Full text of Economic Review (Federal Reserve Bank of San Francisco) : Summer 1987, Number 3

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ederal Reserve Bank
>f San Francisco

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Portfolio Substitution and the Reliability of M l, M2 and M3
as Monetary Policy Indicators........................................................................ 5
John P. Judd and Bharat Trehan

II.

Interest Rate Linkages in the Pacific Basin ...................................................31
Reuven Glick

III.

The Eurodollar Market and U.S. R esidents..................................................43
Ramon Moreno

Editorial Committee:
Gary Zimmerman, Jack Beebe, Adrian Throop, Carl Walsh,
Barbara Bennett and Carolyn Sherwood-Call

John P. Judd and Bharat Trehan*

Based on a single system of equations that contains income, prices, a
market rate of interest, and the components of M3, we find that M1
became highly susceptible to adjustments in the public's portfolio of
liquid assets in the 1980s, and thus is unlikely to be a reliable guide to
monetary policy in the future. The behavior of the broader monetary
aggregates has not changed significantly from the 1970s, and both M2
and M3 are broad enough to internalize most portfolio adjustments that
are likely to occur. Therefore, they are likely to be more reliable as
monetary policy indicators than M 1, although the analysis does not imply
that either will be as reliable as M1 once was.

Last February, Federal Reserve Chairman Paul
Volcker testified before the Senate Banking Committee about the Federal Reserve's 1987 plans for
monetary policy. An important element of those
plans consists of the target ranges for growth in the
monetary aggregates. In his testimony, the Chairman reported that the Fed had reaffirmed the 51/2 to
8 lf2 percent 1987 target ranges for growth in the
broader monetary aggregates, M2 and M3, that had
tentatively been set in July 1986.
Volcker also stated that the Fed had decided not to
set a target range for the narrow aggregate Ml.
Instead, it will closely monitor the behavior of M1
" ... in light of other information, including
whether or not changes in that aggregate tend to
reinforce or negate concerns arising from movements in M2 and M3."1 Then, in its July 1987

meeting, the FOMC tentatively planned not to set a
range for M1 in 1988. Thus, for the time being, Ml
has been given a subordinate role in the formulation
and implementation of monetary policy where, traditionally, it has received greater emphasis than the
broader monetary aggregates.
The downgrading ofM1 's role in monetary policy
for 1987 reflects concern about that aggregate's
continued reliability as an indicator of monetary
policy. Traditionally, M1 was considered a primary
policy indicator, both by the Fed and by many
outside observers, in part because it had the desirable property of containing most of the media of
exchange in the economy, that is, currency and
checkable deposits. Since M1 offered unique transactions services, the public's demand to hold that
aggregate was not highly responsive to the kinds of
portfolio considerations - for example, relative
interest yields and terms-to-maturity - that determine the public's demand to hold the savings-type
instruments that are in M2 and M3.
Because M1 had few close substitutes, its

* Associate Director of Research and Economist,
respectively, Federal Reserve Bank of San Francisco.
5

1980s. In particular, the rapid growth in MI in
1985-86 appears to have been related to a large
reduction in the public's demand to hold small time
deposits. That change in demand probably was
caused by reductions in spreads of yields on small
time deposits compared with those on NOW and
other more liquid accounts. Movements in MI in
1985-86 therefore had little to do with general
output and price trends. Given the nascent susceptibility ofMI to portfolio disturbances, it is unlikely
to be a reliable guide to policy in the future.
The broader monetary aggregates were relatively
accurate monetary policy indicators in 1985-86
primarily because they were broad enough to internalize the portfolio shifts that occurred. Moreover,
our analysis suggests M2 and M3 should be able to
internalize most portfolio reallocations that are
likely to occur. Thus, our analysis strongly supports
the Fed's recent action to downgrade MI in favor of
greater reliance on M2 and M3.
The remainder of the paper is organized as follows. In Section I, we summarize the major potential problems that can develop in the public's
demand to hold money as the result of the financial
deregulation in the 1980s. We then go on to review
the empirical evidence on the demand for money in
the 1980s, focusing special attention on the problems with MI in 1985-86, as well as the stability of
M2 and M3 in this period. In Section II, we use a
statistical technique called vector autoregression to
analyze the behavior of M I , M2, and M3, and their
reliability as monetary policy indicators. Section III
presents policy implications and conclusions.

behavior was not substantially affected by difficultto-predict portfolio substitutions, and, as a consequence, movements in M I were dominated by
changes in macroeconomic variables, such as
income and prices, that are the concern of Fed
policy.
Chairman Volcker's testimony cited two main
sources of concern about MI's reliability as a monetary policy indicator. First, deposit-rate deregulation, which began in the case of MI with the
authorization of nationwide NOW accounts at the
end of 1980 and was completed in March 1986, may
have made M I more of a savings-type aggregate. In
such case, M I most likely would have lost its unique
transactions character and its relationship with
income and prices might thus have become less
predictable. Second, this change may have led to
MI's highly unusual behavior over the past two
years. In both 1985 and 1986, MI grew extremely
rapidly while economic growth was moderate and
inflation was subdued. In contrast, M2 and M3
behaved much more in accordance with their historical relationships with income and prices.
This paper assesses the changes in the relationship between M I and economic developments for
1985-86, and draws out the implications for the
future reliability of that aggregate as a monetary
policy indicator. The paper then assesses the
reliability of M2 and M3 as alternative indicators for
the Fed.
Based on a vector autoregression, our basic finding is that M I became highly susceptible to adjustments in the public's portfolio of liquid assets in the

The Demand for the Monetary Aggregates

Over most of the period since the mid-1970s,
when the Federal Reserve began to express its
monetary policy in terms of the monetary aggregates, M I has received primary emphasis. M I consists of the outstanding stock of currency and fully
checkable deposits, and thus corresponds closely to
the theoretical concept of "money" in macroeconomic theory. It has been found to be subject to
a reasonable degree of control by the Federal
Reserve, and, until recently, has been considered a
more reliable leading indicator of rea! GNP and

inflation than the more broadly defined monetary
aggregates, M2 and M3, which include liquid savings instruments that do not function as fully as part
of the medium of exchange.
An important necessary condition for MI's leading-indicator characteristic is that the public's
demand to hold MI is a stable function of a small
number of macroeconomic variables that are of
interest to monetary policymakers - income,
prices and a market interest rate. MI traditionally
has been considered more likely than M2 and M3 to

contaminate M 1's unique transaction character and
cause it to become a closer substitute for other
financial instruments. As a result, the public's
demand to hold Ml might have become more highly
responsive to changes in the spreads between Ml's
own rate of return and rates paid on a wide range of
other financial instruments. Shifts in investors' preferences for various maturities and liquidity characteristics also could have larger effects on M I
demand.
In general, since Ml may have become more like
financial assets held for investment purposes,
changes in the demand for M I could be dominated
at various times by difficult-to-predict shifts in the
composition of the public's portfolio, and only
incidentally by changes in the variables that are of
interest to the policymaker - income and prices.
Such portfolio shifts would show up both as
instability in estimated M 1 demand functions and as
unexpected shifts in reduced-form relationships
between Ml and nominal GNP.
Deposit rate deregulation also could have made
MI demand more difficult to predict by making it
depend on how depository institutions respond to
movements in market yields in setting their offering
rates both on transactions accounts and on other
time and savings deposits that are substitutes for
Ml. Before deregulation, the "own-rate" on Ml
was fixed by government fiat, as were the yields
payable on most of its close substitutes. With
deregulation, the speed and degree to which banks
adjust deposit rates to follow market rates determine
how sensitively the opportunity cost of Ml varies
with market interest rates, opening up a whole new
range of uncertainties for the policymaker. For any
given elasticity of M 1 demand with respect to the
opportunity cost of holding it, the elasticity of
demand with respect to market rates will be smaller
the more rapidly banks adjust their rates on MI
deposits to changes in yields on market instruments.
Thus, banks' deposit rate-setting behavior helps
determine the overall relationship between a change
in the market rate of interest and the demand for MI.
Deposit rate deregulation can affect the broader
monetary aggregates as well. A recent example is
the introduction of Money Market Deposit
Accounts in December 1982, which caused M2 to
grow extremely rapidly relative to M3 in a transition

have a stable and simple demand function because
of M I 's unique role as the main part of the medium
of exchange, and because its rate of return has not
been determined by market considerations but
instead has been set by regulation. Such a narrow
"medium-of-exchange" aggregate had a good
chance of having a stable and relatively uncomplicated demand function because it had few close
substitutes. At the same time, the constancy of its
own yield meant that changes in the supply of M 1
had predictable effects on the interest yields on
other financial instruments. The deregulation of
deposit interest rates and the introduction of new
liquid instruments therefore have the potential to
interfere with M 1's usefulness for monetary policy
by making the public's demand to hold that aggregate more difficult to predict.
In cataloging the effects of such financial market
changes on money demand, it is useful to distinguish between the adjustment effects during the
transition period after a change and the equilibrium
effects, which persist even after full adjustment has
been made. For example, deregulation of yields on
M 1 deposits initially would cause the demand for
Ml to shift up as the public pursues the more
attractive yields. This shift, in tum, would cause Ml
growth rates to increase temporarily, relative to any
given changes in income, prices and the market rate
of interest, until the new, permanently higher, level
of desired Ml balances is achieved. During such
transition periods, monetary policy can go off
course, since it is difficult to estimate the size, speed
and duration of such demand shifts while they are
occurring.
However, the problems for monetary policy
caused by such transition effects are likely to be
temporary since once the new equilibrium level of
Ml is attained, the relation of Ml growth to its
underlying determinants should return to its historical norm. Since deposit rate deregulation now is
complete, these transition effects, which were of
primary importance earlier in this decade, no longer
are major issues.
Of more immediate concern are the permanent
problems deposit-rate deregulation may have
caused for M I-targeting if higher yields on M I have
led the public to use Ml as a savings vehicle to a
greater degree than in the past. Such a change could

the broader aggregates prior to deregulation were
less severe than the prohibition of the payment of
interest on Ml. Prior to mid-1978, all of the time
and savings deposits in M2 were subject to interest
rate ceilings, but those ceilings were set well above
zero. Then, in mid-1978, the deregulation of M2
began in earnest with the introduction of the small
denomination six-month money market certificates,
which had ceilings that vary with Treasury bill rates.

period that lasted for two months. The introduction
into the broader aggregates of instruments with
interest rates that can vary freely with market rates
undoubtedly has altered the behavior of those aggregates as the general level of rates has varied over the
business cycle.
However, recent deregulation most likely has had
smaller permanent effects on M2 and M3 than on
Ml largely because the interest rate restrictions on

Large time deposits in M3 have been free of interest
rate restrictions since the early 1970s.
In summary, significant proportions of M2 and
M3 offered interest rates that were not far below
market rates even before deregulation, so these
aggregates were attractive savings vehicles for indi
viduals in the earlier period as well. Thus, a priori,
we would expect deposit rate deregulation to have
had a smaller impact on the nature of these aggre
gates. Furthermore, M3 is likely to have been
affected even less than M2, since M3 already con
tained accounts that were free of interest rate ceil
ings.

Chart 1
Monthly Growth Rates of M3 Components
Percent Change

Empirical Evidence on Money Demand
The evidence up to 1985 casts doubt on the
hypothesis that the demand for Ml would be
seriously affected by deregulation. When there were
shifts in Ml demand (1974-76 and 1981), they were
in the downward direction.2’3 This suggests that
these episodes of unusual Ml behavior occurred not
as a result of deregulation, but rather because of
deposit rate regulations that were still in place in a
period of rapid inflation and high nominal market
interest rates. Moreover, empirical tests for changes
in the interest elasticity of Ml demand showed only
a slight change — the elasticity had become slightly
more negative.4
The first clear upward shift in Ml demand during
the 1980s occurred over the last two years. On the
surface, the timing of this shift is surprising since it
occurred after deregulation was largely complete.
We offer a tentative explanation for this timing
below.
Table 1 shows the money demand simulations
obtained from the San Francisco Money Market
Model.5 Except for the first few months in 1985, the
model has consistently underpredicted Ml growth,
so that the difference between the actual and simu
lated value of Ml has increased over time. Ml grew
at an average annual rate of 13.9 percent from
December 1984 to December 1986, while the
model predicted mean annual growth of 8.3 per
cent.
The simulated value of M2 has tracked actual M2
more closely (see Table 1). For the two-year period
ending in December 1986, M2 grew at an 8.5

Percent Change

percent annual rate, 1.0 percent more than the value
predicted by the model. For the two-year period as a
whole the model’s simulation of M3 growth at an
8.0 percent annual rate is quite close to the actual
rate of 7.9 percent.
The stability of the demand for the broader aggre
gates in combination with the upward shift in Ml
demand suggests that Ml has been adversely
affected by portfolio substitutions that were inter
nalized within the broader monetary aggregates.
Chart 1 provides a perspective on these portfolio
substitutions. The upper panel shows growth rates
in the components of M3 that do not carry terms to
maturity plotted against the components of M3 that
do carry terms to maturity. This distinction is based
on the liquidity of financial assets, which is an
important characteristic of investors’ demands for
alternative assets. (See the discussion “Defining the

Monetary Aggregates" in the box.) The non-tenn
M3 components include M1, overnight repurchase
agreements and eurodollars, money market deposit
accounts, passbook savings accounts, and money
market mutual fund shares. The tenn components of
M3 include small denomination (less than
$100,000) time deposits, large denomination time
deposits, and term repurchase agreements and
eurodollars. The upper panel shows that the nontenn component of M3 and the tenn component
have moved in opposite directions, that is, they have
behaved as substitutes. This is true of both trend
growth and of the fluctuations in the growth rates of
these components over this period.
The bottom panel of Chart 1 shows growth rates
of M I a component of non-term M3 - and of the
remainder of non-term M3. This latter component,
which we call liquid savings, contains the instruments in M3 that are not fully checkable, that is,

II.

instruments that are not in M 1 and do not have fixed
terms to maturity. (For these and other monetary
definitions see the box labeled "Monetary Aggregates.") Growth in the two non-term components,
Ml and liquid savings, has been positively correlated during 1985 and 1986. In other words, M1 has
behaved similarly to the liquid savings instruments
inM2.
Taken together, these panels suggest that the
distinction between tenn and non-term accounts has
been an important margin of substitution within
instruments in M3, whereas the distinction between
checkable and non-checkable deposits has not been
an important consideration over the last two years.
The pattern of growth in the components of M3 is
consistent with the idea that M I may have been
contaminated with savings balances and that its
behavior may no longer be determined by mediumof-exchange characteristics only.

Portfolio Substitution

The evidence in Chart 1is consistent with the idea
that M1 has taken on the characteristics of a savings
aggregate, but by no means does that evidence
represent a rigorous test since it covers only two
years of data and does not control for factors other
than portfolio substitution that are likely to affect
growth in the components ofM3. In this section, we
fonnally test the proposition that Ml has become
more susceptible to portfolio shifts in the deregulated environment of the 1980s by estimating a
vector autoregression (VAR).
Estimating a VAR is a method of examining the
relationship between a set of variables and their past
values. By imposing relatively few restrictions on
the dynamic relationships between the variables in
the model, a VAR, in effect, allows the data to speak
for themselves. Statistical tests are used to check
whether past values of a given variable are significant in a particular equation. The estimated equations can then be transfonned to obtain "impulse
response functions" that show how the variables
respond over time to various shocks, or unpredicted
movements, in the variables of the system. Finally,
the relative importance of different shocks for predicting future values of the variables in the system

can be estimated using "variance decompositions".
The VAR we estimated includes the variables that
appear in conventional Ml demand equations (Ml,
real personal income, RPY, the implicit consumption deflator, DEF, and the 6-month commercial
paper rate, R), and, in addition, the quantities of
monetary assets believed to be close substitutes for
Ml. 6 We hoped that inclusion of these quantities, in
combination with a market interest rate, would
enable us to capture the combined effects of portfolio considerations in the demand for Ml including changes in relevant interest rate spreads,
changes in preferences for tenn-to-maturity and
risk, as well as any other factors that consistently
cause individuals to re-allocate their portfolios
across various assets. We chose to include quantities
rather than interest rate spreads because the quantities are likely to pick up the effects of changes in
spreads plus other factors such as those mentioned
above.
To illustrate the last point, in April 1987 there was
a large movement in Ml that cannot be attributed to
changes in interest rates. Ml increased by $11
billion, apparently because individuals moved

The specific monetary components we include, in
addition to MI, are small time deposit,i, liquid
savings, and large term accounts (see the box
"Monetary Aggregates"). As will become evident,
this set of monetary components permits us to
analyze the important portfolio substitutions that
have occurred in recent years between accounts with
and accounts without terms to maturity. Further-

funds from non-transactions accounts to pay taxes.
To the extent that these funds were moved out of
other accounts in M3, they should be picked up by
our specification but not by a model that relied on
interest. rate spreads. (In theory, seasonal adjustments should remove such movements from the
da.ta. In pra.ctice, however, it is difficult to determine
exactly how large such effects are likely to be.)

large time deposits. The sample ends in mid-1979 to
avoid distortions from the change in Federal Reserve
operating procedures later that year (see Spindt and
Tarhan, 1987, for a description of the change). We
have also included a dummy variable for the period
up to June 1976 to capture the well-known downward shift in Ml demand over that period (see Judd
and Scadding, 1982).
In the latersample, we omit the first six months of
data for 1981 to avoid confusing the one-time porte
folio reallocations that may have followed the introduction of nationwide NOW accounts with the
interactions that may have occurred once the initial

more, .by aggregating these components, we can
assess the effects of portfolio disturbances on the
broader aggregates, M2 and M3. 7 (Note that M2 =
Ml + small time deposits + liquid savings, and
M3 ::::; M2.+ large term accounts.)
To analyze the effects of financia14ereguilltion on
the behavior of the monetary aggregates, we have
defined two sample periods: the pre-deregulation
period extending from Jam.lllry 1974 to June 1979
and the post-deregulation period extending from
July 1981 to December 1986. The beginnillg date
for the early period avoids the disturbances caused
by the removal (in 1973) of interest rate ceilings on

Chart 2
Impulse Response Functions Components of M3 in Levels
Post-Deregulation

Pre-Deregulation
Response to Interest Rate Shocks
Percent

Percent

Small Time

o
-1

Large

Small Time

O!-'E---------------

-1

Liquid Savings

Liquid Savings
-2
5

20
25
Months alter shock

Months alter shock

Response to Large Term Account Shocks
Percent

Percent

Term

o
-1

" Small Time
Ol---eo=--------------,
Li~~avin~~_~,_

Small Time

-1

Liquid Savings

Months after shock

adjustment was complete. We also have included
constant dummy variables for the months from
December 1982 to February 1983 to take account of
theone-time portfolio re-allocation following the
introduction of MMDAs andSuper-NOWs.
All variables are included as the first difference of
logs. We use Sims' (1980) Chi-square test to determine the appropriate lag length for the VAR over
both sample periods. Our tests reveal that in both
samples a lag length of 2 months is statistically
indistinguishable (at a 5 percent significance level)
from lag lengths of 3 to 5 months.

Empirical Results
Mland the Other Components of M3
The results fromtheVAR support the hypothesis
that deregulation has changed the nature of the
monetary ·aggregates. They are consistent with MI
having become more like savings-type assets in the
period of deregulation, andhence having lost much
of its transactions character.
Table 2 shows summary statistics from the estimated equations for the monetary components over
the two sample periods. Abbreviations for the mon-

Chart 3
Impulse Response Functions Components of M3 in Levels
Pre-Dere gul ation

Post-Deregulation
Response to Small Time Deposit Shocks

Percent

Small Time

oh...~~~~-===~~=======-

'" M1

-1

Liquid Savings

Large Term
-1

Liquid Savings

-2

-2
10

Months after shock

Response to Liquid Savings Shocks
Percent

Percent

Large Term

Liquid Savings

o~~~~

o~~====~=====~===
Small• Time

Liquid Savings

-1

-3

i i i iii

Small~ Time

Large Term

iii

-2

iii

i ~5

Months after shock

etary variables are explained in the box "Monetary
Aggregates." The marginal significance levels indicate which variables are important in predicting
future values of the various components. According
to convention, a significance level less than 0.05
suggests that past values of that variable do have an
impact on the dependent variable.
In the post-deregulation period, past values of
hoth small time deposits and liquid savings individually provide statistically significant information
about MI. By contrast, during the pre-deregulation
period, none of the other monetary components
provides significant information about MI. For each
component of M3 we also tested whether the
remaining components of M3 taken together
provide statistically significant information about
future values of that particular component. For M I ,
the answer is yes after deregulation, but not before.
There is evidence that the same is true for large term
deposits and small time deposits, although there the

results are weaker. (Correlations between the
residuals obtained from the VAR, that is, the prediction errors in the equations, are shown in Table Bl
of Appendix B.)
These results show that, in the post-deregulation
period, movements in the various componeI}ts of
M3 (with the exception of the liquid savings component) are more closely related to one another than
before - even after the effects of past changes in
income, prices, and a market rate of interest have
been taken into account.
The impulse response functions in Charts 2 and 3
show what typically happens to the levels of Ml,
liquid savings, small time deposits, and large term
accounts over time when there is an unpredicted
increase in selected variables, taking into account
the full dynamic interactions estimated in the VAR.
These responses are plotted in terms of the percent
deviation of the responding variable from its initial
level in response to a one-standard deviation change

in the "shock" variable. Since our focus is on
substitutions between different monetary components, we show the effect of interest rate shocks and
shocks to the monetary components (large term
accounts, small time deposits and liquid savings)
only. 8
The portfolio-substitution characteristics of MI
across the two periods are strikingly different. Consider, for example, the effects of interest rate shocks.
Panel (a) of Chart 2 shows that in the pre-deregulation period, an unanticipated increase in the interest
rate had only a small negative effect on the level of
Ml. In the second period, by contrast, the effect is

noticeably larger, with the decline in M I continuing
for at least two years following the interest rate
shock.
The response of M I to shocks to the other monetary components also is markedly different in the
two periods. In the pre-deregulation period, Ml
stays close to its original level after a shock to any of
the components of M3. In the post-deregulation
period, by contrast, Ml decreases immediately following shocks to both large term accounts and small
time deposits, and then keeps declining for approximately a year before stabilizing at the new lower
level. MI increases contemporaneously with a liq-

Chart 4
Errors in Projecting Growth Rates
of M3 Components 1980:1 - 1986:12

Small Time Deposits Error

M1 Error
Percent

Percent

2.5

1.5

.5
- 1

o
- .5

- 2

- 3

- 1.5
1980

1981

1982

1983

1984

1985

1980

1986

Liquid Savings Error

1981

1982

1963

1984

1985

1986

Large Term Account Error

Percent

- 1

I
I

- 2

I
I
I
-3

11 i

1980

' I

iii iii iii iii iii iii iii iii i i iii

1981

1982

1983

1984

1985

- 3

i iii

1986

I Iii i i i
1980

Iii

iii

1981

iii iii Iii i

1982

1983

iii

iIi Ii

1984

til

1985

iii i i

1986

deposit) in the large term accounts component of
M3. As discussed below, this result has important
implications for the stability of the broader monetary aggregate, M2.
Table 3. presents the variance decompositions for
Mloverthe two sample periods. 9 In the prederegulation period, innovations to Ml itself
accounted for around 80 percent of the variance of
the error in predicting MI. The interest rate variable
accounted for no more than 4 percent of the forecast
error variance ofMl at any forecast horizon, while
the. three monetary components - large term
accounts, small time deposits and liquid savingstaken together accounted for only 5 percent of the
Ml forecast error variance contemporaneously and
did not account for any more than 8 percent at any
forecast horizon. This situation is considerably different after deregulation. After the first few months,
MI accounts for only one-third of its own forecast
error variance, while interest rate innovations
account for around one-fourth. The other three components of M3 account for close to 20 percent of the
contemporaneous forecast error variance of M 1,
and close to 30 percent as the horizon lengthens.
This evidence supports the hypothesis that under
deregulation Ml has lost some of its unique characteristics as a transactions aggregate and has taken on
the characteristics of a savings-type aggregate. M I
now appears to be much more susceptible to portfolio shocks than it was prior to deregulation and it
responds to these shocks much more like the savings-type assets in liquid savings. (JUdd and Trehan,

uid savings shock but then falls and keeps declining
for nearly a year as well.
The impulse response functions suggest that the
reactions of M 1 to portfolio shocks have undergone
a number of changes after deregulation. Ml reacts
noticeably more strongly to innovations in the market interest rate, large tetms accounts, liquid savings, and small time deposits in the 1980s than in
the pre-deregulation period. In the later period,
shocks to large term deposits and small time
deposits led to large, permanent changes in the level
of Ml; these shocks do not appear to have had a
significant effect on Ml in the earlier period. Moreover, in the 1980s, Ml and liquid savings accounts
react in the. same direction and with the same
dynamic pattern to interest rate and large term
deposits shocks. Such behavior is much less evident
in the 1970s.
The behavior of the term components, namely
small time deposits and large term accounts, also
shows a noticeable difference across the two periods. In the pre-deregulation period, these two components tended to move in opposite directions. In
the post-deregulation period, they move in the same
direction, which is usually opposite the movement
in liquid savings and Ml. The change in the
behavior of small time deposits probably reffects the
removal of theinterest rate ceilings on them, which
has allowed banks to use these accounts as a managed liability in the post-deregulation period. Small
time deposits therefore behave more like the managed liabilities (such as, large certificates of

1987, show that this similarity in response is due to
the similarity between NOW accounts and liquid
savings.) Moreover, it appears that the term/nonterm distinction between monetary components,
which is important for investors in choosing among
savings-type assets, has become more significant
than the transactions/nontransactions distinction.

Chart 5
Selected Interest Rate Differentials
Percent

15
~

Small Time minus NOW

The 1985-86 Episode
In Section I, we presented evidence showing that
structural money demand equations systematically
underpredicted M I in April 1985 through the end of
1986. To be sure that the VAR results are not
dominated by developments in 1985-86, we estimated the VAR over the period from July 1981 to
March 1985. The M I variance decomposition from
the shorter period (Table 4) shows that the effect of
innovations to the other monetary aggregates is
similar to that obtained from the larger post-

0+--------1-----------~

Small Time minus MMDA
1981

1982

1983

1984

1965

1986

deregulation sample. Thus, Ml was sensItive to
innovations.in the other monetary aggregates even
before 1985.
On the surface, the apparent sensitivity of Ml to
changes in the other components of M3 throughout
the 1980s contradicts the evidence from the structural M1 demand equations discussed above. If M1
had been contaminated with savings-type balances
throughout the 1980s, why is there so little evidence
of upward shifts in Ml demand until 1985? An
answer is provided by Chart 4. This chart shows
successive twelve-month-ahead errors made in predicting the growth rate of the monetary components

Ml, liquid savings, small time deposits, and large
term accounts using the equations from the VAR
and assuming actual values for the righthand-side
variables. The projections for each year were based
on the model estimated over the prior fiVe years.
The panel in the top left comer shows the errors in
predicting small time deposits. While the errors
made by the equation are relatively large prior to
1985, they tend to be scattered around zero. That is,
the errors do not appear to be systematically positive
or negative. 10 However, the errors are almost uniformly negative beginning in the second quarter of
1985 (indicated by the dashed vertical line). This is

Chart 6

Impulse Response Functions Ml, M2, M3 in Levels
Pre-Deregulation

Post-Deregulation
Response to Interest Rate Shocks
Percent

Percent

0"':::::::::::::;;::------- -.2

-.2

-.4

-.6

-.8

-1. 0 '-r"T""T-,-,...,....,.-"...,...,.-,--rr-,-,...,....,....,-,--r-r-,-.,5

Months after shock

Post-Deregulation
Response to Large Term Account Shocks
Percent

Percent

01---'=.........: : : : : - - - - - - - - - - - - -

.•......,.._'_M_1_ __..--

-.6

-.8

-1.0
5

-1.0
10

Months after shock

Ii i

iii iii

iii

Iii

Months After Shock

also the period when the demand for M I equation
began to underpredict M I growth by a wide margin.
Moreover, theoverprediction of small time deposits
in 1985-86 is consistent with the underprediction in
Mldemand, given the negative response of MI to
an innovation in small time deposits shown earlier
in the MI impulse response functions. The bottom
two panels of the chart show that there are no
systematic errors in predicting liquid savings or
large term accounts.
The results in Chart 4 provide a resolution of the
apparent contradiction between the M I demand
results and the VAR results. It appears that MI
demand did not show sustained upward shifts
related to deregulation prior to 1985 despite having
been contaminated with savings-type balances
because there were no large shocks to the monetary
components prior to 1985. In other words, although
the potential for instability in M I had been

increased by deregulation, actual instability did not
show up until sizeable shocks actually occurred.
This evidence leaves open the question of why the
large shocks to M I occurred in 1985-86, after
deregulation was largely complete. A plausible
hypothesis relates the instability to declines in the
spreads between yields on MI and those on close
substitutes. As shown in Chart 5, these spreads have
declined sharply since the nationwide introduction
of NOWs in 1981; the substantial drop in market
rates relative to rates on NOWs and Super-NOWs
beginning in the latter half of 1984 brought these
spreads to all-time lows. The public may have
shifted nontransactions balances from small time
deposits into M I in response to the decline in the
yield on less liquid M I substitutes relative to yields
on NOWs.
Some analysts have argued that the very sharp
response of MI to this decline in yield implies that

savings). The weight used for each component of
M2 was the average ratio of the level of that component to the level of M2 over the sample period. The
response of each of the 3 components of M2 to an
interest rate shock was then multiplied by thecorresponding weight and the resulting terms added to
obtain the response of M2 to an interest rate shock.
The same procedure was repeated to obtain the
response of M2 to the other shocks to the system.
The M2 forecast error variance decomposition was
obtained from these responses in the usual manner.
Charts 6 and 7 present the effect of unexpected
movements in interest rates, large term accounts,
small time deposits, and liquid savings on the
monetary aggregates M 1, M2 and M3. As shown in
Chart 6, prior to deregulation, an interest rate shock
led to a permanent decrease in the level of all three
aggregates. The decrease in the level of M2 was the
largest, while M 1 and M3 decreased by smaller, and
roughly equal amounts. After deregulation, Ml
decreases the most, while M3 actually returns to its
pre-shock level. M2's post-deregulation response is
only slightly smaller than its pre-deregulation
response.
Second, the charts show that post-deregulation,
M2 and M3 tend to move closely together in
response to a shock to any of the monetary components. This is not surprising in view of our earlier
demonstration that in the post-deregulation period,
the responses of large term accounts to the portfolio
innovations are similar to the responses of small
time deposits.
The charts also show that the sensitivity of M 1 to
the other portfolio shocks has increased in the 1980s
over the pre-deregulation period more than that of
M2 and M3. Moreover, over the post-deregulation
period, the response of M 1 to any kind of innovation
is substantially larger than the response of either M2
orM3.
Tables 5 and 6 present the standard error of the
VAR forecasts and the variance decompositions for
M2 and M3 respectively. 12 Table 5 shows that the
error in predicting M2 more than a month into the
future actually has declined after deregulation.
However, the standard errors of the M 1, liquid
savings and small time deposit forecasts are all
higher after deregulation. At a 3-month forecast
horizon, for example, the standard error of the M 1

Ml 's interest elasticity has increased. (See
Kretzmer and Porter, 1986.) Although this may be
the case, it is too soon to tell. If the public were
transferring balances to M 1 because the yield differential earned for close cash management has
become very small, the rapid growth in Ml may
represent a transitional adjustment rather than a
permanent change in the interest rate elasticity of
Mldemand. ll Indeed, the long run elasticity ofMl
demand may even have declined: for money holders
who have made the choice not to manage Ml
balances actively, a small change in the yield on
NOW accounts versus, say, the yield on small time
deposits, would have little effect on their demand
for MI.
The fact that two quite different interpretations of
the 1985-86 episode are possible illustrates the
recent nature of the "problems" with Ml demand,
problems that do not allow a reliable estimate of the
complex structural M I-demand relationships to test
alternative hypotheses. Consequently, it will continue to be difficult to interpret movements in Ml in
the foreseeable future.

M2 and M3
The analysis so far has focused on the interactions
between M 1 and the other components of M3. It
also is of interest to examine what these interactions
imply for the behavior of the broader monetary
aggregates, M2 and M3, since the Fed established
target ranges for those aggregates. Our results suggest that portfolio disturbances that disrupt the
behavior of M 1 do not tend to disrupt M2 and M3 as
much because these other aggregates are broad
enough to internalize the shocks.
We use the VARs shown in Table 2 to obtain
results in terms of M2 and M3. This involved
aggregating the impulse response functions for the
various components obtained from the VAR and
then constructing variance decompositions. The
procedure followed is best illustrated by focusing on
a specific case, say the response of M2 to an interest
rate shock. Since the model is estimated in growth
rates and since the various components of M2 are of
different sizes in dollar levels, aggregation requires
the use of weights for the growth rates of each of the
components (Ml, small time deposits, and liquid

variance has increased from 0.15 to 0.20. Underlying this is a substantial increase in the forecast error
variance of large term accounts, which (at the
3-month horizon) has increased from 0.75 in the
pre-deregulation period to 1.14 in the postderegulation period. Notice also that the variance of
the errors in predicting M3 is close to the variance of
the errors in predicting M2 after deregulation,
whereas earlier the former was noticeably smaller.
Our results suggest that M2 and M3 are about
equally robust in the face of portfolio shocks.
However, M2 traditionally has been preferred over

forecast was 0.33 prior to deregulation and 0.48 in
the 1980s (see Table 3). The corresponding numbers
for liquid savings are 0.48 and 0.78 and for small
time deposits, 0.42 and 0.59. Thus, M2 has become
easier to predict after deregulation not because its
components are more "well-behaved", but because
the unpredictable changes in its components tend to
offset each other more than they did prior to
deregulation.
By contrast, Table 6 shows that the forecast error
variance of M3 has increased after deregulation. At
the 3-month forecast horizon, for example, this

Chart 7
Impulse Response Functions Ml, M2. M3 in Levels
Pre-Deregulation
Post-Deregulation
Response to Small Time Deposits Shocks
Percent

Percent

M3 ....

M2"

0
~

-.2

-.4

-.6

-.8

-.8
-1.0

-1.0
5

20
25
Months after shock

Months after shock

Response to Liquid Savings Shocks
Percent

Percent

-.2

-.4

-.6

-.8

-.8
-1.0
10

Months after shock

iii

Iii

iii

20
25
Months after shock

M3 on the grounds that M3 includes banks' managed liabilities, such as large certificates of deposit.
(See, for example, Gramley, 1986.) Because very
close substitutes for large term accounts exist in the
credit market - such as commercial paper - it is
argued that the demand for large term accounts is
likely to be relatively unstable. As a result, movements in M3 are not likely to provide any information that is useful for policy purposes. Moreover, it
is argued that since the instruments in M2 are not
managed liabilities, that aggregate is less likely to
be adversely affected by substitutions with credit
market instruments.
However, the impulse response functions shown
in Charts 2 and 3 contradict the latter assertion.
They suggest that there is little difference in the
behavior of small denomination time deposits
(which are in M2) and large term accounts. This

III.

result is confirmed by a survey conducted by the
Federal Reserve Bank of New York between
November 1986 and January 1987 that concluded
that "To banks, consumer CDs (what we have called
small time deposits) are an alternative to funding
through wholesale deposits" (our large time
deposits). 13, 14
To summarize, our analysis of the conventional
monetary aggregates suggests that deregulation
appears to have had the greatest impact on M I, and
that changes in the behavior of M2 and M3 have
been relatively small. M1 appears to have become
more susceptible to portfolio shifts, but these
shocks to M1 generally are represented by portfolio
re-allocations within the broader aggregates. In
addition, M2 has become easier to predict in the
post-deregulation period, even as its components
have become more difficult to predict.

Policy Implications

Our results support the FaMe's decision to drop
Ml from the set of variables being targeted. The
increase in the degree of substitutability between
M1 and other other components of M3 implies that
the behavior of Ml is likely to be dominated by
portfolio considerations, at least over the short run.
Consequently, movements in Ml are not likely to
provide useful information about variables such as
prices and income, which are of interest to policymakers. Moreover, our results suggest that M2 and
M3 are not as susceptible as Ml to being disturbed
by portfolio shifts because they are broad enough to
internalize most of those shifts. Thus, our results

support the FOMC's decision to continue to establish target ranges for M2 and M3.
If M2 and M3 were the aggregates of choice, is
there any evidence that favors greater emphasis on
one rather than the other? Some analysts have
argued that M2 is clearly superior for monetary
policy purposes because M3 includes instruments
that are used by banks as managed liabilities. Our
results suggest no basis for preferring one over the
other since small time deposits, which are in M2,
now appear to be used by banks much like the
managed liabilities in M3.

ApPENDIX A

Definitions of Variables
Note to Table I
CPRT
DDLBL
LMI
LM2DlF
LM3DlF
LP
LY
TIME
TIME2
TIME3
TIMEDR
TIMEDR2

three-month commercial paper rate
second difference in the log of total loans of commercial banks, including loans sold to affiliates, and
adjusted for the introduction of international banking facilities.
10gofMl
log of the non-M 1 component of M2
log of the non-M 1 component of M3
log of personal consumption expenditures deflator
log of nominal personal income
1,2, ... 12 during January 1981 through December 1981.
the square of TIME
the cube of TIME
1,2, . . . 13 during December 1982 through December 1983, zero elsewhere.
the square of TIMEDR

LMI

+ Al *DDLBL + A2*(LY-LP)
A3*LP + A4*CPRT
A5*TIME + A6*TIME2
+ A7*TIME3 + A8*(LMI, j-LP)

+
+
AO

-0.0009
(0.008)

0.23
(2.96)

= 0.99

A2
0.099
(5.31)

1.00

-0.00195
( -7.81)

0.0023
(1.43)

-0.0005
(1.38)

A7
0.00002
(1.14)

AS
0.88
(47.30)

0.0045

DW = 1.77
A3 = 1.00

RESTRICTIONS:

Sample Period: August 1976 - December 1984

LM2DIF = CO

+ Cl *CPRT + C2*LY + C3*TIMEDR + C4*TIMEDR2

-0.76
(-1.90)

0.0076
3.122)

= 0.999

= 0.0032

C2
1.006
(19.31)

C3
0.0075
(2.05)

0.00028 - .00000529
(.418)
(- .154)

DW
= 1.96
AUTO 1 = 1.43 (17.32)
AUT02 = -0.47(-5.64)
RESTRICTIONS: Coefficients Cl and C2 estimated with a second order Almon distribution over lags t to t - 14 and
t to t - 8, respectively, where the far end-point is tied to zero. Reported coefficients are for the sums of
the lag distributions.
Sample Period: August 1976 - December 1984

LM3DIF = DO

+ DI*CPRT + D2*LY + D3*TIMEDR + D4*TIMEDR2

-1.71
(4.80)

-0.007( 2.93)

1.19

0.000084
(0.027)

0.000081
(0.1333)

- 0.0000046
(-0.1511)

= 0.0999

SE
DW
AUlDi
AUT02

= 0.0026

(24.0)

= 1.97
= 1.53 (18.92)
= - 0.55 (

6.45)

RESTRICTIONS: Coefficients DI and D2 estimated with a second order Almon distribution over lags t to t - 14 and t to
t 8, respectively, where the far end-point is tied to zero. Reported coefficients are for the sums of the
lag distributions.
Sample Period: August 1976 - December 1984

ApPENDIX

Table 81
Correlation Matrix of Residuals from VARS in Table 2
Pre-Deregulation Period

Real Income
Prices
Interest Rate
Large Term Accounts
Small Time Deposits
Liquid Savings
Ml

Real
Income
1.00

Prices
- .38
1.00

Large
Small
Term
Interest
Time
Accounts Deposits
Rate
- .10
-.08
.07
.01
.01
.03
-.06
1.00
.28
-.61
1.00
1.00

Liquid
Savings
.31
-.24
-.12
- .30
.12
1.00

M1
.13
.19
.03
-.11
.01
.19
1.00

Post-Deregulation Period

Real Income
Prices
Interest Rate
Large Term Accounts
Small Time Deposits
Liquid Savings
Ml

Real
Income
1.00

Prices
- .49
1.00

Large
Small
Interest
Liquid
Term
Time
Rate
Accounts Deposits Savings
- .10
-0.12
.12
.08
.06
.04
-.01
.22
- .42
.10
1.00
.22
-.13
1.00
.01
1.00
.54
1.00

M1
.18
.02
-.11
-.21
-.30
.34
1.00

Table 82
M1 Variance Decomposition
Ordering: M1, Liquid Savings, Small TIme Deposits, Large Term Accounts, R, DEF, RPY
Pre-Deregulation

Months
Ahead
0

Real
Income

1
3
6
12

5
5
5
5

Price

1
1
1

Interest
Rate

3
3
3
3

Large
Term
Accounts

Small
Time
Deposits

0
0

0
0
1
1

1
1

Liquid
Savings

2
2
2

100
91
88
86
86

Post-Deregulation

Months
Ahead
0

Real
Income

1
3
6
12

3
4
7
9

Price

Interest
Rate

Large
Term
Accounts

Small
Time
Deposits

Liquid
Savings

3
2
2
2

5
22
21
22

1
3
5
6

7
17
18
19

7
5
5
4

100
73

47
42
39

Table 83
M2 Variance Decomposition
Ordering: M1, Liquid Savings, Small Time Deposits, Large Term Accounts, R, DEF, RPY
Pre-Deregulation

Months
Ahead

0
1
3
6
12

Real
Income

5
4
4
4

Price

2
2
2

Interest
Rate

Large
Term
Accounts

Small
Time
Deposits

Liquid
Savings

11
9
10
10

0
1
6
13
16

29
27
29
27
26

29
27
26
22
21

42
29
24
22
22

Large
Term
Accounts

Small
Time
Deposits

Liquid
Savings

0
1
1
1

28
20
15
16
16

35
29
22
20
20

Post-Deregulation

Months
Ahead
0

Real
Income

1
3
6
12

5
9
10

Price

0
1
2
3

Interest
Rate

17
28
29
29

37
27

24
21
21

Table 84
M3 Variance Decomposition
Ordering: M1, Liquid Savings, Small Time Deposits, Large Term Accounts, R, DEF, RPY
Pre-Deregulation
Months
Ahead
0
1
3
6
12

Real
Income

Price

Interest
Rate

4
13
12
11

2
2
2
2

2
3
6
6

Large
Term
Accounts
49
45
35
34
36

Small
Time
Deposits
0
0
2
3
3

Liquid
Savings
11
13
18
20
19

M1
39
34
26
24
24

Small
Time
Deposits
15
20
18
20
21

Liquid
Savings
21
18
16
14
13

M1
14
12
14
12
12

Post-Deregulation
Months
Ahead
0
1
3
6
12

Real
Income

Price

Interest
Rate

3
3
3
4

0
3
4
4

6
12
16
16

Large
Term
Accounts
50
41
33
30
30

FOOTNOTES
Under the assumption that the expected inflation rate in
any given month is equal to actual inflation over the previous twelve months, the coefficients in the model suggested that disinflation reduced the annual growth rate of
M1 velocity by 1.7 percentage points in 1981 through
1983. Thus, without the disinflation that occurred in those
years, M1 velocity would have increased at a 1.2 percent
rate - close to its steady state trend.

1. Testimony of Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking, Housing and Urban Affairs, United States
Senate, February 19, 1987, pg. 26. Also see, Board of
Governors of the Federal Reserve System, "Monetary Policy Report to Congress Pursuant to the Full Employment on
Balanced Growth Act of 1978," February 19, 1987.
2. See Keran (1983), Judd (1983), Judd and Motley
(1984).

Of course, these velocity declines would not have caused
problems for monetary policy had they been anticipated.
Unfortunately, they did seriously complicate the setting of
monetary targets because, as often is the case, disinflation
proceeded in unpredictable "fits and starts".

3. Disinflation seems to have caused greater problems
than did deregulation for using M1 as an intermediate
target of monetary policy. Disinflation after 1980 induced
declines in nominal interest rates that led to temporary
decreases in M1 velocity that contrasted with its steady
upward trend in the preceding two decades. In fact,
disinflation appears to account for all of the net reduction in
M1 velocity in 1981 through 1983. Estimates using the San
Francisco Money Market Model implied an M1 velocity
growth trend of 0.8 percent per year in steady state, that is,
when interest rates and inflation are constant and real GNP
is advancing at its long-run potential rate of 3 percent.
From the fourth quarter of 1980 to the fourth quarter of
1983, M1 velocity declined at an annual rate of 0.5 percent.

4. See Mehra (1986).
5. These simulation results rest on movements in the
conventional money demand arguments of real income, an
aggregate price index, and a nominal market rate of
interest. As shown in Appendix A, the M1 equation also
includes the growth in bank loans as an explanatory variable, but this non-traditional argument has little effect on
the simulation results presented in the table. See "A Model
of the Money and Bank Loan Markets," Federal Reserve

Bank of San Francisco, April 1987.

innovations more or less unchanged in the post deregulation period as well. The share of the other components of
M3 taken together is also approximately the same as under
the original ordering. However, the share of small time
deposits goes up somewhat and the share of liquid savings innovations is correspondingly smaller.

6. A similar model is estimated in Trehan and Walsh
(1987). That model does not include small time deposits
and liquid savings, but does include a forward rate of
interest.
7. Even though Institution only Money Market Mutual
Funds are more liquid than time deposits, we did not
remove them from large term deposits to include them in
liquid savings. Doing so would mean that we would no
longer be able to aggregate the various components in a
straightforward manner to obtain M2 and M3. The other
alternative, including these accounts as a separate vanable in the VAR, was rejected because it would increase
the number of variables in the system without yielding any
further insights.

10. The equation does not, of course, predict the movements associated with the introduction of Super-NOWs
and MMDAs. The errors in these months have been set to
zero.
11. In terms of the Baumol-Tobin model of the demand for
transactions balances, a larger proportion of cash holders
may have reached cash-management "corner solutions".
12. The ordering is the same as before, that is, the variables are ordered RPY, DEF, R, large term deposits, small
time deposits, liquid savings and Mi. Results from the
reverse ordering are shown in Tables B3 and B4 in Appendix B.
13. See Davis, Korobow and Wenninger.

8. The results were calculated under the following
"ordering" of the model's variables: RPY, DEF, R, large
term accounts, small time deposits, liquid savings, and
Mi. The ordering imposed upon the variables is a way of
transforming the residuals from the VAR so that they can be
interpreted as disturbances to specific variables in the
system. This transformation is necessary because the
residuals from the VAR tend to be correlated with each
other. Consequently, the data can only be interpreted after
the researcher has chosen some method of determining
which variable is the causal factor behind the observed
correlations.

14. More direct evidence on the extent of the potential
problem with M3 is provided by a VAR we estimated that
contained, in addition to the variables in the previous VAR
(Table 2), assets included in the Fed's liquid asset measure, l, but not in M3 (for example, short-term treasury
securities and commercial paper). We call these credit
market instruments Netl. Under the hypothesized problem
of M3, variations in large term deposits should be closely
correlated to movements in Netl. For example, when
banks raise interest rates on large time deposits to obtain
more funds, individuals would respond by selling off shortterm Treasury securities and commercial paper to acquire
large time deposits. Further, since NetM2 is hypothesized
to be less sensitive to these influences, it should be much
less closely correlated with Netl. (NetM2 is the difference
between M2 and M1 and equals the sum of our liquid
savings and small time deposits components. See the box
on "Monetary Aggregates." Note also that our large term
accounts component is the same as the conventional
NetM3)

By placing income first in our ordering, we are assuming
that the entire contemporaneous correlation between
unpredicted movements in income and other variables in
the system is due to shocks to income. In other words, we
assume that a shock to any of the other variables has no
contemporaneous impact on income. Next, the entire contemporaneous correlation between DEF and the remaining
variables in the system is assumed to be due to shocks to
DEF. Similarly, while shocks to the interest rate have a
contemporaneous impact on the monetary components in
the VAR, shocks to the latter have no contemporaneous
impact on the former, and so on.
The ordering we chose is equivalent to that imposed in
studies of the money demand function, that is, contemporaneous shocks to income, prices, and interest rates are
allowed to have an effect on money, but money is not
allowed to affect the others. In principle, the results could
be sensitive to the precise ordering imposed upon the
system. Therefore, in Appendix B we present some results
for the case where the ordering is the reverse of what we
impose here. In general, our results are not very sensitive
to this change.

An examination of the contemporaneous correlations
between the residuals from the VAR estimated over the
post-deregulation period does not support these hypotheses. The correlation between Netl and large term
deposits is .01 , between Netl and small time deposits is .1.,
and between Netl and liquid savings, - .25. The assocIated variance decompositions also do not suggest that
there is a marked difference between NetM2 and NetM3. In
particular, with Netl ordered before both NetM2 and
NetM3, innovations to Netl account for approximately 3
percent of the forecast error variance of NetM2 and 5
percent of the forecast error variance of NetM3 for forecast
horizons up to 2 years. Consequently, the evidence does
not justify a preference for M2 over M3.

9. In Table 3, the variables are ordered in the way they
were for the impulse response functions, specifically, the
ordering is RPY, DEF, R, large term accounts, small time
deposits, liquid savings and M1. Table B2 in Appendix B
reverses this ordering. While the reversal increases the
share of M1 forecast variance explained by M1 innovations
(or shocks) as expected, the change in the variance
decomposition is not startling when compared to the original ordering. In the pre-deregulation period, interest rate
innovations account for a maximum of 3 percent, while the
other 3 components of M3 taken together account for a
maximum of 4 percent of the M1 forecast error variance
Reversing the ordering leaves the share of interest rate

The result that innovations in Netl explain very little of the
forecast error variance decomposition of NetM2 and large
term deposits has another important implication, namely,
that there appears to be little gain in going from M3 to a still
broader aggregate. In other words, while the recent portfolio disturbances have not been internalized within M1,
they do appear to have been internalized Within M3 and, to
a lesser extent, within M2.

REFERENCES
Keran, MW. "Velocity and Monetary Policy in 1982,"
Weekly Letter, Federal Reserve Bank of San Francisco, March 18, 1983.
Kretzmer, P.E., and RD. Porter. "The Demand for the
Narrow Aggregates - Is a Transactions Approach
Sufficient?," mimeo, Board of Governors of the
Federal Reserve System, 1986.
Mehra, Yash. "Recent Financial Deregulation and the
Interest Elasticity of M1 Demand," Economic Review,
Federal Reserve Bank of Richmond, July/August
1986.
Motley, Brian. "Money, Inflation and Interest Rates,"
Weekly Letter, August 5, 1983.
Spindt, PA, and V. Tarhan. "The Federal Reserve's New
Operating Procedures: A Post Mortem," Journal of
Monetary Economics, January 1987.
Trehan, B., and C. Walsh. "Portfolio Substitution and
Recent M1 Behavior," Contemporary Policy Issues,
January 1987,

Davis, R.G., Leon Korobow, and John Wenninger.
"Bankers on Pricing Consumer Deposits," Quarterly
Review, Federal Reserve Bank of New York, Winter
86·87.
Gramley, L.E. "M·2s Puzzling Behavior," Credit Week,
December 8, 1986.
Judd, J.P. "Deregulated Deposit Rates and the Role of
Money in Monetary Policy," Economic Review,
Federal Reserve Bank of San Francisco, Fall 1983.
Judd, J.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 Fran·
cisco, Summer 1984.
Judd, J.P., and J.L. Scadding. "The Search for a Stable
Money Demand Function: A Survey of the PosH 973
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nents," Federal Reserve Bank of San Francisco, Work·
ing Paper, 87-05,

III

I
Reuven Glick*

Empirical estimates indicate that the degree of linkage between
domestic real interest rates in Pacific Basin countries and that of the
United States is comparable to the linkage between most European
countries and the United States. Financial liberalization and other
developments that have affected the determination of interest rates in the
Pacific Basin region also are discussed.

ers to international financial flows may prevent real
interest rates from being equalized, linkages
between rates in different countries may still exist.
The major purpose of this paper is to examine the
extent to which domestic real interest rates in Pacific
Basin countries have been linked to rates in the
United States in recent years. The paper is
organized as follows. Section I discusses factors
affecting the relation of real interest rates among
countries. Section II summarizes specific financial
liberalization developments in the six countries
examined in the empirical section of the paper:
Hong Kong, Singapore, Malaysia, Japan, Taiwan,
and Australia. These countries were chosen because
each possesses a sufficiently long time series of a
market-influenced interest rate.
Section III empirically analyzes relationships
among real rates in the countries under study. This
section first describes the methodology of generating estimates of ex ante real rates and of measuring
the extent to which these rates are related to that of
the United States. The methodology of Cumby and
Mishkin (1986) is employed to obtain consistent
estimates from ex post observations of real rates. It
then presents and discusses the empirical results.
Section IV provides a brief summary of conclusions.

The relation among real interest rates in different
countries is an important issue for policymakers
since the effectiveness of stabilization policies is
determined largely by the extent to which domestic
monetary and fiscal authorities can influence the
domestic real rate relative to the world rate.
While a number of studies of interest rate linkages between the U.S. and European countries exist
(von Furstenberg, 1983; Mishkin, 1984a, 1984b;
Cumby and Obstfeld, 1984; and Cumby and Mishkin, 1986), similar studies for other parts of the
world, particularly the developing regions, are scant
(see Blejer and Khan, 1983). This relative neglect
often has been justified by the rationale that competitive forces have played little role in the determination of interest rates in most other countries, and
that controls and other market barriers impeded the
development of any linkages.
With the recent liberalizing financial trend in
many countries, however, particularly in the Pacific
Basin, this rationale no IQnger seems justified.
Moreover, as shall be discussed below, while barri-

* Senior Economist, Federal Reserve Bank of San
Francisco. Research assistance by John Duffy is
gratefully acknowledged.
31

Theory of Real Interest Rate Linkage
Equation 2 states that real interest rates may differ
between. countries because of two factors given by
the last two terms on the righthand side of the
expression. The first of these terms represents
expected deviations from purchasing power parity
(PPP) or, equivalently, expected real exchange rate
movements. According to PPP, the nominal
exchange rate is anticipated to change according to
the anticipated differential in rates of inflation,
leaving the real exchange rate constant. Thus, when
foreign inflation exceeds U. S. inflation, a foreign
currency depreciation is necessary to sustain purchasing power parity between foreign and U.S.
currencies.
The last term represents deviations in uncovered
interest parity (DIP). According to DIP, the anticipated rate of depreciation of the foreign currency
should equal the nominal interest differential (presuming U.S. and foreign assets are otherwise comparable). Thus, an anticipated foreign currency
depreciation should lead to a higher foreign interest
rate to compensate for the expected currency loss
associated with the anticipated depreciation, and
thereby leave the overall return to investing in
foreign assets equal to that from investing in U. S.
assets.
The existence of deviations from PPP and DIP
depends on a number of factors. Barriers to international trade may create PPP deviations by limiting
the ability of goods market arbitrage to link domestic and foreign inflation rates and the exchange rate.
PPP may not hold, even in the absence of goods
market trade barriers, when domestic and foreign
goods are not perfect substitutes. Moreover, deviations from PPP may also occur because of various
factors affecting the equilibrium real exchange rate.
Differential changes in taste, technology, or factor
supplies can permanently influence relative price
competitiveness among countries and therefore the
real exchange rate between them. In addition,
changes in monetary and fiscal policy and other
economic demand and supply shocks can lead to
fluctuations in real exchange rates and hence deviations from PPP. I To the extent that the effects of
these policy changes average out over time,

A country's real interest rate is equal to its nominal interest rate minus the expected rate of inflation.
The relation of real interest rates between two countries thus depends on the relationship of nominal
interest rates through the interaction of their financial markets, on the relationship of price levels
through the interaction of their goods markets, and,
since their price levels are denominated in different
currencies, on the exchange rate between their currencies.
To see this, define the ex ante foreign and U.S.
real interest rates by
(1)

where rrj (rrus ) and ij (ius) represent for country j (the
U. S.) the expected real and nominal rates of return,
respectively, at time t earned by holding the asset
from time t to t + I , and pf (p~s) denotes the expectation at time t of the inflation rate from t to t + I,
where time scripts are omitted.
Let s denote the nominal foreign exchange price
of the dollar, Pj (Pus) the foreign (dollar) price of
foreign (D. S .) goods, and q = sPuslPj, the real
foreign price of the dollar. Note that a rise in s
represents an increase in the amount of foreign
currency necessary to buy a dollar and hence a
nominal foreign currency depreciation or, correspondingly, a nominal appreciation of the dollar. A
rise in q represents an increase in the relative foreign
currency price of U. S. goods and hence a real
foreign currency depreciation or, correspondingly, a
real dollar appreciation. A real foreign depreciation
occurs when a rise in nominal foreign currency
value of the dollar and in U.S. prices exceeds the
rise in foreign prices.
Adding and subtracting appropriately and using
the definition of the U. S. real rate implies

+ W + P~s - pf) + (ij - ius - §e)
= ITus + qe + (ij - ius
§e)
(2)
where qe = §e + P~s - pf denotes the expected
= ITus

change in the real exchange rate.

however, the magnitude of this cause of real interest
differentials diminishes.
Restrictions on international capital flows can
inhibit the ability of financial market arbitrage to
link domestic andforeign nominal interest rates and
.the exchange rate and thereby create deviations
from DIP. DIP may not hold precisely even in the
absence of financial market imperfections when
domestic and· foreign assets are not perfect substitutes. In this case, deviations would arise from the
risk premium necessary to compensate investors for

II.

holding the asset with the higher risk.
To summarize, real interest rates are equal across
countries only in the absence of deviations from
PPP and DIP. They may differ because of deviations
from PPPand/or DIP. Thus, for example, the foreign
real rate can be below that in the U.S. in the case of
an expected real appreciation of the foreign currency
(qe < 0), a deviation from PPP, or because the foreign
nominal return is less than the dollar equivalent
return(ij < ius + se), which is a deviation from UIP.

Pacific Basin Experiences

The discussion of the previous section implies
that the degree of international linkage of real interest rates depends on the degree of integration of
financial and goods markets as well as on expected
changes in the real exchange rate. In recent years,
the majority of countries in the Pacific Basin have
undertaken steps to liberalize their domestic financial systems and to remove restrictions on international capital f1ows. 2 At the same time, these countries have been subject to various domestic and
foreign disturbances that have influenced their real
exchange rates. These disturbances include oil price
changes, commodity export price shocks, and foreign economic policy changes, such as the U.S.
fi seal expansion of the 1980s.
Since the process of financial liberalization has
been the foremost economic development within
most countries in the Pacific Basin region during the
1970s and 19805, the individual experiences of the
six countries examined in the empirical portion of
this paper are briefly discussed below. These countries include: Hong Kong and Singapore, which
liberalized earliest, in the early to mid-1970s; Malaysia and Japan, which began liberalization somewhat later, in the late 1970s; and Australia and
Taiwan, which did not begin liberalization significantly until the 1980s. 3

ished its last official exchange controls in December
1972, and, in general, now imposes no controls on
international capital receipts or payments by residents or nonresidents.
Over the period 1979 to 1983, Hong Kong's
financial system was subject to a number of
changes. In February 1979, the government
required the major note-issuing banks to back all
reserve assets with either currency or foreign
exchange assets. In April 1981, the banking system
was restructured and withholding taxes on domestic
assets were eliminated. In February 1982, withholding taxes on foreign currency deposits were abolished as well. In October 1983, interest withholding
taxes on Hong Kong dollar deposits were eliminated, and the Hong Kong dollar, which had been
allowed to f10atfreely since November 1974, was
pegged to the U. S. dollar. In addition, in the early
1980s, considerable uncertainty about the political
future of Hong Kong occasionally influenced financial markets.

Singapore
Singapore began deregulating the pricing of most
of its financial markets in July 1975 and completely
liberalized foreign exchange transactions in June
1978. In principle, near perfect international capital
mobility exists: residents are free to make transactions in any currency as well as to invest in any
currency. While nonresidents are similarly free to

Hong Kong
Hong Kong has been one of the least restricted
economies in the Pacific Basin. It formally abol-

transact in Singaporean dollars, the authorities have
sought to some extent to segment domestic money
markets from the Asia dollar market - an offshore
currency market where rates are freely determined
(this practice differs from that of Hong Kong, which
has not sought to limit nonresidents' use of local
currency).
In addition, there is some historical evidence that
on occasion Singapore has sought to limit the effects
of U.S. interest rates on domestic rates by "moral
suasion" (see Fry, 1985). Since 1975, the Monetary
Authority of Singapore has officially pegged the
Singaporean dollar to a trade-weighted basket of
currencies.

transactions since the mid-1970s, including lifting
interest rate ceilings and controls on international
capital flows. In May 1979, foreigners were allowed
for the first time to acquire gensaki securities three-month repurchase agreements traded on one
of the few markets in Japan with competitively
determined interest rates. 5 Japanese banks were
allowed to make short-term foreign currency loans
to residents (impact loans) in June 1979 and longterm loans in March 1980. By freeing all international transactions, in principle, from direct government influence, amendments to the Foreign
Exchange and Foreign Trade Control Law in
December 1980 officially recognized the gradual
process of de-control of capital flows that had
already taken place. Nevertheless, the government
has periodically used "moral suasion" to limit
international capital transactions.
Efforts by the United States to induce the Japanese government to adopt a list of measures further
liberalizing its capital markets resulted in the May
1984 YenlDollar Agreement. Subsequent reforms
that have further facilitated increased international
capital flows include the end of yen-dollar swap
limits for foreign banks operating in Japan and the
removal of the requirement that all forward
exchange transactions be related to export and
import merchandise transactions or remittances in
June 1984.

Malaysia
Malaysia followed Singapore in the pursuit of a
policy of financial deregulation. Starting in August
1973, certain nonbank interest rates were freed, and
steps were taken to create more effective competition among commercial banks. In addition, the
currency was allowed to float. In October 1978,
measures were announced that reduced the extent of
administrative guidance, that made bank interest
rates more market-oriented, and that introduced
several new instruments, such as bankers' acceptances and CDs. These steps significantly increased
the responsiveness of deposit rates to the interbank
rate. However, despite the fostering of price competition, allocative requirements on bank loans are
still regularly imposed and priority sectors are
favored with low interest rates.
Malaysia has a system that is generally free of
exchange controls; its authorities impose virtually
no. restrictions on capital inflows or on capital
outflows as long as they are not financed by local
borrowing. However, the public is prohibited from
dealing in foreign exchange unless there is an underlying "genuine" trade transaction. Moreover, commercial banks, which form the core of the foreign
exchange market, are limited in the open positions
they may undertake in foreign exchange transactions.

Taiwan
Taiwan has been somewhat slower than the countries above in pursuing financial reform, although it
too began establishing open money markets in the
late 1970s. In April 1980, Taiwan relaxed official
restrictions on bank lending rates. The rates are
currently set by a bankers cartel, the Taipei Bankers'
Association, which allows somewhat more flexible
rate adjustment. In November 1980, more flexible
interest rate adjustment was permitted on other bank
instruments, including negotiable CDs and debentures.
Even as Taiwan has liberalized these aspects of its
financial market, it has kept international capital
movements greatly restricted. In December 1978,
residents were permitted to hold foreign exchange
deposits in designated banks and to buy and sell

Japan
Japan has followed a gradual process of deregulation of both domestic and international financial

Australia

foreign exchange through these banks. In February
1979, a foreign exchange market in which the
exchange rate was allowed to float within pre-set
limits was established. (The exchange rate was
devalued in July 1978; a further devaluation
occurred in August 1981.) In practice, the exchange
rate is set by a small group of commercial banks
together with the Central Bank.

III.

Australia has only recently liberalized its financial markets although, in contrast to Taiwan, undertook reforms in quick succession. Not until December 1980 were some interest rate ceilings and
quantitative guidelines on bank lending removed.
However, by December 1983, Australia had floated
its currency and abolished almost all foreign
exchange controls.

Analyzing Real Interest Rates

In this section, we analyze real interest rate
linkages between the United States and six Pacific
Basin countries - Hong Kong, Singapore, Malaysia, Japan, Taiwan, and Australia. These countries were chosen because each possesses a domestic financial market that has been free enough to
provide meaningful interest rate statistics. A comparison of findings involving these countries with
those for developed countries provides useful evidence of the extent of international integration of
asset and goods markets within the Pacific Basin.
Tests performed for the U.S. and other major
industrial countries by Mishkin (1984a, 1984b), von
Furstenberg (1983), Cumby and Obstfeld (1984),
Mishkin (1984a, 1984b), and Cumby and Mishkin
(1986) generally reject the hypothesis that real
interest rates are equalized across countries. 6
However, Cumby and Mishkin have measured the
extent to which real rates in the U.S., Canada, and
Europe are linked and move together over time.
They find that real rates have climbed dramatically
from the 1970s to the 1980s in the U. S. and abroad,
and that there is a significant positive association
between movements in U. S. real rates and those
abroad. This strong and statistically significant
tendency for real rates to move together in different
countries, even though the movement is not one-forone, suggests that some degree of international
linkage exists among the countries.
We proceed by discussing the econometric methodology of the tests employed, which were based on

the work of Cumby and Mishkin (1986). As Cumby
and Mishkin point out, the major difficulty in such
tests is that the expected inflation rate, and hence the
ex ante real interest rate, is unobservable. One must
therefore take care in making statistical inferences
about ex ante real rates from observed data. The
methodology is described more fully below, and
empirical results follow.

Methodology
Restating definition 1, the ex ante real interest
rate associated with a given asset at time t is given by
rr=i-pe,

(3)

where i and rrrepresent the nominal and expected
real rates of return, respectively, at time t earned by
holding the asset from time t to t + 1, and pe denotes
the expectation at time t of the inflation rate from t to
t + 1. The ex post real rate can be calculated by
subtracting from the nominal interest rate the ex post
inflation rate
eprr = i - p,

(4)

where eprr represents the realized real return to
holding an asset from t to t + 1, and p, the ex post
rate of inflation.
Relationships 3 and 4 imply that the ex ante real
rate can be expressed as

+ (p
= P-

rr = eprr
where

- pe) = eprr

(5)

pe represents the forecast error of

inflation. Thus the ex ante and ex post real rates
differ only because of inflation forecast errors.
Since ex ante inflation expectations cannot be
observed, ex ante real rates cannot be determined
directly from the calculation of ex post rates.
However, by inferring information about the relationship between expected inflation and other variables known at time t, it is possible to generate
results about the ex ante real rate from regressions
involving only ex post data.
More specifically, assuming rational expectations, that is, that expectations of future inflation at
time t depend on all available information,

E[p I 0]

The tests of interest rate linkage are constructed
from the hypothesis
(11 )
where rrj denotes the ex ante real rate in country j,
rrus that in the U.S., and Wj is an error term. The
hypothesis of equal real returns implies aj = 0 and
bj = 1, while the hypothesis that there is no link
between rates implies bj = o. Partial linkage is
indicated if O<bj < 1.
Because the ex ante real returns are not observed,
this regression equation cannot be estimated
directly. However, using the expression for the ex
post real rate in equation 5, one can rewrite equation
11 as

(6)

and hence

eprrj

(7)

E[tIO] = 0,

(8)

that is, the ex ante real rate is given by the expected
value of the ex post rate conditional on the information set e or, equivalently, by the fitted linear regression relationship between the ex post rate and e.
To take account of the fact that an econometrician
does not know all the information available to
agents, assume that the ex ante real rate formed at
time t is linearly correlated with variables in the set
X that can be observed by an econometrician at time
t and are contained in the available information set
O. This implies
rr = XB

+ u,

(9)

where B is a vector of coefficients and u is a
measurement error term such that E[u I X] = 0. 7 .
Because rr is not observable by an econometrician
either, equation 9 cannot be estimated directly.
However, substituting equation 9 into equation 5
and re-arranging gives
eprr = XB

E) = XB

+ bjeprrus +

(Wj - Ej

bjEuJ,

(12)

which depends only on observables. However,
because the error term Wj - Ej + bjE us is not
uncorrelated with the explanatory variable eppr us
(eprrus is realized at time t + 1 and is thus correlated
with Eus ), an instrumental variables estimation
method is necessary to obtain consistent estimates.
Consistency requires that the instruments used to
estimate the ex ante U. S. real interest rate be uncorrelated with the error components in equation 12the inflation error terms in the foreign country and
the U.S., Ej and Eus ' and the linkage error w j .
Choosing the instruments from the available information set e implies by definition that they are
uncorrelated with the expectational errors, Ej and
Eus . To ensure that they are also uncorrelated with
the linkage error Wj' it is necessary to choose
instruments that exert no additional influence on the
interest rate in country j apart from their influence
on the real rate in the U .S. As suggested by Cumby
and Mishkin, a natural choice for instruments that
satisfy these requirements are those variables in X
that predict the U.S. ex post real rate well.

where 0 = all available information at time t. In
other words, the forecast error of inflation is uncorrelated with any information available at time t.
Correspondingly, 5 and 7 imply
rr = E[eprrIO]

Empirical Results
The sample range in the empirical analysis consisted of quarterly data over the period I 974QIV to
1986QI (to 1985QIV for Malaysia). All data were
obtained from the IMF International Financial Statistics or national sources. Where available, the rates
used were end-of-period 90-day rates. More specifically, the 90-day Treasury bill rate was used for the

(10)

which, because both eprr and X are observable, can
be estimated by ordinary least squares. Estimates of
the ex ante real rate can then be obtained from the
fitted values of this regression. 8

regime after the third quarter of 1982. For Japan a
regime shift was found to occur in 1979QI. This
shift may be identified as related to the greater focus
of the Bank of Japan on monetary aggregates than
on interest rates that purportedly began in July 1978
(see Hutchison, 1986).
Shifts found for other countries took place in
Hong Kong in 1981QIV, Singapore in 1977QIII,
Malaysia in 1980QII, and Taiwan in 1979QIV;
although no significant shift was found for Australia. These shifts may be attributable to the effects
of financial liberalization steps, although the cause
is impossible to determine conclusively. It should be
noted that these regime breaks cannot be determined precisely; breaks may have occurred before
or after the periods indicated, and other breaks also
may have occurred. The ones reported are those
with F-statistics with less than 5 percent significance.
The final estimates of ex ante real rates were
obtained by including in the regression equation
multiplicative dummy terms for all variables in X;
the dummy was set equal to 0 before the shift point

U.S., the 3-month gensaki rate for Japan,9 and the
90-day commercial bill rate for Australia. For Taiwan, the short-term curb rate was employed, 10 and
for Malaysia the overnight commercial bill rate. 11 In
the case of Hong Kong, the mid-point of the lowhigh range of the overnight interbank rate in the last
month of each quarter was used.
The variables in the information set X used instrumentally to estimate real rates in individual countries included a constant term, linear and quadratic
time trend, the nominal interest rate, and three
values of lagged inflation. The addition of other
variables, such as money growth, was not found to
provide any additional explanatory power, except
for the case of Malaysia.
Quandt statistics (1960) and Chow tests were
used to test for evidence of shifts in the stochastic
structure of real interest rate levels. A regime shift
was found for the U.S. from 1980QI to 1982QIII.
This result is consistent with the findings of Huizinga and Mishkin (1986) and others of a shift in
monetary policy behavior by the Federal Reserve in
late 1979, with subsequent return to the original

and one at the shift point and after (except for the
U.S. where it was set equal to 0 again after
1982Qm).
Charts 1 through 7 (appended) graph the ex ante
real (and nominal) interest levels in each of these
countries. Observe that the real interest rate appears
to have risen in all cases in the 1980s in correspondence with the rise in the U. S. real rate. Note that in
the case of Taiwan, interest rate levels are particularly high due to the higher transaction costs and
risk associated with the interest rate measure
employed - the curb rate.
Table 1 contains the results of linkage regressions
for the six Pacific Basin countries with the United
States. As discussed above, econometric considerations dictate the use of the information set X used to
predict the U. S. real rate - a constant, linear and
quadratic time trend, the nominal U. S. interest rate,
and three values of lagged U.S. inflation, as well as
multiplicative dummy terms involving these variables as instruments. Intercept dummy coefficients
were also included for several of the countries to
remove outlying observations from the sample, but
are not reported. 12
Of particular interest in Table 1 is the coefficient b
that describes the amount of movement in the country's real rate for a given movement in the U.S. rate.
The hypotheses that real rates are equal across
countries, a = 0 and b = 1, or are fully linked
across internationally, b = I, are generally rejected.
However, in all cases the hypothesis of no linkage
between real rates in different countries, b = 0, is
rejected as well. In all cases, the b coefficient lies
between 0 and I: Hong Kong has the highest coefficient at .64; Malaysia has a coefficient of .62;
Singapore, .48; Japan, .46; Australia has the lowest
coefficient, .38. Somewhat surprisingly the coefficient for Taiwan, at .58, appears somewhat high
given the limited extent of financial liberalization in
that country. None of the results appeared sensitive
to correction for serial correlation.
It is interesting to compare these results with
those obtained by Cumby and Mishkin for linkages
between Canada, several European countries, and
the U.S. over the period June 1973 to December
1983. 13 Using domestic money rates, they obtained
figures for b of .91 for Canada, .77 for the United

Kingdom, .63 for Italy, .58 for France, .52 for the
Netherlands, .44 for Germany, and .16 for Switzerland. These results indicate that, for most Pacific
Basin countries, the degree of linkage with the U. S.
is less than that of Canada but comparable to that of
most European countries.
To investigate the possibility that financial liberalization or other developments have influenced the
degree of linkage over the sample period, tests for
shifts in the estimated b coefficients were performed. One of the difficulties encountered in these
tests is that, in most cases, the relaxation of financial
controls has been gradual rather than abrupt. This
makes it difficult to identify any single point in time
that corresponds with a discrete change in the relationship between domestic and foreign rates. As a
result, the usefulness of tests such as the Quandt
statistic, which are best used for detecting the occurrence of discrete changes at particular points in time
within a sample, is limited.
The approach adopted here was to introduce
various dummy variables, both separately and multiplicatively, for periods of one or more quarters.
The durations chosen correspond to dates on or over
which financial liberalization measures were
announced as well as dates on which shifts in
domestic real interest rate determination had previously been identified.
Significant intercept dummies at times were
found, but shifts in the b coefficients were not.
Taking account of the intercept shifts and outlying
observations generally improved the fit of the relationship without affecting the magnitude of the b
coefficients. Thus, the analysis provided no evidence of changes in the degree of sensitivity to the
U. S. real rate.
The lack of evidence of any change in the degree
of interest linkage has several possible explanations.
One explanation, of course, is that there may have
been no actual change in the levels of linkage over
the period studied. For some of the countries in the
analysis, the interest rate used may have been determined relatively competitively over most of the
sample period; for other countries, any change in
the degree of international arbitrage may have
occurred too late in the period to have been identified econometrically.

Second, the results may indicate that, while
financial market liberalization has allowed domestic
interest rates in most countries to be more competitively determined in relation to domestic economic
conditions, remaining restrictions on international
capital flows and intermittently applied government
controls have effectively limited changes in the role
of international factors. 14
A third explanation lies in recognizing, as argued
in Section I, that real interest rate linkages depend
not only on international financial market arbitrage
but also on linkages between prices in different
countries through the interaction of goods markets.
The latter may have masked the effects of interest

IV.

rate liberalization. More specifically, it is possible
that while financial market liberalization in the
countries studied has resulted in smaller deviations
from uncovered interest parity, thereby leading to
closer real rate linkage, larger deviations from purchasing power parity associated with expected real
exchange rate movements may have weakened the
linkage. One can make a strong case for this possibility since, during the 1980s when the process of
financial liberalization was in full swing in the
countries under study, the real value of the dollar
underwent a dramatic appreciation that generated a
strong expectation of subsequent real dollar
depreciation.

Conclusion

This study has discussed developments affecting
real interest rates in the Pacific Basin. In recent
years, the countries in this region have allowed both
domestic and foreign market forces to playa greater
role in the determination of interest rates in their
economies. Empirical estimates indicate that the
degree of real interest rate linkage with the United
States is comparable to that of most European
countries. Efforts to detect any increase in the extent
of this linkage over time were unsuccessful.
The result that the real interest rates of Pacific
Basin countries analyzed in this study are not tied

one-for-one to that of the United States implies that
the monetary and fiscal authorities of these countries have some influence over their domestic real
rates and some control of their stabilization policies. However, the existence of interest rate linkages indicates that, as with countries in more
developed regions, economic market forces are at
work integrating their financial and goods markets
with those abroad. Thus, domestic economic conditions in the Pacific Basin area are sensitive to
developments abroad.

Chart 1
United States Interest Rates

Chart 2

Japanese Interest Rates
Percent

Percent

o-k+"""....---,---,..,L---------

O-l-+:--N'\+----\,/-H\:(-L---------

-4

-8

-8
1975 1976

1978

1980

1982

1984

1975

1986

1976

1978

1980

1982

1984

1986

Chart 4
Singapore Interest Rates

Chart 3
Hong Kong Interest Rates
Percent

Percent

O-j-L...:;++H-t-;-~ftf+lt-ftt~¥~.r--~-=--

0+--yt,1-I'-""""'"1++---------~

-4

-8

-12

-8
+.......,.~,.,...."..,.......,rro-..,............,.~TTT."..,.......,.~.,..,..,....,..,..........,
1975 1976
1978
1980
1982
1984
1986

19751976

1978

1960

1982

1984

1986

Chart 6
Taiwanese Interest Rates

Chart 5
Malaysian Interest Rates
Percent

Percent

12
8

-Real

O+---\+"'o...-l+-F-+-:--:-----,H-+--"------4

-10

-8

-20
1975

1977

1979

1981

1983

1985

19751976

1978

Chart 7
Australian Interest Rates
Percent

20
16

8
4

0+---;::=_-----------4
-8
19751976

1978

1980

1982

1984

1986

1980

1982

1984

1986

FOOTNOTES
1. Various explanations exist for the real exchange effects
of disturbances. Some argue that labor and/or goods
market rigidities imply that the adjustment to disturbances
does not occur simultaneously, leading to short-run effects
on real variables, such as real exchange rates (Dornbusch, 1976 and Obstfeld, 1985). Others attribute these
effects to confusion about the source of these disturbances (Kimbrough, 1983; Flood and Hodrick, 1985; Glick
and Wihlborg, 1986; Glick, 1986).

against purchasing power parity.
7. Note that u is also in the information set e because
agents know the ex ante real rate even if the econometrician does not.
8. It should be noted that the regression residuals must
not be heteroscedastic or serially correlated to yield correct standard errors for B. Furthermore, the estimates of rr
obtained are good only when the variance of the u term is
small. The variance would be small if no relevant information left out were highly correlated with X.

2. The appropriate order of liberalization of domestic and
international restrictions is an important topic in the
development economics literature. In some cases, particularly countries in Latin America, international controls
were removed at the same time that domestic interest rates
were allowed to rise at the very beginning of the liberalization process. E3ecause this oftel'l resulted in large scale
capital inflows (due to the return of funds involved in past
capital flight in response to higher domestic rates as well
as new borrowing from foreign financial institutions) that
caused the domestic currency to appreciate, it has been
argued that international liberalization, particularly of the
capital account, should be delayed. See Edwards (1984)
and Frenkel (1982). By contrast, countries in the Pacific
Basin generally appear to have adopted a more gradual
approach to liberalization.

9. Gensaki transactions consist of the resale or
repurchase of bonds at a fixed price after a fixed period,
generally within 3 months. In essence, they are short-term
capital transactions using bonds as collateral.
10. The curb market is an unofficial, largely unregulated
financial market involving small borrowers and lenders. In
the mid-1970s, the aggregate size of the curb market in
Taiwan was as large as all other financial institutions put
together. In 1980, it accounted for roughly 30 percent of
total domestic assets (see Cheng, 1986, p. 151). Due to
higher transactions costs, risk premiums, etc., the cost of
funds in the curb market is substantially greater. No consistent series exist for rates on new instruments permitted
in the late 1970s. Data for this series was obtained from
monthly issues of the Hong Kong Monetary Authority.

3. Among other countries in the Pacific Basin, New Zealand experienced a brief period of interest liberalization
between 1976 and 1981 that, after an abrupt reversal, was
resumed in 1983. More cautious movements towards liberalization have occurred in Thailand. While Korea and the
Philippines have also taken certain steps toward deregulation, they still continue to maintain restrictive controls on
most financial transactions, particularly international financial transactions. Greenwood (1986) provides a survey of
financial deregulation developments in seven East Asian
countries, including Taiwan, South Korea, Hong Kong,
Malaysia, Singapore, Thailand, and Indonesia. Also see
Jao and Lee (1982).

11. Commercial paper rates are preferable to other interest series in Malaysia. Treasury bills are held mainly to
satisfy minimum liquidity requirements and other portfolio
restrictions imposed on commercial banks and other financial institutions and are sold at below-market yields. Similarly, interest rates on call loans to discount houses are
influenced by the use of call loans in satisfying minimum
liquidity requirements. Furthermore, the corporate bond
market is extremely thin, and a consistent interest rate
series is not available for the negotiable CDs introduced in
1978.
12. Individual intercept dummies were set equal to 1 for
the following dates: Singapore, 7501, 79011; Malaysia,
7501, SOOIV; Taiwan, 7901V, 81011, 780111-81011; and
Australia, 750111, 8301V-8601. The last dummy for Taiwan
corresponds to a period of severe exchange market controls, whereas the last dummy for Australia corresponds to
a period of rapid financial market liberalization.

4. It should be pointed out that, in general, the monetary
and banking relationship between Singapore and Malaysia is not close, even though these countries were
formerly one political entity, used the same currency (the
Malay dollar), and had the same banking system.
5. The gensaki market evolved spontaneously in the
mid-1970s with relatively little government intervention. In
March 1976, Japan's Ministry of Finance formally acknowledged the existence of the gensaki market by laying down
ground rules for trading. Many observers attribute Japan's
policy reversal in the late 1970s, which allowed foreigners
access to the gensaki and other markets, to a desire to
encourage capital .inflows at a time when the yen was
beginning to depreciate.

13. The data set of Cumby and Mishkin, unlike that in this
paper, involves overlapping observations. Because this
leads to serially correlated errors, they use a two-step, twostage least squares procedure developed by Cumby,
Huizinga, and Obstfeld (1983). This procedure avoids
problems associated with applying Cochrane-OrcutHype
techniques to models assuming rational expectations (see
Flood and Garber, 1980).

6. Frankel (1986) contends that the primary source of the
rejection of real rate equality for the industrialized countries
is the failure of purchasing power parity since international
goods market integration is far weaker than international
financial market integration (or equivalently that goods in
different countries are far from being perfect substitutes).
However, others (Cumby and Obstfeld, 1984), have
provided evidence in the case of developed countries
against uncovered interest parity that is as strong as that

14. For example, Frankel (1984) contends that, since
1979, covered interest parity through forward markets has
held as closely for Japan as for the U.K., Germany, and
Switzerland. By this criterion, he argues that Japan has
been as open internationally as other developed countries,
and disputes the claim that the Japanese still employ
capital market restrictions.
However, Otani and Tiwari (1981), who analyzed capital

control distortions in the gensaki market over the period
197801 to 198101, find evidence of capital flow restrictions
even after such restrictions were supposedly eliminated.
They found that from 197801 - 197901, distortions were
indeed on a declining trend - with almost no distortions
from 1979011 - 197901V. However, they found that distortions increased in 198001 and 19800111 due to a Japanese

government "request" that deposit institutions exercise
restraint in accepting foreign exchange from the sale of
foreign currency assets; distortions declined again beginning in 198001V. These results suggest that despite official
policies, the Japanese government still retains the ability to
influence capital flows when it so wishes.

REFERENCES
Blejer, M. and M. Khan. "The Foreign Exchange Market in a
Highly-Open Developing Economy: The Case of Singapore," Journal of Developing Economics, Vol. 12,
1983.
Cheng, H. "Financial Policy and Reform in Taiwan, China,"
in H. Cheng (ed.), Financial Policy and Reform in
Pacific Basin Countries, Lexington, Mass: Lexington
Books, 1986.
Cumby, R. and F. Mishkin. "The International Linkage of
Real Interest Rates: The European-U.S. Connection,"
Journal of International Money and Finance, Vol. 5,
March 1986.
Cumby, R. and M. Obstfeld. "International Interest-Rate
and Price-Level Linkages under Flexible Exchange
Rates: A Review of Recent Evidence," in J. Bilson and
R. Marston (eds.), Exchange Rates: Theory and Practice, Chicago: University of Chicago Press for the
NBER,1984.
Cumby, R., J. Huizinga, and M. Obstfeld. "Two-Step TwoStage Least Squares Estimation Models with Rational
Expectations," Journal of Econometrics, Vol. 21,
1983.
Dornbush, R. "Expectations and Exchange Rate
Dynamics," Journal of Political Economy, Vol. 84,
December 1976.
Edwards, S. "The Order of Liberalization of the External
Sector in Developing Countries," Princeton Essays in
International Finance, No. 156, December 1984.
Flood, R. and P. Garber. "A Pitfall in Estimation of Models
with Rational Expectations," Journal of Monetary Economics, Vol. 6,1980.
Flood, R. and R. Hodrick. "Optimal Price and Inventory
Adjustments in an Open-Economy Model of the Business Cycle," Quarterly Journal of Economics, Vol. 98,
August 1985.
Frankel, J. The Yen/Dollar Agreement: Liberalizing Japanese Capital Markets, Policy Analyses in International Economics, No.9, Washington, D.C.: Institute
for International Economics, 1984.
_ _ . "International Capital Mobility and Crowding Out,"
in R. Hafer (ed.), How Open is the U.S. Economy?,
Lexington, Mass.: Lexington Books, 1986.
Frenkel, J. "The Order of Economic Liberalization: Discussion," in K. Brunner and A. Meltzer (eds.) Economic
Policy in a World of Change, Amsterdam: North HoIland, 1982.
Fry, M. "Financial Structure, Monetary Policy and Economic Growth in Hong Kong, Singapore, Taiwan and
South Korea, 1960-83" in A. Krueger, V. Corbo, and F.

Corso (eds.), Export-Oriented Development Strategies, Boulder, Colorado: Westview Press, 1985.
von Furstenberg, G. "Changes in U.S. Interest Rates and
their Effects on European Interest and Exchange
Rates," in D. Bigman and T. Taya (eds.), Exchange
Rate and Trade Instability: Causes, Consequences,
and Remedies, Cambridge, Mass: Ballinger, 1983.
Glick, R. "Real Exchange Rates, Imperfect Information,
and Economic Disturbances," Federal Reserve Bank
of San Francisco, Economic Review, Fall 1986, NO.4.
Glick, R. and C. Wilhborg. "The Role of Information
Acquisition and Financial Markets in International
Macroeconomic Adjustment," Journal of International
Money and Finance, Vol. 5, September 1986.
Greenwood, J. "Financial Liberalization and Innovation in
Seven East Asian Economies" in Y. Suzuki and H.
Yomo (eds.), Financial Innovations and Monetary Policy: Asia and the West, Tokyo: University of Tokyo
Press, 1986.
Huizinga, J. and F. Mishkin. "Monetary Policy Regime
Shifts and the Unusual Behavior of Real Interest
Rates," Carnegie Rochester Conference Series on
Public Policy, Vol. 24, 1986.
Hutchison, M. "Monetary Control, Interest Rates, and
Exchange Rates: the Case of Japan, 1973-1986,"
Working Paper No. 145, University of California at
Santa Cruz, November 1986.
Jao, Y. and S. Lee. Financial Structure and Monetary
Policies in Southeast Asia, New York: St. Martin's
Press, 1982.
Kimbrough, K. "The Information Content of the Exchange
Rate and the Stability of the Real Output Under Alternative Exchange Rate Regimes," Journal of International Money and Finance, Vol. 2, April 1983.
Mishkin, F. "The Real Interest Rate: A Multi-Country Empirical Study," Canadian Journal of Economics, Vol. 17,
May 1984a.
_ _ . "Are Real Interest Rates Equal Across Countries?
An Empirical Investigation of International Parity Conditions," Journal of Finance, Vol. 39, 1984b.
Obstfeld, M. "Floating Exchange Rates: Experience and
Prospects," Brookings Papers on Economic Activity,
No.2,1985.
Otani, I. and S. Tiwari. "Capital Controls and Interest Parity:
The Japanese Experience, 1978-81," IMF Staff
Papers, Vol. 28,1981.
Ouandt, R. "Tests of the Hypothesis that a Linear Regression System Obeys Two Separate Regimes," Journal
of the American Statistical Association, Vol. 56,1960.

ill

Ramon Moreno·

An empirical test confirms that, in the 1980s, eurodollar deposits held
by U.S. residents were influenced slightly by the level ofinterest rates and
the availability of monetary reserves available to the banking system.
Total eurodollar deposits, however, do not appear to be sufficiently close
substitutes for money, or to have been sufficiently large in volume even at
their peak in the early 1980s, to affect U. S. interest rates. For purposes of
monetary cOlltrol, policymakers need not be concerned about the impact
of domestic currency holdings of their nationals in the eurocurrency
market.

The rapid development of international banking
and the euromarket that started in the late 1960s
generated extensive discussion about the implications for monetary policy. While concern about the
inflationary implications of the euromarket has
receded in the 1980s, the possibility that
euromarket activity may limit the effectiveness of
monetary instruments remains pertinent.
The U.S. is at once more and less vulnerable than
other economies to the external influence of the
euromarket. On the one hand, the U. S. is a "large"
economy, and the volume of euromarket transactions in which U.S. residents are engaged remains
small in comparison to domestic financial transactions. This is particularly true with regard to the
eurodollar bank deposits of U .S. nonbank residents.
On the other hand, the few restrictions on capital
movements, the use of the U.S. dollar as the major
currency of denomination in the euromarket, and

the size of eurodollar deposits held by U.S. residents in comparison to narrow domestic money,
make the U.S. financial market more susceptible to
external influences by enhancing the substitutability
of euromarket assets for U.S. assets and hence the
arbitrage activities of U. S. banks between the
domestic market and the euromarket. The U.S.
experience may thus indicate the susceptibility of a
large economy to external influences when there are
relatively few impediments to arbitrage between the
domestic financial market and the euromarket.
Aside from promoting linkages between domestic and foreign capital markets by stimulating capital flows, it has been argued that the development of
the euromarket may lead to the emigration of the
intermediation activities of domestic banks to the
euromarket. 1 Such emigration would have several
implications. For economies seeking to target monetary aggregates, the appropriate definition of the
aggregate may be complicated by the creation of
potentially close substitutes in the euromarket.
Moreover, even an appropriately defined aggregate
may be less susceptible to direct control. The crea-

* Economist, Federal Reserve Bank of San Francisco. Thanks to John Duffy and Laura Shoe for
capable research assistance.

relevant foreconomiesthatareexpanding the scope
of their international banking actiVities . The most
notable exampleis Japan, Which today faces issues
similar to those the United States started to face in
a result of the rapid growth of the
eurodollar market. The growing internationalization of Japanese banking, the use of the yen in
international transactions, and the possibility that
Japanese residents may shift intermediation to an
incipient euroyen market raise questions that may be
clarified by the U.S. experience.
This paper will discuss the influences on the
emigration of domestic banking activity to the
eurocurrency market, and assess the potential
implications of the emigration of domestic banking
activity for domestic financial markets, specifically,
for interest rates. The next section discusses how
certain institutional features that characterize the
euromarket and international banking activity
explain the growth of these sectors, leading to the
emigration of U.S. banking activity to the eurodollar market via the process of arbitrage. Section II
examines the determinants of equilibrium in the
eurodollar market. Section III assesses the potential
implications for domestic interest rates and monetary policy of the shifting of domestic bank intermediation to the euromarket.
Using the framework developed in Section II,
Section IV examines the actual growth of eurodollar
deposits held by U.S. non-bank residents since the
late 1970s. Section V contains an empirical test to
ascertain the determinants of eurodollar deposit
creation and the influence of the euromarket on
domestic interest rates. The conclusion follows in
Section VI.

tion ofeuromarket substitutes for domestic money
may also weaken the ability of monetary policy to
influence interest rates or exchange rates, or· be
associated with disturbances to asset preferences
that increase the volatility of those rates.
The extent to which the eurodollar market affects
U.S. financial markets, and interest rates in particular, has not been conclusively determined. The
earlier structural models of the linkages between the
euromarket and domestic economies, such as Herring and Marston (1977), assumed that U. S. interest
rates are unaffected by foreign rates. This assumption is supported by some recent evidence. For
example, an unpublished study using vector autoregressions by Genberg, Saidi and Swoboda (1982)
found that U .S. domestic interest rates were generally not influenced by interest rates in foreign financial markets, although U.S. rates did have a weak
influence on foreign rates.
However, by applying a vector autoregression to
monthly data of the 3-month U.S. commercial
paper and eurodollar deposits rates, Hartman
(1984), found that while U. S. interest rates
appeared to have been unaffected by foreign rates
before 1975, between 115 to 2/3 of the variation in
domestic rates can be traced to foreign sources from
1975 to 1978. 2 Using weekly data, Reinhart and
Harmon (1986) found closer integration in the
1980s between the federal funds market and the
overnight eurodollar market, and evidence. that
overnight eurodollar rates Granger caused the
federal funds rate. 3
An understanding of the linkages between the
eurodollar market and domestic financial markets
and the implications of the use of a national currency in international transactions is particularly

International Banking and the Eurodollar Market
ment on eurodollar borrowing has been 3 percent,
the same as that on domestic CDs.
Banks operating in the eurodollar market generally do not issue checkable deposits, but they do
issue a substantial volume of very short maturity
liabilities held by U.S. nonbank residents. In further contrast to the domestic money market, where
banks raise the bulk of their funds from nonbanks,
interbank transactions account for about 70 percent
of all eurodollar market transactions.
Although other currencies have gained some
prominence in recent years, dollar-denominated
deposits and loans offered outside the United States
or in International Banking Facilities in New York,
which are exempt from domestic banking regulations, still represent the bulk of eurocurrency market activity.6 The settlement of dollar transactions
originated by U. S. or foreign banks operating in the
eurodollar market ultimately involves the transfer
(using the Clearing House Interbank Payments System, or CHIPS) of reserves (that is, claims on the
Federal Reserve) in the domestic U. S. banking
market: Such reserve transfers typically involve
U.S. banks, rather than the branches of foreign
banks operating in the United States'?
Such close links between the domestic and the
eurodollar markets lead observers to treat the latter
as an extension of the U.S. banking system. 8 Since
bank reserves are ultimately required in the settlement of claims originating in the eurodollar market,
the availability of reserves will tend to influence the
volume of eurodollar deposit creation. In addition,
efforts to tap the domestic and eurodollar markets to
acquire reserves imply that the markets for federal
funds and overnight eurodollar deposits are closely
connected by arbitrage, as are the markets for term
domestic and eurodollar deposits. 9 These arbitrage
activities are reflected in the eurodollar deposit
holdings of U.S. residents and the international
assets and liabilities of banks based in the U.S.

International banking can be described in several
ways, but for our purposes, it will be useful to focus
on two aspects:
I. The eurocurrency market, in which deposits
and loans denominated in a given currency are
offered outside the country where the currency is
issued. The largest segment of the eurocurrency
market is the eurodollar market, where transactions
are denominated in U. S. dollars. U. S. banks and
U. S. nonbank residents are active participants in the
eurodollar market.
2. The cross-border activities of banks based in a
given country, which form part of what is traditionally understood to be international banking.
This includes lending by domestic banks to foreign
residents, and foreign resident deposits in domestic
banks.
Certain characteristics that historically have distinguished banking in the eurodollar market from
domestic banking account for the rapid growth of
the former. Unlike domestic deposits, eurodollar
deposits are not subject to FDIC premia or to reserve
requirements. For many years, eurodollar deposits
also benefited from the absence of restrictions on
interest paid that applied to domestic banking.
These institutional advantages encouraged demand
for eurodollar deposits, particularly during the inflationary I970s .
However, under certain conditions, borrowing by
U. S. residents from the eurodollar market is subject
to reserve requirements ,4 and has affected the extent
to which U. S. residents have used the eurodollar
market as a source of funds. In the early 1970s,
reserve requirements on eurodollar market borrowing were much higher than domestic reserve
requirements, effectively discouraging such borrowing. In the mid-1970s, the reverse was true as
the Federal Reserve sought to encourage borrowing
from the eurodollar market to strengthen the value
of the dollar. 5 Since the implementation of the
Monetary Control Act of 1980, the reserve require-

Understanding Eurodollar Deposit Creation

Eurodollar Supply and Demand
The arbitrage process described earlier is associated with the emigration of domestic banking
activity to the eurodollar market.
The extent to which intermediation will shift from
the domestic to the eurodoUar market will depend
on the interest rate paid on eurodollar deposits. At
very high eurodollar deposit interest rates, the
demand for eurodollar funds by banks will be small.
As the differential between eurodollar rates and
domestic U. S. rates approaches the difference in
costs between dealing in the domestic and eurodollar markets, banks will be increasingly indifferent
between operating in the domestic or eurodollar
market, and the demand schedule will tend to flatten. The slope of the demand curve is determined by
matching the marginal revenue from lending against
the marginal cost of raising funds in the eurodollar
markets at any given eurodollar rate. 10
Domestic residents may be indifferent between
holding domestic and eurodollar deposits when
these deposits pay a premium over the domestic
deposit rate sufficient to compensate them for the
perceived risk of acquiring eurodollar assets.
Beyond a certain point, however, depositors may
require higher eurodollar rates to supply more funds
to the eurodollar market, tracing an upward sloping
supply schedule for eurodollar funds. The slope of
the supply curve reflects the rate at which assetholders must be compensated for the perceived risk
or inconvenience of banking in the eurodollar market. The equilibrium is shown by lines Sand D in
Chart 1.

Chart 1
Eurodollar Market Equilibrium
Eurodollar Bid
Rate Minus
U.S. CD Rate

Eo E2

E1
Eurodollar Deposits

deposit rate is set by banks to reflect the higher cost
(reserve requirements and FDIC insurance premia)
of funds in the domestic deposit market. Banks are
then indifferent between demanding funds from the
eurodollar or domestic deposit market. The perfectly elastic demand for funds determines the
eurodollar rate, and a less than perfectly elastic
supply of funds schedule is said to determine the
volume of eurodollar deposits. In Giddy's version of
the cost of regulation view, the demand schedule in
Chart I would be a horizontal line.
In the market price of risk view, derived from
portfolio management theory, the differential
between the eurodollar and domestic deposit rates is
set by depositholders to compensate them for the
perceived risk of placing funds in the eurodollar
market. Depositholders are then indifferent between
placing funds in the eurodollar or domestic market.
The perfectly elastic supply of funds determines the
eurodollar rate, and a less than perfectly elastic
demand schedule is said to determine the volume of
eurodollar deposits. According to this view, the
supply schedule in Chart 1 would be flat.
Giddy argues that the cost of regulation and
market price of risk views are irreconcilable because
market equilibrium cannot be determined when
both demand and supply are infinitely elastic. One

DelteriTlil1lents of Equilibrium
In an illuminating discussion of the supply and
demand framework presented here, Giddy (1979),
distinguished between two polar views of the
eurodollar market: the cost of regulation view,
which reflects the behavior of banks that demand
eurodollar funds, and the market price of risk view,
which reflects the behavior of assetholders who
supply funds to the eurodollar market.
According to the cost of regulation view, the
differential between the eurodollar and domestic

way around this disturbing conclusion, which suggests that either banks or assetholders may not
behave rationally, is that neither view need imply
that the demand or the supply of funds are everywhere perfectly elastic." This reasoning underlies
the less than perfectly elastic segments illustrated in
Chart 1.
The supply and demand framework introduced
above does not explicitly state where the funds
raised in the eurodollar market will ultimately be
placed. Kreicher (1982) analyzed this question
under the cost of regulation framework by discussing the two choices available to banks, namely to
obtain funds from the domestic market to fund
lending abroad (outward arbitrage) or to obtain
funds from the eurodollar market to fund lending in
the U. S. (inward arbitrage). When the cost of
domestic funds (the domestic CD rates adjusted for
reserve requirements and FDIC premia) is less than
the return from depositing such funds in the
eurodollar interbank market (the eurodollar bid
rate), there is an incentive for outward arbitrage. In
the process of bidding for funds, the differential
between the domestic U.S. rate and the eurodollar
rate will narrow until the incentive for outward
arbitrage is eliminated. The cost of domestic funds
thus imposes a ceiling on the eurodollar bid rate.

In contrast, when the cost offunds in the eurodollar market (the eurodollar offer rate adjusted for the
cost of reserve requirements applied
from the eurodollar market) is less than
cost of
funds in the domestic market, there is an incentive
for obtaining funds in the eurodollar market to fund
domestic lending. This case raises the possibility of
a "round trip", whereby domestic residents
the funds in the eurodollar market and these funds
are subsequently lent to domestic borrowers. Once
more, the cost of funds in the domestic market, this
time adjusted by the reserve requirements on
eurodollar borrowing and the spread between the
eurodollar bid and offer rates, places a floor on the
eurodollar bid rate.
Between the two thresholds for inward or outward
arbitrage is an "arbitrage tunnel" within which
banks are largely indifferent between obtaining
funds in the domestic market and the eurodollar
market. When the differential between the eurodollar rate and the domestic rate is sufficiently large,
the net foreign asset position of the U.S. banking
sector would tend to be positive; the reverse would
be true when the eurodollar interest rate is low
enough to create an incentive for inward arbitrage.
The recent U.S. experience in this regard is analysed in section IV.

Implications of Intermediation via the Euromarket
induce the public to accept the new money supply.
For example, a policy that shrinks bank reserves
forces banks to reduce their deposit liabilities (and
therefore money creation) to satisfY reserve reaum~
ments. The yield on assets that are alternatives to
money must then rise to eliminate the resulting
excess demand for money.
The extent to which interest rates will respond to
the monetary policy objectives of the central bank
depends ou(l) the existence of close substitutes for
money and (2) the tightness of the link between
reserve creation by the Federal Reserve and domestic money creation by banks. If bonds were close
substitutes for money, a small increase in their yield
would suffice to eliminate the excess demand for
money. The effect of a given change in reserves on
interest rates in that case would be small. In a closed

While the preceding analysis highlights some of
the key features of eurodollar market equilibrium, it
is a partial analysis because it does not explicitly
discuss the impact eurodollar market activities may
have on domestic interest rates. In general, the
impact may be derived from macroeconomic considerations.
In the analysis of monetary policy in a closed
economy, the existence of two assets, money and
bonds, is typically assumed. Money here refers to
currency and checkable deposits (Ml) that pay a
fixed (possibly zero) rate of interest, and bonds refer
to a spectrum of interest-bearing assets. In this
framework, monetary policy affects interest rates by
changing the supply of money; changing the supply
of money, in tum, requires changes in the yield on
bonds (and hence, the relative yield on money) to

demand equation and the reduced form St. Louis
equation) improved when eurodollar deposits of
short maturity were included. 15 Goodman's results
imply that shifting deposit activity to the eurodollar
market would create substitutes for domestic
money.

economy, the tightness and predictability of the link
between reserves and domestic money creation is
strengthened by reserve requirements.
The growth of eurodollar deposits held by V.S.
residents presents a potential problem for domestic
monetary policy because it tends to weaken the two
conditions needed for an effective monetary policy
cited above. Eurodollar deposits are believed by
some observers to be close substitutes for domestic
money. Furthermore, because eurodollar deposits
are not subject to reserve requirements, banks could
potentially create a large volume of such deposits in
a manner that offsets the monetary policy objectives
of the Federal Reserve.

Tightness of Link to Monetary Reserves
Giyen that eurodollar deposits are, to some
undetermined extent, SUbstitutes for domestic
money, the process by which eurodollar deposit
creation may offset the intention of monetary policy
is best seen by example. Consider a deflationary
monetary policy which induces a rise in domestic
interest rates in relation to those in the euromarket.
If this policy were to raise loan rates by more than it
raises deposit rates, and thereby increase the profit
margins on lending, the rise in interest rates would
create an incentive for banks to increase their intermediation. At the same time, however, by raising
the cost of noninterest-bearing reserves, as well as
domestic CD rates, the rise in domestic rates would
tend to shift intermediation towards the eurodollar
market, where the marginal cost of funds is comparatively lower. In Chart I, these effects are illustrated by a rightward shift in the demand schedule
for eurodollar funds to D 1.
Although the link between eurodollar deposits
and monetary reserves may be weaker than the
corresponding link between domestic deposits and
reserves, the rightward shift in demand for eurodollar funds will still be limited by the following:
(1) Liquidity Constraints: While eurodollar
deposits are not subject to reserve requirements
(abstracting from reserve requirements on borrowing from the eurodollar market), banks eventually
have to settle their eurodollar liabilities with dollar
reserves. 16 When lending rates rise, a bank raising
funds in the eurodollar market trades off the
increased margins on lending these funds against
the growing risk of illiquidity due to increasing
intermediation. This trade-off should tend to limit
the volume of loans and eurodollar deposit creation
according to the availability of reserves created by
the Federal Reserve, although the link is looser than
in the case of the domestic market where reserve
requirements are binding. The extent to which

Money Substitutes
The argument that eurodollar deposits may be
close substitutes for domestic money is analogous to
arguments motivated by the financial innovation of
the 19708, namely, that certain domestic assets may,
in various ways, reduce the demand for transactions
balances. Because eurodollar deposits are of relatively short maturity, they could be close substitutes
for domestic money. In addition, eurodollar
deposits, particularly for the shortest maturities,
may increase transactions efficiency (much like the
domestic RP market), thus reducing the need for
cash balances.
While domestic assets that are potential money
substitutes have generated an enormous literature, 12
the evidence on the substitutability of eurodollar
deposits for domestic money is thin. Studies of
interest parity suggest a high degree of substitutability between assets of comparable maturity
held in the V. S. and abroad,13 with very small risk
premia imposed on the assets held in industrial
countries.
However, authors have generally not tested for the
substitutability of eurodollar deposits for domestic
money, limiting themselves instead to comparisons
of the size of eurodollar deposit holdings of residents with measures of narrow domestic money. 14
The comparison implicitly assumes a high degree of
substitutability between eurodollar deposits and
domestic money but provides no direct evidence of
such. An exception is Goodman (1984a), who found
that the forecasting performance of two standard
equations using narrow money (the Goldfeld money
48

for eurodollar deposits is not perfectly inelastic.
This conclusion may have implications for domestic
interest rates and monetary policy.
Consider now a shift in the supply of funds from
domestic demand deposits to eurodollar deposits.
The shift from reservable to non-reservable assets
should lower the demand for reserves, and tend to
lower domestic as well as eurodollar interest rates.
A monetary authority seeking to stabilize output
must offset such disturbances to interest rates
caused by shifts in asset preferences. In general, the
magnitude of shifts in the supply of funds between
domestic demand deposits and the eurodollar market may be greater the greater the substitutability
between those two assets, or smaller depending on
the cost to assetholders of shifting to eurodollar
deposits.

reserve availability limits eurodollar deposit creation depends partly on the substitutability of
eurodollar deposits for transactions balances and
partly on the extent of maturity transformation in the
eurodollar market; 17
(2) Loan Market Constraints. Higher interest
rates create adverse selection towards riskier borrowers and increase the probability of default. 18
These effects are generally associated with •credit
rationing, which limits the demand for funds on the
part of banks;
(3) Capital Constraints. Intermediation in the
eurodollar market tends to reduce capital-asset
ratios. While the effect is reduced to the extent that
such intermediation substitutes for intermediation
in the domestic market, capital constraints have
been a matter of great concern to banks in the 1980s.
For any given rightward shift in demand, motivating non-banks to place their funds in the eurodollar
market bids up the eurodollar deposit rate. The rise
in the rate would tend to reduce the margins on
lending. This sequence may be seen as a movement
from point b to point c in Chart 1 (with the differential increasing as the eurodollar rate rose). In fact, if
the supply of eurodollar market funds were inelastic
(for example, in times of great uncertainty abroad),
eurodollar deposit rates could rise so far as to
eliminate any advantage in raising funds in the
eurodollar market. 19
Our example thus suggests that the volume of
eurodollar deposits will rise during periods when
interest rates are high as long as the supply schedule

IV.

Inward and Outward Arbitrage
The extent to which a shift from domestic money
towards eurodollar deposits will affect domestic
interest rates will also depend on the extent of
inward or outward arbitrage For example, if a rise in
domestic interest rates were to create an incentive
for inward arbitrage, banks may demand eurodollar
deposit funds to lend at home. Such a "round trip"
would tend to lower domestic interest rates and thus
offset the impact of monetary policy. The effect on
domestic interest rates would be attenuated if the
differential between eurodollar and domestic interest rates were instead to create incentives to lend
funds to the eurodollar market.

U.S. Residents and the Eurodollar Market
part of M2, and term eurodollar deposits are part of
M3 in V. S. monetary statistics.
Two features are apparent. First, after very rapid
growth in the 1970s, total eurodollar deposits held
by nonbank V. S. residents peaked in 1984 at
approximately $105 billion, and declined subsequently. Overnight eurodollar deposits continued to
grow, although they accounted for only 18 percent
of total eurodollar deposits in 1986. Second, the
size ofeurodollar deposits held by V.S. residents is
small in comparison to domestic monetary aggregates. At their peak, total eurodollar deposits were

We may now use the preceding heuristic framework to review the actual behavior of the eurodollar
market and the reasons explaining the emigration of
V.S. bank activity to the eurodollar market in the
late 1970s and 1980s. Two indicators of the emigration of V.S. banking activity to the eurodollar
market are the eurodollar deposit holdings of V.S.
nonbank residents and the external asset position of
V. S. banks compared to their foreign affiliates. 20
Chart 2 shows the trend in the total, term, and
overnight eurodollar deposit holdings of V. S. nonbanks with the foreign affiliates ofU .S. banks since
1977. Overnight eurodollar deposits are included as

associated with improved profit opportumttes in
lending, and relative interest rates favored intermediation via theeurodollar market. The information in charts 4 and 5 tend to confirm this explanation,as well as clarifY the apparent absence of
inward arbitrage.
Chart 4 illustrates the behavior of the 3-month
eurodollar deposit rate and domestic CD rate. In line
with~urhypothesis, the fastest growth of eurodollar
deposit holdings by nonbank residents occurred
when interest rates were rising or at their highest
levels, and eurodollar growth peaked in 1983,
shortly after interest rate levels began their decline.
Chart 5 shows the difference between the
3-month eurodollar and the 3-month domestic CD
rates. The top line, which is the unadjusted differential, represents the incentive to the nonbank sector
to move deposits to the eurodollar market. It is
remarkable that between 1979 and 1982, when the
level of interest rates were at their highest, the
spread between the eurodollar rate and the domestic
deposit rates also peaked. The fact that eurodollar
deposit growth continued at a fast pace over this
period suggests that rising demand for eurodollar
funds, presumably due to profit opportunities in
lending, increased the unadjusted differentials
between the eurodollar and domestic deposit rates.
Since 1982, the spread between the eurodollar and
domestic deposit rate has fallen significantly, and
contributed to the contraction in eurodollar deposits
held by U.S. residents.

Chart 2
Eurodollar Deposits of
U.S. Nonbank Residents
$ Billions

125
Total

D~poSits

100

75
50
25

Overnight Deposits

~
1977 1978 1979 1980 1981 1982 1983 1984 1985 1988

20 percent as large as Ml and 3.7 percent as large as
M3. 21
Note also that, for most of this period, there was
little if any evidence of inward arbitrage, or a round
trip in the form of eurocurrency market lending to
U. S. residents via the banking sector, associated
with these eurodollar deposits. Except for a brief
episode between 1979 and 1980, U.S. banks have
been net lenders to their foreign affiliates since
1977, as illustrated in Chart 3. 22
The growth of the eurodollar market as a whole in
the 1970s is often explained as a supply phenomenon: sharp increases in oil prices provided oil
producers with a large supply of dollar funds which
they preferred to place in the eurodollar market.
However, the rapid growth of eurodollar deposits
held by U. S. residents over the same period must
mean that the demand for eurodollar funds - associated with the explosion in international lending
starting in the 1970s
exceeded the increased
supply of funds by oil producers. The growth trend
was reversed by the 1982 debt crisis as declining
expected returns on lending, and tightening capital
constraints, lowered the demand for eurodollar
funds.
Our earlier discussion suggests that, given the
more favorable regulatory treatment that applies to
the eurodollar market, eurodollar deposits must
have grown in part because rising interst rates were

Chart 3
Net Assets of U.S. Banks
Versus Their Foreign Branches
$ Billions

-20 I

iii

I i '

1977197819791980198119821983198419851986

This timing roughly corresponds to the period when
the net foreign asset position of domestic banks in
comparison to their foreign affiliates turned nega
tive (Chart 3).
To sum up, while the unadjusted differential of
the deposit rates paid to the nonbank sector in the
late 1970s (top line of Chart 5) appeared to encour
age the shifting of deposits to the eurodollar market,
the adjusted differential (bottom line of Chart 5),
which reflects the cost of funds to the banks, simul
taneously favored net lending abroad by the U.S.
banking sector rather than the use of funds raised in
the eurodollar market in the domestic market. Per
haps even more surprising is that, while the unad
justed differential between the domestic and
eurodollar rate narrowed significantly since 1983
when the U.S. began importing unprecedented
amounts of capital, the adjusted differential still
reflected an outward arbitrage incentive for banks.
This is confirmed by the rising net foreign assets of
U.S. banks versus their foreign affiliates over the
period.
While our discussion sheds some light on the
behavior of eurodollar deposits over the past ten
years, the importance of the various interst rate
effects for eurodollar deposit holdings of U.S. resi
dents is still unclear, as is the ultimate impact of
eurodollar market on domestic interest rates. A
more precise characterization of these effects
requires more formal analysis.

C hart 4
T hree-M onth Eurodollar Deposit Rate
and U.S. CD Rate

The reason that the funds raised in the eurodollar
market were used for international rather than
domestic lending is suggested by the bottom line of
Chart 5, which represents the differential between
the eurodollar bid rate and the domestic CD rate
adjusted for reserve requirements. This differential
reflects the incentive for banks to use the domestic
market as a source of funds for lending to the
eurodollar market, or the outward arbitrage cited
earlier. When the differential is above zero, the
eurodollar bid rate exceeds the tunnel ceiling dis
cussed earlier, and banks have an incentive for
outward arbitrage. When the differential is negative
but sufficiently close to zero, banks' are indifferent
between using the eurodollar or the domestic market
as a source of funds. When the differential is suffi
ciently low, the eurodollar bid rate falls below the
tunnel floor, giving banks a possible incentive for
inward arbitrage. The period in which this last case
applied is illustrated by the shaded areas in Chart
5.23
Chart 5 shows that, for most of the ten years since
1977, banks have either been indifferent between
tapping the domestic or eurodollar markets, or had
an incentive for outward arbitrage. The exception is
1979, when the second oil price shock created a
large supply of eurodollar funds. At that time,
eurodollar market rates fell sufficiently below
domestic CD rates to create an incentive for banks to
use the eurodollar market to fund domestic loans.

C hart 5
T hree-M onth Eurodollar Deposit
Rate / U.S. CD Rate Differential

Percentage Points

Dynamic Relationships
causality does not imply causality in the behavioral
sense understood in structural models (for example,
that an increase in interest rates would cause money
demand to fall), but does permit statements about
whether two variables appear to be connected in a
systematic way over time. While Granger causality
tests are useful indicators, they do not show the
extent to which lagged values of x will improve the
forecast of y. This information is provided by two
other results obtained from VARs.
2. Variance Decompositions. These decompositions indicate how much of the forecast error of a
particular variable results from innovations in each
variable included in the VAR.
3. Impulse Response Functions. Based on the
moving average representation of the VAR, impulse
response functions provide an explicit characterization of the dynamic response of a variable to an
innovation to itself or other variables.

In the absence of an elaborate structural model,
the determinants of the behavior of eurodollar
deposits over time and the implications of the
eurolllarket for domestic interest rates (and therefore monetary policy), can be examined more systematically by performing a vector autoregression
(VAR). A VAR takes a set of variable and regresses
them on the lagged values of the same set of
variable, thus indicating whether the dynamic relatit.:mships in the data appear to be consistent with the
relationships postulated by our understanding of
how the eurodollar market works. VARs may be
interpreted as reduced forms of complex structural
links, they assume limited knowledge of the precise
nature of these links.
Three useful results may be obtained with VARs:
1. Tests of Granger Causality. A variable x is
said to Granger cause another variable y if the
lagged values of x improve the forecast of y. Granger

A four-variable VAR was estimated. The variables werenonborrowed reslerv~s(usledas a proxy
for liquidity constraints that may affect deposit
creation in the domestic and eurodollarmarkets),
the 3-month U.S~Treasury bill rate (as a proxy for
the level of domestic interest rates), the differential
between the unadjusted 3-month eurodollar and
domestic CD rates (representing the incentive for
arbitrage between markets· and the influence of
eurodollar rates), and total eurodollar deposits held
by U. S. residents (representingJhe shift in domestic
intermediation. towards the eurodollar market). 24

The data are monthly, the variables expressed in
differences of logs andlagged 1 to 3 months, and the
estimation period is 1979:1 to 1986:12. Short lags
were chosen on the beliefthat the arbitrage .relationships we have been discussing take place over a very
shortspan.of time. The estimation period Was
chosen to focus largely on the behavior of eurodollar
deposits in the 1980s,. when. the strong variation in
interest rates provides a good potential experiment
for the responsiveness of eurodollar deposits. 25
The objective of OUr VAR study is to shed some
light on the potential impact of eurodollar deposit

creation on domestic interest rates and on whether
such eurodollar deposit creation could sys
tematically offset the intention of monetary policy.
Eurodollar deposit creation would do the latter if it
were very responsive to interest rate behavior and
relatively unfettered by the availability of reserves in
the U.S. banking system. The dynamic links
between the price (interest rate) and quantity vari
ables should conform with the analysis presented
earlier and may be interpreted as follows:
1. If U.S. interest rates were affected by the
euromarket, eurodollar deposits as well as the
eurodollar/domestic CD rate differential should
Granger cause the U.S. Treasury bill rate, and
should explain a large portion of its variance. If
eurodollar deposits were to Granger cause the U.S.
Treasury bill rate, one may infer that eurodollar
deposits would be close substitutes for domestic
money, and that, at the margin, such deposits would
be large enough to have an impact on interest rates
that is pertinent to domestic monetary policy.
2. If the volume of eurodollar deposit creation
were responsive to interest rates, the U.S. Treasury
bill rate, and the euromarket/domestic CD rate dif
ferential would Granger cause eurodollar deposits,
and explain an important proportion of the variance
in such deposits. In this case, eurodollar deposit
creation may tend systematically to offset the direc
tion intended by domestic monetary policy in the
manner suggested earlier. In contrast, if eurodollar
deposits were subject to liquidity constraints, nonborrowed reserves would Granger cause eurodollar
deposits, and the extent of the offsetting effects on
monetary policy will be correspondingly limited.
Table 1 reports the results of the VAR, with
columns 2 and 4 being of direct interest. As can be
seen in the second column of Table 1, under the
specification adopted here only the lagged Treasury
bill rate is statistically significant in forecasting the
U.S. interest rate. In contrast to Hartman’s results
for the period 1975-1978, there is no evidence that
the behavior of eurodollar interest rates, reflected by
the interest differential between eurodollar and
domestic rates, Granger cause domestic U.S.
rates2 6 in the 1980s. The fourth column of Table 1
reveals that eurodollar deposits are Granger caused
by the domestic Treasury bill rate and nonborrowed
reserves. However, the lagged values of the

C hart 6
Response of U.S. Treasury Bill Rate to
One Standard Deviation Shock In:

euromarket domestic CD rate differential are not
significant.
The variance decomposition and impulse
response functions characterize the specific contri
butions of innovations in the different variables to
the variation of each variable in turn. Such a charac
terization requires the innovations specific to each
variable to be isolated. For example, the innovations
in nonborrowed reserves must be treated separately
from innovations to the U.S. Treasury bill rate. This
cannot be done by looking at the residuals of the
vector autoregression equations because such
residuals are typically correlated with each other.
The traditional procedure, in this case, is to con
struct a moving average representation of the vector
autoregression that recovers innovations that are not
correlated with each other. 2 7
The variance decompositions reported in Table 2
show the percentage of the expected squared predic
tion error of each of the four variables in the system
that is produced by an innovation in each of the
variables in turn, for forecasts for 1 to 24 months
ahead. The contribution of innovations in each
variable is expressed as percentages. For example,
in the last item under Nonborrowed Reserves, col
umn 1, the portion of the 24-month ahead forecast
error in nonborrowed reserves that is attributed to
innovations in the eurodollar/domestic CD rate dif
ferential is divided by the total expected 24-month
54

ahead squared. prediction .error .of nonborrowed
reservesconditionaLon information available at the
time ·.theforecast isheing .made.i.Thistotal error will
depend on innovations innonborrowedreserves, the
V.$. interest rate, and the vohnneofeuro4011ar
deposits, as wellas on innovations in the.eurodollar/
domestic CDrate ·4ifferential (recall that these variabies are expressed in log differences). As can be
seen ,after 24 months, 78 percent ofthe· errorin
nonborrowed reservesis due to innovations in nonborrowe4 reserves, andneiU'ly 14 percentis due·to
innovations in the eurodollar/domestic CD rate differential.
In general, Table 2 shows that innovations in
other variables playa limited role in explaining the
standard error in the forecast of nonborrowed
reserves, the V.S. interest rate, and the euromarketl
domestic CD rate differential. The contribution of
innovations in interest rates and nonborrowed
reserves to the forecast error in totaleurodollar
deposits is also .small. 28 After 24 months,. innova~
tions. in the Treasury bill rate and nonborrowed
reserves explain 15 and 13 percent, respectively,of
the forecast error in total eurodollar deposits, as
compared to 70 percent explained by innovations in
eurodollar deposits.

Chart 7
Response of Eurodollar Deposits to
One Standard Deviation Shock In:
.05
.04
.03

.02

Eurodollar/CO[)ifferential

o +-/2::.~::"-::::::::::::::::::::::::::==:::::::=---.01 -t-.,.--,---r---r-.-,---,---.,.--,---r---r-,,.......,
1

Months

The impulse response functions presented in
Charts 6 and 7 illustrate the path of the response of
the levels of the V. S. Treasury bill rate and total
eurodollardeposits, respectively, toa Ist<Uldard
deviationshock.intheir own values andothervariabIes inthe system. The U .$ . Treasury bill rate rises
in response to a shock in the V .$. Treasury bill rate,
but falls overall in response toa shock innonborrowed reserves, the interest rate differential,and

source of observed dist~rbances.The present VAR
assumes that disturbances to nonborrowed reserves
are the primary source, followed by disturbances to
the U.S. Treasury bill rate, the euromarket/domestic
CD.·differential· and·eurodollar deposits.· The sensitivityofthe impulse responSe and variance
decomposition results to the ordering adopted here
depends on the covariation between the residuals of
the equations, reported in Table 3. As can be seen,
the correlations between the· residuals are comparatively low, the highest being· - 32 percent for
nonborrowed reserves and the U. S. Treasury bill
rate. The results reported therefore are not very
sensitive to the order assumed.

eurodollar deposits. As indicated earlier, the effects
of the last three are very small.
Total eurodollar deposits rise in response to a 1
standard deviation innovation to the U. S. Treasury
bill rate and to nonborrowed reserves. This at least
partly confirms our earlier suggestion that eurodollar deposit creation is positively associated with
changes in domestic interest rates, but it also indicates that such deposit creation will tend to be
constrained by the availability of dollar reserves.
In constructing a moving average representation
of a VAR, which is the basis for the variance
decompositions and impulse response functions, an
assumption needs to be made as to the original

VI.

Conclusions
deposits do not appear to be sufficiently close substitutes for money, or to be sufficiently large in
volume even at their peak in the early 1980s, to have
a strong influence on U.S. domestic rates. For
purposes of monetary control, U.S. policymakers
need not be concerned about the impact of domestic
currency holdings of their nationals in the eurocurrency market.
This result may have implications for other large
countries concerned about extending the scope of
their international banking relationships. Of course,
the internationalization of banking has other
implications not fully explored here. Further
research should seek to identify the importance of
other channels that connect the euromarket to
domestic financial markets, particularly, the eurobond market.

Since the late 1970s, disturbances to U.S. interest rates and nonborrowed reserves influence
eurodollar deposit creation. The effect of U. S. interest rates implies that eurodollar deposits may be
created in a manner that offsets the intention of
monetary policy. The effect of nonborrowed
reserves implies that the extent of such offset will be
curtailed by the availability of reserves. It should be
stressed that these two effects are small. Eurodollar
deposit holdings of U.S. residents are explained
largely by the lagged values of those holdings.
In addition, any influence the euromarket has on
domestic interest rates is negligible. Neither a proxy
for the effect of the euromarket interestrate nor the
volume of eurodollar deposits held by U.S. residents explains much of the variance in domestic
U.S. interest rates. Specifically, totaleurodollar

FOOTNOTES
1. See Mayer (1982). Similar reasoning underlies the
framework used by Henderson and Waldo (1980, 1981).

theqeposits of offshore banks can be thought of as the
growth of the deposits of domestic branches not subject to
reserve requirements ... Banks do. not hold separate
reserves against offshore deposits because the reserves
heldagai~,st domestic deposits exceednormalliquiqity
ne.eds ..••.
9. The arbitrage between the federal funqs and overnight
eurodollar market is discussed by Reinhart and Harmon
(1987). The arbitrage between dOmestic and eurodollar
CDs is highlighted by Johnston (1979) and Kreicher
(1982),

2, The apparentabsence of any inf.luence of foreign rates
on US ratys reported by GenberQ,Saidiand Swoboda
may be caused by two factors: (a) changes in the return on
assetsqenominatedinforeigncurrencyaffectexchange
rate expectations in a way that diffuses the observed
impact on U.S. rates, and (b) domestic interest rates and
the rates in financial markets abroad are subject to such a
widevarietyofinfluencesthat no direct link between them
may be apparent.

10. The marginal conditions can be derived from the
theory of the banking firm. The marginal revenue to be
equated to marginal cost is the interest income from lending funds received by increasing eurodollar liabilities. For a
given level of domestic deposits and interest rates, the
marginal cost depends on the extent to which increasing
eurodollar liabilities will affect desired holdings of (noninterest-bearing) reserves, the interest cost of the additional
eurodollar liabilities, the expected penalty associated with
the increased probability of becoming illiquid as eurodollar
liabilities rise, and the marginal cost to the firm of an
increase in its size. In a profit-maximizing equilibrium, the
size of the banking firm, the share of the domestic and
eurodollar market in loans and deposits, and the quantity
of desired reserves are all determined simultaneously.

The absence of direct linkages between national financial
markets in the U.S. and abroad does not rule out the
possibility that interest rates in national financial markets
abroad may influence eurocurrency market interest rates,
which, in turn, may influence U.S. interest rates. Thus, the
results of Genberg, Saidi and Swoboda may still be consistent with Hartman's (1984) results. However, as indicated
later, Hartman's results do not appear to apply for the
1980s.
3. Overnight eurodollar rates Granger cause the federal
funds rate if. lagged values of the former improve the
forecast of the latter. The test of Granger causality is
discussed in a later section.
4. The eurocurrency liabilities of U.S. residents subject to
reserve requirements are defined as the net interbank
liabilities of U.S.-based banks versus those of banks operating in the euromarket and the borrowings of U.S. residents from branches of U.S. banks operating in the
euromarket. AS discussed later, U.S. banks have been net
creditors compared to their foreign branches over
extended periods, so the reserve requirements in many
cases do not apply.

11. Such an approach would explain why the differential
between the eurodollar deposit rate and domestic deposit
rates of comparable maturity is not explained by the differential in the cost of funds in the two markets when there
are large disturbances to asset preferences (for example,
following the Herstatt Bank failure of June 1974). This
implies that for SUfficiently large changes in interest rates
associated with shifts in the supply of eurodollar funds, the
demand for eurodollar deposits is not perfectly elastic
either.

5. In 1971, the reserve requirement on eurodollar borrowing was doubled to 20 percent; it was then reduced to 8
percent in June 1973. Over this period, reserve requirements on eurodollar borrowing were higher than the 5-8
percent reserve requirements on domestic CDs. From the
last quarter of 1973 to 1978, the reserve requirement on
eurodollar borrowing was progressively reduced to 0 to
encourage borrowing from the eurodollar market in order
to strengthen the value of the dollar, while the domestic CD
requirement had risen to as high as 11 percent.

12. See Judd and Scadding (1982).
13. For a recent discussion, see Frankel (1985).
14. For example, see Mayor (1982).
15. Goodman's definition of eurodollar deposits of short
maturity includes overnight eurodollar deposits and either
20 percent or 40 percent of term eurodollar deposits held
by U.S. residents (the latter is taken as the upper limit on
eurodollar deposits under 8 days). Her equations are
estimated quarterly from 1959 to 1974 and then simulated
out-of-sample through the third quMer of 1982.

6. The share of dollar-denominated transactions in the
euromarket has fallen in recent years. For example, lending denominated in U.S. dollars by banks in London which is the major euromarket center - has fallen from a
peak of 80 percent in 1983 to 72 percent in 1985, while the
shares of transactions denominated in yen and deutschemarks have risen (to 7 and 10 percent respectively).

16. When foreign banks are involved, the settlement may
first involve bank deposits held with U.S. banks. This
eventually will result in the transfer of reserves.
17. Niehans and Hewson (1976) argued that banks
largely match the maturities of their assets and liabilities in
the euromarket, suggesting that the extent of maturity
transformation, and therefore liquidity creation, is small.
However, more recently, Sneddon-Little (1979) found that
the extent of maturity transformation may be as large as for
domestic banking.

7. The reason is that foreign bank branch daylight overdrafts at the Federal Reserve are restricted, so foreign
banks prefer to settle using deposits held with U.S. banks
rather than with the reserves they have been required to
hold with the Federal Reserve since 1978. Originally, foreign banks were not allowed to run daylight overdrafts. At
present, foreign bank overdrafts are limited to 5 percent of
their U.S. liabilities.
8. For example, Aliber (1979), points out: "The growth of

The tunnel floor is described by: f = [(i + p)(1 re )/(1 - rd)J
- s, Where re is the reserverequirement on borrowing from
the eurodollar market, and s is the spread between the
eurodqllarbidand offer rates. Fora diScu$sion of how
these values are derived, see Kreicher (1982). Unlike
Kreicher, $latutoryFQ1Cpremia areu$edhere.
24.. Jnstead oUaking the U.S. Treasury tJillJa.te andthe
difference between theeuromarket and domestic CD
rates, we could have used a U.S. domestic rate and a
comparableeuromarketrate. The two series would have
reflected both the effect o/the overall.leveloftherates as
well as the effect of the differential between them. Experiments with this "Iternative specification gave similar
results.

18. See Stiglitz and Weiss (1981); or Sachs (1984).
19.. One may also think ofa Ieftward shift in the supply of
funds schedule caused by the rise in domestic lending
rates'\lVhichmay or may not fully offset the rightward shift in
dema.nd.
20. These two indicators do not provide a complete representationaf ·eurodollaractivity·that may be •relevant .for
domesticmonetary policy because the arbitrage activities
of nonbank foreign residents between the domestic U.S.
rnarketand the .e(jrodqllar market .• are. not considered.
However, a large portion of the foreign resident holdings of
eurodollars is unconnected with U.S. economic activity (for
example, eurodollarentrepotoperations). Since .iUs difficult, if not impossible, to ascertain that proportion of foreigneurodollarholdings that should be included in the
analysi$, we have confined our study to the emigration of
intermediation by U.S. residents.
21. The analysis raises the question of whether it is appropriate to compare total eurodollar deposits with M1.
Because of their short maturity, overnight eurodollar
deposits are considered the closest substitutes for M1.
However, a large proportion of eurodollar deposits are of
very short maturity. Goodman (1984a), for example,
assumes that up to 40 percent of eurodollar deposits
mature in less than 8 days.
22. The pattern in the overall net foreign asset position of
U.S. banks appears to be consistent with the pattern
shown in Chart 3. Although the U.S. economy as a whole
has been a net creditor from early this century up to the
1980s, total U.S. international banking liabilities typically
exceeded assets up to the early 1970s. This was partly
because the role of the dollar as a reserve currency
resulted in the holding of significant dollar-denominated
deposit holdings on the part of foreign governments.
However, growing bank lending reversed this situation by
the end of 1975. The net foreign assets of U.S. banks rose
from $1.1 billion in thatyeartoa peak of $130.2 billion in the
first quarter of 1983, before falling to $42.1 billion in the first
quarter of 1986. The decline reflected the 1982 debt crisis,
which prompted U.S. banks to reduce the growth of their
external lending, particularly to less developed countries,
and that portion of growing U.S. borrowing that had been
channeled through the banking sector.

25. Extending the estimation period to 1977 does not alter
the basic results.
26. Hartman estimates a two-variable vector autoregression with the 3-month U.S. commercial paper rate and the
3-month eurodollar deposit rate and finds evidence that
the 3-month eurodollar rate Granger caused domestic
rates for the period 1974-1978. Direct estimates performed
by the author using a similar bivariate system in levels and
rates of change confirmed this finding, but indicated that,
after 1979, the eurodollar rates do not Granger cause
domestic rates. This is consistent with the results in the
text. Reinhart and Harmon's (1986) finding that overnight
eurodollar rates Granger cause the federal funds rate in
the 1980s then indicates that the term structure relationship of the euromarket and domestic interest rates has
changed. This warrants further investigation.
27. In vector autoregressions, variables that are not
expected to have predictive values for other variables are
put last. This assumption is reflected in the ordering of the
equations reported in Table 1.
The procedure for isolating the innovations in each variable follows naturally from this assumption. The innovations to nonborrowed reserves were left unchanged. Any
systematic relationship between the residuals in the nonborrowed reserves equation and the U.S. Treasury bill
equation was then eliminated to obtain the innovations to
be attributed to the U.S. Treasury bill rate. The innovations
in the euromarket/domestic CD differential were then
obtained by eliminating any systematic relationship with
the residuals of nonborrowed reserves and U.S. Treasury
bill equations. A similar process yielded the innovations in
the eurodollar rate. As indicated later, the low correlation
between the innovations suggests that the results are not
very sensitive to the order assumed.

23. The cost of domestic funds, which defines the tunnel
ceiling, may be described by the formula: c =
(i + p)/(1 - rd), where c is the cost, i is the interest paid on
the domestic deposit, p is the FDIC premium, and r is the
reserve requirement on domestic deposits.

28. Recall that all variables are expressed in log differences.

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Full text of Economic Review (Federal Reserve Bank of San Francisco) : Summer 1987, Number 3

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