NOW is much greater than that for either
de
ll1and deposi\S or currency. The holding of 1l10re
savings~type funds in these accounts could account
for this faster adjustment if savings balances react
more quickly than transaction balances to changes
in int~rest rates. The rapid speed of ~djustin~nt for
the MMDA, which presumably consists mostly of
savings balances, provides supporting evidence. In
addition, the point estimate of Afor NgWs prior to
the introduction of Super NOWs (although not
statistically significant) also is higher than those of
demand deposits Or currency.
The results on income elasticities are less clearcut than those on interest elasticities. Although the
point estimates of the income elasticities of Super
NOW and NOW accounts are generally larger than
those of either currency or demand deposits,. their
standard errors also are large and none of the estimates ~s statistically significant. As a result, it is not
possible to determine whether these accounts are
more income-elastic than currency or demand
deposits. The estimated income elasticity for the
MMDA also is not statistically significant, possibly
because its balances are of a longer term inve~tment
nature and therefore do· not respond to monthly
fluctuations in income.
Interpretation of Results
The results on the demand fOr varioustransactionsmedia suggest that deregulation has increased
the. absolute value of the media's short-run interest
elasticities. OneintefPretation ofthese re~ults is that
they confirm the hypothesis of the traditional inventory model that a higher level of rates on deregulated
accounts. in conjunction.with .rel~tively.little.OWn
rate variation cau~es the demand for deregulated
~ccounts to. be more interest elastic, at least.in the
short-run. ThisintefPretation is consistent with both
the lower interest elasticity of demand for cUrrency
(whose own rate is zero) comPared to <that for
demanddeposit~(whOSe implicit rate is gre~terthan
zero),. and the. higher el~ticity of Super NOW
accounts compared to that. ofdemand deposits.
lbeseresultsare.also consistent withthe notion
that •lifting the ceilings·. on consumer. checkable
accounts has reduced the inefficiencies of nonprice
57
competition and thus increased the effective rate
depositors receive.
An alternative explanation might be that Super
NOWs and NOWs contain more savings-type balances than do demand deposits, and that savings
balances are more sensitive at the margin to interest
rate changes.
The interest elasticity results are consistent with
our finding that the own rates on Super NOWs do
not vary closely with open market rates in the shortrun. As a result, a change in market rates causes a
larger percentage change in the opportunity cost of
holding Super NOWs. Since the inventory model of
money demand implies that the elasticity of demand
with respect to the opportunity cost is constant,
greater variability in the opportunity cost of deregulated accounts would explain why those accounts
apparently have higher interest-sensitivities with
respect to market rates.
deregulated account with respect to its opportunity
cost rather than the open market rate. If the hypothesis were correct, the short-run interest elasticity of
demand with respect to the opportunity cost for a
deregulated account should be much closer to that of
a regulated account with respect to the open market
rate.
This type of test can be carried out best for the
Super NOW since it is the only checkable deposit
entirely free from interest ceilings and for which
data are available on its own rate. However, as
discussed previously, it is likely that Super NOWs
do pay some implicit interest. Using its explicit rate
as a measure of the total rate therefore probably
biases the measured opportunity cost upward, and
thus the estimated interest-sensitivity.
The results of estimating the model described by
equation 7 for Super NOWs, but using the log of the
difference between the open-market rate (the threemonth Treasury bill rate) and the Super NOW rate
are as follows. As expected, the estimated short-run
elasticity with respect to the opportunity cost is
much lower (in absolute value) than the elasticity
One Additional Test
One additional test of this hypothesis is to estimate the interest-sensitivity of the demand for a
58
with respect to the open market rate as reported in
Table 2. (- .026 versus - .090). The estimated
short-run elasticity with respect to the opportunity
cost. is close to the elasticity of demand deposits
with respect to the market rate in the pre-NOW
period (- .017). Thus, this result also is consistent
with the prediction of the traditional inventory
demand model that deregulation will increase the
short-run elasticity with respect to the open-market
rate if the own rate does not vary strongly with the
open-market rate.
aggregates' components - the weights being each
component's share ofthe aggregate. Below,we test
the hypothesis by comparing the short-run interest
elasticity of Ml before and after the introduction of
NOWs.The results ofthistest are preselltedinTable
3.
To determine whether the short-run interest elasticityofdemand for Ml increased after NO\Vs were
introduced nationwide in January 1981,weestimated the basic model described by equation .7
separately for the two periods 1959.01- 1980.10
and 1981.04 - 1986.02. The first three months of
1981. were excluded because NOW accounts were in
an adjustment phase then, and possibly attracted
funds . not previously held in checkable deposit
accounts. The last two months of 1980 were
excluded because many batiks promoted the new
accounts by offering high rates on retail RPs at the
time.
Effects on l1li1
One implication of these results is that the
deregulation of rates should have increased the
interest-sensitivity of an aggregate such as Ml,
which includes NOW and Super NOW accounts.
The interest elasticity of an aggregate such as Ml is
a weighted sum of the interest elasticities of the
59
The results indicate that the short-run interestsensitivity of Ml apparently more than tripled (in
absolute value) from - .012 to - .041. To test
whether this increase was statistically significant,
the data from the two periods were pooled and a
fully interactive version ofequation 7 was estimated
on the pooled sample, allowing each parameter to
take on different values in the two periods. In the
bottom part of Table 3, T-tests are presented of
whether the key parameters in the post-NOW period
are statistically significantly different from those in
the pre-NOW period. The tests show that the
increase in interest elasticity was statistically significant at the 1 percent level, whereas neither
income elasticity nor the adjustment parameter
changed by a statistically significant amount. Thus,
the results provide very strong evidence that the
short-run interest elasticity of Ml in the period after
NOWs were authorized nationwide was higher (in
absolute value) than before. This result is consistent
with the much higher interest elasticities of Super
NOWs and NOWs, but does not prove that their
introduction was the sole cause of the increase in
interest-sensitivity of MI.
Another possible cauSf of MI's increased interest-sensitivity is an increase in the interestsensitivity of the other components of Ml as well,
perhaps due to the deregulation of noncheckable
accounts, such as the money market certificate, and
limited checking accounts, such as the MMDA. To
test this hypothesis, we estimated the model
IV.
described by equation 7 for demand deposits and
currency before and after the nationwide introduction of NOWs. The results are reported in Table 4.
The point estimates of the interest elasticities of
demand deposits and currency are higher (in absolute value) in the post-NOW period. However, only
the increase in the demand deposit interest elasticity
is statistically significant.
The increase in the estimated interest-elasticity
for demand deposits may be due to a switch by
consumers into NOWs and Super NOWs that left
businesses holdin~ an increased portion of demand
deposits. It also might be due to deregulation of
other accounts that are substitutes for demand
deposits. Whatever the reason, the increase in the
interest elasticity of demand deposits is part of the
explanation for the increased interest elasticity of
M1. (It is also possible that currency contributed to
the increase, but we cannot determine statistically
whetheritdid.)16 Also, Super NOWs andJorNOWs
contributed to the increase since the elasticity of Ml
in the post-Super NOW period exceeds the elasticities of either currency or demand deposits.
Because of an increase in the short-run interest
elasticity of each of the components of the Ml
monetary aggregate after deregulation, Ml is now
more interest-sensitive - about 4 times more sensitive according to our findings. Thus, MI should
show wider variations in response to exogenous
interest-rate changes now than before deregulation.
Summary and Conclusions
Deposit rate deregulation has caused a major
change in the composition of M1. As of mid-1986,
30 percent of Ml consisted of interest-bearing
checking accounts. This changed composition of
Mland the associated rapid growth of its interestpaying components has raised the question of
whether deposit rate deregulation has also changed
the demand for M 1.
The empirical results presented in this paper
suggest that the short-run elasticity of demand for
MI with respect to the open market rate has been
affected, but that there were no statistically significant changes in other parameters of the demand
function. Specifically, our results suggest that the
short-run interest elasticities of demand for NOW
and Super NOW deposits exceed those of either
demand deposits or publicly held currency prior to
the nationwide authorization of NOW accounts.
One explanation for these higher interest elasticities is that deposit rate deregulation has
increased the total (implicit plus explicit) returns to
depositors by lessening the inefficiencies of nonprice competition while not increasing, at least by
much, the short-run covariation of total deposit
returns with respect to the open market rate. The
combination of these two factors, in tum, has led to
increased variation in the relative opportunity cost
of NOW and Super NOW deposits. Assuming the
elasticity of demand with respect to the opportunity
cost is constant implies that the short-run interest
60
elasticity of these accounts with respect to the openmarket rate has increased.
An additional factor accounting for the increase
in the short-run interest-sensitivity of Ml is the
apparent coincident increase in the interest-sensitivity of demand deposits with the nationwide
introduction of NOW accounts. Also, there appears
to be an increase in the short-run interest elasticity
of· currency associated with·· the introduction of
money market certificates - an important first step
in the deregulation of deposit rates on nontransaction accounts.
Not only has deposit rate deregulation apparently
changed the short-run behavior of the Ml monetary
aggregate, it is also likely to make the composition
ofMl more variable than before. This is because the
demand for the interest-bearing components of Ml
appears to be much more interest-elastic than the
nQninterest-bearing cornponents, at least in the
short-run. Moreover, deposit rate deregulation has
apparently indirectly increased. the. short-run. interest elasticity of demand for the noninterest-bearing
components.
These changes in demand raise questions for
1ll0Iletary policy under virtually anY view of what
money is and how money is related to other aspects
of the economy. For one, they suggest that the
traditional relationships between Mlandthe economy have changed. For another, they raise an .even
more basic question of whether an aggregate comprised of both interest-bearing and noninterest-bearing components with different interest elasticities
and changing relative prices is useful as a guide to
monetary policy.
FOOTNOTES
1. While deregulation has made interest-bearing checking accounts available to all consumers, the prohibition
against the payment of interest on traditional noninterestbearing demand deposits remains. Hence, consumers
have the option of either interest-bearing NOW or Super
NOW accounts, or noninterest-bearing checking
accounts, which typically have both lower minimum balance requirements and lower fees.
2. M1 ($639.9 billion as of December 1985, not seasonally
adjusted) is defined to include only financial assets that are
used as media of exchange. It includes publicly held
currency ($173.1 billion), travelers checks ($5.5 billion),
net demand deposits at banks ($281.3 billion), and other
checkable deposits consisting of NOWs, Automatic Transfer Service (ATS) accounts, credit union share drafts and
demand deposits at thrifts ($115.8 billion), and Super
NOWs ($64.2 billion).
Functional Cost Analysis, published by the Federal
Reserve Banks. Average account balances in NOWs and
Super NOWs are well above typical minimum balance
requirements for free NOW and Super NOW accounts
which averaged $1073 and $3300 respectively, as
reported in Sheshunoff and Company's study entitled
"Pricing Bank Services and Loans," 1985.
6. See Federal Reserve Bulletin, July 1981, page 542.
7. The statistical estimates are from a statistical model in
which the change in demand deposits was regressed on
the change in NOW deposits and changes in interest rates,
a time trend, seasonal factors, and a dummy variaple for
the period covered by the special credit restraint program
in 1980. The model was estimated for the period from
February 1959 through June 1981 to include the first sixmonth adjustment period following the nationwide introduction of NOW accounts. A $1.00 increase in NOWs
(including ATS accounts) was estimated to result in a
statistically significant $.71 decline in demand deposits.
8. We were unable to obtain a statistically significant
estimate of the shift from NOWsinto Super NOWs.
9. There are reasons that not all (personal) transactiol')
deposits shifted into Super NOWs even though their total
returns likely exceeded those on other transaction
deposits. For one thing, implicit interest is nontaxable,
explicit interest is taxable and transactions fees are not
deductible. Thus, some depositors with high transactions
needs, small average balances, or high tax rates might
prefeno receive nontaxable implicit interest through "free"
transaction deposits that earn no explicit interest rather
than receive taxable interest and pay (nondeductible)
transaction fees.
Similarly, many depositories continue to require minimum
balances in Super NOW accounts as a method of compensation for the transaction services they provide rather than
3. The broader monetary aggregate, M2, includes both
transaction balances reported in M1, and savings-type
balances, such as MMDAs, savings deposits, small time
certificates, general purpose money market mutual fund
shares, and other short-term financial assets. M3 is an
even broader aggregate. In addition to M2, it includes
large-denomination time deposits, term RPs and Eurodollars, and institution-only money market funds. Because
both M2 and M3 contain both· savings and transaction
balances, they are much less likely to be affected by
portfolio shifts between transaction and savings balances
than M1 which contains only transaction balances.
4. Ceilings for banks and savings and loans were 5%
percent, while during some periods, credit union share
drafts were allowed to pay higher rates.
5. Data on NOW and Super NOW balances are from the
Federal Reserve Board's "Quarterly Survey of Number of
Selected Deposit Accounts" for November 1985. Personal
checking account average balances for 1980 are from the
61
chargeJees directly. This is sensible even though such
balances incur the implicit reserve tax because this tax is
still far lower than the typical personal marginal income tax
rate.
CD rates (two other open-market rates). The results are as
follows:
Period
Federal
- .0068
1.08***
Funds
(:0048)
(.056)
1-Month
-.0033
1.05***
CD:
(.0036)
(.041)
'-*Significant at the 1% level
10. In addition, the gradual reduction in reserve requirementsthat has been occurring may increase the absolute
(but not relative) variation of interest payments on transaction deposit accounts with open-market rates. The ratio of
required reserves to checkable deposits has declined
frprnover 22 percent inthe early 194013 to about 10 percent
now; there. was a 40 percent decline in the time since the
Monetary Control Act of 1980 was passed. As reserve
requirements decline, we expect that the absolute variation in interest rates on reservable deposits accounts with
respect to open-market rates will increase. This increased
variation, in turn, may affect the degree to which persons
substitute among different accounts and among deposit
and nondeposit investments depending on whether
demand depends on the absolute or relative variation in
rates.
.92
83.03-86.02
.95
83.03-86.02
These regressions have zero intercepts and unitary
slopes, .as expected, and confirm that the T-bill rate is a
good measure of an open-market rate.
15. The model described by equation 7 in Table 2 was
also estimated in first difference form as a check on the
rooustness of the estimates (see Plosser and Schwert,
1977 and 1978, and Plosser, Schwert and White, 1982).
Also, the model was estimated excluding the first six
months after the account was offered to allow for a longer
adjustment not related to the explanatory variables. The
results, however, are relatively robust with respect to these
two changes.
11. See, for example, the discussion in Simpson (1984).
12. The simple model derived by Baumol implies income
and interest elasticities should be one-half. However, a
more general formulation is silent on the magnitude of
these parameters.
13. All interest rates are continuous time annual yields,
and thus have the same dimension.
16. It is possible that the interest elasticity of the demand
for currency increased when nontransactions accounts
were deregulated. If so, the test reported in Table 4 has
little power because the wrong breakpoint was used.
Using June 1978 as the breakpoint - the date the 6-month
money market certificate was authorized and the date
many argue was the first important step in deregulating the
interest rates on noncheckable accounts - we found that
the estimated short-run interest elasticity of currency
increased by a statistically significant amount. In fact, it
more than doubled from - .014 to - .031.
14. To determine whether our use of the T-bill rate as a
measure of the open-market rate was appropriate, we
regressed the T-bill rate on the Federal Funds and 1-month
REFERENCES
Barro, Robert J. and Anthony M. Santomero. "Household
Money Holdings and the Demand Deposit Rate,"
Journal of Money, Credit and Banking, Vol. IV, May
1972.
Baumol, William J. "The Transactions Demand for Cash:
An Inventory Theoretic Approach," Quarterly Journal
of Economics, Vol. LXVI, November 1952.
Flannery, Mark J. "Retail Bank Deposits as Quasi-Fixed
Factors of Production," American Economic Review,
Vol. 72, No.3, June 1982.
Huizinga, John and Frederick S. Mishkin. "Monetary Policy
Regime Shifts and the Unusual Behavior of Real Interest Rates," unpublished paper. National Bureau of
Economic Research, Cambridge: March 1985.
Judd, John P. and John Scadding. "The Search for a
Stable Money Demand Function," Journal of Economic Literature, Vol. XX, No.3, September 1982.
Judd, John P. "Deregulated Deposit Rates and Monetary
PolicY," Economic Review, Federal Reserve Bank of
San Francisco, Fall 1983.
Judd, John P. and Brian Motley. "The Great Velocity
Decline of 1982-83: A Comparative Analysis of M1
and M2," Economic Review, Federal Reserve Bank of
San Francisco, Summer 1984.
Keeley, Michael C. and Gary C. Zimmerman. "Competition
for Money Market Deposit Accounts," Economic
Review, Federal Reserve Bank of San Francisco,
Spring 1985.
Klein, Benjamin. "Competitive Interest Payments on Bank
Deposits and the Long-Run Demand for Money,"
American Economic Review, Vol. 64, No.6, December 1974.
Plosser, Charles I. and G. William Schwert. "Money,
Income and Sunspots: Measuring Economic Relationships and the Effects of Differencing," Journal of
Monetary Economics, Vol. 4,1978.
Plosser, Charles I., G. William Schwert and Halbert White.
"Differencing as a Test of Specification," International
Economic Review, Vol. 23, No.3, October 1982.
Santomero, Anthony and Jeremy J. Siegal. "Deposit
Deregulation and Monetary Policy," #16-85. Rodney
L. White Center for Financial Research, 1985.
Simpson, Thomas D. "Changes in the Financial System:
Implications for Monetary Policy," Brookings Papers
on Economic Activity. Vol. 1, 1984.
Startz, Richard. "Competition and Interest Rate Ceilings in
Commercial Banking," Quarterly Journal of Economics, May 1983.
Startz, Richard. "Implicit Interest on Demand Deposits,"
Journal of Monetary Economics, Vol. 5,1979.
62
Adrian W. Throop*
Thrift institutions supplying nearly half of the total credit needs of
housing have experienced recurrent bouts of deposit outflows during
periods ofhigh interest rates. Such outflows would have had a significant
impact on the pace of residential investment to the extent that the market
for mortgage credit was not fully integrated with money and capital
markets. In recent years, financial deregulation has tended increasingly
to integrate the mortgage market with other financial markets. This
article estimates the magnitude ofcredit availability effects on residential
investment from disintermediation at thrifts both before and after financial deregulation, as well as the effect that this deregulation has had on
the cyclical volatility of interest rates.
In recent years, financial deregulation has tended
to integrate the market for mortgage credit with
the money and capital markets. This article examines how the extent of integration has changed the
cyclical behavior of interest rates and residential
investment.
Three major factors insulated the mortgage market from other financial markets in the past: 1)
Regulation Q ceilings on the interest rates paid on
deposits at thrift institutions that specialize in housing finance, 2) usury ceilings on mortgage loans,
and 3) a limited secondary market for mortgage
loans. The disintermediation created by ceilings on
deposit rates tended to restrict deposit flows into
thrift institutions in periods of tight credit. The thrift
institutions had difficulty offsetting the lack of
deposit inflows by selling off mortgage loans from
their portfolio because of a limited secondary market as well as an unwillingness to show capital
losses. Also, usury ceilings reinforced the short-run
tendency of mortgage lenders to ration credit by
means other than interest rates. To the extent that
restrictions on the availability of mortgage credit at
thrift institutions could not be offset by other
lenders, the result was more severe fluctuations in
residential investment.
Since most ceilings on deposit rates and usury
ceilings on mortgage rates were removed in the late
1970s and early 1980s, housing should now be able
to compete on .a more nearly equal basis for funds;
and swings in housing construction should be
dampened. Nevertheless, housing still is likely to be
affected by tight credit conditions more than other
sectors of the economy because housing demand
has a relatively high sensitivity to interest rates. An
additional consequence of financial deregulation
should be a greater volatility in the general level of
interest rates. This follows because the overall supply of credit is now being rationed to a greater
degree by price, and also because tight credit conditions now strike less specifically on housing.!
This article estimates the degree to which financial deregulation has both moderated the cycle in
residential investment and contributed to greater
volatility in market interest rates. Section I provides
a simplified theoretical framework for analyzing the
effects of tight credit conditions on the cyclical
behavior of residential investment and interest rates
in regulated versus unregulated financial environments, and discusses its applicability to recent
housing cycles. Sections II and HI identify past
* Research Officer, Federal Reserve Bank of San
Francisco. Research assistance by Hamid-Reza
Davoodi is gratefully acknowledged.
63
periods when regulatory constraints were at least
partly binding and disintermediation at thrifts
resulted in less residential investment than would
have occurred in a deregulated financial environment. To make the identification, a model of the
housing market based purely on demand factors was
constructed, and then was tested for the additional
influence of deposit inflows at thrift institutions
during periods of disintermediation.
Next, Section IV compares the cyclical behavior
of market interest rates and housing activity in
j')¢riodsofbinding regulatory constraints with what
they Would have been in a deregulated financial
enVironment. For this purpose, the model of resipential investment was embedded in a small-scale
structural macroeconomic model. The degree to
which financial deregulation has made interest rates
more volatile and swings in the housing cycle less
severe was then simulated by removing the estimat~d effect of deposit flows on housing activity.
~inal1y, Section V provides a summary of the main
findings.
I. The Availability of Credit to Housing
depicted in Panel A of Figure I, where, for simplicity, we assume that at the outset the deposit rate
(and mortgage rate) is the same as the interest rate in
the open market. Each of the initial supply functions
is drawn on the assumption of an equilibrium value
of the interest rate in the other market.
Consider now an increase in the demand for credit
in the open market, which has the effect of shifting
the demand schedule from Do to D' o' In an unregulated financial environment, the resulting higher
interest rate in the open market would shift the
supply of funds in the intermediated market, Sm' to
the left, raising the mortgage rate and deposit rate as
well. These higher rates would, in tum, shift the
supply of funds in the open mark:et'i,S", to the left
and raise the interest rate in the op~n.market still
further, and so forth.
The ultimate configuration of interest rates
between the two markets depends upon the substitutability in supply between the two markets and
the relative elasticities of demand. As long as
lenders do not regard market instruments and thrift
deposits as perfect substitutes, open market rates
would rise by somewhat more than deposit and
mortgage rates. Even in the unregulated environment, residential investment would fall as more
funds flow toward open market.
The outcome in this unregulated financial
environment contrasts with that when a ceiling is
imposed on the deposit rate at financial intermediaries at the initial level of interest rates, shown in
Panel B. Since the deposit rate cannot change, the
Theoretical Framework
We begin with a simplified theoretical framework
foranlllyzing the effect of regulatory constraints on
residential investment. For this purpose, consider a
rudimentary financial system in which a regulated
set of financial intermediaries provides housing
finance, whereas borrowers in other sectors of the
economy o~taillcredit in the open market without
the use of intermediaries. The demand for credit in
each of these §~ctors is assumed to be independent
of the demlj.ndfOr credit in the other, but suppliers of
credit shiftJr:e~lY between the two markets in
response to relative interest rates. Without loss of
generality, the cost of intermediation is assumed to
be ~ero, sqthat the. supply of deposits to the financial intefP.1e~i~es is identical with the supply of
mortgage <:;redit.lo ultimate borrowers. We also, at
least initially, abstract from problems related to the
maturity structure of interest rates.
This model contains two demand functions and
~~g.supply functions. The demand for mortgage
loans, Dm , depends upon the mortgage rate, im ,
Which, in the unregulated financial environment, is
e9u~1 to the deposit rate, id ; and the demand for
other types of credit, Do, is a function of the interest
rate in the open market, io. The supply of credit to
financial intermediaries, Sm' and thus ultimate
mortgage borrowers, depends upon both the deposit
rate, id , and the open market rate, io. The supply of
credit to the open market, So, is a function of these
two rates as well.
An initial full equilibrium in the two markets is
64
rates in the open market rise by less. As a result,
nonhousing activity rises more, and residential
investment therefore falls by more than in an unregulated situation. Note also that, although in this
example intere¥ rates rise because of an increase in
the demand for credit, a similar difference between
controlled and uncontrolled environments exists if
interest rates were to rise because of a restriction in
the supply of credit (as, for example, due to monetary policy).
The excess of mortgage credit demanded over
that supplied, which results from the disequilibrium
created by the deposit rate ceiling, must somehow
be rationed. 3 If usury ceilings on mortgage loans
were binding, mortgage credit would be rationed by
means other than the mortgage rate, such as by
increasing down payments or simply by refusing to
lend. Alternatively, if usury ceilings on mortgage
loans were not binding, the mortgage rate could rise
supply schedule for credit to the open market now
remains fixed when the demand for credit rises in
that market. The resulting increase in the interest
rate in the open market then causes a shift of funds
away from deposits at intermediaries, and reduces
the supply of deposits from Sm to S'm.
The resulting decline in mortgage credit and
housing activity at the controlled level of the deposit
rate will be greater than in the case of uncontrolled
intermediaries (Qm - Q'mis greater in Panel B than
in A). Also, the difference in the impact on housing
between the regulated and unregulated financial
environments will be greater the larger is the substitutability in supply between the two markets. 2
The deposit rate ceiling reduces residential
investment by more than would otherwise occur
because of the temporary market disequilibrium and
resulting restriction in the availability of credit.
Compared to the unregulated environment, interest
Figure 1
Interest Rate Ceilings and the Availability
of Credit to Housing
A. No Interest Rate Ceiling on Deposits
Q'o
B. With Interest Rate Ceiling on Deposits
65
relative to the deposit rate to ration the available
supply of funds. In the short-run, however, mortgage rates are slow to adjust to market forces while
other dimensions of price tend to be altered first.
Still, the argument about the effect of disintermediation on the availability of credit to housing
does not depend on the exact means used to ration
the restricted supply of mortgage credit.
This simple model captures the essence of the
credit availability effects generated by deposit rate
ceilings at thrift institutions. However, because
thrift institutions generally supply no more than half
of total residential home mortgage credit, these
availability effects could be offset by other lenders
less subject to deposit rate regulation than thrifts.
The extent of offset depends on the substitutability
of other investments for mortgage loans. Unless
mortgage loans and investments in the portfolios of
these other lenders were perfect substitutes, restricting credit availability at thrifts could still have some
impact on the total supply of mortgage credit and
residential construction.
In addition, thrift institutions themselves may be
able to reduce the effects of deposit rate ceilings by
tapping alternative sources of funds. If these alternative sources were not perfectly substitutable for
regulated deposits, however, some credit availability effects due to disintermediation may remain.
housing credit through them. The differential ceilings prevented an outflow of funds from thrifts to
banks but did little to prevent outflows into unregulated intermediaries and to the open market during
periods of disintermediation in 1966-67, 1967-70,
and 1973-74 brought on by rising interest rates.
Commercial banks were generally able to adjust
to periods of disintermediation better than thrifts for
several reasons. First, in the earlier years, commercial banks had relatively large holdings of government securities that could be sold off to offset the
effects of deposit outflows. Second, banks sought to
overcome the effects of disintermediation by
developing new sources of funds - the most important of which were Eurodollar borrowings and
issues of bank-related commercial paper. Third,
Regulation Q ceilings were ,lifted on large negotiable CDs maturing in 30 to 89 days in 1970, and on
all such CDs in 1973.
In contrast, thrifts did not have large holdings of
secondary reserves. They were slow to develop new
sources of funds beyond Federal Home Loan Bank
advances, and they did not begin to issue significant
amounts of large CDs until the late 1970s. Since
thrift institutions are the main suppliers of mortgage
credit, there was a potential for significant credit
availability effects on residential investment during
the periods of disintermediation.
Government-sponsored agencies have pursued
activities to offset some of the effects of disintermediation4 . The most important offset for thrifts has
consisted of advances from Federal Home Loan
Banks, which tend to rise in periods of disintermediation and weak housing activity, and to fall in
other periods. Since Federal Home Loan Banks
obtain the funds for these advances by borrowing in
the open market - a practice that puts further
pressure on market interest rates, their activities
have tended to generate further disintermediation at
thrifts. Nevertheless, the net effect of Federal Home
Loan Bank advances has probably been to reduce
credit availability effects on residential investment,
at least in the short-run.
The Federal National Mortgage Association
(FNMA or "Fannie Mae") and, to a lesser extent,
the Federal Home Loan Mortgage Corporation
(FHLMC or "Freddie Mac") have also tended to
Regulation Q and Government Support of
the Mortgage Market
We now tum to a discussion of the degree to
which Regulation Q has affected different types of
mortgage lenders, as well as the major alternative
sources of funds available to thrifts. Regulation Q
ceilings were imposed on deposit rates at commercial banks in the 1930s. Their purpose was to
prevent excessive competition for funds, which was
thought to have been one of the major causes of bank
failures. Because market rates of interest typically
were below the ceilings, these ceilings had little
effect on the financial system until the mid-1960s.
As the ceilings became binding, however, they were
extended to savings and loan associations and
mutual savings banks, although these institutions
were given a favorable rate differential over commercial banks in an attempt to protect the flow of
66
offset some of the effects of disintermediation. They
have done so by issuing debt and using the proceeds
to buy mortgage loans from thrifts. Constituting
another source of support have been sales of
federally guaranteed participations in mortgage
pools by the Government National Mortgage Association (GNMA or "Ginnie Mae) and Freddie Mac.
These pools, which tap broader sources of mortgage
finance than just deposits at thrifts, became important after 1970. However, the activities of FNMA
and the other agencies have been less countercyclical than those of the Federal Home Loan Banks.
interest and dividends paid on deposits and accounts
at depository institutions. The phase-out period
lasted until April 1986, but substantial deregulation
took place almost immediately. 6 In addition, the
Deregulation and Monetary Control Act eliminated
state usury ceilings for residential mortgage loans
and broadened the asset powers of thrift institutions.
These. changes have enhanced the ability of thrift
institutions to attract funds in periods of tight credit
and given them more flexibility in managing their
assets. As shown in Chart I, however, sharp cycles
in the flow of real, or inflation-adjusted, deposits to
thrifts were not eliminated. Even after the introduction of Money Market Certificates in June 1978, the
total flow of real deposits into thrifts varied sharply
and inversely with the overall level of interest rates.
Nevertheless, the fact that movements in deposit
inflows continued to be associated with changes in
interest rates does not necessarily indicate that regulation effectively continues to constrain housing
finance. Nor are earlier cycles in deposit flows
necessarily evidence of effectively binding regulatory constraints in those periods.
Deposit inflows to thrifts would tend to follow a
cyclical pattern in response to variations in interest
rates even in a completely unregulated financial
environment. Outflows of deposits could still occur
Recent Financial Deregulation
Although the extent of countercyclical support to
mortgage finance by government agencies has not
changed much in recent years, financial deregulation has integrated the mortgage market more completely with money and capital markets. The first
major element of deregulation affecting housing
was a relaxation of Regulation Q ceilings in June
1978. This relaxation allowed both thrifts and commercial banks to issue Money Market Certificates
with an interest rate tied to the rate on six-month
Treasury Bills. 5 Subsequently, the Deregulation and
Monetary Control Act of 1980 authorized the phaseout and ultimate elimination of all limitations on
Chart 1
Real Deposits at Thrift Institutions
Percent
(Quarterly Percent Change at Annual Rates)
20
16
12
8
4
0 .........- 4
- 81962 1964
1968
1972
67
1976
1980
1984
in such an environment when the demand for mortgage finance is curtailed by high levels of mortgage
rates, thus reducing the amount of deposits that
thrift institutions are willing to supply.
In Section III, we will estimate the impact that
regulatory constraints have had on residential
investment through restricting the supply of mortgage credit from thrifts. As part of this analysis, we
examine whether credit availability effects at thrifts
continued to play a role after 1978 or whether the
fluctuation in deposit flows at thrifts in the
post-1978 years was purely demand-induced.
II. An Empirical Model of Residential Investment
In this section, we develop an econometric model
of residential investment in which the demand of
housing in combination with the current stock of
housing determines the current relative price of
housing. The amount of residential investment then
responds to the profitability of construction as determined by the relative price of housing7 •
We begin with an analysis of the determinants of
the demand for the stock of housing. The per capita
real demand for the stock of housing is assumed to
depend upon per capita permanent real disposable
income and the nominal user cost of capital in
housing relative to the general price level. Thus,
~*
where
=
bo
t
(Y~P) b
( ; ) -b
2
where:
=
quantity of housing demanded in
1972 dollars
N
population
YDP
=
=
Pu
=
P
=
nominal user cost of housing
capital
general price level.
=
nominal user cost of capital
Ph = asset price of housing
=
p =
d
=
market rate of interest
expected rate of inflation
rate of physical depreciation of
housing assets.
Thus, the nominal user cost, Pu ' equals some
fraction of the asset price of housing, Ph' determined by the market rate of interest, i, the expected
rate of inflation, p, and the rate of physical depreciation, d. The rate of interest, i, is equal to the nominal
cost of capital so that i - P is the corresponding real
long-term rate of interest. 9 The ratio of the nominal
user cost to the asset price of housing (equal to
i - P+ d) is referred to as the real user cost, DC.
The real user costs for owner-occupied and rental
units differ because of the effects of taxation. 10 We
employ a weighted average of these costs - with
weights of three-fourths and one-fourth, respectively - to obtain the aggregate real user cost, DC.
Pu from equation 2 can then be substituted into
equation I to obtain:
(1)
K*
Pu
permanent disposable income in
1972 dollars 8
(3)
The nominal user cost of housing capital, Pu ' is
the per period payment for capital and is analogous
to a wage rate for labor. In the absence of taxes, the
nominal user cost in the current period can be shown
to be proportionate to the asset price of housing
according to the formula:
or
In K*
In bo
+
I - b l In N
+
- b 2 1n DC - b 2 In(Pph)
(2)
68
b l In YDP
(3a)
Thus, the stock of housing demanded is a function of population, pennanent disposable income,
and the real asset price of housing, as well as tax
factors, the depreciation rate, and the real interest
rate contained in the real tiser cost ratio, Uc.
In the short~run, the current stock of housing, K,
is fixed, and the real asset price of housing, Ph/P,
adjusts to clear the market for housing, as shown in
Panel A of Figure 2. SettingK equal to K* and
rearranging terms, this equilibrium condition
implies:
The supply of residential investment in the model
is characterized by a conventional supply function.
Because of capacity constraints, marginal costs
increase with the rate of construction. The amount
of building is therefore an increasing function of the
real asset price of housing, scaled by the size of the
existing capital stock:
(5)
or
lnfph\=_l_lnbo + I-blInN
(4)
b2
b2
+ ~ In YDP - In UC - ~ In K
\PI
b2
In IFIXR = In
~ + alln(~h) + In K
(5a)
b2
This supply function for residential investment is
shown in Panel B of Figure 2. Gross real residential
investment can therefore be obtained by substituting
the detenninants of the real asset price of housing in
equation 4 into equation 5a, giving.
With a given stock of housing, an increase in
population or pennanent income drives up the real
asset price of housing until the higher relative user
cost equates the quantity demanded with the available stock. Conversely, an increase in the current
housing stock reduces the real asset price, and hence
the relative user cost, until the increase in the
quantity demanded equals the increase in the stock
available. Finally, a change in the real interest rate,
the effective tax on the cost of capital, or the
depreciation rate would produce offsetting changes
in the real asset price of housing until the relative
user cost is the same as before.
(6)
In IFXR =
Figure 2
The Model of Residential Investment
(a)
S
(b)
s
o
IFIXR
K
Stock of Housing
Residential Investment
69
with most adjustment in the short-run taking place
intl1ehll1'd-to-measure nonprice terms of credit.
Therefore, a distributed lag on the real after-tax 6month commercial paper rate was used instead. II
The real after-tax commercial paper rate was first
usedto define the user cost for owner-occupied and
rental housing. Then the resulting real aggregate
user cost, DC, was entered into the investment
equa.tion in distributed lag form. The best fitting
distributed lag was three quarters in length. This lag
covers the interval between changes in short-term
interest rates and the response in the cost of mortga.ge credit as well as the time it takes for builders to
respond to the resulting change in housing prices.
Also, short-term interest rates enter directly into the
construction costs of builders.
Several modifications were made to this basic
equation to reflectinstitutional realities in the housingmarket. First, a dummy variable, CC, having a
value of 1 for the second and third quarters of 1980
and zero otherwise, was added to capture the effect
of President Carter's credit control program that
caused a temporary decline in the availability of
credit. Second, all the explanatory variables were
lagged three quarters to allow for an interval
between a change in underlying supply and demand
conditions and the response of housing asset prices
and building activity.
A third modification was a change in the measurement of the real user cost. In principle, this
measurement should contain the real after-tax mortgage rate and non-price terms of mortgage credit.
However, mortgage rates tend to move sluggishly,
m. Testing for Credit Availability Effects
The model of residential investment in the preceding section assumes that housing construction is
driven by the demand factors determining housing
prices and the response of builders to the profitability of new construction. The availability of
credit to housing was not viewed as an additional
constraint on residential investment. More specifically, the real after-tax interest rate in the real user
cost of housing capital was assumed to depend only
upon open market interest rates (as represented by
the 6-month commercial paper rate) and not on
variables specific to housing.
Previous researchers, in contrast, have found
evidence of significant credit availability effects on
residential investment in three periods: 1966.Q31967.Ql, 1969.Q3-1970.Q3, and 1973.Q41975.Q2. 12 As shown in Chart 1, these periods
correspond to times of severe disintermediation at
thrift institutions, when Regulation Q ceilings were
binding and growth in real deposits fell to less than a
I-percent annual rate. If restrictions on credit availability resulting from deposit outflows were not
fully offset by adjustments of thrift institutions
themselves or by increased quantities of credit from
other lenders in the mortgage market, the user cost
of housing capital would rise by significantly more
than open market interest rates in these periods. A
greater reduction in housing demanded and residen-
tial investment than could be captured by the model
would result; and the model's prediction error in
these periods would tend to be associated with the
extent of deposit outflows.
Even after the major relaxation of Regulation Q
ceilings in June 1978 that allowed the introduction
of Money Market Certificates, thrift institutions
suffered another major slowing in deposit flows
between 1979.Q3 and 1982.Q 1. For this most
recent period, a question of particular importance is
whether the remaining regulatory constraints contributed significantly to the slowdown in deposit
flows or whether the slowdown reflected only the
response of housing demand to variations in the
generallevel of realinterest rates. As shown earlier,
even in an unregulated market, thrift institutions
would be expected to raise their deposit rates less
than other market rates when higher real interest
rates produce a contraction in residential investment. Deposit flows would slow as a result, even in
the absence of significant credit availability effects
on housing.
We tested for the presence of credit availability
effects on residential investment by adding variabIes to the basic model that have values equal to the
percentage change in real deposits at thrift institutions, lagged either 1 or 2 quarters (DFI and DF2),
for each period of severe disintermediation, and a
70
Estimated Model
of Real Residential Investment
value of zero otherwise. 13 The same deposit flow
variables for aU the other remaining quarters
(DFl:OTHER and DF2:0THER) were also
included as controls to make sure that lagged
were not picking up normal variations
in residential investment not adequately captured by
the basic modeL Finally, since the relationship
between credit availability effects and deposit flows
I1Yljothes:ize:d to be a marginal one occurring only
in periods of severe disintermediation, dummy variables (DUM) aU()wing for .shifts in the intercept
term were also entered for each period of severe
disintermediation. The resulting estimate of the
complete model (with t statistics given in parentheses) is shown as equation 1 in the table.
The explanatory variables in the basic model all
have theoretically plausible signs and are statistically significant at greater than the 1 percent leveL
In addition, the Carter credit controls have a significant impact, even if only for a brief period. Most
importantly, the deposit flow variables measuring
potential credit availability effects on residential
investment are statistically significant at either 1 or
2 lags in each of the first three periods of severe
disintermediation, but not in the fourth period that
occurred after the introduction of Money Market
Certificates in 1978.
Although the deposit flow variable at 2 lags in the
first period of disintermediation (DF2: 66-67) is
significant at only the 15 percent level in equation 1
of the table, it becomes significant at better than a 1
percent level when other insignificant variables are
dropped, as shown in equation 2 of the same table.
The deposit flow variable at 2 lags for the third
period of disintermediation (DF2: 73-75) is significant at only the 10 percent level in both equations 1
and 2. To simulate the effect of financial deregulation, we accept the hypothesis of credit availability
effects in that period even thoughthe statistical basis
for doing so is somewhat weak. This assumption
tends to maximize the potential effect that financial
deregulation can have on the simulated behavior of
the economy.
Finally, neither of the deposit flow variables for
the remaining quarters (DFI :OTHER .and
DF2:0THER) is statistically significant. The lack of
statistical significance for these control variables
indicates that the deposit flow variables in periods of
Terms
(Sample Period: 1962.01 -1984.04)
Equation 1
Equation 2
-85.0
(- 3.35)*
-80.1
(- 3.65)*
12.7
(3.60)*
12.0
(3.96)*
2.21
(2.38)*
-1.05
( -4.13)*
2.58
(3.19)*
(- 5.55)*
In K_ 3
-11.0
(-3.85)*
-10.7
( -4.40)*
CC
.125
(- 3.43)*
- .127
( -4.38)*
Constant
In N_ 3
In YDP_3
!
3
InUC_ i
i=O
DFl:0THER
-.0226
(- .169)
DF2: OTHER
-.0551
(- .411)
DUM: 66-67
.104
(- 3.46)*
DFl: 66-67
-2.14
(- .497)
DF2: 66-67
1.53
(I. II)
DUM: 69-70
-.0142
(- .524)
DFl: 69-70
1.53
(2.69)*
DF2: 69-70
.182
(.409)
DUM: 73-75
- .00402
(- .134)
DFl: 73-75
-.00392
(- .00751)
DF2:
.631
(1.23)
DUM: 79-82
(
e-l
-.107
(- 3.84)*
2.22
(3.56)*
1.52
(3.13)*
.554
(I.22)
.00521
(.180)
DFl: 79-82
DF2: 79-82
-LI5
-.0136
.0282)
.285
(.686)
1.25
(I 1.0)*
e_2
.302
(- 2.80)*
SER
.0352
1.21
(II. 2)*
-.265
2.61)*
.969
D.W.
2.09
.0334
2.07
I-statistics in parentheses.
*Significantly different from zero at the one percent level.
71
periods of severe disintermediation at thrifts prior to
1978 but not afterwards, and that the extent of these
credit availability effects was closely related to
marginal variations in deposit inflows.14
severe disintermediation are not simply picking up
normal variations in residential investment not ade
quately captured by the basic model.
Thus, the evidence indicates that financial regula
tion created distinct credit availability effects during
IV. Simulated Effects of Financial Deregulation
Although credit availability effects on housing
appear to have been present in periods of disinter
mediation prior to 1978, the quantitative magnitude
of these effects and their impact on the cyclical
behavior of both residential investment and interest
rates remains to be examined. For this purpose the
model of residential investment estimated in equa
tion 2 of the table, including significant deposit flow
effects, was embedded in a small-scale structural
model of the economy.15 Historical errors in each
equation of the model were added back so that a
dynamic simulation could replicate history exactly.
Then, the degree to which financial deregulation
would have made interest rates more volatile and
lessened the severity of the housing cycle was
determined by setting the coefficients of the deposit
flow variables (including intercept dummies) in
equation 2 equal to zero and re-simulating the
model. The paths of monetary growth, as measured
by M l, and all other exogenous variables were kept
unchanged in the simulation, giving interest rates
full scope to adjust.16
The key short-term interest rate in the model that
drives the general level of interest rates is the 6month commercial paper rate. Charts 2 and 3 show
the difference between the historical paths of real
Chart 2
Billions of
1972 Dollars
1962 1964
R eal
Residential Investment
1968
1972
1976
Shaded areas represent periods of estimated
credit availability effects.
72
1980
1984
Regulation Q ceilings were binding during only part
of the historical period, the reduction in the overall
cyclical variability of residential investment result
ing from the elimination of credit availability effects
is estimated to be relatively small.
A quantitative measure of cyclical variability is
the standard deviation in percentage terms of a
variable from its trend. The lower this standard
deviation, the less the variability. For the period
1966 to 1975, the standard deviation of residential
investment from its trend fell from 18.9 percent to
18.3 percent in the simulated absence of credit
availability effects, reducing overall variability by
only 3.2 percent.
Both this statistic and a visual examination of
Chart 2 confirm that the major reason for cycles in
residential investment in the past has been the
relatively high sensitivity of housing demand to
interest rates rather than the credit availability
effects caused by interest rate ceilings and other
financial regulations.
residential investment and the real 6-month com
mercial paper rate over the 1962 to 1984 period
compared to those resulting from the simulation
where no credit availability effects are allowed to
operate through deposit flows. In that simulation,
the lack of any credit availability effects directed
specifically at housing in periods of tight credit
reduces the cyclical variability of residential invest
ment. While the absence of such credit availability
effects put greater pressure on the general level of
interest rates in those periods, it also tends to
dampen interest-sensitive expenditures in all sectors
of the economy and not in housing alone. The result
is a net benefit for housing as the impact of tighter
credit conditions is more evenly distributed.
An absence of credit availability effects was sim
ulated to increase residential investment by up to 12
percent in some quarters during the periods of
severe disintermediation in 1966.Q3-1967.Q1,
1969.Q3-1970.Q3 and 1973.Q4-1975.Q2. How
ever, because of the overall sensitivity of the
demand for housing to interest rates and the fact that
Chart 3
Real Commercial Paper Rate
1962 1964
1968
1972
1976
Shaded areas represent periods of estimated
credit availability effects.
73
1980
1984
Atthe same time that it has reduced the variability
ofresidentialinvestment, financial deregulation has
increased the. volatility of interest rates..The simulation shows that, in the absence of the credit availabilityeffectsij$sqciatecLwith interestr~teceHings
andotherJinancial regulations, real interest rates
would. have risen by somewhat larger. amounts in
periods of tight credit. However, because credit
avaHability\effectsareestimateg to be quite small,
tlleoveraUincrease in the v;rriability of real interest
rates is alW relatively small. Thus, in the 1966 to
1975. period,. the standard deviation of the real
commercial paper rate from its mean rose .from 131
basis points in the historical observation to 141 basis
points in the simulation, giving only a 7.6 percent
increase in the variability of real short-term interest
rates.
The removal of credit availability effects in past
periods of tight credit would have raised real GNP
somewhat in those periods. This is because the
boost to interest rates from eliminating credit availability effects wouldhave raised the incomevelocity
of MI. With an unchanged path ofgrowth forM1,
the rise in its income velocity would have raised the
level of GNP. Thus,. the .higher level ofresidential
investment would not have been fully offset by
reductions in othertypes of interest-sensitive expenditures. Since periods of significantcredit availability effects tended to coincide with either growth
recessions or actual recessions,financial deregulation would have had an overan stabilizing effect on
the economy. The overall degree .ofcyclicalvariability as measured by the standard deviation ofreal
GNP from trend in percentage terms would have
been reduced only slightly, however -from 3.0
percent to 2.97 percent in the simulation. Thus, we
estimate that eliminating credit availability effects
would have stabilized the economy as a whole to an
even smaner degree than it would have moderated
cycles in residential investment.
74
V. Conclusions
Thrift institutions supplying nearly half of the
total credit needs ofhousing have experienced recurrent bouts of deposit outflows during periods of high
interest rates.· Earlier periods ofdisintermediation at
thrifts appear to have been related mainly to the
effects of Regulation Q ceilings. However, even
after the substantial relax.ation of Regulation Q
ceilings in 1978 allowing the introduction ofMoney
Market Certificates, thrifts experienced deposit outflows in the next period of high interest rates.
Manifestly, disintermediation at thrifts can occur
with or without pervasive Regulation Q ceilings.
Indeed, since residential investment is highly interest-sensitive, strong cycles in deposit flows at thrifts
would be expected to occur even in completely
unregulated markets since the thrifts' needs for
deposits vary with the amount of mortgage loans
demanded.
In general, analysts have linked significant credit
availability effects on residential investment with
earlier periods of disintermediation. However, even
in those periods of disintermediation, the flow of
credit to housing need not have been reduced if
thrifts could have sold off assets in secondary markets or borrowed from govemment agencies while
other lenders provided alternative sources of housing finance. Similarly, the disintermediation occurring at thrifts after 1978 does not necessarily indicate significant credit availability effects. The extent
of credit availability effects in both the earlier and
more recent periods is an empirical issue.
We have tested for the influence ofdisintermediation at thrifts on residential investment in the context
of an econometric model of the housing market.
Statistically significant credit availability effects on
residential investment were found for the periods of
1966.Q3-1967.Q1, 1969.Q3-1970.Q3, and
1973.Q4-1975.Q2,.but not for the most recent
period of disintermediation, 1979.Q3-1982.Q1,
which followed a substantial relaxation of RegulationQ.
Regulatory restrictions are estimated to have
reduced residential investment by up to 12 percent
in some quarters during the three earlier periods.
However, those periods were relatively short, and
residential investment is highly cyclical even in the
absence of credit availability effects. As a result, we
estimate regulatory restrictions to have accounted
for only about 3 percent of the total variability of
residential investment in the 1965 to 1975 period.
Credit availability effects on housing, when they
were found, were estimated to have reduced the
overall variability of real short-term interest rates by
only 7 to 8 percent. This reduction in the volatility of
interest rates resulted from financial regulations that
tended to concentrate the effects of tight credit on
residential investment. Conversely, financial
deregulation since the mid-1970s has increased the
volatility of interest rates, but only to the same
modest degree of 7 to 8 percent. The much higher
variability in real interest rates experienced since the
late 1970s cannot be explained by the estimated
effects of financial deregulation.
75
FOOTNOTES
1. More than a decade ago, Duesenberry (1969) anticipated that financial deregulation would result in more
variation in interest rates over the business cycle. More
recent discussions of this point are Lombra (1984) and
Keaton (1986). The quantitative importance of thiS effect
has been a matter of considerable dispute, however. Two
extreme views are Arcelus and Meltzer (1973) and
Wojilower(1980).
2. These two points are most easily demonstrated in the
simplest case where the total supply of credit to the two
markets is fixed. Since there is a smaller Increase In open
market .interest rates, and hence movement along the
demand curve, 0'0' when the deposit rate IS controlled,
there IS a larger Increase In credit supplied to the open
market. Given that the aggregate supply of credit IS fixed,
the quantity of credit supplied to the mortgage market must
then fall to a larger extent when deposit rates are
regulated.
Introducing some positive response of the total supply of
credit with respect to interest rates increases the size of the
impact of deposit rate ceilings on the availability of credit to
housing. In this situation, the amount of credit available to
the mortgage market declines by more when deposit rates
are regulated not only because the rise in the interest rate
paid by the competing open-market sector is less, but also
because the total amount of credit available to both sectors
is reduced by the relatively lower interest rate.
The parameter ex, chosen to minimize the error in the
equation, is equal to 0.5.
9. Hall (1977) and Jorgensen (1963) offer a different interpretation of this formula in which the appropriate interest
rate is the real short-term rate even though the capital good
is along-lived asset. For criticisms of their approach and
support for the more traditional one, see comments and
discussion in Hall (1977) and Throop (1984).
10. Income from rental housing is taxed at the rate, c,
applicable to either corporate or individual income after
deductions are made for depreciation. If the present value
of depreciation allowances per dollar of investment is
denoted by z, the nominal user cost of capital invested in
rental housing can be shown to be:
pr = pr n1-cz)
u
h[ 1-c
P~
5. The effect of the introduction of Money Market Certificates on housing starts in the 1978-79 expansion has been
explored in Jaffee and Rosen (1979). A limitation of this
study is that the introduction of Money Market Certificates
is assumed to have no effect on the general level of interest
rates. More specifically, in their simulation, the Federal
Reserve is assumed to follow an interest rate target.
However, when the Federal Reserve targets the stock of
money, rather than interest rates, the stimulus to housing
from the introduction of Money Market Certificates (or other
relaxations of restrictive regulations) would be blunted by
upward pressure on market interest rates. The present
study allows for such interest rate effects by incorporating
a model of residential investment into a complete macroeconomic model.
=
Pg[(1-t)i -
P+
=
d + tp (1-t)]
Pg • UCO
11. The estimated equation for forecasting U.S. inflation
over the maturity of the 6-month commercial paper rate is:
16
Pi+2 =
.141 + .463 ~ M1
i=O
(- .486)
.812
6. The details and economic implications of the Deregulation and Monetary Control Act of 1980 are analyzed in
Cargill and Garcia (1982).
S.E.
(3.11)
=
1.26
10
1
+ .552 ~ P-i
i=O
(4.24)
OW
=
1.09
Equations based on monetary growth overpredict inflation
in 1982 and 1983 by a substantial margin because of an
unusual decline in M1 velocity. However, because the
demand for M1 was stable, the decline in M1 velocity can
be explained statistically by the decline in inflation and
nominal interest rates that occurred in the period. When
M1-growth is adjusted for this effect, it continues to predict
the growth of nominal income and inflation reasonably well.
Consequently, for this period, an adjusted M1-growth was
used in the inflation forecasting equation instead of actual
7. For further elaboration of this approach, see De Leeuw
and Gramlich (1969) and Kearl (1979).
8. Permanent disposable income is calculated as a 15quarter distributed lag on disposable income with geometrically declining weights adjusted for the trend in
income:
15
d + tp(1-c)] = Ph· UCR
The appropriate tax rate, t, for owner-occupied housing
is the average marginal tax rate for households, while the
higher valued corporate tax rate is used for rental housing.
For derivations of these formulas, see Ott, Ott, and Yoo
(1975) or Throop (1984).
Data on the stock of housing, the corporate tax rate, the
property tax rate, and the present value of depreciation
come from the Board of Governors. The data series for the
average marginal tax rate on household income is from
Barro and Shahasakul (1983). The latter series has been
updated by the Economics Research Group of Goldman
Sachs and the author.
4. Useful surveys of the impact of government-sponsored
agencies on the mortgage market include Grebler (1977),
Hicks (1978), and Hendershott and Villani (1977, Ch. 3).
1=0
p+
where tp is the property tax rate.
.
..
The return on owner-occupied capital takes the ImpliCit
form of the services provided, and therefore is not taxed.
Consequently, the nominal user cost of owner-occupied
housing capital is:
3. The important distinction between this type of disequilibrium credit rationing and that which can occur even
in market equilibrium is discussed in Baltensperger
(1978).
YDP = ~
1
J [(1-c)i
(1-ex)ex i (1+T)iYD_ i
76
M1-growth. The adjustment factors that were used are
described in Judd and McElhattan (1983). For an analysis
of the effect of the decline in velocity on inflation and why it
occurred, see Throop (1984a,b).
The expected inflation term in the real interest rate was
given a weight of only one-half, which effectively weights
the real interest rate by one-half and the nominal interest
rate by one-half. This weight was determined by fitting the
model with weights on expected inflation ranging from zero
to one. The significance of the nominal interest rate is due
to the fact that a higher ratio of nominal mortgage payments to current income makes borrowers less able to
borrow and lenders less willing to lend.
15. The theory underlying the model follows the mainline
neo-Keynesian view embodied in most large-scale structural econometric models. In the short-run, the slow speed
of adjustment of wages and prices allows monetary policy
and other factors to influence real interest rates, which, in
turn,drive real aggregate demand and output. However, in
the long-run, real interest rates are determined by the
balance between saving and investment atfullemployment. Particular attention is paid in the model to the way
that real interest rates enter into the cost of capital for
specific types of investment.
An earlier version of this structural model of the economy
is described in summary form in Throop (1985) and in
greater detail in Throop (1984c). Both publications are
available upon request. Additional equations for the
demand for M1, the unemployment rate, the share of
personal disposable income in GNP, and the inflation rate
have been included in the current version of the model. A
complete description of the current version and simulations of its dynamic properties will be pUblished in a
forthcoming issue of the Economic Review.
12. See, for example, the housing sector in the MPS
econometric model of the U.S. economy, as described in
Brayton and Mauskopf (1985).
13. The exact periods of severe disintermediation are
defined as intervals of less than 1-percent growth in real
deposits with a 1-quarter lag to allow forthe time between a
change in deposit flows and significant effects on
expenditu res.
16. Actual values of M1 could not be reproduced exactly
in this simulation of the effects of deregulation because of
the dynamic properties of the model. Interest rates affect
both the demand for M1, given the level of income, and the
level of income itself, with distributed lags. Thus, only a
fraction of the total direct and indirect effects on M1 from a
change in interest rates occurs within the current period.
If interest rates were changed enough to hit an M1 path
exactly in the current period, then the lagged effects of the
change in interest rates would have to be offset in future
periods, resulting in future interest rate movements in the
opposite direction. To reproduce the M1 path exactly in
each period may require ever larger changes in interest
rates over time. This is an example of instrument instability.
See, for exampl~, Holbrook (1972). A degree of interest
rate smoothing was therefore required. Still, the average
deviation of simulated M1 from historical M1 was only half a
billion dollars.
14. These results do not appear to be particularly sensitive to the precise methodology used. For example, ordinary dummy variables take on significantly negative signs
during the first three periods of severe disintermediation,
but are not generally significant in either the fourth period
of severe disintermediation or in the control period. Moreover, the size of the estimated quantitative effects on
residential investment in the first three periods obtained by
using dummy variables is roughly the same as that estimated with deposit flow variables.
The finding of an absence of credit availability effects
after 1978 is consistent with the work of Jaffee and Rosen
(1979) and Furlong (1985). Jaffee and Rosen found that
the growth rate of small-denomination deposits at savings
institutions had a significant impact on mortgage rates
prior to 1979, but Furlong shows that this relationship
ceased to hold in subsequent years.
77
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