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2
Fiscal Policy- Influence on Money,
Saving aeid Exchange Rates
I.
II.
Introduction and Summary
5
Disentangling Monetary and Fiscal Policy
7
William G. D ew ald
. . . Impact on monetary policy: Growth in the monetary aggregates, especially those parts
directly controlled by the Federal Reserve, helped finance the large government deficits
of the 1970s to a significant extent.
III.
Monetary and Fiscal Impacts on Exchange Rates
Joseph Bisignano and Kevin D. Hoover
19
. . . Impact on exchange rates: In the short run at least, a combination of large Federal
deficits and slow monetary-base growth should lead to a major appreciation of the dollar.
IV.
Consumption, Saving and Asset Accumulation
37
Brian Motley
. . . Impact on personal saving: Households are likely to save more and to consume less out
of their incomes if interest rates and tax rates are lowered— but less rapid inflation would
have the converse effect.
Editorial committee for this issue:
John P. Judd, Yvonne Levy, Roger Lister, and Adrian Throop.
3
Proper harnessing of monetary- and fiscal-policy
objectives is the key problem facing policymakers
in this bitter winter of 1982. Two articles in this
issue of the Economic Review contribute to the
policy discussion by examining the domestic and
international aspects, respectively, of the controversy. A third article, on household-saving decisions, ties in with this broader theme because of the
importance of household savings for financing Federal deficits in a non-inflationary manner.
William Dewald raises the question whether
budget deficits and monetary growth have been in
fact related in the United States. The economics
literature yields no conclusive answer, but he reexamines the question by introducing the concept of
fiat money as a way of disentangling monetary from
fiscal-policy actions. Fiat money is that part of the
total monetary base-currency plus depositoryinstitution reserves-which is directly controlled
by Federal Reserve actions.
Dewald's analysis of data over a number of business cycles supports the view that deficits have led
to faster money growth in the United States since
World War II. He notes two potential avenues
whereby fiscal policy may affect monetary policy:
"Deficits may apply upward pressure on interest
rates which automatically induces increases in the
uncontrolled part of the monetary base, leading
to faster money growth. The other potential link
may occur as the Federal Reserve increases the
controlled part of the base (fiat money) leading to
more rapid money growth." The former factor was
most evident prior to 1970, while the second factor
dominated the money-deficit relation after 1970.
Dewald argues that without monetary accommodation, via one or another of these approaches,
fiscal policy would have had only a transitory effect
on nominal GNP in the last several decades, "Thus,
in order to prevent fiscal deficits from being inflationary, the Fed must use the controlled part of
the money supply to offset the automatic accom-
modation of the deficits by the induced part of the
money supply." He concludes that the likelihood of
non-inflationary deficits has improved in recent
years-now that the Fed is focusing on controlling
monetary aggregates, rather than interest rates, in
its policy decisions.
Turning to the international scene, Joseph Bisignano and Kevin Hoover test the proposition that
the mixture of monetary and fiscal policies significantly affects exchange rates. Since exchange-rate
floating began in March 1973, the countries cited in
their study followed very different domestic economic policies-and exhibited very different exchange-rate patterns. Over the period covered by
their estimations, the rate against the U.S. dollar
appreciated sharply for Germany and Japan, and
depreciated sharply for Canada and Italy. Their
estimations thus suggest that asset-market models
help explain these movements, which means that
different mixtures of economic policies can explain
such developments.
Bisignano and Hoover caution against accepting
the model results too literally-especially since
their portfolio models are short-run models, whose
long-run implications have not been empirically
described. "Nonetheless, the estimated portfolio
models suggest that the dollar exchange rate against
the German mark, Italian lira, and Japanese yen will
appreciate in the short run should the U.S. run a
sizable government-deficit which is financed in the
private market. Our evidence suggests that in the
short run, at least, a combination of large Federal
deficits and slow monetary-base growth will result
in a major appreciation of the U.S. dollar."
Substantial and prolonged deviations from purChasing-power parity apparently had occurred in
recent years between the U.S. and other major industrial countries. In the preceding issue of the
Economic Review, Charles Pigott attributed such
deviations to shifts in relative prices. Bisignano and
Hoover claim, however, that these deviations could
5
household durables and financial assets. "Thus, if
real interest rates can be brought down from current
high levels, the flow of financial savings available
to finance business investment and government deficits should expand." However, Motley also finds
that the direct effect of a reduction in the inflation
rate would be to increase current consumption and
to reduce total saving, because households would
not have to set aside funds to offset the ravages
of inflation.
A major finding of Motley's study is a strong
association between saving behavior and the personal tax rate. "During the sample period, tax-rate
increases stimulated current consumption as well as
purchases of homes and consumer durables, and led
households to assume more debt to finance these
outlays." This finding was predictable: interest
payments on household debt are tax-deductible, so
that higher tax rates reduce the net cost of borrowing
to finance both tangible-goods purchases and current consumption. He thus concludes, "Lower tax
rates, whether brought about by legislation or by
a slower movement of families into higher tax
brackets, conversely should reduce the demands
which households make on the nation's resources,
both real and financial, and thus should release
funds for the financing of business investment and
government deficits."
also be due to the behavior of real interest rates,
caused by changes in the monetary-fiscal policy mix
among major countries. "A large increase in U.S.
government debt in 1982, combined with low monetary growth, would thus continue to keep the
effective (trade-weighted) U.S. dollar exchange
rate away from its purchasing-power value, as has
occurred since late 1980."
Brian Motley turns to a key element in the Administration's program for higher productivity and
growth-the encouragement of personal saving.
Specifically, he investigates the effects of inflation,
interest rates, and taxes on the consumption and
saving behavior of households. However, Motley's
study differs from most others in that its primary
focus is on saving rather than on consumption. He
treats the act of saving as a demand for various kinds
of assets-both financial and tangible-which are
expected to yield returns in the future, so that total
saving depends on all the factors which influence
the public's purchases of assets.
As Motley notes, economic theory suggests that
decisions to consume or to save are likely to be
influenced by changes in interest rates, inflation,
and tax rates. But theory frequently cannot predict
which way these effects will go. His results indicate, however, that increases in real after-tax interest rates on securities are likely to encourage current
consumption, but to discourage purchases of both
6
Fiscal
William G. Dewald*
Fiscal year 1982 began amid widespread concern
that the Federal budget deficit would exceed the
Reagan Administration's original estimate of $42.5
billion. This concern, which helped hold interest
rates at historically high levels, was reinforced
when the Administration itself announced new estimates of a $99 billion deficit in 1982, $92 billion in
1983, and $83 billion in 1983 and 1984. The projected deficit in 1982, for example would be around
3 V2 percent of a consensus forecast of GNP, the
largest such percentage since World War II. However, this percentage is not large by comparison
with those in some countries which have had comparatively low inflation and interest rates. In Japan,
for example, the 1981 deficit also was about 3 V2
percent of GNP, while inflation was about 5 1/2 percent, and money-market interest rates were around
7 Vz percent.
Why, then, the concern about deficits in the United States? Investors fear that future large deficits
foreshadow a future acceleration of monetary
growth, and in tum a reacceleration of inflation.
Such expectations apparently held interest rates up
through most of 1981. This fear that growing deficits will lead to rising inflation apparently did not
operate in Japan because the monetary authorities
there held monetary growth rates to noninflationary
levels for years despite large deficits.
But is it even true that budget deficits and monetary growth have been in fact related in the United
States? Surprisingly, the professional economics
literature yields both yes and no answers to that
question. This paper reexamines the question by
introducing the concept of "fiat" money as a measure of monetary-policy actions, and as a way to
disentangle monetary from fiscal-policy actions.
Fiat money is that part of the total monetary base
which is directly controlled by Federal Reserve
actions. It is also that part of the monetary base
which must increase if the Federal Reserve is going
to finance Federal budget deficits directly.
The analysis of data for entire business cycles
supports the view that deficits have led to faster
money growth in the United States since World War
II. Prior to 1970, the association between money
and deficits occurred to some extent because uncontrolled sources of monetary growth were positively related to interest rates, which tend to rise
with deficits, thereby inducing monetary growth.
But since 1970, controlled sources of monetary
growth (i.e. fiat money) appear to have been closely
linked to deficits. Thus the Federal Reserve partly
financed the large Federal government deficits during the 1970s through changes in its controlled
policy variable, fiat money.
The paper also examines the effect of monetary
and fiscal-policy impulses on nominal spending
(GNP) growth in the U.S. economy. This analysis
shows that high-employment government spending, a measure of fiscal-policy impulses, has had a
significant long-run influence on nominal GNP, but
mainly through an induced effect on monetary
growth. In contrast, monetary-policy actions as
measured by fiat money are shown to have exerted a
significant independent effect on total spending.
Thus, to prevent an automatic accommodation of
deficits by monetary policy, the Fed must actively
reduce growth in fiat money. It is important that the
Fed do so over the next few years to prevent the
possibility of another round of inflation being induced by the large government deficits currently
projected.
Section I of this paper defines fiat money and
*The author is Professor of Economics, Ohio State
University, and Editor, Journal of Money, Credit,
and Banking. This article was written while he was
Visiting Scholar, Federal Reserve Bank of San
Francisco. Research assistance was provided by
Mary Byrd Nance.
7
Section III analyzes the impact of monetary fiscalpolicy impulses on aggregate demand, and Section
IV presents conclusions and policy implications.
discusses its relationship to the monetary base.Sec·
tion II examines the historical relationship between
Federal deficits and monetary growth in the United
States on the basis of the concept of fiat money.
I. Fiat Money and the Monetary Base
of gold and the debt of foreign governments and
the borrowings of U.S. commercial banks (see
Table I).
The concept of fiat money (as opposed to base
money) is of interest, first, because it is part of the
Federal government's budget constraint. When the
government spends more than it collects through
taxes and sales of assets, the resulting deficit must
be financed either by selling interest-bearing securities to the public or by increasing fiat money. The
latter is accomplished mainly when the Federal
Reserve buys government securities through its
open-market operations, issuing reserves to banks
in exchange for government securities.
Second, fiat money is the main exogenous or
controlled part of the monetary base: i.e., if a
government deficit is financed by increases in fiat
The monetary base consists of bank reserves plus
currency held by the public, i.e., the net monetary
liabilities of the Federal Reserve and Treasury held
by the public and financial institutions. The monetary base is important for the conduct of monetary
policy because growth in the base is closely associated with growth in the monetary aggregates, the
main conduit of Federal Reserve policy.
Fiat money is essentially that part of the monetary base not issued against private liabilities or
international monetary assets. Specifically, it is that
part of the monetary base that is matched by the
Federal Reserve's holdings of Treasury securities,
plus Treasury currency outstanding (less deposits
issued by the Fed to the Treasury and Treasury
holdings of cash).1 Most of the rest of the monetary
base is matched by Fed and Treasury holdings
Table 1
Fiat Money and the Monetary Base
Outstanding in Fourth Quarters
(Billions of Dollars)
1980
Less:
Treasury Deposits
Treasury Cash
1960
$60.5
$27.4
7.1
5.4
3.0
.5
Federal Reserve Holdings of:
U.S. Government Securities
Federal Agency Securities
Treasury Currency Outstanding
1970
$120.4
9.0
13.4
Sources of Fiat Money
.9
.4
-139.3
1.9
Fiat Money
Less: Reserve Adjustment Magnitude
Fiat Money Adjusted
$137.4
.5
-66.3
5.4
-$60.9
.4
--
$17.7
31.9
4.0
$27.9
Other Sources of Monetary Base
(not in Fiat Money)
Gold Stock & Foreign Exchange
Holdings of the Federal Reserve
Loans to Commercial Banks
Float
Foreign Deposits
Miscellaneous
$ 16.2
1.8
4.5
.4
- 1.5
$ 21.4
MONETARY BASE
8
$13.2
-$17.7
$158.8
SUBTOTAL
$10.9
.3
4.3
.3
- 2.6
$74.1
$45.6
1.9
.2
-2.1
by induced increases in the uncontrolled part of the
base are "acts" of omission.
What are these induced or noncontrolled sources
of growth in the monetary base? The part of base
money not included in fiat money is about 15 percent of the monetary base, as compared with 39
percent in 1960 (see Table I and Chart I). The
uncontrolled items included in base money are
mainly member-bank borrowing from the Federal
Reserve, the international monetary-reserve holdings of the monetary authorities, and Federal Reserve Float. These noncontrolled sources vary
directly and significantly with respect to interest
rates? First, a higher Federal funds rate relative to
the discount rate induces banks to borrow more
from the Federal Reserve. Second, attracted by
comparatively high interest rates, foreign investors
and governments would have an incentive to sell
their currencies and gold to get dollars to buy U.S
securities. If U. s. monetary authorities take actions
to stabilize exchange rates, they would buy the
foreign currencies in exchange for newly created
money, this can be regarded as a conscious policy
action of the Federal Reserve. The part of the base
not included in fiat money, the "uncontrolled"
portion, is positively related to interest rates. Thus
government deficits also may induce increases in
this endogenous part of the base by applying upward pressure on interest rates. These increases in
the base can occur without a conscious policy action
of the Federal Reserve.
The monetary aggregates will grow more rapidly
in response to faster growth in either fiat money or
the uncontrolled part of the base. Thus there is a
potential direct link from deficits to fiat money to
growth in the monetary aggregates, and an indirect
link from deficits to higher interest rates to induced
increases in the base and money growth. The latter
linkage works more or less automatically. The former linkage need not work at all unless the Federal
Reserve chooses to finance government deficits by
increasing its holdings of government securities.
Thus, deficits financed by increases in fiat money
are "acts" of commission, whereas those financed
Chart 1
Fiat Money and Monetary Base
$ Billions
200
Ratio Scale
100
,
Adjusted Base
50
~
Adjusted Fiat Base
25
10 L-L.....L...L............L...JL...L....A...I.....L...L.............I..I..L...Jl...l-...L...L...I.....I............L...Jl...l-....................
1948 1950
1955
1965
1960
9
1970
1975
1980
dollars of base money. Thus, an increase in a government deficit (and associated higher interest rates)
tends to induce increases in the monetary base,
which then lead to higher money growth.
In summary, it makes no difference in moneygrowth terms whether base money is created
through the issuance of fiat money and direct financing of Federal deficits, or through induced increases
in the uncontrolled part of base money. Both cause
the money supply to grow faster, leading ultimately
to more inflation. But for the purpose of evaluating
Federal Reserve reactions to deficits, fiat money
represents the principal magnitude that can be manipulated by the monetary authorities, and thus it
may provide some clues about how monetary and
fiscal policy have been related.
II. Federal Deficits and Monetary Growth
As noted earlier, there is no necessary association between deficits and monetary growth. Whatever the deficit, the monetary authorities could
always take sufficiently contractionary actions in
reducing fiat money to prevent monetary growth.
This reduction could be accomplished by the Fed
selling Treasury securities and thereby lowering
bank reserves. The question is not whether mone-
Table 2
Federal BUdget Deficits and Monetary Growth
in Business Cycle Expansions and Contractions
Annual Rate of Change in
Federal Budget
Deficit (DEF)*
($Billions)
DEF/PXF
- 1949:4
- 1954:2
- 1958:2
1961: I
- 1970:4
1975:1
- 1980:3
1.46
8.73
4.50
.03
9.10
15.92
58.97
All contractions
M-1B 2
M-2 2
A2
.53
2.38
.95
- .01
.88
1.04
2.16
- .55
.59
.49
1.41
3.87
3.59
3.52
- .18
2.32
3.72
4.11
5.59
6.01
6.69
- 1.44
.48
1.52
1.77
4.86
6.56
5.25
12.19
1.08
1.89
3.99
2.82
Expansions
1949:4 - 1953:3
1954:2 1957:3
1958:2 1960:2
1961:1 - 1969:4
1970:4 - 1973:4
1975:1 - 1980:1
- 1.74
2.72
2.96
2.58
15.25
42.27
- .65
- .62
.63
.39
1.33
2.24
3.68
1.62
1.84
4.06
6.25
6.64
3.83
2.61
2.25
6.49
9.17
8.50
3.29
.87
.77
4.70
6.94
7.53
All expansions
10.45
.60
4.27
5.96
4.49
Contractions
1948:4
1953:3
1957:3
1960:2
1969:4
1973:4
1980: I
1
*
Quarterly average
I
The Federal deficit relative to nominal high-employment output (PXF), i.e., real potential output times the
implicit GNP price deflator.
Definitions of monetary aggregates:
M-1B
M-2
A
Money narrowly defined to include currency, demand deposits, travelers checks, and other
checkable deposits.
Money defined to include currency plus demand deposits plus time deposits at commercial banks
other than large negotiable CD's. Values for 1980 were extrapolated on the basis of the growth
rates for newly defined M-2.
Adjusted monetary base = member-bank reserves plus adjustment for reserve-requirement
changes, plus currency held by the public and non-member banks.
F = Fiat money Federal Reserve holdings of U.S. government securities, plus Treasury currency
outstanding, less Treasury deposits with the Federal Reserve Banks and Treasury cash holdings,
plus reserve requirement adjustment.
IO
Secular Evidence
We have used data averaged over entire business
cycles (i.e., peak-to-peak or trough-to-trough) to
focus on the long-run relationship between deficits
and monetary growth. These data allow us to abstract from the inverse relationship between deficits
and money growth over business-cycle expansions
and contractions, and thus to focus attention on the
longer-run trends in both policies.
The data show a close association between monetary growth and deficits over the 1948-80 period
(Table 3 and Charts 1-3). We show deficits both in
absolute nominal magnitudes and as a percentage of
nominal high-employment output (PXF). Monetary
growth measures include M-I, M-2, A and F (the
monetary base and the fiat monetary base, respectively, both after adjustment for required-reserve
ratio changes).
The pre-1970 experience suggests at best a weak
association between monetary growth and (relatively small) deficits. There were Federal budget surpluses or small deficits over the two cycles from
1948 through 1958 (Cycles I and 2 in Table 3). The
money supply as measured by the standard aggre-
tary growth and deficits have to be related, but
whether they have been related in the United States.
The divergent cyclical movements in budget deficits and monetary growth have clouded the relationship. Monetary growth-as measured by M-I,
M-2, and the monetary base-historically has been
most rapid during business-cycle expansions,
whereas the deficit has been largest during contractions (see Table 2). Such divergent patterns suggest
a negative relationship in the short-run.
However, the long-run relationship is of most
interest, because it takes a long-run increase in
money growth to raise the underlying rate of inflation. Popular opinion contends that in the long-run,
deficits increase the demand for credit and·thereby
put upward pressure on interest rates. To mitigate
the impact of Federal borrowing on interest rates,
the Federal Reserve buys government securities and
increases monetary growth. However, the professional economics literature is not conclusive in this
area? As will be shown, data for the post-World War
II period confirm the popular view that monetary
growth and deficits have in fact been positively
associated.
Table 3
Federal Budget Deficits and Monetary Growth
Over Complete Business Cycles
Complete
Business Cycles
Annual Rate of Change in
M-2
A
Federal Budget
Deficit (DEF)*
($Billions)
DEF/PXF*
M-1B
- 1954:2
- 1958:2
- 1961:1
1970:4
- 1975:1
- 1980:3
0.07
- 1.02
2.55
3.57
16.09
44.70
- .13
- .25
.54
.47
1.23
2.27
3.22
1.81
1.85
4.13
5.40
6.82
3.71
2.45
3.06
6.51
8.17
9.00
2.87
.88
1.16
4.84
6.82
7.90
8.78
1.64
7.19
7.65
7.76
8.11
1949:4 - 1980:3
11.43
.72
4.05
5.92
4.51
7.08
1953:3
1957:3
1960:2
1969:4
1973:4
1980:1
1.22
- 0.58
2.73
2.77
13.30
36.07
- .48
.06
.58
.34
1.16
1.94
2.81
1.48
1.54
3.89
5.91
5.97
3.02
2.69
2.92
6.38
8.66
7.94
2.27
.83
1.08
4.52
6.74
7.31
6.73
.45
7.12
8.14
8.44
7.47
1948:4 - 1980:1
9.70
.61
3.87
5.68
4.22
6.74
Trough to Trough
1949:4
1954:2
1958:2
1961:1
1970:4
1975:1
F
Peak to Peak
1948:4
1953:3
1957:3
1960:2
1969:4
1973:4
-
* Quarterly average
See Table 2 for definitions of monetary aggregates
11
gates M-l, M-2 and A increased roughly at a 3percent annual rate over the 1948-54 cycle (2)
compared with the previous cycle. Annual budget
deficits rose to average $2 '/ 2 to $3*/2 billion over the
two cycles (3 and 4) in 1958-70. Average monetary
growth increased somewhat in the 1958-61 cycle,
but at a much faster pace in the 1961-70 period.
But the deficit and money-growth changes that
occurred in the next two cycles reveal a strong
association, not unlike what had been observed
during World War I and World War II. Over 197074, the average deficit quadrupled and monetary
growth accelerated further (see Charts 2 and 3).
During the 1974-80 period, deficits increased an
additional three-fold and monetary growth acceler
ated again. Regression analysis confirms the statis
tically significant relationship between deficits and
money growth on a cyclical average basis.4
The analysis of quarterly data for the entire 194880 period reinforces the significant association be
tween deficits and monetary growth (Table 4). The
estimated money-supply model resembles the one
estimated previously in the literature. Money
growth is explained by a distributed lag on deficits,
measured as a ratio to nominal high-employment
output (PXF).5 These estimates indicate a statis
tically significant relationship, with around 50
percent of the variation in money growth being
explained by deficits.
This relationship has generally been attributed to
the behavior of the monetary authorities in attempt
ing to damp interest-rate movements associated
with Federal deficits and changes in outstanding
Federal debt.6 But the longer-term data for fiat
money-base growth suggest that this was not gener
ally the case for the controlled part of money growth
Chart 2
Deficit/High-Employment Output
Percent
III B-L-LAUJ 1 1 1 1.1.11 I N N .
1948 1950
1955
1960
1965
1970
Shaded areas represent business cycle contractions
as defined by National Bureau of Economic Research
1
2
I I 1 1 111 1 1
.J
1975
1980
Table 4
Federal Budget Deficits and Monetary Growth: 1948:3 -1980:4
M = Constant + a (D EF/PXF) + bM^
Monetary
Aggregate
Constant
(T-value)
a
(T-value)
b
(T-value)
R2
(SE)
M-1B
1.015
(3.46)
.287
(2.76)
.722
(12.03)
.423
(2.380)
-.246
(-2.88)
1.998
M-2
1.705
(4.43)
.407
(3.32)
.678
(11.38)
.605
(2.197)
- .011
(-.13)
1.944
A
.707
(3.03)
.186
(2.14)
.831
(17.77)
.574
(2.161)
- .447
(-5.68)
2.227
F
7.631
(6.41)
- .124
(-.241)
.338
(4.07)
2.018
- .057
(- .640)
.101
(7.24)
RHO
(T-value)
DW
See Table 2 for definitions of monetary aggregates
Chart 3
Growth Rate for M-1B
1948 1950
1955
1960
1965
1970
Shaded areas represent business cycle contractions
as defined by National Bureau of Economic Research
13
1975
1980
1973, the monetary authority no longer needed to
sell gold or foreign exchange to peg the exchange
rate. Fiat money growth itself became the main
factor explaining high rates of growth in the stan
dard monetary aggregates. This may reflect the
Federal Reserve’s desire to prevent interest rates
from rising during a period of cumulating deficits
and rising inflation. Ever since the end of World
War II (with the exception of a brief period in the
1950s), fiat-money growth was a highly expansion
ary factor. But until the 1970s, fiat money growth
was partly offset by flows of gold and foreign ex
change, and thus was not nearly so expansionary as
it subsequently proved to be.
up to 1970. According to Table 3, fiat base growth
was inordinately large relative to monetary growth
and to real growth, both during cycles with compar
atively small deficits, such as 1948-53 (Cycle 1) or
1957-60 (Cycle 3), and during cycles with compara
tively large deficits, such as 1969-73 (Cycle 5) and
1973-80 (Cycle 6). From the late 1950s through
1971, the U.S. monetary authorities pumped in fiat
money at a high rate, at least in part to prevent an
undesired decline in the uncontrolled part of the
monetary base (Chart 1). This decline resulted from
sales of gold by the United States to foreign govern
ments to preserve the fixed price of gold under the
dollar-gold standard.
But with the relinquishing of the gold standard in
1968 and the adoption of floating exchange rates in
Chart 4
Growth Rate for Fiat Money
Percent
1948 1950
1955
1960
1965
1970
Shaded areas represent business cycle contractions
as defined by National Bureau of Economic Research
14
1975
1980
III. Impacts of Monetary and Fiscal Policy on Aggregate Demand
ing, whereas the effects of fiscal policy are only
transitory (Table 5). This result implies that without
monetary accommodation (i.e., with constant
monetary-growth rates), larger government spending would not lead to higher inflation rates.
In contrast, the results obtained with a fiat-money
monetary variable show a significant long-run effect of increases in the growth of government
spending on the growth in nominal GNP. This is to
be expected, since the uncontrolled sources of the
monetary base are positively associated with interest rates. By implication, the money-supply function for a given setting of fiat money is positively
This section focuses on the effects of monetaryand fiscal-policy impulses on aggregate demand for
goods and services (i.e., nonimal GNP). It examines estimates of so-called St. Louis equations in
which the change in nominal GNP (Y) is related to
current and past changes in a monetary aggregate
(M); a fiscal-policy variable, high-employment
government spending (EF); and an internationaltrade impulse, exports (EX). Increases in each
would theoretically increase Y?
The results obtained with certain monetary variables (M-I, M-2 and A) confirm that monetary
growth has a permanent long-run impact on spend-
TableS
Aggregate Equations: 1953:1 • 1980:4
V, = CONSTANT + L m j Mj.1 + .L e I EF,_1 + .L xj EX"1 *
1=0
'=0
M-2
M·1B
Constant
Monetary Impulse: M
'=0
F
A
2.351
( 3.435)
.867
.998)
.673
.217
.242
.233
- .325
( 5.550)
( 1.802)
( 3.207)
( 1.827)
(- 2.194)
.290
.370
.024
.304
( 1.982)
( 2.071)
( .119)
( 1.892)
.395
.310
.228
.090
- .161
1.888)
1.742)
1.781)
( .513)
( - .760)
- .093
.044
.106
. I 15
.094
.067
.056
.087
1.040
( 6.624)
.988
( 7.049)
.862
( 5.168)
.475
( 3.456)
.065
.060
.011
- .047
- .083
- .061
.051
( 1.779)
( 2.621)
( .467)
(-2.529)
(- 3.569)
(- 2.691)
( 1.650)
.050
.058
.009
..056
- .099
- .080
.039
( 1.216)
( 2.266)
( .348)
(- 2.695)
(-3.782)
(- 3.165)
( 1.131)
.062
.044
- .004
- .057
- .086
- .066
.030
( 1.434)
( 1.573)
( .150)
.149
.1l1
.047
- .017
.056
- .043
( 3.228)
( 3.228)
( 1.549)
( - .577)
(- 1.641)
(- 1.009)
.003
( - .052)
- .078
(- 1.037)
.078
( - .894)
.191
( 2.504)
.041
( 2.253)
.053
( 2.797)
.040
( 1.905)
.051
( 2.447)
3.203 ( 4.210)
1.669)
1.855
((
(
(
(
(
(
(
1.497)
1.348)
2.969)
3.958)
3.389)
1.965)
1.803)
1.541)
Fiscal Impulse: EF
(- 2.492)
(- 3.082)
(- 2.409)
( .790)
Trade Impulse: EX
.566
.032
2.062
.473
.035
1.861
* Logarithmic first differences in:
Monetary aggregates (see Table 2 for definitions)
Y
=
Total spending, i.e., nominal GNP.
EF = High employment government spending.
EX = Exports.
IS
.394
.037
1.717
.359
.039
1.672
Table 6
Changes in Nominal GNP, High-Employment Government Spending,
Exports, and Various Monetary Aggregates: 1953:1 -1980:4
Annual Rates of Change (Percent)
Expansions
(Peaks)
Contractions
(Troughs)
y
8.09
5.17
2.92
4.86
EF
7.66
6.47
6.65
7.65
EX
12.07
16.16
7.76
7.38
M-2
6.68
4.05
5.73
8.75
M-IB
4.54
2.38
2.91
5.50
A
4.90
315
4.36
5.24
F
6.81
7.99
9.75
12.37
Table 7
Impacts on Nominal GNP of Various Impulses High-Employment Government Spending (EF),
and Exports (EX): 1953:2 - 1980:4
Expansjons
Monetary
Impulse
M
M-2
6.65
M-IB
4.46
Contractions
EX
EF
EX
4.83
-.60
.24
.34
.002
M
.34
EF
- .5
3.58
- .07
.19
A
4.17
- .55
.32
3.52
.61
.18
F
3.52
1.36
.42
3.18
1.51
.24
EX
M
EF
EX
.43
Peaks
M
Troughs
EF
M-2
4.79
-.57
- .22
5.77
- .28
M-IB
5.02
.03
- .17
1.49
.21
.33
A
4.12
- .58
- .16
3.19
- .38
.32
F
2.43
1.64
.21
4.24
2.13
.41
private spending by government spending; and a
significant permanent effect of government spending on total spending was estimated. This result,
together with the total fiscal crowding-out obtained
with the M-I, M-2 and A monetary variables, suggests that fiscal policy has a permanent effect on
spending only when accommodated by monetary
growth. Otherwise the effects are transitory. Furthermore, to prevent such monetary accommodation, the Fed must actively use its controlled policy
instrument (fiat money) to offset movements in the
endogenous part of the money supply.
associated with the rate of interest. Thus one would
expect an increase in government spending, which
increases interest rates, to induce an increase in the
quantity of money. This in tum would amplify the
effect of an increase in government spending on
total spending. If, instead, the induced increase in
monetary growth had been offset by changes in fiat
money, one would expect the expansionary effect
of the increase in government spending to be offset
at least in part by the contractionary effect of a
decrease in fiat money.
As hypothesized, the total effect on nominal
GNP of fiat money was smaller, and the fiscal effect
was larger, than in the specifications including M-l,
M-2 and A. With the fiat-money specification, there
was some (although incomplete) crowding out of
Policy Impulses and the Cycle
Government expenditures and monetary impulses also affect the pattern of business cycles (Table
16
6). The government spending data move positively
with the business cycle, with average annual growth
of 8.09 percent per quarter (at an annual rate) during
expansions and 2.92 percent growth per quarter
during contractions. With one notable exception,
the monetary aggregates grew faster in expansions
than in contractions-the familiar procyclical pattern. The exception occurred in the case of fiatmoney growth, which was more rapid during
contractions than during expansion-a countercyclical pattern. In other words, the actions of the
monetary authorities, as measured by fiat money,
were more expansionary during recessions than
expansions, but not enough to change the procyclical pattern in other monetary aggregates.
It is tempting to credit monetary-policy actions
for a countercyclical stance on the basis of these
data. But this does not take into account lags in the
effect of monetary and fiscal policy on nominal
GNP. When we take these lags into account (Table
7), monetary and fiscal policy, by every measure,
contributed to economic instability.
IV. Conclusions
First, there are two potential avenues whereby
fiscal policy may affect monetary policy. Deficits
may apply upward pressure on interest rates, and
thus automatically induce increases in the uncontrolled part of the monetary base, leading to faster
money growth. The other potential link may occur
as the Fed attempts to prevent high interest rates
by increasing the controlled part of the base (fiat
money), leading to more rapid money growth.
Second, growth in the monetary aggregates,
especially those parts directly controlled by
the Fed, helped finance the large Federal government deficits in the 1970s to a (statistically) significant extent.
Third, without monetary accommodation via one
or both of the above methods, fiscal policy would
have had only a transitory effect on nominal GNP in
the U.S. economy. Thus in order to prevent fiscal
deficits from being inflationary, the Fed must use
the controlled part of the money supply to offset the
automatic accommodation of the deficits by the
induced part of the money supply.
Fourth, with large budget deficits looming on the
horizon, the Fed should restrict growth in fiat money sufficiently so that M-I and M-2 growth do not
finance a significant part of those deficits. Now that
the Fed is no longer focusing on controlling interest
rates, having switched more of its attention to the
monetary aggregates, the likelihood of noninflationary deficits has improved.
FOOTNOTES
1. Reserve requirements also affect fiat money since the
interest-bearing Federal debt in the hands of banks, the
public, and foreign investors would tend to decrease if
required-reserve ratios were raised. The reason is that
deposit. decreases otherwise associated. with raising required-reserve ratios generally are offset by Federal. Reserve open-market purchases of government securities.
Such purshases gererally dec:rease thenet-interest-bearing Federal debt and increase fiat money enough to permit
banks tq meet th~.increased reserve requirements. A precise relationship existsthatfranslates cl1angesin req.uiredreserve ratios into equivalent units of the monetary base
that would have the. same effect on deposits. Controlled
sources of monetary growth thus include not only fiat money, but also the required-reserve adjustment magnitude
(RAM), which is the change in base money that would have
an equivalent effect on monetary growth as a change in
required-reserve ratios. Fiat money adjusted is the sum of
fiat money and RAM. It is a policy controlled variable and an
important source of monetary growth.
Percent Changes in Noncontrolled Sources
of the Monetary Base (N) and
Long Term Government Bond Rates (R)
Monthly, 1959-80.*
- 0.001 + 0.470 R
(00058) (4.71)
4.31
DW
1.93
N
Monetary Base Less Fiat Money
R
Average U.S. Government Bond Rate with
Maturity Greaterthan 10 Years
(percent change in).
• A 16-quarter distributed lag yielded a slightly higher
regression coefficient with respect to R, but the same 4.3percent standard error of the regression.
N
R2
SE
3. The politics of the process was discussed in detail by
Buchanan and Wagner. Nevertheless, in tests of this view,
both Barro and Niskanen could not find a significant link
between annual M-1 growth and the deficit over the postWorld War II period. This finding was reversed when Hamburger and Zwick repeated the exercise for the period since
2. This point is substantiated by the following ordinary
least-squares regression.
17
that fit the experience of other countries as well as that of
the United States.
See L.C. Andersen and K.M. Carlson, "A Monetarist
Model for Economic Stabilization," Federal Reserve Bank
of St. Louis Review (April 1970), 7-25; and L.C. Andersen
and J.L. Jordan, "Monetary and Fiscal Actions: A Test
of Their Relative Importance in Economic Stabilizatibn,"
Federal Reserve Bank of St. Louis Review (November
1968),11-24.
Both Feldstein and Benjamin Friedman, in evaluating
theoretical models that included not only bonds and money
but also real capital, found that whether government deficits
were inflationary or not (Le., the degree of financial crowding out) depended on the comparative substitutability of
money for bonds and bonds for real capital. If bonds resemble money, then deficits are inflationary and can be
offset only by tax policies or debt-management policies that
raise the net real yield on capital and lower real output and
growth. See M. Feldstein, "Fiscal Policies, Inflation, and
Capital Formation," American Economic Review (September 1980), 636-50; and B.M. Friedman, "CroWding Out
or Crowding In? Economic Consequences of Financing
Government Deficits," Brookings Papers on Economic
Activity (1978),593-641.
Wallace and Bryant have taken the extreme position that
government bonds and money are perfect substitutesand thus only deficits matter and open-market operations
don't matter at all. J. Bryant and N. Wallace, "Open Market
Operations in a Model of Regulated, Insured Intermediaries," Journal of Political Economy (February 1980),
146-73; and N. Wallace, "A Modigliani-Miller Theorem for
Open Market Operations," American Economic Review
(June 1981), 267-74. This paper's argument that fiat money
(mainly open-market operations) independently affects
total spending tends to refute the Bryant-Wallace proposition. That government spending (and hence the deficit) is
estimated to exert an independent effect on spending for
a given setting of fiat money tends to confirm the Feldstein-Friedman proposition-namely, that a deficit independently increases inflation and concomitantly raises real
interest rates and induces growth in the standard monetary
aggregates.
The best-fit spending equation was the one that included
M-1B as the monetary impulse. The estimated larger
spending effect of M-1B growth than F growth, and the
better fit, both reveal that monetary growth (regardless of its
source) affects spending. This result tends to disconfirm
the Sargent-Wallace hypothesis that only fiat monetary
growth increases spending growth and inflation. T.J. Sargent and N. Wallace, ''The Real Bills Doctrine vs. the Quantity Theory: A Reconsideration," Federal Reserve Bankof
Minneapolis, Staff Report 64 (January 1981); T.J. Sargent,
"The Ends of Four Big Inflations," Federal Reserve Bankof
Minneapolis Working Paper 158 (December 1980); and T.J.
Sargent, "Stopping Moderate Inflation: The MethodS of
Poincare and Thatcher," Processed (May 1981).
1960 when, according to Buchanan and Wagner, major
changes occurred in the way macroeconomic policy is
formulated. This result in turn was reversed when McMillan
and Beard used revised GNP data in the calculations.
For these discussions, see D.R. Francis, "How andWhy
Fiscal Actions Matter to a Monetarist," Federal Reserve
Bank of St. Louis Review (May 1974), 4-7; J.A. Buchahan
and R.E. Wagner, Democracy in Deficit: The Political
Legacy of Lord Keynes. New York: Academic. Press,
1977; R.J. Barra, "Comment from an Unreconstructed
Ricardian," Journal of Monetary Economics (August
1978), 564-81; W.A. Niskanen, "Deficits, Government
Spending, and Inflation: What is the Evidence?" Journal of
Monetary Economics (August 1978), 591-602; M.J.
Hamburger and B. Zwick, "Deficits, Money and Inflation,"
Journal of Monetary Economics (January 1981), 14150; W.O. McMillan and T.R. Beard, "Deficits, Money and
Inflation: Comment," Journal of Monetary Economics
(forthcoming).
4. This point is substantiated by the following ordinary
least-squares regression.
Federal BUdget Deficits and Monetary Growth Over
Six-Post-World War II Business Cycles, 1948-80
M = a + b (DEF/PXF)
Monetary Growth Rate
M-1B
M-2
A
F
Constant
(t-value)
2.36
(3.87)
3.65
(4.55)
2.19
(245)
5.97
(4.33)
Coefficient
(I-value)
R'
(Trough to Trough)
1.92
(3.64)
2.50
(3.61)
2.57
(3.33)
1.20
(1.00)
SE
OW
.77
1.15
2.00
.77
1.51
2.16
.74
1.69
2.11
.20
2.60
2.65
(Peak to Peak)
M-1B
M-2
A
F
2.54
(3.37)
3.80
(3.91)
2.23
(2.28)
5.49
(3.58)
1.72
(2.32)
2.39
(2.51)
2.53
(2.62)
1.47
(.98)
.57
1.47
1.80
.61
1.9
1.96
.63
1.92
1.88
.19
3.00
2.40
Note: "Signiticant at 95-percent level.
'Significant at 90-percent level.
5. See Hamburger and Zwick, 1981.
6. See, for example, S.E. Hein, "Deficits and Inflation,"
Federal Reserve Bank of St. Louis Review (March 1981),
3-10; and MW. Keran and T. Babb, "An Explanation of
Federal Reserve Actions (1933-68)," Federal Reserve
Bank of St. Louis Review (July 1969), 7-20.
7. In this paper, the original St. Louis spending equation
was modified by specifying the relationship in percent
changes, by not constraining the ends of a third-degree
polynomial lag distribution to zero, and by adding exports
as an autonomous variable based on a spending equation
18
Joseph Bisignano and Kevin D. Hoover*
Second, the United States, as the principal reserve currency country, could "export" its inflation under fixed exchange rates. Attempting to
maintain fixed exchange rates required that any
excess supply of U.S. dollars, putting downward
pressure on the dollar, had to be absorbed in the
foreign exchange market by countries within the
fixed rate system. Purchasing these dollars at a fixed
rate tended to expand foreign money supplies and,
over time, to lead to additional inflation. Attempts
to offset this expansion in foreign money supplies
by individual "sterilization" operations usually
proved to be only moderately effective.
Floating exchange rates promised to do away
with these problems. Instead of reducing a country's international reserves, an incipient balanceof-payments deficit would trigger an appropriate
exchange rate depreciation. Such a depreciation, it
was hoped, would no longer be unpopular because
it would represent an automatic market responsea smooth adjustment, rather than a decision
by politicians to devalue by a discrete amount.
Furthermore, U.S. inflation could no longer be
exported because U.S. monetary expansion would
depreciate the dollar, alleviating the incipient price
pressure in other countries. Floating exchange rates
thus would permit independent domestic stabilization policies, because any domestic move which
would have encountered international constraints
under the fixed exchange-rate regime would now
only produce automatic and-it was thought-less
painful adjustments in exchange rates.'
Since the advent of floating, the industrial countries have indeed followed independent domestic
economic policies, in the sense that policies have
differed radically both between countries and between the pre- and post-floating periods in any given country. The quadrupling of oil prices in late
1973 severely strained the industrialized countries,
forcing most into recession in 1974 and 1975. Sev-
This paper describes and tests the proposition that
the mixture of monetary and fiscal policies significantly affects exchange rates. We begin with the
historical background describing the major shift in
policy mix since the 1973 oil crisis. We then test two
models of exchange-rate determination for' four
currencies vis-a-vis the U.S. dollar. Finally, we
consider the policy implications of the shift in U.S.
policy mix-expanding government debt and contracting money growth-for the behavior of the
dollar-exchange r~te, the conclusion.
Many analysts argued during the early 1970s that
individual countries would gain greater independent control over their domestic stabilization policies if they adopted a system of floating exchange
rates. Two problems related to fixed exchange rates
commanded a good deal of attention before generalized floating actually began in 1973.
First, rapid economic expansion in an open economy often tended to increase imports and decrease
exports, leading to deficits in the balance of payments. A current-account imbalance which was not
offset by capital flows had to be met out of official
foreign-exchange reserves. When pressure on these
reserves increased, a country had to choose between a politically unpopular devaluation or politically unpopular deflationary measures.
* Bisignano is Vice-President and Associate Director of Research, and Hoover was Research Assistant, Federal Reserve Bank of San Francisco.
Hoover is currently a research fellow at Nuffield
College, Oxford University. Preliminary work on
this paper was begun while Joseph Bisignano was at
the Bank for International Settlements on sabbatical. Professor Jeffrey Frankel (University of California, Berkeley), David King (OECD), and Paul
R. Masson (Bank of Canada) provided useful comments on an earlier version of this paper.
19
eral countries ran large budget deficits in the hope of
stimulating economic growth and getting out of the
recession. The distinguishing feature between
countries, however, was their choice of means to
finance these deficits.
An expansionary budget deficit must be financed. If the central bank buys government bonds
by increasing the reserve base of the banking systern, the debt is monetized resulting in monetary
expansion. If the debt is sold directly to the public, however, the policy may be characterized as
fiscal expansion. In either case, the debt is ultimately held by the public either as money or as
government debt.
Wary of kindling rapid inflation, some countries-notably Japan-shifted their policy stance
in the 1974-75 recession away from monetary
expansion towards fiscal expansion. Others maintained the previous balance between monetary
and fiscal policy, while some shifted toward monetary expansion.
The United States showed a fairly consistent rate
of monetary expansion between the 1968-73 and
1973-79 periods-slightly lower after floating began than before (Table I). Germany, the United
Kingdom and (especially) Japan showed lower
monetary growth between the two periods, while
Canada and Italy showed increasing rates of growth.
The disparities in fiscal expansion were even
greater (Table 2). Every country in our sample
displayed a major increase in total government debt
between 1968-73 and 1973-79. In the latter period,
government debt increased between 94 percent (the
U.S.) and 667 percent (Japan), with the increases
elsewhere spread between 100 and 300 percent.
The expansion of government debt was particularly noticeable in Japan. Following the 1973 oil
crisis, Japan's sectoral saving behavior changed
dramatically. According to flow-of-funds statistics,
the public-sector deficit as a percent of nominal
GNP rose from 2 percent to 9 percent between 1973
and 1978, while the corporate-sector deficit dropped
from about 6 percent of nominal GNP in 1973 to
almost zero in 1978. According to the Bank of
Japan, following the oil crisis, Japan and other
countries "resorted to fiscal me~ures in an attempt
to stimulate business activity, which caused the
substantial increase in the financial deficit of the
public sector. Subsequently, the financial deficit of
the public sector in leading Western countries has
tended to decrease, while in Japan it has accelerated, necessitating massive issues of public bonds,
mostly government bonds, which caused the inevitable increase of the stock of public bonds."2
Table 1
Annual Average Growth of
M-2 Money Supply
(Percent)
Table 2
Percentage Increase in
Total Government Debt
(Percent)
1968-73
1973-79
Canada
29.1
139.2
Germany
30.0
230.2
France
-14.1
186.9
209
Italy
127.1
301.7
20.2
12.0
Japan
102.1
666.8
U.K
15.8
11.4
U.K*
10.6
134.2
U.S
9.2
8.5
U.S.
21.4
93.9
1968-73
1973-79
Canada
12.3
17.0
Germany
I I. I
8.6
Franee
14.2
14.4
Italy
16.9
Japan
SOURCE: International Financial Statistics, [MF, November
1981 Data Tape, Lines 88 and 88b. *U.K. figures are for national
debt in sterling; csa Financial Statistics, February 1979 and
February 1981.
SOURCE: International Financial Statistics, [MF, November
1981 Data Tape, Lines 34 and 35.
20
I. Monetary-Fiscal Mix
remained rather stable, while Italy’s sigma rose
rapidly after 1976.
Obviously, then, industrialized countries have
employed widely different mixtures of monetary
and fiscal policies in the past decade. The promise
of floating exchange rates has been in that sense
fulfilled. But since exchange rates are now designed
to reconcile policies which would have been incon
sistent under the earlier regime, there arises a ques
tion of just how different mixtures of monetary and
fiscal policy interact to affect exchange rates.
This question takes on heightened significance
for the United States, for obvious reasons. This
country has now adopted essentially a policy fol
lowed by Japan after the first oil price shock: one of
curtailing monetary growth while incurring an ex
pansion in government debt. In early 1982, the
Federal Reserve was continuing its anti-inflationary
policy by attempting to reduce the growth rate of the
narrowly-defined money stock, M-l, while fiscal
One way of capturing the monetary-fiscal policy
mix is to compare the ratio (sigma) of government
bonds held by the public to the central bank’s re
serve money stock. An increase in sigma implies a
financing of new government debt by an increase in
the direct holdings of the public; it represents great
er reliance on fiscal policy than on monetary policy.
As a rough indicator of fiscal-monetary policy
mix, the sigma ratios revealed a major shift in
policy emphasis among major industrial countries
after 1974 (Figure 1). Canada, Germany, Italy and
the U.S. all had sigma ratios roughly between .6
and .8 during the 1973-74 period, with Japan’s sig
ma ratio considerably lower. But a dramatic shift
occurred after 1974. Germany and Japan displayed
a rapid increase between 1975 and 1978, with Japan
moving from the lowest ratio of the five countries
to the second highest. The sigma ratio rose slight
ly for the U.S. in 1975-76 but declined there
after. Canada’s sigma ratio fell in 1974 but then
Figure 1
Ratio of Government Bonds to Reserve Money
Ratio
21
The first and simplest approach is a monetary
model. It maintains that, given the nature of international capital markets, only relative monetary
policies are relevant to determining exchange rates.
Thus we specify and estimate a monetary model
for the rates of Canada, Germany, Italy and Japan
against the U. S. dollar. This simple model does not
provide an adequate explanation of exchange-rate
movements, however. Thus we estimate a more
general model, a portfolio-balance model, which
maintains that both monetary and fiscal policy are
relevant to the determination of exchange rates.
Empirical results for the four currencies vis-a-vis
the U.S. dollar help support this model, by showing
that the exchange rate is affected both by the stock
of money and the amount of government debt. The
mix of monetary and fiscal policy thus is important
to exchange-rate determination in the short run.
policy promised to produce record deficits over the
1982-84 fiscal years. The result of such a change in
monetary-fiscal policy mix is the focus of this paper.
Early theories of the determination of exchange
rates emphasized their role as equilibrators of trade
flows between countries. Recent theories, however,
have insisted on a wider role: the exchange rate in
the short-run must equilibrate the demand and supply of financial assets denominated in different currencies. Equilibrium between supply and demand,
according to recent theories, occurs much more
quickly in financial-asset markets than in goodsand-services markets. The exchange rate thus may
be viewed as the equilibrium relative price of financial assets in the short run but only as the equilibrium relative price of goods in the long run.
In this article, we will consider two asset-market
approaches to the determination of exchange rates.
II. Monetary Model
The most popular theory of exchange-rate determination in the post-floating period has been the
monetary approach.' The exchange rate, as the value of one country's currency expressed in units of
another's currency, thus may be viewed as a measure of the relative price of goods between the two
countries, for the value of a country's currency is
just the inverse of its price level.
This monetary approach is distinguished by three
key assumptions. First, there is continuous equilibrium in money and goods markets. Second-a
related point-there is also purchasing power parity, since a unit of one's home currency always buys
as much at home as that same unit buys abroad when
converted into foreign currency.4 Third, there is
perfect substitutability among all bonds, foreign
and domestic-' 'there is only one bond in the
world." Thus the only way in which foreign and
domestic asset markets are distinguished is by their
different currencies. Furthermore, different mixtures of monetary and fiscal policy do not affect the
exchange rate, because by this assumption bonds
issued by any government simply increase the
world bond stock. U.S. dollar denominated bonds
are perfect substitutes for yen denominated bonds in
private portfolios.
As a necessary consequence of these assump-
tions, there is interest-rate parity-or, equivalently,
perfect capital mobility. Abstracting from expectations of appreciation or depreciation, any deviation
of a country's interest rate from the rest of the
world's is reversed by a capital inflow or outflow.
Given these assumptions, the monetary approach
suggests that monetary equilibrium exists in each
country at the intersection of the aggregate supply
and demand curves for money. Because continuous
equilibrium is assumed, one need in theory only
attend to the demand curve (or equally to the supply
curve), for the country is always on both of the
curves.s The monetary approach is fundamentally a
hypothesis of the stability of demand for money
functions across countries.
Money demand is usually thought to be a function, among other things, of the price level, real
income and interest rates. Equilibrium, then, guarantees a unique price level in each country for given
amounts of those variables, and with all other influences on money demand held constant. Purchasingpower parity requires-again as an equilibrium
condition, not as a theory of causation-that the
exchange rate between any two countries be at a
level which preserves the value of one currency
measured in goods when it is converted into the
other.
22
Fonnally, let the money-demand function of the
home country be written:
m= c
+ p + ay
f3i
third, the coefficient on relative interest rates is
positive. An increase in e is a depreciation of the
home currency. Thus, other things constant, an
increase in the domestic money supply should produce an equiproportional depreciation of the exchange rate; an increase in domestic real income
should produce an appreciation; while an increase
in the domestic rate of interest should produce
a depreciation.
This last result may seem illogical: commonly it
is thought that a country supports its exchange rate
by forcing interest rates up. In this model the opposite result holds because, given real income and
money, and given the assumption of money-market
equilibrium, an increase in interest rates reduces
the demand for money, producing incipient excess
supply. By equation (4) prices of goods must rise
in order to equate money demand to the existing
supply, or else the equilibrium assumption will be
violated. This price rise produces a depreciation
because of purchasing-power parity.
We can make the model dynamic by assuming
further that purchasing-power parity holds only in
the long run because prices adjust only slowly.
Some such assumption must be made in practice
to explain extended departures from purchasingpower parity.
The monetary approach is deceptively simple.
Without any further assumptions, the simple model
of equation (5) can be extended to include expectations of exchange-rate movements. The interest-rate
parity assumption is equivalent to an assumption
of completely effective arbitrage-that is, any sustained difference in interest rates must be reflected
in the difference between spot and expected future
exchange rates. Fonnally, for small differentials in
interest rates:
(1)
where m is money; p is prices; y is real income; and
c is a constant, all written in natural logarithms: i is
the rate of interest, and a and f3 are parameters. This
relationship is assumed to hold contemporaneously
for all variables.
Similarly, let the money-demand function for the
foreign country be written:
m* = c*
+ p* + a*y* - f3*i*
(2)
Purchasing-power parity requires that:
e = p - p*
(3)
where e is the logarithm of the exchange rate in units
of home currency per unit of foreign currency.
Making the further assumptions that a = a* and
f3 = f3*-that is, that the money-demand functions
are identical between countries-and subtracting
equation (2) from equation (I), yields:
(m - m*) = (c
c*) + (p - p*)
f3(i - i*)
+ a(y - y*)
(4)
Substituting equation (3) into equation (4) and rearranging gives
e= C
+ (m - m*)
a(y - y*)
+ f3(i
i*) (5)
where C = c* c.
The assumption of identical coefficients in both
money-demand functions greatly simplifies the development of the model. This is arbitrary, however,
and a slightly more complicated version could be
developed without imposing such a restriction.
Equation (5) is the fundamental equilibrium
condition of the simple monetary model of exchange-rate detennination. It suggests three testable hypotheses: first, the estimated coefficient
(elasticity) with respect to changes in relative
money supplies is positive and unity; second, the
coefficient on relative real income is negative; and,
i - i*
e
=e
e
(6)
where is the forward exchange rate over the period
equal to the time of maturity of the bonds to which i
and i* correspond. Substituting equation (6) into
equation (5) and rearranging:
23
Equation (7) suggests that an expectation of an
appreciation reflected in a fall in the forward rate
would be reflected in a spot depreciation as well.
The spot rate, then, is not independent of the forward rate. However, if we assume the forward rate
is the expectation of the future spot rate, conditioned on past and current values of the spot rate,
then the forward rate is itself not independent of
the spot rate.6 Random errors in determining the
current spot rate-the ut in equation (7)-will be
correlated with the forward rate. This violates the
assumption that the error terms be uncorrelated with
the independent variables, which is necessary if
ordinary least-squares estimates are to be unbiased
and consistent.
In the estimations which follow, we make no
assumptions about expectations of exchange-rate
changes; indeed we estimate the simple model of
equation (5). Nevertheless, because of the interestrate parity condition in equation (6), errors in
determining e t are transmitted to the interest-rate
differential, (it - it*). This again introduces a correlation between an independent variable and the
error term, rendering ordinary least-squares estimates biased and inconsistent.
In order to secure consistent estimates of equations (5), we resort to an instrumental-variables
technique in which the instrument for (i
i*) is
((T (T*), where (T =
In(B/RM), the ratio of
government bonds in private hands to central-bank
reserve money (monetary base). This should be
closely correlated with (i - i*) because (T represents
the mixture of government stabilization policiesi.e., the balance between outside bonds and outside
money. A rise in (T must result either from a rise in
bonds or a fall in reserve money, either of which
tends to raise interest rates. Similarly, a fall in (T
would be associated with a fall in rates. This bondmoney ratio, being under government control,
therefore is exogenous and uncorrelated with the
error term in equation (5).1
The results of the exchange-rate estimations
(Table 3 and Chart I) vary somewhat from country
to country, but they give little support on the whole
for the simple monetary approach. In three of the
four cases, the coefficient on the money differential
is positive as predicted. For Japan it is negative but
statistically insignificant, while in Germany it is
correctly positive though insignificant nonetheless.
In the remaining two cases, the coefficients are of
Table 3
Monetary Model for Currencies of
Canada, Germany, Italy and Japan Against the U.S. Dollar
(Monthly, March 1973 - December 1978)
Independent Variables
Dependent
Variable
In
In
In
In
Constant
(U.S. $
1n(Y us/ y )
fj2
OW
RHO
SER
.03
(5.8)
.948
1.78
.73
.013
.033**
(2.8)
.888
1.94
.86
.034
(ius-i)
a
- 1.27
(9.5)
(Canadian $)
(U.S. $
1n(m us /m)
Summary Statistics
)
(Gennan DM)
(U.S. $
(Italian Lira)
(U.S. $
(Japanese Yen)
.54**
(9.2)
.99
(9.8)
(1.4)
.07
(.28)
-3.06
(6.5)
.67**
(7.3)
.02
(.19)
.02**
(4.8)
.971
1.96
.79
.027
- 8.50
(3.6)
_ .52 w
( 1.19)
_ .30e
( 1.04)
_ .04 a
(5.5)
.958
2.12
.83
.028
-
(0.6)
w
1.51 c
t-statistics in parentheses under the coefficients.
All estimates use the FAIR technique with In(O'
w
0'*) as an instrument (see footnote 7).
** Significantly different from zero at the 99-percent confidence level and of the predicted sign.
c
w
a
Insignificant, but of the predicted sign.
Insignificant and not of the predicted sign.
Significant at the 99-percent confidence level, but not of the predicted sign.
See data appendix for a description of the data.
24
Chart1
Monetary Models
Portfolio Balance Models
Units per
U.S.$
Units per
U.S.$
1.20
1.20
1.15
1.15
1.10
1.10
1.05
1.05
1.00
1.00
.95
Canadian $
.90
1973
1975
1977
.95
1978
1973
1975
1977
1978
1975
1977
1978
1975
1977
1978
1975
1977
1978
Units per
U.S. $
Units per
U.S.$
3.0
3.0
2.6
2.4
2.2
2.2
2.0
1.8
1.8
1.6
1.6
1973
1975
1977
1973
1978
Units per
U.S.$
Units per
U.S.$
900
Italy
950
900
lialy
850
850
800
800
750
750
700
700
650
650
600
600
550
500
550
1973
1975
1977
1978
1973
Units per
U.S.$
Units per
U.S.$
320
360
340
320
Japan
300
280
300
260
280
240
260
240
220
220
200
200
180
160
180
¥
¥
160
1973
1975
1977
1978
1973
25
simple monetary model. The U.S. dollar/Japanese
yen rate is the least supportive of the monetary
approach: every coefficient carries the incorrect
sign or is insignificant. The remaining pair of exchange rates show mixed results. The results were
littled improved with the removal of the assumption
of identical money-demand coefficients, or with a
greater role given to real interest-rate differentials
in the short-run determination of the exchange rate.
The mixed results for the monetary approach
may reflect the instability in U.S. money demand
observed over the 1974-75 period. Instability in
money-demand coefficients would create difficulties even for a more sophisticated form of the monetary approach, such as one distinguishing between
real and nominal interest rates or one permitting
short-run deviations from purchasing-power parity.
the correct sign and significantly different from
zero. Contrary to the prediction of the simple monetary approach of equation (5), however, they are
also significantly different from unity.
The coefficient on the income differential is of
the wrong sign in every case but Japan, and it is
insignificant in every case. In contrast, the coefficient on the interest-rate differential is significant in
every case, of the correct sign for Germany and
Italy and of the incorrect sign for Canada and Japan.
In all, the U.S. dollar/Italian lira rate offers the
best support for the monetary approach: it carries a
significant coefficient with the correct sign on both
the money and interest-rate differentials, while its
incorrectly signed coefficient on the real-income
differential is insignificant. Still, the coefficient on
the money differential is significantly different
from unity, violating a crucial prediction of the
III. Portfolio-Balance Model
As with the monetary approach, the portfoliobalance approach models private sector behavior.
Unlike that model, however, it refers to outside
rather than inside assets, that is, liabilities created
by the public sector rather than the private sector. In
the monetary model, the asset markets of the two
countries are linked by the direct effect of money on
the goods market: money as purchasing power determines the price of goods, and the exchange rate
insures parity between the currencies given these
prices. For such a mechanism, money is whatever
can be used to buy goods-currency, of course, but
also demand deposits and other sufficiently liquid
assets (i.e., inside money).
In contrast, in the portfolio-balance approach the
goods market is pushed into the background. The
exchange rate adjusts the domestic currency value
of foreign financial assets in private portfolios to the
level considered optimal by portfolio holders, given
interest rates and asset stocks. Money and bonds are
treated as forms of wealth. Since inside assets (e.g.,
demand deposits or corporate bonds held domestically) are at once the asset of some private entity
and the debt of some other private entity, they
cancel out when all private-sector assets and liabilities are added up. Only the liabilities of the
government-currency, central-bank reserves, and
treasury debt-and of the foreign sector are net
Some of the empirical failings of the simple
monetary model of exchange-rate determination
can be explained if we relax some of the model's
assumptions. The beauty of the monetary model is
its simplicity; but what it loses in simplicity when
these assumptions are relaxed, it gains in greater
realism. Abandoning the assumption of perfect
substitutability between domestic and foreign
bonds implicitly introduces portfolio-balance considerations into the monetary model. In this section,
we set out a fuller model of international portfolio
balance and estimate it.
With this approach, we widen the scope of the
model to include the demand functions for money,
domestic bonds and foreign bonds, each dependent
on the domestic and the foreign rate of interest for a
given expected future exchange rate. In the short
run, the supplies of all three assets are fixed. Domestic bonds and money are determined by the
monetary and fiscal authorities. Domestic holdings
of foreign bonds represent cumulated currentaccount surpluses and deficits. Total wealth denominated in domestic currency equals the sum of
these asset stocks, with the foreign bond stock
converted at the current exchange rate. The interest
rates and the exchange rate must simultaneously
adjust in order to bring the demands for these stocks
into accord with the fixed supplies.
26
The formal structure of the model is:
financial wealth to the private sector. A change in
interest rates may force an individual to alter his
holdings of inside as well as outside assets, yet
taken as a whole the private sector is in equilibrium
once it willingly holds all the outside assets supplied
to it by the government.
The portfolio-balance approach directly models
financial markets. The price level of the home or
foreign country plays no direct part in the short run,
yet the goods market still influences financial equilibrium in this approach. From the home country's
view, higher prices abroad encourage domestic
exports and discourage imports. A resulting current-account imbalance must be counterbalanced by
capital flows into the home country. These capital
flows are simply newly-acquired foreign assets,
which increase domestic wealth and require interest-rate and exchange-rate changes to rebalance
domestic portfolios.
From this general discussion, we next tum to
a simple portfolio-balance model suggested by
Branson, Halttunen and Masson. 8 This model
shares with the monetary model the fundamental
assumption of continuous financial market equilibrium, which simply means that it is a static and not a
dynamic model. Its equations specify the shares of
wealth willingly held by the private sector in various assets for given interest rates. These equations
do not specify the adjustment process followed by
interest rates or exchange rates as they move from
one equilibrium to another with a change in any of
the asset stocks.
The fundamental distinction between the two
models concerns the substitutability between domestic and foreign bonds; domestic and foreign
bonds are perfect substitutes in the monetary model
but are not in the portfolio model. Purchasingpower parity need not hold even when prices have
fully adjusted, since changes in domestic asset supplies can alter interest rates so as to drive the exchange rate away from its purchasing-power parity
value over a sustained period.
A further assumption, useful in simplifying the
model and peculiar to it, is that the home country is
small-i.e., it cannot affect the foreign country's
rate of interest. Consequently, the foreign rate of
interest can be assumed to be exogenous.
RM = m(i,i*)W Central Bank Reserve
Money Equilibrium
B =
eF =
b(i,i*)W Domestic Government
Bonds Equilibrium
f(i,i*)W Domestically Held
Foreign Bond
Equilibrium
RM + B + eF
W Wealth Constraint
(8)
(9)
(10)
(11)
where RM is central-bank reserve money (monetary base), B is privately-held domestic government
bonds, F is domestically-held foreign assets denominated in foreign currency, e is the exchange rate
expressed in units of domestic currency per unit of
foreign currency (e.g., dollar per Deutschemark), i
is the rate of interest on B, i* is the rate of interest on
F, and W is total wealth defined by the identity,
equation (11). RM and B are assumed to be nontraded assets. The desired fraction of wealth held as
money is m; held as domestic bonds, b; and held as
foreign assets denominated in foreign currency, f.
Although expectations of future exchange-rate
changes are theoretically important in the portfoliobalance model, they are assumed to be static for
simplicity in this exposition. Moreover, because of
the wealth constraint, equation (11), equations
(8)-(10) are not independent. Given Wand any two
of RM, B or F, the remaining one can be calculated
from equation (11); equivalently, anyone of equations (8)-(10) can be eliminated from the system.
For example, with equation (10) eliminated, the
system as written has only two equilibrium equations, but three variables-i, i* and e. It is, therefore, formally undetermined. Here is where the
small-country assumption helps simplify things. If
the home country cannot affect the foreign rate of
interest, then i* = i *, some fixed rate in the extreme
short run. Then only equations (8) and (9) are needed to determine the domestic rate of interest and the
exchange rate.
27
substitutes in domestic portfolios. An increase in
the domestic interest rate, other things equal, increases the demand for domestic bonds and decreases the demand for foreign bonds as shares in
total wealth. An increase in domestic bonds stocks
and outside money shifts the curves (f) up and to the
left. To understand this point, consider an equiproportional increase in Band RM: the ratio (B/RM)
remains constant and therefore for a given i* and
f(i,i*), i remains constant; nevertheless, W has increased [see equation (II)]; and, therefore, by equation (10), eF must be greater by the amount f· Aw.
Now let us consider the effects of changes
in various asset stocks (Figure 2). Begin with a
bond/money ratio (B/RM)" an interest rate i,
and-reading off curve f;-the value of holdings
of foreign assets (eF)',. Now, holding Band F
constant, allow RM to rise so that the bond/money
ratio moves left to (B/RM)(). The new interest rate is
iO' At the same time the increase in the stock of
money shifts the curve f; outward to f" because
total wealth is now greater. The intersection of f,
Let us examine the mechanism through which
this formal model determines the exchange rate. In
the right-hand panel in Figure 2, the ratio of domestic government bonds to outside money (B/RM) is
plotted against the domestic interest rate (i) for a
constant domestic rate of inflation and a constant
foreign rate of interest (i*). The shape of A depends
on the functions m and b. For simplicity we will
assume it to be linear. In the model with equation
(10) eliminated and i* =1*, dividing equation (9) by
equation (8) yields (B/RM) = b(i,i*)/m(i,i*) =
cP(i). Hence for each value of i there is a value of
(B/RM), and vice versa, which is independentofW
and F: for any value of i*, the ratio of domestic
bonds to outside money alone determines the domestic interest rate.
The left-hand panel plots the domestic currency
value of private holdings of foreign assets (eF)
against the domestic interest rate for constant inflation, foreign interest rate and the stocks of domestic
bonds and outside money. The curve (f,) slopes
downward because domestic and foreign bonds are
Figure 2
Determination of Domestic
Interest Rate and Exchange Rate
Domestic interest rate
A
f, /"
A
f',
fo
eF
(S/RM)
(eF)~
(eF), (eF)" (eF);
(S/RM)o
Value of domestically-held
foreign bonds
(S/RM),
Domestic bonds/Reserve
money ratio
28
with io corresponds to (eF)~, which is greater than
(eF)'I' According to our initial assumption, F has
not changed, therefore e must be greater: the exchange rate depreciates as the stock of outside
money increases. (Recall that F represents the
domestic holdings of foreign assets accumulated
through the current account. In the short run with
wealth fixed, the current account is in balance, and
hence F is a given. Any change in domestic assets
then alters the domestic interest rate and the value of
the fixed stock offoreign assets.)
The effect of an expansion of the domestic bond
stock is trickier to gauge. Begin with the domestic
bond/money ratio at (B/RM)o, on interest rate io and
value'of holdings offoreign assets (eF)o on curve fo,
and let the domestic bond stock expand until it
moves to (B/RM) p holding RM and F constant.
The. interest rate increases from io to iI' Wealth
increases, shifting the curve fo outward. It is crucial, however, just how far f shifts. In the case in
which f shifts only to f;, the new value of foreignasset holdings (eF)'1 is less than the initial (eF)o'
With F constant, e must fall in order for (eF) to
reach this level: in this case, an increase in the stock
of bonds appreciates the exchange rate. On the
other hand, when f shifts further out to f l , the new
value of foreign-asset holdings (eF) 1is greater than
(eF)o, and therefore e must rise: in this case, an
increase in the stock of bonds depreciates the exchange rate.
A change in the stock of domestic bonds can thus
either appreciate or depreciate the exchange rate,
depending upon the relative size of two effectsthe one shifting the curve f outward, and the other
moving upward along the given f curve. The situation is familiar in economic analysis: a wealth
effect conflicting with a substitution effect. As
the wealth effect dominates, the exchange rate
depreciates; as the substitution effect dominates,
it appreciates.
Branson has shown that if domestic bonds and
money are better wealth substitutes than domestic
bonds and foreign bonds, the wealth effect will
dominate and the exchange rate will depreciate, and
vice versa. To understand this condition, consider
once again the expansion of the domestic-bond
stock leading to the shift from (B/RM)o to (B/RM)j'
The increase in domestic bonds initially tends to
increase wealth, which in tum increases the demand
for both money and foreign assets at an unchanged
rate of interest. The domestic interest rate must rise
in order to increase the demand for domestic bonds
until it equals the new greater supply-and in order
to decrease the demand for money until it equals its
unchanged supply.
If domestic bonds and foreign bonds are better
wealth substitutes than domestic bonds and money,
the rise in the interest rate that restores the equality
between money demand and supply will produce a
greater drop in the demand for foreign assets than in
the demand for money at the new level of wealth.
The value of the unchange stock of foreign assets
(eF)o would then be greater than demand for them.
Thus with F constant, e must fall-that is, the
exchange rate must appreciate-to bring the value
of the supply of foreign assets into line with demand. A fall in the value of foreign.assets, all else
constant, reduces wealth. The curve f, although
shifting outward in line with the wealth increase in
the domestic bond stock, thus exhibits less of a shift
than that increase by itself would warrant.9
On the other hand, if domestic bonds and money
are better wealth substitutes than domestic bonds
and foreign bonds, the rise in the interest rate from io
to i l (which makes money demand equal money
supply) produces a smaller drop in the demand for
foreign assets. That demand at the new level of
wealth exceeds the value of the unchanged stock
(eF)o' and e thus must increase-that is, the exchange rate must depreciate-to adjust the supply
of foreign assets to the demand. This increase in the
value of the supply of foreign assets, all else constant, increases wealth. Thus the curve f shifts farther out than the increase in the stock of bonds by
itself would warrant.
The effect of an increase in F, the stock of foreign
assets denominated in foreign currency, is straightforward. An increase in F does not change the
bond/money ratio, so the interest rate remains
unchanged. At a fixed exchange rate, the increase in
F would increase (eF), the stock of foreign assets
denominated in domestic currency. This in tum
would increase wealth, and thereby increase the
demand for bonds and money beyond the fixed
stocks of each. Hence, wealth must not increase if
the supply and demand of money and domestic
29
F* and B* for i* now eliminates the "small country assumption" for the U.S.; that is, we cannot
assume that other countries' interest rates are insensitive to the monetary-fiscal policy mix of the
foreign country.
bonds are to be equal. Therefore, (eF) must fall to
its former level. Since F is fixed at its new level,
only e can fall. It will fall in the exact proportion
that F increased: an increase in the stock of foreign
assets denominated in foreign currency, appreciates
the exchange rate by the same proportion (i.e., the
elasticity of e with respect to F is -1).
We have seen the effects of changes in each of the
foreign asset stocks on the exchange rate, other
things held constant. The system of equations (8) (11) can be solved to yield the reduced form:
et
=c +
(+)
a,RM t
(-)
(:t)
+
alB t
+
(-)
a 3 Ft
(+)
(+)
+ {3, RMi + {32 B i + (33 Fi +
ut
where c is a constant and the ut are random errors. 1O
The (+) or
signs over the coefficients indicate
the expected direction of change of the exchange
rate resulting from an increase in the corresponding
asset stock, based on the analysis above.
Our estimation results are reasonably supportive
of the portfolio-balance approach, especially when
contrasted with the estimations of other investigators (see Table 4 and Chart 1). Five of eight coefficients on the domestic-bond stock variables are
(12)
The exchange rate depends on the three asset stocks
and the exogenous foreign interest rate. Following
Branson and his colleagues, we estimate a linear
equation in which i* is replaced by the asset stocks
of the foreign country (indicated by stars), which
are the determinants of i*. The substitution ofRM*,
Table 4
Portfolio-Balance Model for Currencies of
Canada, Germany, Italy and Japan Against the U.S. Dollar
(Monthly, March 1973 - December 1978)
Independent Variables
Dependent
Variable
U.s. $
Canadian $
U.s. $
German OM
U.s. $
Italian Lira
U.s. $
Japanese Yen
Constant
1.128
06.25)
.OOOO3
(.06)
B'
RM US
.0072**
0.02)
.00076
(.86)
.19500· 3 )c
(.52)
.00196*
(2.36)
BUS
.0578
(.54)
c
.00183**
0.32)
c
Summary Statistics
RM'
FUS
F'
.. 01OSc
(.61)
ww
.00274
(4.01)
.25600· 5)c
<.73)
.960 2.16
.76
.0109
.749(10· 3 (
(,96)
.714(1O·6 )c
(1.66)
.920
1.90
.44
.0129
W
.00235
(2.08)
OW RHO SER
.. 38200. 5 )*
(2.48)
.76600· 8 )c ..99500· 6 )w .. 23(]O·7)** .. 22800· 5 )c _ .77100· 8 )w
(.44)
(.64)
(1.55)
16)
0.35)
.973
1.86
.80
.0362
.0024
(3.3)
..99 I( 10-5 )*
(2.33)
.45300.7)*
(2.03)
.963
2.04
.65
.0001
o
.94500· 7)w
0.34)
.15200-4)c
(1.45)
t·statistics in parentheses under the coefficients.
All estimates use the FAIR technique with RM f assumed endogenous.
f- superscript indicates foreign'country variables; US superscript indicates United States' variables.
*
iP
.00221
(7.03)
.465( 1O.5 )c
(.61)
(13)
Sil,'T1ificantly different from zero at the 95·percent confidence level and of the predicted sign.
** Significantly different from zero at the 99-percent confidence level and of the predicted sign.
c Insignificant, but of the predicted sign.
w Insignificant, and not of the predicted sign.
W Significantly different from zero at the 95·percent confidence level, but not of the predicted sign.
WW Significantly different from zero at the 99·percent confidence level, but not of the predicted sign.
See data appendix for a description of the data.
30
.14100- 6 )*
(2.05)
try's own viewpoint, which is consistent with
domestic bonds and foreign bonds being better
substitutes than domestic bonds and money.
Only for the U.S. dollar/German DMequation is
the coefficient on the United States' reserve-money
stock significant and of the correct sign. In the other
equations it is insignificant and, in the case of the
U.S. dollar/Italian lira rate, of the wrong sign
as well. The foreign reserve-money stock shows
mixed results. It is insignificant in two cases-of
significant, which suggests that the simple monetary model errs in omitting consideration of nonmonetary assets. We have shown above that the
coefficients on domestic-bond stocks could take
either sign in theory. Interestingly, there is great
consistency in the sign pattern: negative coefficients on the United States' bond stock, BUS, and
positive coefficients on the foreign-bond stock, Br.
In other words, an increase in the domestic-bond
stock appreciates the exchange rate from a coun-
Chart 2
U.S. Effective Exchange Rate and Purchasing Power Parity
1975 = 100
1975 = 100
114
114
112
112
110
110
108
106
Purchasing power parity'
~
104
104
102
102
100
100
98
98
Effective exchange rate" orr
96
96
94
94
o ...............I-..r.....I....I...J....I-.l..L....I...J....I-..r.....I.....t....J~.I..L...L..L..L...L..I.
1975
1977
1979
• Trade-weighted index of foreign wholesale prices relative to
U.S. wholesale prices.
*' Trade-weighted value of the U.S. dollar in terms of the currencies
of fifteen trading partners.
Source: Morgan Guaranty World Financial Markets.
31
• .lLLU.I.I..I.IJ.I,.L.U.l.~l.U.I.Ju.I 0
1980
1981
folio-balance model, both domestic bond stocks
and the Japanese foreign-bond stock are significant,
while both reserve-money stocks are not. This
suggests that non-monetary, financial variables are
crucial in determining this rate. To the extent that
the monetary model assumes these variables away,
then one would expect it to fail.
The Canadian and German equations are flawed
in having significant coefficients with the wrong
sign. The German reserve-money stock carries a
positive, rather than the expected negative sign.
U .S. foreign-asset stock in the Canadian equation
carries the incorrect, positive sign. Canada is a
difficult country to model, however, because of the
close integration of the U.S. and Canadian financial
markets. A significant amount of Canadian debt is
denominated in U.S. dollars, which muddies the
distinction between domestic and foreign assets for
both countries and probably confuses the estimation
of such simple models as those presented here. 11
When we compare the IPs reported for each
equation in Tables 3 and 4, we clearly see that portfolio-balance models generally track actual exchange
rates better than the simple monetary model. (For
Italy they do about the same.) A casual inspection of
the charts strikingly reveals the same point. (For
convenience, Chart I presents fitted and actual values of the exchange rate expressed as units of foreign currency per dollar, rather than as estimated.)
the correct sign with respect to Canada and of the
wrong sign with respect to Japan. It is significant
and of the correct sign in the case of the Italian lira,
but significant and of the incorrect sign in the case of
the German DM.
The coefficient on the United States' foreignasset stock is significant and of the wrong sign in the
case of Canada-but of the correct sign, though
insignificant, for the other rates. The coefficients on
the foreign countries' foreign-asset stock are again
mixed: of the correct sign but insignificant for Canada and Germany; of the wrong sign though still
insignificant for Italy; and of the correct sign and
significant for Japan.
In all, the equations for the U.S. dollar/Japanese
yen and the U.S. dollar/Italian lira best support the
portfolio-balance approach-in both equations, the
only coefficients with incorrect signs are statistically insignificant-yet these equations tell different
stories. The lira equation provided the most support
for the monetary approach. In the portfolio-balance
model, the U. S. bond stock and Italian reserve
money are significant in explaining the exchange
rate. The significance of these two factors-because
bonds are a direct influence on the interest-rate
differential and reserve money on the inside-money
differential-is broadly consistent with the relative
success of the Italian monetary equation.
The Japanese yen equation provided the least
support for the monetary approach. With the port-
IV. Conclusions and Policy Implications
of Italy and Japan. The portfolio-balance model is a
more general model, since it includes more assets
and does not restrict the degree of substitutability
between them. Other technical differences notwithstanding, the monetary model can be thought of as a
portfolio-balance model in which domestic and foreign bonds are perfect substitutes.
The argument can be made that the monetary
approach was not given a fair test. All exchange
rates estimated were vis-a-vis the U.S. dollar and,
as is now well known, a "shift" in U.S. money
demand appears to have taken place around 197475. Thus the assumption of stable money-demand
functions may not have held over the estimation
period. Nevertheless, when cross-exchange rates
not involving the dollar were estimated-e.g., the
In the period since floating began in March 1973,
the five countries in our study followed very different domestic economic policies and exhibited very
different exchange-rate patterns. Over the period
covered by our estimations, the rate against the
U.S. dollar appreciated sharply for Germany and
Japan and depreciated sharply for Canada and Italy.
Our estimations suggest that asset-market models
help explain these movements. So it is fair to say
that they are explained-at least in part-by different mixtures of economic policies adopted by th<;:se
various countries.
To be sure, the monetary model-even in the
best case, Italy-is not well supported. But the
portfolio-balance model generally is moderately
well supported, and does strikingly well in the cases
32
DM/yen exchange rate-the monetary approach
still did not perform any better.
Our results should be interpreted cautiously. The
estimations cover a limited period, and the quality of the data is often poor~especially for the
foreign-bond stocks in the portfolio-balance models. Still, our estimations are favorable enough to
encourage further research emphasizing the effects
of financial-policy mixtures on the behavior of
exchange rates.
The policy implications must also be viewed
cautiously. The portfolio models estimated here are
short-TUn models whose long-run implications have
not been empirically described. Nonetheless, the
estimated portfolio models suggest that the dollar
exchange rate against the German mark, Italian lira
and Japanese yen will appreciate in the short run
should the U.S. run a sizable government deficit
which is financed in the private market. Our evidence suggests that, in the short run at least, a
combination of large Federal deficits and slow
monetary-base growth will result in a major appreciationofthe U.S. dollar.
As Charles Pigott has shown in the Fall 1982
issue of this Review, substantial and prolonged
deviations from purchasing-power parity occurred
in recent years between the U.S. and other major
industrial countries. 12 (See Chart 2.) Pigott attributes the deviations to shifts in relative prices. Such
deviations could also be due to the behavior of real
interest rates, caused by changes in the monetaryfiscal policy mix among major countries. A large
increase in U.S. government debt in 1982, com-
bined with low monetary growth, would thus continue to keep the effective (trade-weighted) U.S.
dollar-exchange rate away from its purchasingpower value, as has occurred since late 1980.
If the dollar remains strong, U. S. goods exports
could remain weak for some time, primarily because 98 percent of U.S. exports are denominated
in dollars. However, a strong dollar does not necessarily imply that other countries' net.exports will
improve at our expense. Such a development would
depend on the currency composition of various
countries' exports. In 1980, for example, Japan
denominated 61 percent of its exports in dollars,
and 93 percent of its imports. 13 For Germany the
U.S.-dollar denominations were 7 percent for exports and 33 percent for imports. Hence, in the
short run, a strong dollar could hurt the net export
earnings of some of our trading partners as well as
the U.S.
The strength of the dollar also affects other countries by the valuation effects on their financial
wealth denominated in dollars. Many European
countries and middle-Eastern oil exporters have a
large portion of their net financial wealth denominated in dollars. A continued strong dollar in 1982
could provide positive wealth effects to countries
which otherwise would be weakened by that factor.
The exchange value of the dollar thus affects a
country's net wealth position as well as its demands
for exports and imports. Testing alternative theories
of exchange rates helps to improve our understanding of how macroeconomic policy affects trade
flows and the value of national wealth.
33
Data Appendix
official holdings by foreigners of home country's debt-direct investment in home country». Generally, we accumulated surpluses
(deficits) on current account less changes in
reserves over annual benchmarks for net
foreign-asset positions. We then interpolated
this quarterly series to monthly. Sources for
benchmark data were:
Data for both the monetary and the portfolio
models cover five countries-Canada, Germany,
Italy, Japan and the United States. Except where
noted in other sections, all data come from the
following sources:
- Board of Governors of the Federal Reserve system, Statistical Release H.6 (FRB), various
issues.
- International Monetary Fund, International Financial Statistics (IFS), February 1980.
- Morgan Guaranty Bank, World Financial Market (WFM) , various issues.
Unless otherwise noted all series run from 1972
to September 1979, even though the estimation period is generally March 1973 to December 1978.
Seasonally adjusted (SA) data are used. Unless
noted differently, all seasonally adjusted data are
adjusted over the period January 1972 to September
1979 (or, for IFS data, to latest available date), with
the use of the XII (multiplicative) method. For
series that are sums or differences of component
series, the components are seasonally adjusted before computations are made.
All stock data are expressed in billions of the
national currencies of each country, except for the
foreign asset stock (F) for Canada and Germany,
which are expressed in millions.
-
-
Bank of Canada Review, February 1980,
Table AIS.
Monthly Report of the Deutsche Bundesbank, October 1979, pp. 27-34.
Bank of Japan, private communication.
Bank of Italy, Annual Report, 1976,
Tables GIS, G 20, G 21.
Department of Commerce, "International Investment Position of the United
States," Table 3, Survey of Current Business, September 1977 and August 1979.
For further details, see data appendix of J. Bisignano and K. D. Hoover, "Alternative Asset Market
Approaches to Exchange Rate Determination,"
Federal Reserve Bank of San Francisco Working
Papers in Applied Economic Theory and Econometrics, No. 105, August 1980.
I
= short-term interest rate = WFM representative money-market rate.
Variable Names and Definitions
B = net private claims on government (private
ownership of government debt) = IFS line
32an (Monetary Survey: Claims on Government (net) (SA)-IFS line l2a (Central Bank:
Claims on Government) (SA)
m
widely defined money stock = IFS line 34
(Money) (SA) + IFS line 35 (quasimoney) (SA). This obtained for all countries except the U. S., for which m = FRB
M-2 (old definition) (SA).
e - end-of-period exchange rate (U.S. dollars
per foreign unit) = l/(IFS line ae (Market
Rate/Par or Central Rate»
RM
central-bank money (monetary base) =
IFS line 14 (Reserve Money) (SA).
y
real income proxied by the index of industrial production = IFS line 66 ..C (Industrial Production) (SA).
cr
= ratio of net private financial claims on gov-
F
net private financial claims on foreigners
«total foreign assets held less official reserves and government holdings of foreign
debt less direct investment in foreign countries) less total liabilities to foreigners less
ernment to central-bank money = B/RM.
34
FOOTNOTES
1. See for example H. G. Johnson, The Case for Flexible
Exchange Rates, Institute for Economic Affairs, London
1969, or Egon Sohmen, Flexible Exchange Rates, University of Chicago Press, 1969. The advocates of floating
of course carried the day; nevertheless, the battle was
pitched: see for instance Paul Einzig, The Case Against
Floating Exchanges, Macmillan, St. Martin's Press, 1970,
and a retrospective survey of the debate in H. Fournier
and J. E. Wadsworth (eds.) Floating Exchange RatesLessons of Recent Experience, Leyden: A. W. Sijthoff,
1976. With the turbulent experience of the 1970's behind
us, the lines of battle are joined once more: see Gottfried
Haberler, "Flexible-Exchange Rate Theories and Controversies Once Again," American Enterprise Institute Reprint
No. 119, January 1981.
lation. Consequently, we now estimate it using the FAIR
technique, an estimation method which guarantees consistent estimates when using Cochrane-Orcutt corrections for
first-order serial correlation with instrumental variables.
See Ray C. Fair, "The Estimation of Simultaneous Equation Models with Lagged Endogenous Variables and First
Order Serially Correlated Errors," Econometrica (May
1970).
8. "Exchange Rates in the Short Run: The Dollar
Deutschemark Rate," European Economic Review, 10,
(1977) pp. 303-324. For other expositions, see W. H. Branson and H. Halttunen, "Asset-Market Determination of
Exchange Rates: Initial Empiricaland Policy Results," in J.
P. Martin and A. Smith (eds.), Trade and Payments Adjustment under Flexible Exchange Rates. London: Macmillan, 1979; W. H. Branson, ''Asset Markets and Relative
Prices in Exchange Rate Determination," Sozialwissenschaftliche Annalen, Band 1, 1977, pp. 69-89; and Joseph
Bisignano and Kevin Hoover, "Alternative Asset Market
Approaches to Exchange Rate Determination," Federal
Reserve Bank of San Francisco, Working Papers in Applied Economic Theory and Econometrics, No. 105,
August 1980.
2. "Recent Trends in the Flow of Funds in Japan-Centering on the Expansion of Public Sector Deficit," The Bank of
Japan,Economic Research Department, Special Paper
No. 79, p. 1, December 1978. Examination ofthe individual
country summaries in the various issues of the O.E.C.D.
Economic Outlook also confirm that public debt expanded
in major industrial countries following the 1973 oil crisis,
especially in Japan.
9. H. Genberg and H. Kierkowski, in "Impact and LongRun Effects of Economic Disturbances in a Dynamic Model
of Exchange Rate Determination," Weltwirtschaftliches
Archiv (1979), provide a very similar analysis with a diagram quite like Figure 3.
3. Two useful reviews of general asset-market and specific
monetary-models approaches may be seen in Michael
Mussa, "Empirical Regularities in the Behavior of Exchange Rates and Theories of the Foreign Exchange Market," in Policies for Employment, Prices, and Exchange
Rates, North-Holland Publishing Company, 1979, and
John F. O. Bilson, "Recent Developments in Monetary
Models of Exchange Rate Determination," International
Monetary Fund, Staff Papers (January 1979). A representative selection of estimated monetary/exchange-rate
models is contained in Jacob A. Frenkel and Harry G.
Johnson, eds., The Economics of Exchange Rates:
Selected Studies, Addison-Wesley Publishing Company
(1978). An important extension of the monetary approach
stressing real interest rates is found in Jeffrey Frankel, "On
the Mark: A Theory of Floating Exchange Rates Based on
Real Interest Differentials," American Economic Review,
September 1979.
10. See Bisignano and Hoover (''Alternative Asset Market
Approaches .. :'). Branson, et al., in fact, drop the domestic
bond stocks, Band B*, for the econometrically spurious
reason that the sign of their coefficients cannot be determined a priori (Branson, et al., 1977, p. 311). Whether or not
the sign of the coefficient is known in advance, an omitted
variable biases the regression. The portfolio-balance model presented here is a model of private behavior. Of course,
it is well known that governments intervene in foreignexchange markets to support their own or another country's
currency. We do not plan to model this process here. Nevertheless, we must mark its effect: buying and selling foreign
exchange produces changes in the monetary base; if these
transactions are. related to the exchange rate (e.g., the
domestic government sells foreign exchange when the
exchange rate depreciates, decreasing its monetary base,
and buys when the rate appreciates, increasing its monetary base), then errors in determining e, the ut in equation
(13), will be correlated with RM. Such a correlation violates
the conditions necessary for ordinary least-squares estimates to be unbiased and consistent. Consistency can be
obtained by using an instrumental variable technique. Preliminary estimations showed that the ut in equation (13)
have substantial first-order serial correlation. Consequently, we have estimated equation (13) using the FAIR technique, an instrumental variable estimator with CochraneOrcutt corrections for.first-order serial correlation described
earlier.
4. Abstracting of course from transportation costs and
barriers to trade.
5. In practice, this is possible only if the demand curve is
more stable than the supply curve-that is, if the supply
curve is subject to more shocks or random error than the
demand curve-or if econometric identification can be
secured in some other way.
6. See Bilson (note 3 above) for an illustration of the use of
rational expectations in the monetary approach, where the
forward rate is equated to the mathematical expected value
of the future spot rate. The now-common procedure showing that the current spot rate is a function of the entire future
history of expectations of the exogenous variables originates with Thomas J. Sargent and Neil Wallace, "Rational
Expectations and the Dynamics of Hyperinflation," International Economic Review (June 1973).
11. In a forthcoming paper, "Some Suggested Improvements to a Simple Portfolio Balance Model of Exchange
Rate Determination with Special Reference to the U.S.
Dollar/Canadian Dollar Rate," Weltwirtschaftliches Ar-
7. Initial estimates of equation (5) for several countries
showed the presence of substantial first-order serial corre-
35
13. See SAB. Page, "The Choice of Invoicing Currency in
Merchandise Trade," National Institute Economic Review (November 1981). Page notes that invoicing some
portion of exports and imports in both domestic and foreign
currencies tends to smooth the adjustment to exchangerate changes, and results in less severe J-curves than
would result when all export transactions are denominated
in the exporters' home currency.
chiv, (Heft 1, 1982), we attempt to improve the portfoliobalance model for Canada by: 1) using bilateral data for the
holdings of foreign asset stocks; 2) explicitly dealing with
the problems of currency of denomination; and 3) setting
out a more general portfolio-balance model which does not
make the small-country assumption. In addition, we use
tests of Granger/causality to test the appropriateness of
the small-country assumption for the case of Canada.
12. See Charles Pigott, "The Influence of Real Factors on
Exchange Rates," Federal Reserve Bank of San Francisco
Economic Review (Fall 1981).
REFERENCES
Bilson, John F. O. "Recent Developments in Monetary
Models of Exchange Rate Determination," International Monetary Fund, Staff Papers, January 1979.
Frankel, Jeffrey, "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials,"
American Economic Review, September 1979.
Bisignano, J. and Hoover, K.D. "Alternative Asset Market
Approaches to Exchange Rate Determination," Federal Reserve Bank of San Francisco, Working Paper in
Applied Economic Theory and Econometrics, No.
105, August 1980.
Frenkel, Jacob A. and Johnson, Harry G. (eds.),. The
Economics of Exchange Rates: Selected Studies,
Cambridge: AddisonWesley, 1978.
Genberg, H. and Kierkowski, H. "Impact and Long-Run
Effects of Economic Disturbances in a Dynamic Model
of Exchange Rate Determination," Weltwirtschaftliches Archiv, 1979.
"Some Suggested Improvements to a Simple Portfolio Balance Model of Exchange Rate Determination
with Special Reference to the U.S. Dollar/Canadian
Dollar Rate," forthcoming, Weltwirschaftliches Archiv, (Heft 1,1982).
Haberler, Gottfried "Flexible Exchange Rate Theories and
Controversies Once Again," American Enterprise Institute Reprint No. 119, January 1981.
Branson, W. H. "Asset Markets and Relative Prices in
Exchange Rate Determination," Sozialwissenschaftliche Annalen, Band 1,1977.
Johnson, H. G. The Case for Flexible Exchange Rates,
London: Institute for Economic Affairs, 1969.
Mussa, Michael "Empirical Regularities in the Behavior
of Exchange Rates and Theories of the Foreign Exchange Market," in Policies for Employment Prices
and Exchange Rates, Amsterdam: North-Holland,
Branson, W. H. and Halttunen, H. "Asset Market Determination of Exchange Rates," in Martin, J. P., and Smith,
A. (eds.), Trade and Payments Adjustment under
Flexible Exchange Rates, London: Macmillan, 1979.
1979.
Branson, W. H., and Halttunen, H. and Masson, P. "Exchange Rates in the Short-Run: The Dollar Deutschmark Rate," European Economic Review, 1977.
Organization of Economic Cooperation and Development,
Economic Outlook, various issues.
Einzig, Paul The Case Against Flexible Exchanges,
London: Macmillan and S1. Martin's Press, 1970.
Sargent, Thomas J. and Wallace, Neil "Rational Expectations and the Dynamics of Hyperinflation," International Economic Review, June 1973.
Fair, Ray C. 'The Estimation of Simultaneous Equation
Models with Lagged Endogenous Variables and First
Order Serially Correlated Errors," Econometrica, May
Sohmen, Egon Flexible Exchange Rates, Chicago: University of Chicago Press, 1969.
1981.
Fournier, H. and Wadsworth, J. E. (eds.), Floating Exchange Rates-Lessons of Recent Experience,
Leyden: A. W. Sijthoff, 1976.
36
Brian Motley*
ing is treated as a demand for various kinds of assets
which are expected to yield returns in the future, so
that total saving depends on all the factors which
influence the public's purchases of assets. In addition, we consider "saving" to include purchases
not only of financial assets but also of all types
of tangible assets, including homes and consumer
durables. 1 Thus, the term "consumption" refers
only to household purchases of non-durable goods
and services.
The study pays particular attention to the effects
of changes in inflation and unemployment on saving
decisions, in order to discover whether the faster
inflation and higher unemployment experienced in
recent years can explain the observed reduction in
saving rates. It also examines the effect of changes
in tax rates and finds that these have a significant
impact on the saving-consumption decision.
In Section I, the accounting relations between the
household's saving-consumption decisions and its
balance sheet are described. It is argued that because of these accounting relationships, decisions
to spend on current consumption and to purchase
various kinds of assets are likely to be interdependent. Section II examines the main factors influencing saving decisions, with particular emphasis on
the role of changes in tax rates and in the rate of
inflation. In Section III the ideas of the preceding
sections are developed into a formal model suitable
for econometric estimation. Sections IV and V take
up some technical econometric issues and describe
the data used in the empirical work. Section VI
presents the empirical results and their policy implications, and Section VII provides a summary
and conclusions.
Personal-consumption expenditures account for
almost 64 percent of U. S. gross national product.
Hence-the collective decisions of the nation's consumers whether to spend or to save have a powerful
impact on its economic health. High and rising
levels of consumption translate into prosperity for
the nation's retailers, and through them into higher
output and more jobs in the industries producing
consumer goods. On the other hand, economists
worry that if too many of the nation's resources are
channeled into current consumption, capital formation will be slighted, so that productivity growth
will slow and future living standards will be hurt. In
recent years there has, in fact, been a marked decrease in the rate of growth of overall productivity.
At the same time, households have been saving a
smaller proportion of their incomes than they used
to. Although economists do not fully understand all
the reasons for the productivity slowdown, the
simultaneous decline in the saving rate probably has
been a contributing cause. In any event, a key
objective of the Administration's economic program is to boost productivity growth by encouraging personal saving.
This article investigates the aggregate consumption-saving decision in the United States. Although
the determinants of household consumption have
been studied intensively, the present study differs
from most others in that its primary focus is on
saving rather than on consumption. The act of sav-
*Economist, Federal Reserve Bank of San Francisco. Brian Dvorak provided research assistance
for this article.
37
I. Saving and Asset Accumulation
owns relative to the amounts which it wishes to
own. The composition, as well as the total value, of
its asset-portfolio influences its saving decisions.
This is because there are costs involved in buying
and selling assets, and these costs differ as between
different types of assets. Holdings of money, for
example, may be promptly increased or decreased
at no cost since money is the medium of exchange,
whereas altering one's holdings of real estate frequently is costly and time-consuming.
The relevance of this second consideration may
be illustrated by an example. Suppose a household
experiences an unexpected reduction in its disposable income but wants to maintain its level of consumption spending. For this to be possible, the
household must either reduce its asset-holdings or
increase its liabilities. Alternatively, suppose it
wants to buy a new car but would prefer not to lower
its regular consumption outlays. In this case, the
household must reduce its holdings of other assets
or go into debt. In the first case the household's total
stock of assets is reduced, while in the second case
its total stock remains unchanged but the types of
assets in that stock are altered. However, in either
case, the required changes in its asset-holdings will
be relatively easy to accomplish if the household
has large holdings of money or other liquid assets,
but will be more difficult and costly if its assets are
mostly illiquid (such as a home) or if it has substantial debts outstanding. Thus the household's ability
The approach to saving behavior developed in
this article begins with the household's balance
sheet, which shows its assets, liabilities and net
worth on a particular date. Assets include not only
financial assets such as bank accounts, securities
and life-insurance policies, but also tangibles such
as homes, cars and household durables. Net worth
is defined as the difference between total assets and
total liabilities. To illustrate these concepts, Table I
shows the aggregate balance sheet of the household
sector at the beginning of 1980.
During any period a household may use its current income either for current consumption or for
saving. In tum, the portion of its income devoted to
saving may be used either to add to its assets or to
reduce its liabilities. If the household saves but
makes no explicit asset purchase or debt repayment,
its holdings of money-the medium of exchangewill rise. Table 2 thus shows that the total income of
the household sector during 1980 was equal to its
consumption expenditures plus additions to its
holdings of tangible and financial assets minus additions to its liabilities.
Because of this accounting relation, a household's decisions to consume or to save will be influenced by the stocks of assets which it presently
owns relative to the stocks which it wishes to own,
given its current and prospective future income. If a
household wants to add to its net stock of assets, it
must spend less on current consumption, while if it
wants to increase its consumption, it must hold
fewer assets or incur more debts.
Moreover, saving-consumption decisions depend not only on the total stock of assets but also on
the amounts of each kind of asset which a household
Table 2:
Disposition of Household Income: 1980
($ Billions)
Gross Disposable Income
Expenditures on Nondurables and Services
Table 1:
Household Balance Sheet: January 1, 1980
($ Billions)
1911.4
1508.5
+
Purchases of Tangible Assets
313.1
+
Purchases of Financial Assets
279.5
Additions to Liabilities
110.1
Statistical Discrepancy*
-79.6
Total Tangible Assets
3,760
Total Liabilities
1,494
1()tal Financial Assets
6,237
Net Worth
8,503
+
Total Assets
9,997
Total Liabilities and
Net Worth
9,997
* Separate data on consumption and saving do not precisely sum
to income. The discrepancy item is added to close the identity.
SOURCE: Board of Governors of the Federal Reserve System.
SOURCE: Board of Governors of the Federal Reserve System
38
In deciding how much to spend on consumption, a
household must pay attention to the implications of
these decisions for its balance-sheet position. Conversely, household decisions to add to holdings of
particular assets may have short-run implications
for its consumption expenditures, even though in
the long run it plans only to rearrange its assetportfolio and does not contemplate any permanent
increase in its total asset-holdings.
to finance a given spending plan depends not only
on the total value of its assets but also on whether
these assets may be sold easily and cheaply. Indeed,
if the household holds only relatively illiquid assets,
it may prefer to reduce its current consumption
temporarily rather than dispose of those holdings.
Because of these considerations, most households make their consumption and asset-purchase
decisions simultaneously rather than sequentially.
II. Determinants of Asset Demand
According to the basic hypothesis of modem
consumer theory, the main determinant of a household's consumption level is its long-run expected
income. In other words, the household plans its
consumption over a relatively long time horizon, on
the basis'of the after-tax income it expects to receive
over that period and the opportunities it has to delay
or accelerate consumption by the purchase and sale
of assets. By using more of its current income to
purchase assets, the household is able to delay consumption into the future. If it buys financial assets it
can use them later to purchase consumer goods,
while if it buys real assets such as a car or a house,
it receives a future flow of consumption services
from those assets. Conversely, by buying fewer assets in the present, the household can enjoy
more current consumption at the expense of less
future consumption.
Household decisions on the allocation of their
resources between present and future consumption
depend on their preferences and on the asset prices
and yields which they face. If the prices of assets
fall-which means that asset yields rise-a household can obtain more future consumption for each
dollar's worth of present consumption which it
gives up. However, the resultant effect on saving
cannot be predicted a priori on the basis of economic theory alone. At higher yields, every dollar
which is saved in the present and used to buy assets
produces a larger addition to future consumption.
This effect tends to encourage households to save
more and consume less. On the other hand, an
increase in asset yields makes it possible for a
household to save somewhat less today (and consume somewhat more) and still be able to enjoy the
same level of consumption in the future. This is so
because the effect of the lower level of current
savings is offset by the higher rate of return earned
by those savings. This effect tends to encourage
households to save less and consume more now.
There appears to be no consensus among economists as to which of these two effects-the substitution effect and the income effect-will dominate
household behavior. If the substitution effect dominates, an increase in asset yields will serve to increase saving and reduce current consumption,
whereas the opposite will be true if the income
effect is dominant.
Other factors also affect returns on assets and
thus household saving-consumption decisions. Reductions in tax rates increase the after-tax returns on
financial assets as well as the net costs of going into
debt. However, they do not change the returns on
tangible assets since those returns-being in the
form of services-are not subject to taxation. Thus
tax-rate decreases are likely to encourage financial
savings and to discourage the purchase of consumer
durables and homes financed by borrowing. As in
the case of nominal-yield changes, however, the
effect of tax-rate changes on total saving and consumption depends on the relative strength of the
substitution and income effects.
Changes in the inflation rate also influence the
returns yielded by various kinds of assets. In this
case, however, people's responses generally differ
according to whether or not the inflation-rate
change was expected. Given the nominal rate of
interest, an increase in the expected rate of inflation
implies a decline in the expected real rate of return
on financial assets. Tangible assets such as cars and
homes provide their return in the form of consumption services, which are not influenced by a change
39
Table 3
Expected Effects on Saving and Consumption of
Changes in Independent Variables
Dependent Variables
Independent
Variables
General Increase in After-Tax
Real Yields on Assets
Total
Consumption
Net Purchases
of Tangible
Assets
+
+
+
Expected Increase in Inflation
Increase in Unemployment
Net Additions
to Liabilities
?
?
Decrease in Tax Rates
Unexpected Increase in Inflation
Net Purchases
of Financial
Assets
-?
"
+
+?
+
goods prices are made more uncertain by inflation.
The effect of this type of uncertainty on current
saving cannot be predicted unambiguously because, like the effects of changes in asset yields, it
involves both a substitution effect and an income
effect.3 When future consumer-goods prices become more uncertain, the household may choose to
consume more in the present, when prices are
known, and less in the uncertain future. This substitution effect thus tends to decrease current saving.
On the other hand, greater uncertainty encourages
households to save more and accumulate more assets to protect themselves against the possibility of
sharply rising consumer-goods prices. This income
effect thus tends to increase current saving.
Economic theory thus provides no way of predicting the "uncertainty effects" of unexpected inflation on purchases of financial assets. With
regard to purchases of tangible assets, theory provides more guidance. Since the consumption services provided by a house or a car do not depend on
the rate of inflation, the uncertainty effect does not
affect their real rates of return but only household
real incomes. In this case, therefore, theory predicts
that unexpected inflation will cause households to
stock up on tangible assets against the possibility of
even faster price rises in the future.
Apart from the effects of inflation and taxes, we
expect saving behavior also to be influenced by the
rate of unemployment. High jobless rates, like unexpected inflation, tend to increase uncertainty
about future real incomes. Such uncertainty will
cause households to reduce the share of their current
incomes allocated to consumption expenditures in
order to accumulate more financial assets and to
in the rate of inflation. Hence, the expectation of
more rapid inflation will tend to encourage the accumulation of tangible assets at the expense of financial assets. In other words, an increase in the
expected inflation rate with no change in the nominal rate of interest makes it more attractive to sell
financial assets or to borrow in order to buy tangible
assets which yield consumer services. Conversely,
an expectation of decelerating inflation will tend to
discourage purchases of tangibles. Again, the existence of substitution and income effects means that
the effect of expected inflation on aggregate saving
cannot be predicted unambiguously.
So much for changes in the expected rate of
inflation. But what of unexpected inflation? Juster
and Wachtel (1972) and Bisignano (1977) have argiJed that when prices increase unexpectedly,
households become more uncertain about their future real incomes. Wage earners become concerned
about their wage rates keeping up with the cost of
living, while older persons begin to worry about
their retirement savings being eroded by inflation.
Since most households are risk averse; this greater
uncertainty about future real incomes may lead
households to consume less in the present in order to
accumulate assets forthe future. Thus, according to
these writers, unexpected inflation will encourage
personal saving.
However, unexpected inflation not only makes
households more uncertain about the real value of
their future incomes but also increases the difficulty
of predicting the real rate of return on financial
assets. The additional consumption obtained in the
future by giving up a dollar's worth of consumption
now becomes less predictable if future consumer-
40
draw down debt. This "uncertainty effect" of
unemployment is separate from the effect coming
via current income. Higher levels of unemployment
will generally be associated with decreases in current income relative to long-term expected income.
Such decreases tend to cause households to reduce
their savings in order to maintain their accustomed
consumption levels. The income and uncertainty
effects on savings decisions thus are opposite in
sign. In our estimating equations, however, the
income effect will be captured by a current-income
variable. Hence we expect higher levels of unemployment to be associated with larger purchases of
financial assets and smaller additions to debt.
III. Model of Consumption and Asset Purchases
In this section we develop these various concepts
into a theoretical model suitable for empirical testing. This model consists of a set of equations which
describe purchases of each type of asset and expenditures on current consumption, in terms of
the factors influencing the desired stock of each
asset and the rate at which actual stocks are adjusted
to desired levels. These equations appear as Equations (7) and (8) below. The non-technical reader
may, with no loss of continuity, proceed directly to
those equations.
Suppose there are M classes of assets which
households may purchase and hold. These classes
include financial assets 4 such as money or securities, as well as tangible assets such as homes and
consumer durables. The household may use its current income, Y, either to buy consumer goods or to
add to its holdings of assets. Thus, if consumption
expenditure is denoted c and purchases of the m th
asset qm'
Y
= c + q I + .. , + qm + '" + qM
change for one of three reasons. First, the household may purchase more of the asset; second, the
price of the asset may rise so that the household
receives a capital gain; third, previous holdings may
depreciate. Hence the asset stock at date t + I is
equal to the stock at date t plus new purchases and
capital gains minus depreciation. Assuming that
depreciation is a constant proportion of the stock,
this accounting identity may be written:
(m = 1,2, ... , M)
where qmt represents new purchases in the period
between t and t + I, and gmt is the rate of capital
gains. For assets (such as money) with fixed prices,
gmt is identically zero. 8m is the depreciation rate;
for physical assets this represents physical deterioration and obsolescence, while for financial assets it
may be interpreted as representing the change in
market value associated with the approach of the
maturity date. For irredeemable and deposit-type
financial assets, 8 mis identically zero.
The household makes its consumption and assetpurchase decisions simultaneously. In deciding
how much to buy or sell of any asset, the household
compares the stock it desires to hold with the amount
it has inherited from the past-after taking account
of depreciation and capital gains. However, as was
argued earlier, the inherited stocks of other assets
may also influence this decision, since assets differ
in the ease and cost with which they can be bought
and sold. Further, as Equation (1) makes clear, asset
purchases must compete not only with each other
but also with consumption for a share of current
income. This income constraint implies that current
(I )
As was argued earlier, the household's desired
stock of each asset, S~, depends on its long-run
expected income, YE, and on K other variables,
x" ... ,xk'''''X K . These x k variables include the expected and unexpected inflation rates, the tax rate,
the unemployment rate and the real interest rate. It
is convenient to assume that the desired stocks are
proportional to expected income with this proportion depending on the x k variables:
(m= 1,2, ... ,M)
Between any two dates, say t and t + I, the value
of a household's actual stock of any asset may
41
tangible assets. Hence, in this study, the equations
were further transformed so as to eliminate the
inherited asset-stocks. The details of this transformation are provided in Appendix A. Essentially, the
method 7 involves taking the first differences of
Equation (4) and then using Equation (3) to replace
the terms representing the lagged first differences of
the asset stocks by the lagged asset purchases. This
yields a system of equations in which consumption
and purchases of each asset class depend on the
current and lagged values of income and of the xk
variables, and on the lagged purchases (rather than
the lagged stocks) of each asset class. Thus:
income influences expenditures on each asset class,
and conversely implies that current-consumption
expenditures depend not only on current and expected income but also on the inherited stocks of
each class of asset relative to the amounts desired.
The preceding argument implies that asset purchases and consumption expenditures may be written
M
CImt =
~ em; [St+ I -
S;/ I
+ g;t)( I
-
8;8
(m=I,2, ... ,M)
(4)
(5)
+ lfJm
In each of these M + I equations, the terms in
square brackets represent the differences between
the targeted and actual stocks of the M assets. Since
consumption plus total asset purchases are necessarily equal to current income; Equation (5) also
may be written as
+ ~
~~
t
gjtSjt
L..JLmj YE t
j~1
+
M
(I - A ) qmt-I
mm YEt
2:
j~1
(7)
Jfm
M
c t = Yt -
(m = 1,2, ... ,M)
2:qmt
m=1
Y
+ lfJ_t_-1
YEt
(6)
The formal derivation of this stock-adjustment
model is due to Purvis (1978), but earlier versions
may be found in Motley (1968) and Wachtel (1972).
To estimate the parameters of Equations (4) and
(6), the unobservable Sf variables, which represent
the desired asset stocks, must be eliminated. This
is done by substituting Equations (2) into (4) and
(6). This yields a system of equations in which
consumption and asset purchases (each expressed
as a proportion of expected income) depend on the
x k variables in Equation (2), on current income, and
on the inherited stocks of assets. Systems of equations of this type have been estimated by a number
of researchers.6
This approach suffers, however, from the weakness of the data on stocks of assets-particularly
(8)
Equations (7) and (8) represent a system of
M + I equations to be estimated.8 However, the
fact that in every period consumption plus total
asset purchases completely exhaust current income
implies that the coefficients of these equations are
not independent of one another. The coefficients
on current income sum to one across the M + I
equations, because if current income increases by
one dollar, the sum of consumption plus asset
purchases must also rise by one dollar. The coefficients on each of the other variables sum to zero
across equations, because if current income is con-
42
stant, a change in anyone of the dependent variabies must be matched by equal and opposite
changes in the others. Thus the coefficients of
Equations (7) and (8) must satisfy the following
"adding-up" restrictions.
M
2: <Pm
M
<P
m=1
M
2:lLmj
m=1
-ILJ
2:t/Jm
m=l
M
2: Amj
m=!
-t/J
\
M
2:f3mk
m=l
IV. Estimation Problems9
equations. However, when this technique is applied
to a set of equations such as (7) and (8), it yields
a set of estimated parameters which do not, in
general, obey the adding-up restrictions. This is
because, when transformed, the independent variables are no longer the same in each equation. This
means that the estimated coefficients will differ
according to which M out of the M + I equations
we choose to estimate. The problem can be avoided
only if the autocorrelation coefficients are the same
in each of the M + I equations, but the preliminary
estimates suggested that in fact these coefficients
differed significantly across equations. 1O
To avoid this difficulty, the M + I equations
were estimated simultaneously rather than singly. A
distinct autocorrelation coefficient was estimated
for each equation, but the parameter estimates were
constrained to satisfy the adding-up restrictions
across equations. These restrictions ensure that the
untransformed fitted values of the dependent variables satisfy the accounting identity, although the
residuals in the transformed equations do not sum to
zero across equations. Appendix B explains how
these constraints were imposed.
The adding-up restrictions on Equations (7) and
(8) imply that the coefficients of anyone equation
may be deduced from those of the other M equations. As long as the same independent variables
appear in each equation, single-equation ordinary
least-squares estimation preserves these adding-up
restrictions. Hence the estimated parameters of any
one equation may be derived from the parameters of
the others, and the results do not depend on which
M out of the M + I equations the researcher
chooses to estimate. If all M + I equations are
estimated by ordinary least squares, their residuals
sumto zero at each observation, and hence the sums
of the actual and fitted values of the dependent
variables are equal. Thus the fitted values of the
dependent variables satisfy the same accounting
identity [Equation (I)] as do the actual values.
Preliminary least-squares estimates indicated the
presence of significant serial correlation in the residuals from the regression equations. The usual
method of dealing with this problem is to use these
residuals to estimate p, the autocorrelation coefficient, to transform the dependent and each of the
independent variables to the form y, - PY'_I' and to
apply least-squares estimation to the transformed
V. Data Sources
and asset-purchase series do not exactly sum to
measured income. For econometric estimation purposes, however, the data should satisfy the theoretical accounting identities. To deal with this problem,
we assumed that each of the dependent variables is
measured with error and that the sum of these errors
is the statistical discrepancy shown in the accounts.
The variables qm and c in equations (4) and (6) are
replaced by qm + Ymd and c + YM+ld, respective-
The flow-of-funds accounts provide the basic
source of data for the dependent variables. Four
balance-sheet categories were distinguished for this
study: financial assets, financial liabilities, residential capitajll and consumer durables. Gross additions to these four categories 12 plus expenditures on
nondurables and services in principle sum to gross
income after tax.
In the flow-of-funds accounts, the consumption
43
ly, where d represents the discrepancy and the )I'S
are the proportions of the discrepancy representing
errors in each of the M + 1 dependent variables.
When the arithmetic operations of Appendix A are
applied to these modified variables, the result is a
system of equations in which the current and lagged
values of the discrepancy enter as additional independent variables."
As for the independent variables, we derive expected income from gross current disposable income using a method 14 suggested by Michael Darby
(1972). Expected inflation comes from the series
derived by Carlson (1977) from the Livingston
price-expectations data. Unexpected inflation is
simply the difference between the actual and expected rates of inflation. We used a six months' unit
of observation because that represented the fre-
quency of the expectations data.
We computed the real after-tax interest rate by
first multiplying the long-term Treasury-bond rate
by one minus the average personal-income tax rate,
and then subtracting the Carlson expected-inflation
series. This method implies that the interest-rate
variable measures the expected real return rather
than that which actually materialized.
The average tax rate 15 represents the ratio of total
personal-tax payments to total personal income. We
entered this tax rate as a distinct independent variable, as well as using it to construct the after-tax
bond rate, because household decisions respond to
a whole series of after-tax rates of return and not
only to the bond rate. Inclusion of the tax rate
as a separate variable captures its effects via these
other rates.
VI. Empirical Results
The results of estimating equations (7) and (8),
shown in Table 4, are based on a sample of 48
semi-annual observations over the 1955-79 period.
The discussion of these results focuses first on the
factors thought to influence households' long-run
consumption and asset-holding decisions, and then
turns to the adjustment of asset portfolios in the
short run.
Our previous argument suggested that long-run
decisions depend primarily on real tax-adjusted
rates of return-and also on uncertainty about both
future real income and future asset yields. In the
estimating equations, these effects are captured by
five principal variables. 16 The real after-tax yield on
long-term Treasury bonds proxies for the terms on
which households can substitute between present
and future consumption through marketable-securities purchases. Although this yield incorporates
both the expected inflation rate and the average tax
rate, these two variables also are entered into the
equations as separate variables because households
may hold their savings in other forms besides securities. During the sample period, for example, Regulation Q rate ceilings effectively limited the yields
on money and other depository-institution liabilities, so that changes in their real yields mainly
reflected changes in the expected rate of inflation.
Similarly, the real costs of borrowing forthe financing of consumer-durable and home purchases var-
ied in response to tax-rate changes, reflecting the
tax-deductibility feature of nominal borrowing costs.
In interpreting the results, one should be aware
that the distinction between the effects of expected
and unexpected inflation (a proxy for uncertainty)
may be less clear-cut in practice than in theory. This
is because the expected-inflation series measures
the public's inflation expectations at the beginning of each six-month period, which are then probably modified in the light of actual inflation during
the period.
Consider first the effects of the three variables
which represent the real rates of return on financial
assets: the real after-tax interest rate on securities,
the expected inflation rate (representing the negative of the real return on money), and the average tax rate (which influences the real cost of
household debt). Each of these variables has a significant effect on consumption and asset-purchase
decisions, corresponding in most cases with theoretical expectations.
An increase in the real after-tax yield on securities
and a decrease in the expected rate of inflation 17_
which corresponds to a rise in the real yield on
money and other fixed-rate financial assets-both
have the effect of significantly increasing current
consumption and reducing total saving. This result
implies that the income effects outweigh the substitution effects: the same amount of future consump44
tion requires less current savings when real rates of
return are high, so that current consumption increases and saving decreases. Correspondingly, this
negative effect on saving of higher bond rates and
lower inflation expectations also shows up in the
form of a statistically-significant reduction in purchases of financial assets. An increase in the aftertax real rate of return on securities also significantly
reduces saving through the purchase of consumer
durables; this is what theory would predict.
Economic theory also predicts that expectations
of higher inflation will be associated with increased
purchases of homes and consumer durables and
with a corresponding expansion of debt. This would
be expected because more rapid inflation does not
affect the real services provided by these tangible
assets but reduces the real cost of borrowing to
finance their purchase. The results support these
predictions, though the relevant coefficients are not
statistically significant. This may be because the
effects of changes in inflation expectations are
confounded with those of changes in average tax
rates. When inflation accelerates, households are
pushed into higher tax brackets so that the average
tax rate rises at the same time. 18 Increases in tax
rates and faster inflation both act to reduce the
after-tax real interest rate on those financial assets
and liabilities which have institutionally fixed nominal interest rates, and hence would be expected to
have similar effects on asset purchases.
The results discussed so far have important
implications for the current economic situation.
Any success achieved by the Administration and
Federal Reserve in reducing the current high level
of real interest rates would tend to reduce current
consumption and increase saving, as households
would find they must accumulate more financial
assets to achieve given targets for future consumption. Although this effect would be partly offset by
increased demand for household durables, the results suggest that there should be a significant increase in the supply of savings available to purchase
financial assets and thus to finance both business
investment and government deficits.
On the other hand, any success by policy-makers
in reducing the rate of inflation could also tend to
reduce the supply of financial savings, since households would no longer have to set aside resources to
counter the effect of future increases in living costs.
However, with inflation slowing, this negative effect could be at least partially offset by the reduced
tendency for households to be driven into higher tax
brackets through bracket creep. In fact, the effects
on consumption and asset purchases of changes in
average tax rates-whether brought about by legislation or by inflation-are perhaps the most dramatic of this study's results. As Table 4 shows-and as
theory suggests-a higher average tax rate leads to
significant increases in debt-financed purchases
of homes and consumer durables. This is because
higher tax rates reduce the effective cost of borrowing but do not change the real returns to household
capital goods which accrue in the form of untaxed
consumption services.
Consequently, reductions in tax rates should
significantly reduce the household sector's claims
on the nation's resources for capital in the form of
homes, cars and other durables. The corresponding
reduction in the demand for consumer and mortgage credit should release funds to finance both
business plant-and-equipment purchases and government deficits. This "supply-side" argument for
the President's tax-reduction program thus receives
strong support from these results.
The equation describing household consumption
implies that a reduction in the average tax ratewhich increases the real cost of borrowing-also
would significantly reduce total consumption and
thus increase total savings. This means that a tax
cut's tendency to reduce saving in the form of tangible assets would be more than offset by its tendency to discourage household additions to debt
liabilities, so that total saving would rise. This
result suggests that the tax deductibility of ipterest
payments operates as a powerful incentive to both
current consumption and tangible-asset purchases,
so that lower tax rates would reduce expenditures
both on current consumption and on tangible assets.
As pointed out earlier, the consumption equation
also implies that an increase in the real return on
securities would increase consumption and reduce
total saving. The difference between the effects of
an increase in the real return on securities and a
decrease in the average tax rate (i.e., an increase in
the real cost of borrowing) apparently can be explained by the fact that tax changes significantly
affect household decisions with respect to debtfinanced purchases of tangible assets, whereas
45
Table 4
Regression Results
Dependent Variables/ Expected Income
Consumption
of Nondurables
and Services
Purchases of
Household
Durable Goods
Purchases of
Residences
Net Purchases
of Financial
Assets
Net Increase
in Liabilities
Constant
0.780
( 1.838)
0.308
(1.502)
0.026
(0.122)
2.168
(2.436)
1.723
(2.088)
Expected Inflation
- 0.326
(2.408)
0.579
(0.899)
0.078
( 1.174)
0.577
(2.100)
0.387
(1.508)
Unexpected Inflation
-0.260
(5.067)
0.273
(1.119)
0.021
(0.812)
0.360
(3.447)
0.148
( 1.519)
Real After-Tax
Interest Rate
0.120
(3.669)
-0.042
(2.711)
0.024
(1.490)
0.144
(2.208)
-0.042
(0.693)
Average Tax Rate
0.778
(2.062)
I.ln
(6.405)
1.811
(9.459)
- 0.059
(0.072)
3.721
(4.938)
Unemployment Rate
- 0.00003
(0.024)
-0.0019
(2.828)
0.002
(2.868)
0.0072
(2.428)
0.007
(2.665)
Constant
0.695
(1. 849)
- 0.173
(0.950)
-0.018
(0.097)
- 2.130
(2.690)
- 1.626
(2.219)
Expected Inflation
0.075
(0.593)
0.063
(1.049)
-0.140
(2.243)
- 0.317
(1.228)
-0.320
(1.329)
Unexpected Inflation
0.048
(0.874)
- 0.045
(1.730)
-0.006
(0.204)
- 0.082
(0.738)
-0.181
(1.741)
Real After-Tax
Interest Rate
- 0.084
(2.522)
0.014
(0.906)
-0.0031
(0.188)
0.118
(1.713)
0.046
(0.715)
Average Tax Rate
- 1.063
(0.845)
0.394
(0.636)
-0.900
(1.413)
3.418
(1.254)
1.848
(0.739)
Unemployment Rate
0.0011
(0.864)
0.0002
(0.249)
-0.0002
(0.343)
0.0027
(0.955)
0.0015
(0.570)
Disposable Income
0.233
(3.261)
0.138
(3.897)
0.038
(1.056)
0.608
(3.903)
0.016
(0.114)
Lagged Disposable Income
0.802
(7.982)
- 0.070
(1.385)
0.004
(0.082)
- 0.363
( 1.569)
0.364
(1.739)
Purchases of
Household Durables
- 0.702
(1.804)
0.205
(4.144)
0.007
(0.033)
- 0.734
(0.867)
- 1.224
(1.576)
Purchases of Residences
- 0.754
(2.083)
- 0.471
(2.624)
0.790
(1.140)
- 1.483
(1,863)
1.918
(2.637)
Net Purchases
of Financial Assets
-0.865
(9.031)
0.019
(0.402)
-0.009
(0.176)
0.377
(2.996)
- 0.478
(2.504)
Net Increase in Liabilities
1.033
(13.44)
~
0.035
(0.906)
-0.017
(0.430)
- 0.023
(0.128)
0.958
(0.263)
Statistical Discrepancy
1.994
(20.25)
- 0.056
(1.175)
0.039
(0.793)
0.957
(4.670)
0.020
(0.107)
Lagged Statistical
Discrepancy
-0.868
(6.733)
- 0.022
(0.344)
0.043
(0.657)
0.425
( 1.520)
0.422
(1.646)
Independent
Variables
CONTEMPORANEOUS
VARIABLES
LAGGED VARIABLES
INCOME VARIABLES
LAGGED DEPENDENT
VARIABLES
DISCREPANCY
VARIABLES
46
changes in security yields do not.
We tum now to the effects of unexpected inflation, which (as we argued) should influence behavior by making households more uncertain of their
future real incomes and of the real yields on financial assets. The results indicate that unexpected
inflation reduces current consumption and increases
purchases of financial assets. Concern about the
erosion of real incomes and savings by inflation
apparently induces households to reduce current
consumption in order to accumulate more financial
assets for the future. This occurs in spite of the fact
that the real return on those assets is also made more
uncertain by inflation. There is also some evidence
that unexpected inflation encourages households to
accept more debt to build up their stocks of consumer durables and homes. This is what economic
theory would predict, though these results are not
significant at conventional confidence levels.
Although the theoretical distinction between expected and unexpected inflation is difficult to make
in practice, both appear to affect household decisions in the same direction. Hence we can conclude
with a fair degree of confidence that more rapid
inflation discourages current consumption and
encourages asset accumulation and debt accumulation. A slowing of inflation should have the
opposite effect.
We should consider also the second variable used
to capture the effects of uncertainty-the unemployment rate. The empirical results support the
premise that more joblessness would make households concerned about their future incomes and thus
induce greater saving-although this effe.ct appears
to be intertwined with other kinds of effects of
higher unemployment levels.
The coefficient on the unemployment rate is negative in the consumer·durable equation and positive
in the financial-asset equation, which suggests that
unemployment"caused uncertainty induces householdS to delay purchases of consumer durables and
to build up their holdings of financial assets. However, the positive coefficient on unemployment in
the residential-capital equation implies, contrary to
expectation, that higher unemployment is associated with increased purchases of residences. This
effect probably reflects the countercyclical movement of residential construction, which reflects the
tendency of market interest rates to decline during
recessions, so that mortgage-financing institutions
find it easier at such times to attract funds and thus
to lower mortgage rates.
We tum now to the evidence with regard to the
adjustment of asset-holdings in the short run. This
evidence is contained in the coefficients on the
variables representing lagged asset purchases. The
estimated equations provide support for the basic
hypothesis that households do not fully adjust their
asset-holdings within a single observation period,
which in this study was six months. However, there
is less evidence for the additional hypothesis regarding the interdependence of spending decisions
among various classes of assets. This may be because the six-month observation period is too long
to pick up these short-run considerations.
If households adjusted their asset-holdings
instantaneously, each of the "own-adjustment"
coefficients would be unity, implying that the
coefficients on past purchases [which represent
(1 - A ) in Equation (7)] would be zero. 19 Hence,
mm
the hypothesis of incomplete adjustment implies
that the coefficients on lagged asset purchases
would be significantly greater than zero. The hypothesis also implies that the level of current income relative to its expected level will influence
asset-purchase decisions: higher-than-expected income levels will induce households to add to their
assets or reduce their debts more rapidly than otherwise. The results bear out both ofthese implications.
Since the own-adjustment coefficients enter the
estimated equations in the fohn (1- Amm ), the
implied values of Amm are 0.623 for financial assets,
TABLE 4 (continued)
NOTES
(I) Figures in parentheses are t-statistics. In case of' 'own-adjustment" coefficients, these test the hypothesis that parameter is
different from one. In all other cases, that parameter is different from zero.
(2) Both Current and Lagged Disposable Income are expressed as ratios to current expected income.
(3) All lagged variables, including lagged discrepancy, are multiplied by YE t_t IYE t
(4) All lagged dependent variables are expressed as ratios to current expected income.
47
levels of home purchases-and hence delay purchases of consumer durables and acquisitions of
financial assets.
The lack of instantaneous adjustment of assetstocks to target levels also implies that asset purchases will depend on the level of current income
relative to its expected level. If assets were adjusted
instantaneously, variations in current income relative to its long-run expected level would necessitate
corresponding variations in current consumption.
But the empirical results find that current income
significantly affects asset purchases. The large and
significant coefficient (0.61) on current income in
the financial-asset equation implies that greaterthan-expected increases in income are primarily
channelled into financial assets. Significant shares
also flow into consumer durables (0.14) and current
consumption (0.23). Unexpected income changes
do not influence decisions to increase or decrease
debt liabilities. The large and significant positive
coefficient on lagged income in the consumption
equation implies that unexpected receipts invested
in financial assets later find their way into consumption expenditures. The negative coefficient on lagged income in the durables equation suggests that
unexpected income gains increase durable-goods
expenditures only temporarily: that is, unexpected
increases in income lead only to a change in the
timing of such purchases as households take advantage of higher incomes to make up deficiencies in
their tangible-asset stocks more rapidly.
0.042 for financial liabilities, 0.795 for consumer
durables and 0.210 for residential capital. These
coefficients are of the expected order of magnitude,
with stocks of consumer durables and financial assets being adjusted most rapidly, and the residential-capital adjustment taking longer.
In the household-debt equation, the own-adjustment coefficient is small (0.042) and not statistically significant. This suggests that households' debt
holdings are essentially a residual item between
current income and total outlays, since it implies
that changes in debt in any period are unaffected by
the events of the preceding period. This interpretation is supported by the fact that the "crossadjustment" coefficients on lagged purchases of
other assets are large, negative and statistically
significant in the debt equation. These coefficients
imply that substantial acquisitions of tangible or
financial assets in the preceding six-month period
will encourage households to reduce their debt liabilities in the current period. Clearly this is a very
plausible result, and strikingly illustrates the interdependence of asset and liability decisions.
However, the only other statistically significant
cross-adjustment coeffic'ients in the asset-purchase
equations are the negative coefficients on lagged
home purchases in the consumer-durable and financial-asset equations. This result-in conjunction
with that on the effect of past home purchases on
household debt-may mean that households seek
to reduce their debt in the period following high
VII. Summary and Conclusions
This article has investigated the effects of inflation, interest rates and taxes on the saving and
consumption behavior of households. In ourmodel,
the household determines its purchases of various
(tangible and financial) assets and consumption
goods simultaneously, subject to an overall income
constraint. The empirical results suggest that this is
a useful way of viewing household behayiQf,. llild
provide valuable information on the determinants of
such purchases, and thus of aggregate saving.
Economic theory suggests that decisions to consume or to save are likely to be influenced by
changes in interest rates, inflation and tax rates,
but frequently it cannot predict which way these
effects will go. The results tell us that increases in
real after-tax interest rates on securities tend to
encourage current consumption and to discourage
purchases of financial assets. Thus, if real interest
rates can be brought down from their current high
levels, the flow of financial savings available to
finance business investment and government deficits should expand.
The direct effect of a reduction in the inflation
rate would be an increase in current consumption
and a reduction in total saving, because households
would not have to set aside funds to offset the
ravages of inflation. This impact would be reduced,
however, by the fact that fewer households would
48
be driven into higher tax brackets by inflation.
A major finding of the study was a strong association between saving behavior and the personal-tax
rate. During the sample period, tax-rate increases
stimulated current consumption as well as purchases of homes and consumer durables, and led
households to assume more debt to finance these
outlays. This finding was predictable: interest payments on household debt are tax deductible, so that
higher tax rates reduce the riet cost dfbotrowing to
finance both tangible"goods purchases and current
consumption. Lower tax rates, whether brought
about by legislation or by a slower movement of
families into higher tax brackets, conversely should
reduce the demands which households make on the
nation's resources, both real and. financial--..and
thus should release funds for the financing of business investment and government deficits.
Appendix A
The complete model represented in Equations (7) and (8) is derived in this Appendix. For this derivation it
is convenient to write Equations (2), (3), and (4) in matrix fonn.
S~+I
YEt
Ax,
S'+I
YEt
Y~ +
q,
YEt
E
(AI)
[s~,
YEt
(I
+ G,)(I
~
S,
)YE,
s'J
- (I + G,)(I - ~) YEt
(A2)
Y,
+ F YE
,
(A3)
The tenns on the left sides of these equations are (M x I) vectors, x, is a (K x I) vector and Y./YE, is a
scalar. A, E, and F are respectively (M x K), (M x M) and (M x I) matrices of coefficients. Finally, G, and
~ are (M x M) diagonal matrices of capital gains and depreciation rates and I is the (M x M) identity
matrix.
By substituting Equation (AI) into Equation (A3) one obtains
q,
YEt
A
S,
EAx, - E(I + G,)(I- u) YE
Y,
, + F YE,
(A4)
This is the equation to be estimated after the lagged asset-stock variables have been eliminated. To do this,
one begins by taking first differences of this equation:
q, - q'-I
YEt
YE,_,
EAx, - EAx,_, YE
A
r
E(I -u) L(I
,
S'_I]
S,
+ G,) YEt - (I + G'-')YE,
+ F Y'-Y'-I
(AS)
YEt
Lagging (A2) one period, rearranging tenns, and adding G,S./YE, to both sides yields:
(A6)
49
Notice that the left side of this equation appeared in the second term on the right side of Equation (AS).
Also, by lagging (A4) one period and solving for St_,/YE t one obtains
~
YEt
= (I + G)-'(I t
~)-'E-'
tI
lEA
YL xt_ YEt_I + F YEt
YEt
1
~J
YEt.
(A7)
When (A7) is substituted into the last term on the right side of (A6) and the result into the second term on the
right side of (AS), one finally obtains
EAx t
YEt_I
A
+ (EuA - EA)x t_, YE
t
E(I _~) GtS t
YEt
[ E(I - ~)
+ E~E",l ~
J
YEt
(A8)
The first component of the vectors x t and x t_ in Equation (A8) represents the constant term. It is
1
convenient to show this component separately and to write (A8) in slightly different form:
Ea
+
YE
(E~a - Ea) y~-I
t
-_
+ EAx t +
-
- _
YEt_I
(E~A - EA) x t_ YE
1
t
Yt
+ F- +
YEt
(E~E-'F
Y
- F)_t-'
YEt
E(I
(A9)
where a is the first column of the matrix A, A is the matrix A with the first column omitted, and x is the
vector x with the first component omitted. This matrix equation corresponds to the system of equations (7)
in the text of this article.
The corresponding equation for consumption is now readily derived. Since all income not used to
acquire assets necessarily is allocated to consumption:
(AIO)
where u is a (M x 1) vector of 1's.
50
Hence, the consumption equation is obtained by substituting (A9) into (AIO) which yields, after some
rearranging of terms,
~
u'Ea - u ' (E~a
YE,
Ea) ~~-l
t
u'EA x t - u ' (E~A
+
(I - u'F)
~ +
YE,
YE t _1
EA)xt _ 1 -Y
E,
u ' (F -
E~KI F) Y'-l
YE,
+ u'E(I _ ~) G,S,
YE,
E(I - ~) - E~KIJ qt-l
YE,
(All)
The coefficients on the current-income terms in Equations (A9) and (All) sum to one, and all other
coefficients sum to zero. These accounting restrictions must be satisfied by the estimated coefficients.
Appendix B
The theoretical derivation of the model implies that the estimated coefficients satisfy certain "adding
up" restrictions (Appendix A). Single-equation ordinary least-squares estimation satisfies these restrictions automatically. However, if the data are transformed to cope with autocorrelation, the restrictions must
be imposed on the estimation process. This was achieved by an iterative process.
First the M + I equations were estimated by single-equation ordinary least squares and the residuals
used to compute initial estimates of the autocorrelation coefficient for each equation, Pm (m= 1, ... , M + I).
These coefficients were used to transform both the dependent and each of the independent variables to the
form y, - PmYt-l. After this transformation of variables, a typical equation appears thus:
I
vm =
J
~'miZmi + ~emjWmj
i~1
(m= 1,2, ... ,M+I)
(BI)
j~1
Ihthese equations v mrepresents the mth dependent variable after autoregressive transformation, while zmi
and w mj represent the similarly transformed independentvariables in the m th equation. Since the autocorrelation coefficients are different between equations, these transformed independent variables also differ.
The coefficients on each of the zmi sum to one across equations while those on eachofthe w mJ StlIlllO zero.
Thus:
M+I
~ 'mi
m=1
M+I
= I ,
~ emj
m=1
(i=I,2,
(j=1,2,
= 0
Using these restrictions, the (M
,I)
,J)
(B2)
+ l)'h equation may be written as
J
M
~ ~emjWM+lj
j~l
m=1
51
(B3)
Rearranging tenns and multiplying by -1 transfonns this last equation thus:
I
~ ZM+li
1=1
I
-
V M+ 1
=
M
J
M
1=1
m=l
j=1
m=l
~ ~ 'mizM+li + ~ ~OmjWM+li
(B4)
Notice that when written in this fonn, the coefficients of this (M
coefficients of the other M equations.
The complete system ofM
+
l)th
equation are the sums of the
+ 1 equations consisting ofBI and B4 may be written in matrix fonn as:
o.
o
o
o
O.
.0 ..
.0
o ...
.0
.0
.0
o
o
o
.0.
.0 .
.0
wm
0
o
••••••
0
.0
where zm and w mrepresent the vectors oftransfonned independent variables in the mth equation, 'm and Om
the corresponding vectors of coefficients, the O's represent appropriately-dimensioned vectors of zeros,
and u is a (I x 1) vector of 1'so
This matrix equation represents one observation for each of M + 1 separate equations, each having
(I • +. J) independent variables. However, it also may be interpreted as representing M + 1 observations for
a single equation having M x (I + J) independent variables. Hence the method of ordinary least squares
may be applied to the complete system to generate new estimates of the parameters. Since the adding-up
restrictions are incorporated in the forrn of the equations, the estimated parameters will satisfy those
restrictions. Moreover, these parameter estimates do not depend on which equation in the original system is
treated as the (M + l)th.
Having generated these new parameter estimates, the equation residuals were used to obtain revised
estimates of the autocorrelation coefficients. A new set of transformed variables was constructed and the
process repeated until the parameter estimates stabilized.
52
FOOTNOTES
12. With liabilities treated as negative assets.
1. This corresponds to the concept of saving used in the
flow-of-funds accounts,. rather than to that in the national
income and product accounts, in which purchases of consumer durables are treated as part of consumption but
purchases of hOuses as part of saving.
13. This definition implies another restriction on the parameters, namely
M+1
~ 'Ym
m~1
2.. As it happens,. the assumption that the household is
averse. to risk is necessary but not sufficient to demonstrate
that greater uncertainty with regard to its future income will
cause the rational household to save more. For a discussion of a sufficient condition-in the context of a complete
analysis of the effects of various kinds of uncertainty on
saving decisions-the reader is referred to Sandmo (1970).
14. In this method expected income in period t is defined by
the equation
YEt
bY t
+ (1
- b)(1
+ {32 + 2{33t)YEt-1
3. For a complete analysis see Sandmo (op. cit.) p. 357.
The value of b is estimated by Darby to be 0.1 using quarterly data. The values of {32 and {33 are derived from the
regression
Log Yt = {31 + {32 t + {33~
4. In the following discussion, liabilities will be regarded as
negative assets and hence not separately distinguished.
The initial value of YEt is exp ({31)' For complete details the
reader is referred to Darby (1972).
5. Since expenditures on assets are defined gross of depreciation, income must also be defined gross in order to
preserve this identity. This is done in the flow-of-funds
accounts, but in the national income accounts personal
income is defined net of depreciation on owner-occupied
housing.
15. A more appropriate variable would be the marginal
rather than the average tax rate, but data on this variable
were not readily available.
16. The method of eliminating the asset stocks from the
equations means that the lagged values of these five variables also enter the estimating equations. However, the
coefficients on these lagged values represent complicated
transformations of the contemporaneous coefficients with
no obvious economic interpretation. In Table 4, these coefficients are separated from those of primary concern.
6. See, for example, David Backus and Douglas Purvis
(1980).
7. The method used is an adaptation of one originally
suggested by Houthakker and Taylor (1966).
17. The coefficients on expected inflation represent the
effects of a change in inflation on the dependent variables,
assuming that all other independent variables remain unchanged. One of these other variables is the real interest
rate, so that this assumption implies that changes in the
inflation rate induce corresponding changes in nominal interest rates on bonds so that real rates remain unchanged.
Over an observation period as long as six months, this
assumption appears highly plausible. However, the reader
who prefers not to make this assumption may compute the
effect of a change in the expected rate of inflation as the
coefficient on expected inflation minus the coefficient on
the interest rate. In no case does this procedure alter the
conclusions of this section. Similar considerations apply to
the effects of changes in tax rates.
8. In Equations (7) and (8), the term gjtSit represents capital gains accruing on the jlh asset. Only in the case of
equities are data available on these gains. Preliminary tests
disclosed that this variable had no significant effect on
consumption or on asset purchases. The economic interpretation of this result would be that-at least initiallyhouseholds leave capital gains invested in the assets in
which they accrue. Hence this variable was excluded from
the remaining analysis.
9. The reader not interested in econometric and data issues may skip this and the following section and proceed
directly to the empirical results in Section VI.
10. Since the adding-up conditions imply that the autocorrelation coefficient should be the same in each of the M + 1
equations, this finding suggests that the "true" autocorrelationprocess is more complex than the simple first-order
one assumed here.
18. The effects of tax-rate changes-which may be
caused by legislation or by inflation-induced bracket
creep-are discussed below.
19. This ignores the effect of the depreciation rate, but is
approximately true if that rate is small. See Appendix A.
11. The household sector includes non-profit institutions,
and the "residential capital" category also includes a small
amount of plant and equipment owned by these institutions.
53
REFERENCES
Juster, F. Thomas and Wachtel, Paul. "Inflation and the
Consumer," Brookings Papers on Economic Activity, Number 1 (1972).
Backus, David and Purvis, Douglas. "An Integrated Model
of Household Flow-of-Funds Allocations," Journal of
Money, Credit and Banking, Volume 12, Number 2
(May 1980).
Motley, Brian. "Household Demand for Assets: A Model of
Short-Run Adjustments," The Review of Economics
and Statistics, Volume L11, Number 3 (August 1970).
Bisignano, Joseph. "The Effect of Inflation on Savings
Behavior," Economic Review, Federal Reserve Bank
of San Francisco (December 1975).
Purvis, Douglas D. "Dynamic Models of Portfolio Behavior:
More on Pitfalls in Financial Model Building," American Economic Review,. Volume 68, Number 3 (June
1978).
Board of Governors of the Federal Reserve System, Flow
of Funds Accounts, various issues.
Carlson, John A. "A Study of Price Forecasts," Annals of
Economic and Social Measurement, Volume 6,
Number 1 (Winter 1977).
Sandmo, A. "The Effect of Uncertainty on Savings Decisions," Review of Economic Studies, Volume 37
(1970).
Darby, Michael R. "The Allocation of Transitory Income
Among Consumers' Assets," American Economic
Review, Volume LXII, Number 5 (December 1972).
Wachtel, Paul. "A Model of Interrelated Demand for Assets
by Households," Annals of Economic and Social
Measurement, Volume 1, Number 1 (April 1972).
Houthakker, H. S. and Taylor, Lester D. Consumer Demand in the United States, 1929-1970, Cambridge,
Mass: Harvard University Press (1966).
54
@FedFRASER