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2
I. Monetary Targeting and Inflation: 1976-1984
......... ........... 5
C arl E. Walsh
II. Inflation, Age, and Wealth ...............................................................17
Randall J. Pozdena
III. Policy Coordination and Financial Interm ediaries..................... 31
M ichael C. Keeley and Carl E. Walsh
IV. Ricardo or Keynes: Does the Government Debt
Affect Consumption? ........................................................................ 47
Brian M otley
Editorial Committee:
Reuven Glick, Michael Keeley, John Scadding,
Jack Beebe, John Judd, Ramon Moreno.
3
Carl E. Walsh·
This article examines the relationship between the money supply and
inflation during the periodfrom 1976 to 1984 when monetary policy was
generally framed in terms of target growth ranges for M1. Empirical
evidence suggests that money supply disturbances were not an important
source of inflation volatility, but that the Federal Reserve allowed such
disturbances to exert a permanent effect on the level ofmoney and prices.
Ml from target. Some critics have argued that the
Fed's procedure for dealing with those deviations
contributed to both higher and more volatile inflation. These criticisms are empirically evaluated in
this article.
The next section contains a discussion of both the
Fed's procedure for setting monetary targets and the
criticisms levied against that procedure. In Section
II, we formulate a simple structural model linking
output, prices, interest rates, and money, and discuss four hypotheses concerning the relationship
between money and inflation that should be true if
the criticisms were valid. The empirical methods
used to evaluate these hypotheses are also presented. Section III consists of an evaluation of the
empirical evidence, and Section IV provides a brief
summary of the findings.
Over the last 18 months, very rapid growth in M 1
has been accompanied by relatively sluggish growth
in nominal income. This anomaly has led many to
conclude that the relationship among Ml, inflation,
and real income has broken down. In response to
this apparent breakdown, the Federal Reserve has
abandoned M 1 targeting as a guide to setting monetary policy. This de-emphasis of M1 comes after a
ten-year period during which monetary policy was
predominantly framed in terms of growth ranges for
Ml.
The purpose of this article is to assess the impact
of monetary policy on inflation during the period
from 1976 to 1984. Monetary policy was criticized
during this period both by those who opposed
monetary targeting and by those proponents of
targeting who opposed the Federal Reserve's tolerance of frequent, and frequently large, deviations of
I.
Monetary Targeting Since 1976
monetary aggregate every quarter that would apply
over a four-quarter period.
This target range was calculated from a base
equal to the average level of the aggregate during the
previous quarter. Thus, in February 1976, the
FOMC set a target range of 4Y2 to 7 percent for Ml
growth to apply to the period from 1975Q4 to
1976Q4; the range was calculated from a base equal
to the average level of M 1 in the fourth quarter of
1975. Three months later, the FOMC announced
another four-quarter target range, in this case 4Y2
Target growth ranges for various monetary aggregates have been publicly announced by the Federal
Open Market Committee (FOMC) of the Federal
Reserve System since the passage of House Concurrent Resolution 133 in 1975. From the first quarter
of 1976 until the passage of the Full Employment
and Balanced Growth Act of 1978 1 , the FOMC
announced a target growth rate range for each
* Senior Economist, Federal Reserve Bank of San
Francisco.
5
percent to 7 percent again, to apply to the period
1976Q1 to 1977Q1. The base for this target range
was the average level of Ml during 1976Q1.
This method of setting the target growth paths for
monetary aggregates leads to upward or downward
shifts in those paths depending on how Ml deviates
from the midpoint of its target range. A succession
of hypothetical target ranges is illustrated in Figure
1. Assume that in period 1, a target range of 3 to 7
percent growth is set, with actual Ml in period 0
used as the base. This target range is represented by
the cone emanating from the actual Ml value at the
end of period 0 (point A in the figure). Suppose the
actual path of Ml during period 1 is given by the
solid line so that at the end of the period, actual Ml
is given by point B. As drawn, actual Ml ended
within the target cone, but above the midpoint of the
cone represented by the dashed line.
In period 2, the FOMC would establish a new
target growth rate range, say 3 to 7 percent again,
and base the new cone on actual Ml at the end of
period 1. The new target cone in the figure therefore
has its apex at point B. If the solid line were to
represent the actual path followed by Ml, subse
quent hypothetical target ranges for periods 3 and 4
would be as depicted.
using actual Ml as the base for each cone causes the
base to drift upward or downward according to M l’s
deviation from the midpoint of any target growth
cone. Such base drift has characterized the method
of calculating growth targets for Ml and the broader
monetary aggregates: at the beginning of each target
period, the base for the new growth range has shifted
to equal the actual level of money at the end of the
previous target period. Base drift makes deviations
of actual money from the midpoint path permanent
at the end of each target period.
To eliminate the automatic occurrence of base
drift each quarter, the Humphrey-Hawkins Act of
1978 required the FOMC to establish, in February
of each year, target growth ranges for the entire
calendar year. This new procedure in effect replaced
automatic quarterly base drift with automatic annual
base drift. That is, each February, the FOMC would
establish target ranges for the fourth quarter of the
previous year to the fourth quarter of the current
year, calculated from a base equal to the average
value of the aggregate in the fourth quarter of the
previous year. Thus, in February 1979, the FOMC
announced a target range of V/2 to 4!/2 percent
growth for Ml starting from the actual value of Ml
in 1978Q4.
According to the new procedure, the FOMC also
reviews its target ranges at mid-year and can adjust
either the base or the target growth rate ranges. For
example, in July of both 1983 and 1985, the FOMC
responded to rapid Ml growth during the first six
months of the year by using second quarter Ml
(instead of fourth quarter Ml from the previous
year) as its new base for calculating growth paths
and by adjusting the growth rate ranges.2
Chart 1 provides an estimate of the cumulative
effect of base drift during the period 1976Q1 to
1985Q4 by plotting both actual Ml and a hypotheti
cal target path that incorporates changes in the
target range midpoint while maintaining actual Ml
in 1975Q4 as the base. The latter series, labeled
“No drift M l ” , shows what the path of Ml might
have been if Ml growth had always been at the
midpoint of the FOMC’s target ranges and no base
drift had been allowed. By the end of 1984, accord
ing to the No drift Ml series, actual Ml was roughly
15 percent higher than it would have been if it had
always grown at the midpoint of the successive
target growth rate ranges.
Base Drift
The successive gray lines representing the mid
point of each target cone show that the procedure of
Figure 1
Base Drift Illustrated
M1
6
Fed's commitment to maintaining a stable, steady
expansion of the money supply over the long-run.
Second, by automatically "forgiving" any target
misses, they claim base drift greatly reduces the
incentives for the Fed to hit its targets. Missing a
target in one year imposes no penalty on the Fed in
subsequent years since each year automatically
starts on target. Third, by incorporating temporary
disturbances that cause money to deviate from target, they believe base drift gives those disturbances
a permanent effect on the money stock and, therefore, the price level. This leads to increased uncertainty about the future price level and reduces one of
the advantages of monetary targeting. 3
At the heart of these criticisms is the belief that
the policy followed by the FOMC contributed both
to raising average inflation over the ten years of
monetary targeting and to increasing the volatility
of inflation.
This criticism is not necessarily valid, however,
since one can argue that some deviation from the
midpoint target path and subsequent base drift is
just what one should expect to observe if the FOMC
is concerned about stabilizing inflation. For example, suppose velocity grows faster than expected
during a year. If the Fed wishes to prevent such a rise
from leading to higher inflation, it must reduce
money growth. Consequently, the actual level of the
money supply at the end of the year would be below
the level implied by the midpoint target path set at
the start of the year.
How should the target growth path for the next
year be set? The answer to this question turns out to
depend on the perceived persistence of the velocity
disturbance. Suppose the unexpectedly rapid
growth in velocity were temporary, with velocity
growth returning to its trend value in subsequent
years. The result of a one-year surge in velocity
growth is to leave the level of velocity permanently
higher, as illustrated in Figure 2 by the line ABCD.
For a given path of money, such an upward shift in
velocity will lead to a similar upward shift in the
price level, thus generating higher inflation during
the transition to a higher price level.
Higher inflation could be avoided if the path of
the money supply were permanently lowered. In
such a case, the FOMC should not use the midpoint
of its prior year target range a..<; the base for the next
Chart 1
Base Drift Raises the Level of M1
Billions of Dollars
560
520
480
440
400
360
320
There is, however, an important reason for
thinking that Chart 1 may not give an accurate
picture of how Ml would have behaved ifthe FOMC
had followed a policy of preventing base drift. It has
been claimed that under the federal funds operating
procedure followed prior to October 1979, the Fed
allowed the money stock to respond to movements
in income, interest rates, and inflation. Under a
different monetary policy, such as one that did not
tolerate base drift, the actual behavior of these
macroeconomic variables would most likely have
been different. This means that the FOMC might
have set different target ranges if it had eliminated
base drift rather than followed its policy of allowing
complete base drift.
Criticisms of Base Drift
The FOMe has frequently been criticized for
allowing money growth volatility and base drift to
occur. Automatic base drift implies that the growth
of the money stock will have no tendency to return
to a constant trend. Thus, a policy that allows
automatic base drift would seem to be inconsistent
with a goal of zero inflation. It has been claimed that
base drift hinders the achievement of both stable
money growth and stable prices over longer periods
by making permanent any short-run deviations from
target that occur at the end of each target period.
Broaddus and Goodfriend (1984) discuss three
major objections to base drift. First, they argue that
base drift reduces the public's confidence in the
7
Figure 2
inflation will depend on the reasons for the deviation. On the one hand, such deviations might arise
because the Fed allows the money stock to respond
to income, interest rate, or inflation movements
caused by disturbances to the economy. As was
pointed out in the discussion of a velocity disturbance, the appropriate monetary policy response
depends crucially on the nature of the initiating
disturbance. Shocks likely to persist call for a different policy response than do more transitory disturbances.
On the other hand, some MI target misses may
represent the effects of money stock control errors or
policy actions unrelated to income, inflation, or
interest rates. Such money supply disturbances will
change output and inflation; they represent an independent source of inflation volatility that can be
attributed to monetary policy.
To evaluate the impact of monetary policy on
inflation, then, it is necessary to answer two questions. First, have money supply disturbances been
an important source of inflation volatility? Second,
has the induced policy response of the money supply to economic disturbances contributed to the
inflationary impact of such disturbances? If the
answer to these questions is "yes" , and the behavior
of the money supply during the period of monetary
targeting has contributed to inflation uncertainty
and volatility, the following four stylized "facts"
should characterize the data:
1. Money supply disturbances should account
for a significant fraction of the volatility of
inflation;
2. Changes in money growth should lead to
subsequent movements in the rate of inflation;
3. Knowledge of money growth should help to
forecast future inflation;
4. Temporary spending or money demand disturbances should lead to persistent, or permanent, responses of the money supply.
The data should have the first three of these four
characteristics if independent money supply disturbances arising from policy shifts or from the failure
to control the money supply were important contributors to inflation volatility. The fourth characteristic
would be true if the Fed has responded to economic
disturbances in a manner that has contributed to
A Surge in Velocity Growth Can Leave
the Level of Velocity Higher
Velocity
o
A
Time
year's range because this will not produce the
required lowering of the path for money. Instead, the
new base should be set at a lower level. Since actual
money was assumed to come in below target, the
actual level of the money supply may provide a new
base that would be more consistent with the prevention of a temporary increase in inflation.
A possible alternative path for velocity after an
initial surge in its growth is labeled ABCEF in
Figure 2. On that path, faster velocity growth is
followed by an offsetting period of slower growth
that returns the level of velocity to its original path
(AF in the figure). In this case, no permanent adjustment in the level of the money supply is needed to
prevent inflation. If the actual level of the money
supply were used as the new target base, the target
growth rates would have to be temporarily increased
for the money supply to return to its original path.
Such situations would result in a negative correlation between deviations from target midpoints and
the target growth rates set for the following year as
deviations of the money supply below the target
path are followed by higher target growth rates
designed to return the money supply to the level of
the original path. 4
Evaluation
This discussion suggests that the impact of M 1
deviations from the target midpoint growth path on
8
raising the average rate of inflation.
To determine whether these stylized facts hold for
the U. S. during the period of monetary targeting, it
is necessary to translate each into a statistical
hypothesis that can be tested. This translation will
II.
be done within the context of a simple structural
model linking money with other macroeconomic
variables. This model is discussed in the next section.
Empirical Framework
(2)
This section discusses an empirical framework
that can shed light on the criticisms levied at the
FOMe's conduct of monetary policy. The model to
be examined consists of four variables: real GNP in
1982 prices, the GNP price deflator, the threemonth Treasury bill rate, and MI. (All observations
are quarterly.) Because most macro variables are
nonstationary, the analysis is carried out in terms of
first differences. Let Yt, Pt, and Mt denote the first
differences of the log of real GNP, the price deflator,
and Ml, respectively. Thus, Y, P, and M are approximately equal to the quarterly growth rates of output, prices, and money respectively. Let Rt denote
the first difference of the level of the bill rate. All
variables are expressed at seasonally adjusted
annual rates.
A simple four-equation model was used to capture the structural relationships assumed to hold
among the equilibrium values of these macro variables. The first equation is a simple IS, or aggregate
spending, relationship that assumes real aggregate
spending depends on the anticipated real rate of
interest. This is represented by equation I:
Again, W 2t - 1 captures the effects of all lagged
values and so would also incorporate the impact on
Pt of expectations of Pt formed in earlier periods.
The coefficient a2 should be positive, as, ceteris
paribus, a rise in output should lead to a rise in the
price level. The disturbance term U2t represents an
aggregate supply shock.
The third structural equation in the model specifies the demand for real money balances as dependent on income and the nominal interest rate as well
as on lagged values of the variables in the model:
For the purpose of estimation, this equation is
normalized on the interest rate and written as
Since a rise in output should increase the demand for
real money balances whereas a rise in the nominal
rate should reduce it, we expect a3 to be positive and
a4 to be negative. The disturbance term u3t represents a money demand shock.
The final equation of the structural model is a
description of money supply determination:
where EtPt + I is the expectation of Pt + I' so that
Rt + Pt - EtPt + I is the expected real rate of interest,
and Wit _ I is a composite term that incorporates all
the dynamic effects of past values of income, prices,
interest rates and money on Yt. Since an increase in
the expected real rate of interest should reduce
aggregate spending, al should be negative. The
disturbance term u It will be referred to as an aggregate demand shock; it captures all contemporaneous
effects on Yt other than those operating through the
real interest rate.
The second structural equation is a simple Phillips curve or aggregate supply relationship;
Equation 4 relates the money supply to the contemporaneous value of nominal income and the nominal
interest rate. As in the other equations, W4t - 1
captures any lagged effects on money supply. If the
Federal Reserve slows money growth when nominal
income growth increases, as would be negative.
However, Fed critics have often charged that the Fed
allows money growth to vary procyclically. This
9
would suggest that as may be positive. Since it is
also often claimed that the Fed "leans against the
wind" by attempting to smooth interest rate movements, a6 would be expected to be positive. The
term U4t represents a money supply shock; it incorporates all contemporaneous influences on the
money supply except the influences of nominal
income and interest rates.
This structural model allows money supply
effects to operate through three channels. First, U4t
represents monetary disturbances that directly affect
the money supply and, through the presence ofM in
equation 3, interest rates, output, and prices. Second, aggregate spending, aggregate supply, and
money demand shocks will affect nominal income
and the nominal rate of interest, and thereby cause
the money supply to respond endogenously, as long
as as and a6 in equation 4 are not both zero. Third,
lagged values of the money supply will also have
effects on current output and prices. Empirical
estimates of these various channels can be used to
shed light on the stylized facts listed in the previous
section.
To cast light on stylized fact 3, the four structural
equations can be solved to express Yo Po Rt and M t
as functions of the lagged values of these variables
and the current values ofthe structural disturbances.
"Fact" 3 can then be interpreted as a statement
about the coefficients on past values of M. If the
coefficients on lagged M in the equation for inflation are jointly zero, then knowledge of past money
supply growth rates does not help in forecasting
inflation once past inflation, output, and interest
rates are taken into account. Hence, nonzero coefficients on past M would provide evidence in favor of
"Fact" 3.
Evidence relevant for judging "Fact" 4 can be
obtained by determining how the money supply
responds to disturbances to the model. Since disturbances in the structural model are assumed to be
serially uncorrelated, a finding that temporary
shocks to, for example, money demand had persistent effects on the money supply and prices would
indicate that the induced response of the money
supply to economic conditions was leaving lasting
effects on prices and contributing to inflation as the
price level adjusts.
Although it will be argued below that "Fact" 3 is
the least interesting of the three stylized facts, it is
the easiest to test since an estimate of the effects of
lagged M on P can be obtained by directly regressing P on lagged values of M, Y, P, and R. However,
to assess "Facts" 1, 2 and 4, it is necessary to
recover information on the true structural disturbances, and this requires first estimating the ais that
characterize the contemporaneous relationships
among Y, R, P and M.s
Statistical Hypotheses
Within the context of the model described, stylized facts numbers I and 2 can both be interpreted as
statements about the effects of money supply disturbances on inflation. Evidence that money supply
shocks account for a large fraction of the variance of
inflation would support "Fact" 1. Likewise, "Fact"
2 would be supported by evidence that a nonzero
realization of the money supply shock led to subsequent movements in inflation.
III.
Empirical Results
The empirical results reported here are all based
on the sample period 1977Q 1- 1984Q4. This period
encompasses several changes in Federal Reserve
operating procedures, the most important of which
was the move, in October 1979, from a federal funds
operating procedure to a nonborrowed reserves procedure. The Fed's commitment to monetary targeting also seems to have varied over this period.
Unfortunately, the shortness of the sample period
precludes dealing adequately with these potential
structural shifts. Nevertheless, estimates derived
from the whole sample may still provide useful
information about the average impact of monetary
shocks. 6
Estimated values of the parameters giving the
contemporaneous relationships between Y, R, P,
and M in the structural model are listed in Table 1.
All parameter signs agree with prior expectations,
and, with the exception of the real interest elasticity
of aggregate spending (a I), all the parameters are
10
1
TABLE
money demand shocks, and aggregate supply
shocks. This ordering is somewhat at variance with
the traditional Federal Reserve view that emphasizes the importance of money demand shocks.
However, U3 was the disturbance for a money
demand equation normalized on the interest rate.
When converted back to the standard form of a
money demand equation, the estimated variance is
.00052. This results in a ranking that seems consistent with the Federal Reserve view.
The estimated coefficients of the structural
model, together with the results of the vector autoregression (VAR) estimation technique used to estimate the effects of lagged variables on Y, R, P and
M, can be used to study the impact of money on the
macroeconomy during the period of monetary targeting. In particular, it is possible to examine the
stylized facts about monetary policy that were discussed in Section II.
If independent monetary volatility has contributed to the volatility of inflation, then one should
expect to find that money supply disturbances, as
identified in the structural model, account for a large
fraction of the variance of errors made in forecasting
future inflation. Table 2 presents the decomposition
of the forecast error variance for inflation. Each
column reports the fraction of the total variance of
the inflation forecast error that is attributed by the
structural and VAR estimates to a particular structural disturbance. 7 Results for various forecast horizons ranging from one quarter to 24 quarters are
reported.
The clear conclusion from Table 2 is that money
supply disturbances contribute very little to inflation uncertainty as measured by the variance of
forecast errors. The evidence from this variance
Parameter Estimate for Structural Model
Parameter
0. 1
0. 2
0. 3
0.4
as
0. 6
Variance of u l
Variance of u2
Variance of u3
Variance of u4
Estimated
Values
Standard
Error*
-0.48
0.19
0.24
-0.56
-0.11
3.39
.00072
.00007
.00013
.00034
0.85
0.G7
0.03
0.04
0.06
0.09
.00028
.000004
.00001
.00001
*These are asymptotic standard errors; see Hansen and Singleton
[1982] for the appropriate formula.
statistically different from zero at conventional significance levels. Of particular interest is the estimated equation for the money supply - equation 6.
The negative estimated value of as - the coefficient on nominal income - indicates some endogenous policy response within the quarter to offset
contemporaneous movements in nominal income.
However, the very large coefficient estimate for 0.6 is
evidence of atendency to attempt to offset nominal
interest rate movements.
The estimated variances of the structural disturbance terms allow some conclusions to be drawn
about their relative importance in generating economic fluctuations. In decreasing order of size are
the variances of aggregate spending shocks, which
are estimated to be more than twice as large as any
of the other variances, money supply shocks,
TABLE
2
Variance Decomposition of Inflation
Quarter
Aggregate
Spending
Aggregate
Supply
Money
Demand
Money
Supply
1
4
8
12
24
24.15
18.64
22.66
22.41
22.18
75.78
73.42
65.19
64.96
64.36
0.03
6.35
9.16
9.34
10.04
0.04
1.59
2.99
3.29
3.43
II
inflation rates, output growth rates, and nominal
interest rates are known. 8 In essence, such a test
examines whether monetary changes precede
changes in inflation. The structural model is not
needed to carry out such a test since, as explained in
Section II, the test involves only the statistical
significance of the coefficients on lagged money
growth rates in the VAR equation for the rate of
inflation. The relevant F-statistic for this test is 0.30
with a marginal significance level of 87 percent.
Thus, the data are quite consistent with the hypothesis that money does not help to forecast inflation.
This test result, however, is not particularly useful
for evaluating the contribution of money supply
disturbances to the level and volatility of inflation.
For example, the evidence that past money growth
does not aid in forecasting inflation once past inflation, real output growth, and nominal interest rates
are known is entirely consistent with the hypothesis
that monetary shocks have a large contemporaneous
impact on inflation. It is also consistent with the
view that nonmonetary disturbances have been the
cause of most inflation fluctuations over the period
studied.
The results in Tables 2 and 3 indicate that money
supply disturbances do not constitute an important
source of independent variation in inflation. Yet this
result in still consistent with the criticism that the
FOMe has let the money supply respond endogenously to interest rates and income in a manner
that has led to more inflation than would have
occurred under a policy that eliminated such
induced movements of the money supply. To assess
decomposition suggests that the first of the four
stylized facts discussed in Section II is not an
accurate description of the money supply-inflation
relationship during the period of monetary targeting.
To gauge whether shocks to the supply of money
lead to subsequent movements in the rate of inflation __ stylized fact 2 - the VAR and structural
model estimates can be used to calculate the impact
of a money supply disturbance both directly on each
of the model's variables and indirectly through the
induced effects of changes in one variable on the
others. Table 3 presents the responses of all four
variables in the model to a money supply disturbance.
The immediate impact of a positive shock to the
growth rate of the money supply is a decline in
market interest rates, a rise in real output growth,
and an increase in the rate of inflation. However, the
impact on the rate of inflation is very small, peaking
6 quarters after the shock to money growth, and then
declining. This evidence, which is consistent with
the variance decompositions reported in Table 2,
suggests that money supply disturbances do not
have large effects on subsequent inflation. As the
last column of Table 3 shows, the small impact is in
large part due to the temporary nature of the effect of
money supply shocks on the rate of growth of the
money supply.
An alternative way to assess the impact of monetary changes on future inflation involves testing
whether information about past money growth rates
is helpful in predicting the rate of inflation once past
TABLE
3
Responses to a One-Standard Deviation Money Supply Disturbance'"
R
Quarter
1
4
8
12
24
y
Output Growth
0.11
-0.10
-0.22
0.13
-0.00
p
Inflation
0.02
0.10
0.01
0.03
0.02
*AII entries have been multiplied by 100.
12
Changes in
Interest Rate
0.34
-0.06
0.09
0.11
-0.02
M
Money Growth
0.66
0.92
-0.11
0.14
-0.04
this criticism, it is necessary to examine the manner
in which the money stock responds to the other
disturbances in the model. The response of the level
of M to each of the various structural disturbances is
reported in Chart 2.
Several interesting conclusions are apparent from
Chart 2. Panel A shows the response of the level of
the money supply to an aggregate spending disturbance. Initially, the money supply responds
positively to a spending increase, but this is reversed
by the end of four quarters. The net effect of the
aggregate spending shock is to leave the level of the
money supply lower than it would have been in the
absence of the positive spending shock. The pattern
of response to an aggregate supply shock, shown in
Panel B, is similar. The net effect of an aggregate
supply shock on the level of the money supply,
however, is more than offset within a year. Eventually, the. path of the money supply appears to
return to what it would have heen in the absence of
the shock.
In Panel C, the response of the money supply to a
money demand shock is illustrated. A positive
money demand disturbance induces an increase in
money growth that appears to be fairly quickly
reversed. Atthe end of five quarters, the level of the
money supply is back to where it would have been
had it remained on its initial path.
Chart 2
Response of Money to Various Shocks
A. Aggregate Demand Shock
x10-3
C. Money Demand Shock
x10-3
2
3
2
01--0+------------
0
-2
-3 0
-1
2
4
6
8
10
12
14
16 18
20
-2 0
22 24
2
4
6
8
10
12
14
16
18
22 24
20
Quarters
Quarters
B_ Aggregate Supply Shock
x10-3
D. Money Supply Shock
x10-3
2
5.0
4.5
4.0
0
3.5
3.0
-1
2.5
-2
-3 0
2.0
2
4
6
8
10
12 14
16
18
20
1.5 0
22 24
2
4
6
8
10
12
14 16
18
20
22
24
Quarters
Quarters
13
evidence is consistent with Table 3 which showed
that money supply shocks led to a period of temporarily higher inflation. Because these shocks are
never offset, the price level is left permanently
higher.
One interpretation of these results is that the
FOMC lets temporary errors in its control of the
money supply result in permanent changes in the
price leveL This interpretation supports the criticism of automatic base drift - that base drift
converts temporary deviations (due to control
errors) from the target path into permanent deviations of the price level from the path consistent with
a constant rate of inflation.
In none of these first three panels is there evidence that aggregate spending, aggregate supply, or
money demand shocks induce permanent effects on
either the growth rate of the money supply, or even
the level of the money supply, that would produce
sustained inflation. 9
Panel D paints a somewhat different picture. A
positive shock to the money supply is not completely offset afterward. Instead, the shock leaves
the nominal money supply permanently higher. This
implies that money supply disturbances do seem to
have the effect of permanently raising the price
level, and, during the transition to a higher price
level, producing an increased rate of inflation. This
IV.
Summary and Conclusions
This article has examined the relationship
between the money supply and inflation during the
period from 1976 to 1984 when monetary policy
was generally framed in terms of target growth
ranges for MI. The major criticisms of the Federal
Reserve's loose control of the money supply focused
on the implications of money growth for inflation.
To assess the empirical validity of these implications, evidence obtained from a vector autoregression and an estimated structural model was
employed. The empirical sections of the paper
examined the impact of money supply shocks on
subsequent in~ation, the fraction of inflation forecast error attributable to money supply shocks, the
contribution of past money growth to the forecast of
inflation, and the induced response of money to
aggregate spending, aggregate supply, money
demand, and money supply disturbances.
In general, little evidence was found to indicate
that money supply disturbances have independently
made a major contribution to the level of inflation or
its unpredictability. However, it does appear that the
FOMC has allowed random disturbances in the
growth rate of the money supply to exert a permanent effect on the level of money and prices. Fasterthan-expected money growth generates temporarily
higher inflation that leaves prices permanently
higher. Such a finding is not surprising given the
FOMe's policy of automatic base drift, in which
deviations of the money supply from target are
allowed to affect the level of the money supply
permanently. However, given the short sample
period and the changes in Federal Reserve operating procedures that occurred in 1979 and 1982,
these conclusions must be considered tentative.
14
FOOTNOTES
1. This Act is better known as the Humphrey-Hawkins Act.
in Hansen and Singleton (1982) and Chamberlain (1984).
The strt,!ctural disturbances can then be recovered as AVt
where A is the estimate of A and t is the vector of VAR
residuals. See also Walsh [1987).
2. Each year, the Federal Reserve Bank of St. Louis publishes in its Review an analysis of the FOMC deliberations
on setting targets during the previous year.
v
6. In Walsh (1987), the mOdel was expanded to include a
measure of the Fed's M1 target and a dummy vari<iple for
the period 197904 to 198203, when the Fed used a
nonborrowed reserves operating procedure. This slight
change in the specification had a large impact on the
estimated dynamics implied by the VAR system. Points
where the results of this paper differ from those of walsh
(1987) are noted in footnote 9.
7. Unlike standard methods of orthogonalizing the VAR
residuals to construct variance decompositions, the
approach taken here, which combines a VAR with a structural model, yields results that are independent of the
ordering of the variables. Thus, the fact that money supply
shocks are listed last in Table 2 has no significance.
3. The Shadow Open Market Committee (1985) has
recommended the elimination of base drift. See also M.
Friedman (1982, 1985) and McCallum (1984). In one of the
earliest attacks on base drift, Poole (1976) suggested, as
an alternative procedure, that the midpoint of the previous
year's target range, and not actual M1, be used as the new
base. This recommendation was also proposed in the
1985 Economic Report of the President.
4. In fact, this correlation is positive. For a more detailed
analysis of base drift, see Walsh (1986).
5. Actual estimation proceeds in two steps, If Zt is the
column vector of Y" Pt, Rt, Mt, then the structural model can
be written as AZ t = B(L)Zt_1 + u t· Hence, Zt =
D(L)Zt_1 + vt. The lag coeffiA-1B(L)Zt_1 + A- 1ut
cients in D(L) can be obtained in the first step from estimating a vector autoregression (VAR) in Zt. This also yields
estimates of vt. A lag length of four was used in the VAR and
each equation also included a constant and a time trend. In
the second step, an estimate of A was obtained by noting
that the population covariance matrix of v is A - 12: u A - l '
where 2: u = E(u'u) and applying a Generalized Methods of
Moments estimation procedure. For further discussion of
this approach, see Bernanke [1986] or Sims [1986]. The
Generalized Methods of Moments estimator is discussed
8. This is just a test of the null hypothesis that money does
not Granger cause inflation.
9. Somewhat different results were obtained from an
extended model that included a dummy variable for
197904 to 198203. In this model, aggregate supply
shocks appear to produce a permanent increase in the
rate of money growth. This indicates that the endogenous
Federal Reserve policy response contributed to the inflationary impact of aggregate supply disturbances. See
Walsh, (1987).
15
REFERENCES
Bernanke, Ben S."AlternativeExpl<lnCitionsofthe Mqn~y"
Incom eC o rreI Cition,"NBERWorkingPaper,NQ..1842,
•.. . .. •• •. ••.. •.•••. •. • ••.••
• .•..•
February 19.86. •.
Broaddus, Alfred and Marvin Goodfriend."Base Drift and
the LonqerJ3yn Growth qfM1;Experienoe from. a
D.eoadeqf Monetary Targeting, "Federal Reserve
Bank of Hichrnond,,Economic Review, November/
Deqember19.84.
Brunner,. Karl. "The Politics ofMyopia and Its Ideology," in
ShadOW Open Market Qqmmitlee Po!icy Statements
and Position. Papers, GraduateSohoolof Manage"
ment, University of Rochester, September 1Q83:
Campbell,John Y. and N. Gregory Mankiw. "Are Output
Fluctuations Transitory?" NBER Working Paper No.
19.16, May 19.86.
Chamberlain, Gary. "Panel Data," in Z. Griliohes and MD.
Intriligator, eds., Handbook of EC'lnometrics, Vol. 2,
North"Holland,1984.
Cochrane, John H. "How Big is the Random Walk in
GNP?," mimeo.
Federal Reserve Bank of St. Louis, Review, various issues.
Friedman, Milton. "Monetary Policy: Theory and Praotice,"
Journal of Money, Credit, and Banking, 14(1), Febru"
ary 19.82.
_ _. "The Fed Hasn't Changed Its Ways," Wall Street
Journal, August 20, 1985.
Gould, J.P., M.H. Miller, C.R Nelson, and CW. Upton.
"The Stochastic Properties of Velocity and the Quan"
my Theory of Money," Journal of Monetary Economics. 4(2), April 1978.
Hansen, Lars Peter and Kenneth J. Singleton. "Generalized Instrumental Variables Estimation of Nonlinear
Rational Expectations Models," Econometrica, 50(5),
September 1982.
Kim,J.C. "Random Walk and the Velocity of Money: Some
Evidence from Annual and Quarterly DatCi, " Economic
Letters,<18,1Q85.
McCallum,· Bennett T. "Credibility and Monetary Policy,"
F~deralHeserveBankofKansasCity,Price Stability
and PublicPolicy,1984.
_________."OnConsequencesandCriticismsofMonetary
Targeting,"Jouma/ofMoney, Credit,and Banking,
17(4), November 1985, Part 2.
Muth,J.F. "Optimal Properties ofExponentiallyWeighted
Forecasts,"Journa/oUhe American Statistical Association,55, June 1960.
Nelson,charles Rand Charles I.. Plosser.''Trendsand
Random Walks in Macroeconomic Time Series: Some
Evidence and Implications," Journal ofMonetary Economics, JO,SePtemberlQ82.
Poole, William. "Interpreting the Fed's MonetCiry Targets,"
Brookings Papers on Economic Activity, 1976:1.
____. "Fiscal and Monetary Policy Overkills," in Shadow
Open MCirket Committee Policy Statements and Position Papers, Graduate School of Management, Universityof Rochester, March 19.86.
Shadow Open Market Committee. "Policy Statement,"
Center for Research in Government poliOY and Business, Graduate School of Management, University of
Roohester, March 1985.
Sims, ChristopherA "Are Forecasting Models Usable for
Policy Analysis?," Federal Reserve Bank of Minneapolis, Quarterly Review, Winter 1986.
U.S. President. Economic Report of the President, 1985.
Walsh, Carl E. "In Defense of Base Drift," American Economic Review, 76(4), September 1986.
___. "The Impact of Monetary Targeting in the United
States: 1976-1984," mimeo, January 1987.
16
Randall J. Pozdena*
A comparison ofdata from two special surveys ofhousehold assets and
liabilities conducted by the Federal Reserve System in 1977 and 1983,
respectively, reveals a significant redistribution of household wealth
toward older Americans. This change in the age-distribution ofwealth is
consistent with the notion that the unexpectedly high rates of inflation
during the period between the surveys resulted in increases in home
values, social security income, and other sources of wealth from which
older households benefited disproportionately.
A stable price level is considered a desirable
objective of economic policy for well-known reasons of equity and efficiency. I Among the equity
issues is the effect of inflation on the distribution of
wealth within a society. 2 In particular, unanticipated
changes in the rate of inflation and uncertainty about
the inflation rate can change the value of various
assets and liabilities held in household and business
portfolios.
The purpose of this article is to examine selected,
recent changes in the age-distribution of household
assets and liabilities. In particular, we examine
empirically the changes in the age-distribution of
net worth that occurred during the period of the late
1970s and early 1980s. The reason for this particular
focus is twofold. First, the sharp increases in inflation that occurred during this period are likely to
have had important age-specific effects due both to
differences in the composition of portfolios of
households of various ages and to the existence of
inflation-indexed programs designed to assist older
Americans.
Second, to the extent that there has been a significant change in the age-distribution of wealth, it may
be desirable to revise federal budget policy. A
significant proportion of federal expenditures consists of programs that emphasize support for older
Americans. Social Security retirement programs
and Medicare, for example, together represent
nearly 40 percent of total federal expenditures. As
the Administration and Congress attempt to deal
with the large federal budget deficit, information on
the age-distribution of household net worth should
be helpful in the debate over program priorities.
The study in this article employs data from two
special surveys of consumer finances conducted by
the Federal Reserve System. The two surveys
provide very detailed information on the composition and value of household portfolios, and afford us
the opportunity to obtain a rough "before-andafter" glimpse of the age-distribution of net worth
during the high-inflation period spanned by the
surveys. Data from the surveys reveal a significant
change in the relative wealth status of various age
groups that generally favors older Americans, and
enable us to determine which components of household portfolios have contributed most to this
change.
The remainder of this paper is structured as follows. We review in the first section the changes in
economic and policy conditions that occurred during the period of the late 1970s and early 1980s. In
the second section, we discuss why these changes
may lead to age-specific changes in household
* Senior Economist, Federal Reserve Bank of San
Francisco. The author wishes to thank Robert B.
Avery and Gregory E. Elliehausen of the staff of the
Federal Reserve Board of Governors for their assistance in providing the data employed in this study. I
wish also to thank William M. Robertson for his
excellent research assistance and diligence in managing the databases for this study.
17
wealth.··The third section of the paper summarizes
our analysis of survey data. In a fourth section, we
briefly review other evidence about the changing
economic status of the elderly. The paper concludes
I.
with a discussion of qualifications to the study's
findings and some policy implications of those
findings.
A Changing EconomlcEnvironment
By the mid-1970s, the economy of the United
States was experiencing seriously stagnating growth
and a rising
and increasingly volatile
inflation
rate. The annual rate of change in the consumer
price index (CPI) was 5.8 in 1976, but had risen to
over 13.5 percent in 1980 (see Chart I). As important as the actual changes in the rate of inflation were
the apparent upward revisions in inflation expectations that also occurred during this period.
Although it is difficult to measure long-term inflation expectations directly, they are, in theory, a
component of nominal interest rates, and contributed to the observed rapid increase in long-term
rates that began in the mid-l 970s and peaked in the
early 1980s.
Notable among the indexing procedures
employed by government programs was the process
used to detennine Social Security benefit levels. In
particular, in 1972, Congress introduced automatic
indexing into Social Security pensions. Social
Security payments were determined using a formula
applied to a nominal, base income standard. As
wage inflation occurred, of course, this base automatically was adjusted upward. In addition, as a
result of the 1972 amendments, benefit levels
derived from this formula also were inflation-indexed. The combined effect was a form of "doubleindexing" of Social Security benefits to inflation
that resulted in a rise in the average level of monthly
Social Security benefits of over 270 percent between
1970 and 1983 - a real increase of 120 percent. 4
Since it is unlikely that then-current and prospective
Social Security beneficiaries anticipated the inflation of this period and its impact on benefits, inflation may have conferred a windfall gain on Social
Security recipients. (Double-indexing was eliminated in later amendments to the Social Security
Act.)
Policy Conditions
These abrupt changes in the inflation rate, inflation expectations, and nominal interest rates took
place in a policy environment that was not configured with high rates of inflation in mind. In particular, the federal income tax system incorporated a
progressive rate structure, with the rate brackets
defined on the basis of nominal taxable income. As
their nominal incomes rose, taxpayers found themselves facing higher average and marginal tax rates
even if their real (inflation-adjusted) incomes had
not risen. Thus, the effective marginal tax rate
facing households - an important variable in portfolio decisions
also changed abruptly during this
period.
Labor markets too were caught unawares by the
rapid acceleration in inflation. Because few labor
market participants enjoyed wage adjustments as
rapid as inflation, the real hourly wage of the
average worker fell by one percent between 1975
and 1980. 3 The practice of indexing wages to the
cost of living (so-called cost-of-living allowance or
COLA) was not a common feature in the private
sector, although a number of government programs,
including many income transfer programs,
employed such indexing.
Chart 1
Housing Prices Rose Faster than
General Prices
5°1967 1969 1971 1973 1975 1977 1979 1981 1983
Source: U.S. Department of Commerce; C27 Construction
Series and U.S. Department of Labor; Bureau of Labor Statistics
18
1986
II.
Theoretical Implications for the Household Portfolio
that this utility receives in lifetime utility is a measure of the strength of the bequest motive.
Maximization of lifetime utility is constrained, of
course, by the resources available to the individual
during his lifetime. The availability of resources, in
tum, depends on the individual's initial endowment, if any, of assets, and income that flows to the
individual from market earnings. In concept, the
pattern of earnings over the life-cycle (the "earnings
profile") is itself endogenous to the lifetime wealth
maximization process because of decisions to
enhance human capital through education and decisions about how much labor to supply at each point
in time.
Out of their income flows, individuals make
consumption (and hence savings) allocations, borrowing and lending in the capital markets to obtain
the desired pattern of consumption. The interest rate
encountered in borrowing and lending - and its
relation to the rate of time preference - influences
the way in which individuals will arrange their
consumption and savings patterns over their lifecycle. 8
This process of maximizing lifetime utility subject to resource constraints results in life-cycle patterns of consumption, saving and, hence, financial
wealth positions. Depending upon the assumed
degree of uncertainty about the length of life and
earnings, the relationship between market interest
rates and the rate of time preference, the strength of
the bequest motive, and other characterizations of
the model, various configurations of life-cycle
behavior can be derived. If one can assume that
most individuals expect the last phase of their "lifecycle" to consist of a period of detachment from the
labor force (a period we might call "retirement"),
then a general profile of financial wealth over the
course of the individual's life emerges. In particular,
the distribution of wealth over an individual's lifecycle will be "humped" - rising initially and then
falling as the end oflife approaches. 9
The preceding describes the pattern of financial
wealth held by individuals at various dates in their
own life cycle. The comparative wealth positions of
individuals of different ages measured at the same
point in time (the "age-distribution of wealth") will
To provide a framework for reviewing the effects
of this economic and policy environment on the age
distribution of net worth, it is helpful first to discuss
the simple theory of household asset accumulation.
The Life-Cycle Saving Hypothesis
Economists long have had an interest in the
accumulation and disposition of assets over the
course of an individual's lifetime. s The process is a
complicated one as it is likely to depend upon such
diverse factors as the earnings profiles of individuals
over their "life-cycle", individuals' preferred pattern of consumption over time, how accurately the
death of the individual can be forecast, and the
strength of bequest motives. The interaction of these
and other factors on saving and the distribution of
wealth typically is studied in the context of the socalled "life-cycle theory of saving."
The development of the life-cycle theory of saving is credited most frequently to the economist
Franco Modigliani, although work by Irving Fisher,
Milton Friedman and others also was critical to its
development. 6 Because detailed descriptions of the
many variants of the theory are easily available in
the literature and because its implications for the
pattern of wealth accumulation over the life-cycle
are not always unambiguous, we will review only
the essence of the model and its relationship to our
study.
The life-cycle theory of saving begins with the
notion that individuals wish to maximize lifetime
"utility" - the economist's nomenclature for what
colloquially might be called well-being. Lifetime
utility has two components. The first consists of the
utility derived from consuming goods, services, and
leisure time throughout the individual's lifetime.
Within this component, the utility of consumption
in the future contributes differently to lifetime utility
than utility derived from present consumption.
Specifically, the utility of future consumption is
discounted by the individual's so-called "rate of
time preference": the greater the rate of time preference, the less important is future consumption in the
perception of lifetime utility.7 The second component of lifetime utility is the utility derived from
bequesting assets at the end of one's life. The weight
19
only be the same as the life-cycle distribution iflifecycle income prospects were the same for all generations. Historically, however, incomes have grown
from one generation to the next. This growth should
(everything else being equal) skew the observed
III.
age-distribution of wealth toward younger generations. Conversely, a secular decline in the income
prospects of newer generations would skew the
observeq age-distribution of wealth per individual
toward older generations.
A Life-Cycle View of the 1970s
results in a proportional increase in holdings of
financial assets in all phases of the life-cycle. II The
impact of changes in real and financial asset values
on the distribution of wealth therefore will depend
upon the distribution of these "windfall" gains
among households.
About half of the nation's nonhuman wealth is in
the form of residential real estate. 12 Since such real
estate tends to be held mainly in the portfolios of
older households, a change in its value is likely to
change the age-distribution of household net worth.
Moreover, because most mortgage debt in the
mid-1970s was fixed coupon debt, homeowners
enjoyed not only increases in the market value of
their homes but also a decrease in the market value
of their debt burden. Households on the brink of
retirement could "capture" a significant proportion
of this net worth because retirees no longer are tied
to developed metropolitan areas (for example, by
work), where housing supply is least elastic (and
home price inflation most pronounced). Also,
various court rulings often permitted the buyer to
assume the low-coupon mortgage debt, something
likely to be reflected in the home sales price. 13 This
scenario suggests that there may have been a significant transfer of wealth to homeowning households
near retirement age.
In this section, we study empirically the effects of
the various "shocks" that occurred in the 1970s on
patterns of wealth accumulation. In doing so, it is
useful to characterize the events of the 1970s in the
language of the life-cycle saving theory. We necessarily are selective, both in the economic events we
emphasize as well as the characterization of these
events in terms of the life-cycle model.
Shocks to Real and Financial Asset Values
The abrupt increases in inflation, inflation expectations, and nominal interest rates that occurred in
the late 1970s significantly influenced the relative
prices of important financial and real assets. The
price of housing, for example, rose sharply over this
period, far outstripping the general rate of increases
in prices (see Chart 1). Such behavior in housing
prices follows directly from the effect of inflation
expectations on the demand for durable goods coupled with the fact that the stock supply of housing is
relatively price inelastic. 1O Individuals already
owning homes, therefore, experienced sharp
increases in the value of the housing component of
their asset portfolios.
The value of fixed-coupon debt instruments, such
as bonds or fixed rate mortgages, for example, fell as
nominal interest rates increased. Holders (lenders)
of such debt experienced decreases in the value of
this component of their financial asset holdings.
Borrowers (such as corporations and homeowners,
for example) experienced increases in financial
wealth.
From the viewpoint of the life-cycle theory of
saving, unanticipated increases in asset values are
analytically similar to larger initial asset endowments and should have similar effects on the pattern
of asset accumulation over the life-cycle. Generally
speaking, an increase in initial asset endowment
Social Security Programs
The implications of changes in Social Security
programs for saving over the life cycle is difficult to
model anq, in fact, have been the subject of intense
debate in the economics literature. 14 In essence, the
Social Security program consists of a tax on the
wliges of current workers that funds benefits to
individuals who have reached a prescribed retirement age and who have severed their attachment to
the labor force. Even if the tax and benefit features of
20
the Social Security system were permanent and
could be perfectly forecasted, the effects on private
saving still would be ambiguous.
Some have argued that the combination of
reduced after-tax income during the working years
and the anticipation of benefits to be received in the
retirement years will reduce private wealth
accumulation. IS Others have argued that the effect
on the accumulation of private wealth depends upon
the rationale and strength of bequest motives. In
particular, they claim that the wealth implicitly
"transferred" from the working generation to the
retired generation by the Social Security system will
be returned to the younger generation through
heightened post-retirement saving and larger
bequests. 16 If so, saving over the life-cycle could be
largely unaffected by the Social Security system.
Social Security's effect on private saving efforts
is further clouded by the possibility that Social
Security taxes, benefits or both may be perceived as
impermanent or uncertain. In fact, the tax and
IV.
benefit features of Social Security have changed
frequently and are difficult to interpret because of
the complexity of tax and benefit formulae and the
relationship of taxes and benefits to other economic
circumstances. 17 The extent to which Social
Security's features are viewed as impermanent or
uncertain may affect private saving efforts.
The sharp increase in benefit levels (and concomitant increases in Social Security taxes) that
occurred in the 1970s may therefore have had a wide
range of possible effects on the private accumulation of wealth. For those at or near retirement age,
the decision to add to or dispose of current assets
may depend upon whether they view the benefit
increase as permanent or temporary and likely to be
offset by a future decrease in benefits. Their decision will also depend on whether they believe the
increase in retirement benefits is a transfer of
income from the younger generation that is offset
when retirees adjust their saving for bequest purposes.
The Age Distribution of Net Worth: 1977 vs. 1983
The ambiguity that pervades the theory of saving
over the life-cycle limits what we can draw from
life-cycle models in the way of useful inferences
about likely changes in the age-distribution of
wealth. Moreover, the life-cycle saving hypothesis
formally deals with the way in which assets accumulate and are disposed of by individuals over their life
cycle, whereas as a practical matter, policymakers
are less concerned with how policy affects the
pattern of accumulation of savings over the life
cycle than they are with one of its consequences: the
age-distribution of net worth at a given point in
time. In the remainder of this paper, we look at two
"snapshots" of the distribution by age of household
financial wealth. Such an approach can shed light
only indirectly on the processes that detennine lifecycle savings behavior, but it can reveal chaIlges in
the financial wealth status of various age groups.
The findings that follow, therefore, are largely
descriptions of changes rather than an attempt to
verifY a particular model of the life-cycle saving
theory. Nevertheless, findings that support (at least
anecdotally) some of the implications of the lifecycle saving model are highlighted below.
Studying Household Net Worth
There are a number of surveys that, in concept,
should provide data useful to our exercise. 18
However, of these, only one publicly available
database is designed specifically to survey the financial "balance sheets" of American households
accurately. This survey is the Federal Reserve System's Survey of Consumer Finances. Because the
survey in its present form was conducted in 1977
and again in 1983, it provides a convenient span for
us to see the consequences of the turbulent economic conditions of that time.
Approximately 2,600 and 3,800 randomly
selected households, respectively, were interviewed
in each survey to obtain information on their various
realand financial assets and liabilities. 19 The table
presents the components of net worth from the
coarse balance sheet categories in the surveys. The
only major categories omitted were consumer durabIes and the present value of private pension assets.
Data on consumer durables stocks were not collected in either survey, and data on pensions were
not obtained in the 1977 survey, preventing comparison on these items. Theory and some empirical
21
work argue that institutionalized saving through
pension funds will partly depress private wealth
accumulation.20 To the extent that pensions have
become more generous and ubiquitous over time,
their exclusion may lead to an understatement of the
relative wealth of younger versus older households.
Household Net Worth
We turn first to the most aggregative measure of
nonhuman household wealth explored in this paper
— household financial “net worth.” The net worth
measure is the residual of the market value of assets
and liabilities of the households in our sample.
Chart 2 displays the average household net worth for
selected age groups in 1977 and 1983.
From Chart 2, it is apparent that, on average,
nominal net worth rose for all but the youngest
category of households between 1977 and 1983.
This is not particularly surprising since nominal
income — at least for households as a group — was
rising during this inflationary period. The life-cycle
savings theory offers an explanation of the relation
ship between real wealth and real lifetime or perma
nent income: as nominal incomes rise, so should
nominal net worth, everything else being equal.21
Also apparent from Chart 2 is the change in the
shape of the age/net worth relationship. In 1977, the
net worth relationship was “humped” , with mea
sured net worth peaking somewhere near the pre
vailing retirement age. The existence of saving and
wealth relationships that are “humped” with age are
predicted by the life-cycle saving theory only at
different ages of a given cohort. Since our data
measures net worth at a cross section of age cohorts
at two points in time, we would expect a “humped”
age-net worth relationship only if all of the age
groups in our sample had the same life-cycle income
expectations.22
In general, however, growth in life-cycle income
over time (as would be expected in a growing
economy) should cause each successively younger
cohort to have higher life-cycle income expectations
and, hence, higher observed accumulated savings
per household. This would result in a skewing, over
time, of the age/wealth distribution toward younger
individuals. The data, in fact, show the opposite
tendency. Specifically, the bar graph in Chart 2
presents net worth by age group as a percentage of
the average household net worth for each of the two
surveys. A significant relative shift in net worth per
Chart 2
Age - Distribution of Household Net Worth
1977 and 1983
Dollars
Mean $ Values in 1977 ■
120,000
200 r — Mean $ Values in 1983 ■
180
160 -
Pet. of Sample Mean in 1977
Pet. of Sample Mean in 1983 9
100,000
140 120
-
100
-
80,000
60,000
40,000
20,000
0-24
25-34
35-44 45-54
55-64
65-74
75+
Age
* The difference between the 1977 and 1983 values is not statistically
different from zero for this group at the 95% confidence level
22
means, reveal a skewing in the age-distribution of
this asset toward older households that is similar,
although less pronounced, to that observed for net
worth in the aggregate (Chart 2). In addition, house
holds in the 45-54 age category had consistently
higher holdings of real estate assets relative to the
sample mean in 1983 than in 1977, contrary to the
finding for their total net worth.
Data on homeownership derived from the surveys
also suggest that homeownership prospects deterio
rated for younger households. The percentage of
homeowners is greater in 1983 than in 1977 for all
age categories except the youngest. In fact, the
increase in homeownership observed in the oldest
age groups is progressively greater for older groups.
household from young to older households is evi
dent. In particular, between 1977 and 1983, families
headed by individuals 55 years and older had
increased net worth relative to the population while
younger households displayed decreases. This drop
is consistent with a relative secular deterioration in
the lifetime income expectations of younger genera
tions’ households.
HomeowneirshSp arid Wealth Changes
By decomposing average household net worth
into its constituent elements, we find that a signifi
cant proportion of the observed increase in net worth
between 1977 and 1983 is “explained” — in an
accounting sense — by an increase in the value of
residential real estate. As data from the Net Worth
table indicates, the value of residential real estate
per household increased sharply and represented
nearly 75 percent of total asset changes between
1977 and 1983.
Furthermore, the mean value of residential real
estate assets increased for all household age groups.
Chart 3 shows that the average value rose from
$29,870 in 1977 to $53,947 per household in 1983.
The bar graphs in Chart 3, which express the nomi
nal value as a percentage of the relevant sample
Liquid Assets, Stocks and Bonds
Differences in liquid asset and stock and bond
holdings also contribute significantly to the
observed shift in the age-distribution of wealth
toward older households. Chart 4 displays the dis
tribution by age in the two samples of liquid assets
(defined as the value of bank deposits, money mar
ket mutual fund shares and savings bonds) and
holdings of other bonds and stocks. Once again,
these measures are presented in bar graphs as a
Chart 3
Age - Distribution of Residential Real Estate
1977 and 1983
Mean $ Values in 1977
Mean $ Values in 1983
Pet. of Sample Mean in
Pet. of Sample Mean in
150 ~
■
IS
_
1977 IS
1983
Dollars
70,000
-
60,000
50,000
0-24
25-34
35-44 45-54 55-64
65-74
75+
Age
* The difference between the 1977 and 1983 values is not statistically
different from zero for this group at the 95% confidence level
23
while employed. They then would have been able to
“capture” a portion of the net worth in real estate
and increase their holdings of financial assets. The
oldest households (those aged 75 years and older)
may already have made their relocation decisions
and, in the time frame of our study, “missed” the
opportunity to capture increases in housing value.23
Such a scenario may help explain the seemingly
paradoxical finding discussed earlier that the agedistribution of residential real estate assets did not
shift as dramatically as net worth in favor of older
households despite increases in rates of homeownership. The economic conditions of the late
1970s and early 1980s simply afforded retirementaged households the opportunity both to capture
appreciated real estate values and to increase homeownership by migrating to lower cost areas.
percent of the sample means in each of the two
survey periods.
For both categories of financial assets, an inter
esting pattern emerges. First, generally speaking,
households headed by individuals younger than 55
years of age actually hold less (in dollar terms) of
these assets in 1983 than in 1977, whereas older
households hold significantly more. This change is
reflected in a shift in the age-distribution of the asset
categories when household holdings are measured
relative to sample means.
Among the older households, those aged 75 years
and older display the smallest increase between
1977 and 1983. Data disaggregation by type of asset
(not shown here) show that the position in stock and
bond holdings of this age category deteriorated
relative to the sample means in 1983. In contrast,
the largest absolute and relative “gains” between
1977 and 1983 are displayed by households aged 65
to 74.
Lacking true panel data, it is not possible to
explain this somewhat inconsistent behavior by the
oldest (75 years and older) household category with
any confidence. The pattern is consistent, however,
with what one would expect if, upon retirement,
households relocated their residences to areas with
lower housing costs than those in which they lived
Mortgage and Consumer Debt
Growth in mortgage and consumer debt liabilities
of the average household were a significant — but
far from complete — offset to the growth in the
average value of household assets. As the Net Worth
table indicates, changes in average mortgage and
consumer debt liabilities constituted only 20 per
cent of the total increase in asset holdings observed
between 1977 and 1983. Charts 5 and 6 show that
Chart 4
Age - Distribution of Stocks, Bonds and Liquid Assets
1977 and 1983
Percent
Dollars
250 r—
50,000
200
-
400,00
150 -
- 30,000
100
-
24
nominal mortgage and consumer debt increased for
virtually all age categories between 1977 and 1983.
In addition, as illustrated by the bar graphs (which
display these nominal values as a percentage of
sample means), there was a greater propensity for
older households to hold both categories of debt in
1983 than in 1977.
That is, the age-distribution of debt, as well as of
wealth, shifted toward older households. This shift
is consistent with the notion that the demand for
debt is positively related to wealth,24 and with the
notion that older households may have been borrow
ing against equity in relatively illiquid real estate
assets to make other desired changes in their port
folio or consumption habits.
Unfortunately, a conceptual problem in the mea
surement of the market value of mortgage debt
makes it difficult to be confident about these find
ings. In particular, the mortgage measure used here
is the book value of outstanding debt rather than its
market value. Since interest rates increased signifi
cantly between the survey periods, it would be
desirable to re-value fixed coupon debt outstanding
in 1983 accordingly. Everything else being equal,
this re-valuation would tend to reduce the value of
mortgage debt held, particularly the debt in the form
Percent
Average Household Net Worth
and Its Components, 1977 and 1983
Assets
Total Assets
Total Real Estate
Liquid Assets
Stocks
Bonds
Other
1977
19S3
Difference
$43,262
29,870
8,292
4,288
812
N/A
$76,614
53,947
11,607
5,641
2,347
3,072
$33,352
24,077
3,315
1,353
1,535
N/A
9,123
7,465
1,658
15,858
12,568
3,399
6,735
5,103
1,741
34,139
2,563
60,755
3,823
26,616
Liabilities
Total Debt Liabilities
Real Estate Debt
Consumer Debt
Net Worth
n=
Source: Federal Reserve System, Surveys of Consumer Finances.
1977 and 1983.
of older, low-coupon mortgages typically held by
older households.
The problem for our analysis is one of potential
double counting. Since many of these low-coupon
mortgages also were assumable, the estimates of
Chart 5
Age - Distribution of Mortgage Debt
1977 and 1983
Mean $ Values in 1977 ■
Mean $ Values in 1983 ■
Pet. of Sample Mean in 1977 IS
Pet. of Sample Mean in 1983 ■
200
175
150
125
-
Dollars
25.000
20.000
15,000
100
H 10,000
5,000
0-24
25-34 35-44 45-54
55-64 65-74
75+ Age
* The difference between the 1977 and 1983 values is not statistically
different from zero for this group at the 95% confidence level
25
overall changes in the age-distribution of net worth
in favor of older households. In addition, a similar
pattern in the age-distribution of debt holding for
consumer debt (which is typically of shorter term
and therefore has a book value that may approximate
its market value despite interest rate changes) lends
further support to our finding that the demand for at
least certain categories of debt appears positively
related to household wealth.
home value reported by households may include a
premium that represents the households’ ability to
sell their property with an assumable, low-coupon
first mortgage.
Thus, although the data are available in the sur
veys to estimate the market as well as the book value
of outstanding mortgage debt, we do not report
those computations here.25 Reporting those com
putations also would simply reinforce the observed
IV.
Other Observations
The incidence of extreme poverty among the
elderly also has declined. In Chart 8, the percent of
households of various age groups living below the
officially defined poverty level is plotted. Those
families headed by someone 65 years and older
enjoyed (as of 1984) the lowest incidence of poverty
of any age group. In addition,, the incidence of this
measure of poverty declined by 20 percent between
1977 and 1984 for those older than retirement age;
the incidence of poverty increased — sharply in
some cases — for all younger households over the
same time period.
It should be emphasized that none of these find
ings is based on a direct measure of changes in the
level of well-being of older versus younger Ameri
cans. Older households face considerable uncer-
The finding that the distribution of household net
worth has shifted in favor of older households is
only one measure of the changing economic circum
stances of older Americans. It also is interesting to
examine the average incomes to households of dif
ferent ages. The available data suggest that the
income position of older households also has been
improving steadily relative to younger households.
In Chart 7, for example, the mean family income for
families headed by someone 65 years of age and
older is compared with that of younger families.
Relative to the average income of all families, the
average incomes of older households have increased
dramatically in the last decade or so, whereas the
relative incomes of younger households have
declined.
Chart 6
Age - Distribution of Consumer Debt
1977 and 1983
26
tainty about inflation, their futurehel:tlth, the
reliability of Social Security programs, and other
influences on the quality of their lives. In addition,
the "average" measures presented here do not
provide information on the disparities.in net worth
or income that may exist within an age category.
Nevertheless, the data are consistent with the
viewthat changesin Social Security programs and
inflation ~ particularly as inflation affected the
housing market ~ benefitted older households. Not
only do the incomes of older households appear to
be rising relative to younger households, the
observed skewing in the pattern of net worth toward
older households is consistent with the view that
older households have enjoyed enhanced lifetime
income expectations.
Chart 8
Percent of Households
with Income Below Poverty Level
( by Age Group)
Percent
30
25
20
15
Householders Ag~45-54
10
Householders Age 65 +
5
o
1977
1978
1979
1980
1981
Source: U,S, Bureau of the Census
Current Population Reports, Series P-60
Chart 7
Household Income by Age Group
as a Percent of the Mean Income of
All Households
Percent
Percent
67
115
65
113
Householders 64 and Younger
r
~
63
61
...
59
,
Householders 65 and Older
571-.......1975
............1977
.......- 1 . . . -......1979
Source: U,S, Bureau of the Census
Current Population Reports, Series P-60
27
1981
............----1105
1983
1982
1983
1984
V.
ConclusionsahdPolicylmplication$
What is clear from the Survey of Consumer
Finances is that, as of 1983 at least, older households on average were not a disadvantaged group
with respect to financial net worth. Indeed, household wealth became an increasing function of the
age of the household. This observation, coupled
with data from other sources that show changes in
the poverty rate and average household income
favorable to older households, suggests that the
conventional view that older households should
receive greater income transfers may be outdated.
Given the significance of programs directed at
assisting older groups in the federal budget, this
observation may imply that changing the level or
structure of these programs could be part of an
equitable solution to the problem of federal budgetary imbalance.
In summary, our data reveal a significant shift
and 1983 in. the age-distribution of
financiaL\Vealthtoward older households. This
observation issonsistent with the changingeconomicconditiomriand increases in Social Security
benefitsduringtl111ttime.2§ 'fi1edata do not allow.us
to ascertain whether the drllmllticshift. occurred
because the beneficiary age •groups believed the
economic changes were transitory (causing them to
save rather than spend out of windfall gains) or
whether. they believed them to be permanent enhancements. to their income and we.alth at the
expellse ofyounger age groups. Even iftbe latter
were the case, the higher-than-average net worth
observed for even the most elderly age groups may
reflect a desire to make a compensating bequest to
the younger households.
bet,#~enJ 977
28
FOOTNOTES
1, Edward Foster, "Costs and Benefits of Inflation,"
Federal Reserve Bank of Minneapolis, March 1972,
2, Conceptually, the accumulated stock of human capital
also should be embodied in any definition of a societal
"wealth" measure, Colloquially,however, the term wealth
is employed to describe accumulations of money or property net of.claims on those assets ~ (or, more formally, net
worth). Our analysis focuses only on the nonhuman
aspects of wealth. In keeping with colloquial usage, terms
"wealth" and "neLworth" will be.used interchangeably to
refer to the net value of accumulated nonhuman assets
and financial liabilities, An analysis of changes in the
broader concept of wealth (namely, One that includes
changes in accumulated human capital), while potentially
more relevant to a formal study of changes in economic
well-being, is not feasiblE! with the available data,
3, Bureau of Labor Statistics, U,S, Department of the
Census data,
borrower who attempted to sell her home without retiring
the mortgage as called for by the "Due-an-Sale" clause in
the mortgage instrument Virtually throughout the period
studied in this paper, the Due-on-Sale clause, while present inmost mortgages, was voided or of uncertain legal
status, permitting sellers of homes to provide implicit
below-market financing for buyers,
14, See Blinder, et ai, op cit.
15, Martin Feldstein, "Social Security, Induced Retirement
and Aggregate Capital Accumulation", Journal of Political
Economy, 1974, pp, 905-926.
16, Robert Barro, "Reply to Feldstein and Buchanan,"
JournaIof Political Economy, April 1976, pp, 343-349,
17. The complexity of the computation of net expected
Social Security wealth and its dependency upon age,
income and family structure is well illustrated by the simulation performed in APellechio and G. Goodfellow, "Individual Gains and Losses from Social Security Before and
After the 1983Amendments,"theCATOJournal,Fall 1983,
pp,417-442,
4. In 1974, special supplementation income (SSI) also
was begun for the poor, aged, blind and disabled, The rate
of increase in these benefits has been modest, with average monthly benefits only doubling between 1974 and
1984,
18. The Retirement History Survey (RHS) conducted by
the Social Security Administration between 1969 and 1979
followed a sample of near-retirement individuals, and
accumulated data on prior work, health and wealth circumstances as well as pre- and post-retirement consumption
and saving behavior. This survey has proved very useful in
testing a number of hypotheses about retirement, but the
detail and reliability of the financial asset data and the
particular age group studied do not make it useful here,
However, it does permit interesting (though somewhat
dated) analyses of a particular age cohort's pre- and postretirement income, See M, Boskin and j, Shoven, "Poverty
Among the Elderly, Are There Holes In The Safety NetT
NBER Working Paper No, 1923, May 1986, who find that
there are "pockets" of problems within a generally comfortable retired population, The Michigan panel survey also
assembles data on a variety of variables regarding household behavior on a frequent basis, Unfortunately, the financial asset data in this survey is relatively crude.
5, See, for example, Duesenberry, j, S" Income, Saving
and the Theory of Consumer Behavior, Cambridge: Harvard University Press, 1949,
6. The life-cycle saving hypothesis and the permanent
income hypothesis were articulated at approximately the
same time, See, for example, Friedman, Milton, A Theory
of the Consumption Function, New York: NBER, 1957;
Modigliani and Brumberg, "Utility Analysis and the Consumption Function," in Post-Keynesian Economics, New
Brunswick, New Jersey: Rutgers University Press, 1954;
and Ando and Modigliani, "The Life Cycle Hypothesis of
Saving," American Economic Review, March 1963, pp.
55-84,
7, See Ando and Modigliani, ibid,
8, This is because the rate of interest at which an individual
can borrow and save influences his ability to smooth
cohsumption optimally in response to stochastic changes
in income flows, whereas the rate of time preference is the
implicit "discount rate" which the individual uses to evaluate consumption flows in present terms,
19. The data sources are the 1977 and 1983 Surveys of
Consumer Finances, jointly sponsored by the Federal
Reserve Board, the Department of Health and Human
Services and five other federal agencies, The surveys were
random samples by household; in 1983 a special additional survey of high income households was conducted,
This nonrandom sample is not employed in our study, For
details on the surveys, see the series of articles by Robert
Avery et ai, in the Federal Reserve Bulletin, September
1979, December 1984 and March 1986,
In 1977 total assets consisted of (1) value of the family's
home, (2) value of other properties, (3) liqUid assets, (4)
stocks, and (5) bonds, Detail within these categories varied across surveys, For example, in 1983 separate categories for notes and land contracts, trusts and investment
accounts, and other assets were isolated,
Total liabilities included mortgages on homes and other
properties and consumer debt defined as (1) installment
debt, (2) single payment loans, and (3) credit card debt.
These variables were constructed directly from survey
detail.
9, The theoretical conditions necessary to produce this
pattern are discussed in King, M. A and Dicks-Mireaux, L"
"Asset Holdings and the Life Cycle," The Economic Journal, June 1982, pp, 247-266,
10, This is discussed in some detail in Pozdena, R. j,
"Inflation Expectations and the Housing Market," Economic Review, San Francisco: Federal Reserve Bank of
San Francisco, Fall 1980.
11, See Blinder, Gordon, and Wise," Social Security,
Bequests and the Life Cycle Theory of Saving," National
Bureau of Economic Research, Working Paper No, 619,
January 1981,
12, Flow of Funds Accounts, Board of Governors of the
Federal Reserve System, 1985,
13, A watershed legal case in California, Wellenkamp v.
Bank of America, was decided in favor of a mortgage
29
In 1983, an O\.J~lyingqt>$ervationw~s eHrn.inated because
during the process of computing aggregate variables we
observed reported bond holdingsinexcessQf twelve
million dollars fQrtax-free bonds and stock holdings in
excess of three million dollars. These were deemed to be
unreliableestim$tes and would havearbitr$rily biased our
analysis.
23. The opportunity is "missed" on the assumption that
households, upon retiring, tend to become increasingly
fixed in their residential location, particularly with advancing age.
For details on· the surveys, see the series· ofartitles by
Robert Avery et ai, in the Federal Reserve Bulletin, September 1979, December 1984 and March 1986.
25. In particular, the possibility exists that during the time
period of our study, because of widespread assumability
of mortgages, perceived home values and actual transactions prices capitalized, at least partly, the difference
between book and market value of the assumed mortgages.
24. Dunkelberg, W. and Stafford, E, "Debt in the Consumer Portfolio," American Economic Review, September
1971, pp. 598-613.
20.· See Feldstein, op cit, for example.
21. Indeed, one of the difficulties encountered in attempts
to explore theshap/i> of the age cohort relationship in
wealth usingcrO$S-section data is design of the appropriate "real life-cycle income" measure. See, for example,
King and Dicks-Mireaux, op cit.
26. An interesting direct study of the effect of Social
Security on wealth accumulation in the aggregate,
however, is available in Feldstein, M. and Pellechio, A,
"Social Security and Household Wealth Accumulation:
New Microeconomic Evidence," Review ofEconomics and
Statistics, 1979, pp. 361-368.
22. That is, the cross-section age-distribution of w/i>alth
must be "deflated"by cohort-linked changes in life cycle
income expectations. For a "humped" age-distribution of
wealth to be taken as evidence of a humped pattern over
the life-cycle, it must be assumed that all age groups have
the same life-cycle income expectations.
30
Michael C. Keeley and Carl E. Walsh*
Summary of proceedings from the 1986 Fall Academic Conference
sponsored by the Federal Reserve Bank of San Francisco.
On November 20 and 21, 1986, the Federal
Reserve Bank of San Francisco held its annual Fall
Academic Conference. This conference provides a
forum for academic and business economists,
together with the staff economists of the Federal
Reserve Bank of San Francisco, to discuss recent
academic research on topics of current policy interest.
The 1986 conference focused on two topics. The
first, macroeconomic policy coordination, is a topic
that has figured prominently in recent discussions of
the United States' monetary policy. Frequently during 1986, commentators linked the Federal
Reserve's setting of the discount rate to attempts to
coordinate interest rate cuts with Japan and West
Germany. The Reagan Administration also
expressed a desire to coordinate U. S. monetary and
fiscal policy with more expansionary policies in
Japan and W. Germany as a means of reducing the
U.S. trade deficit. Two papers and a panel discussion during the first day of the conference examined
various aspects of international policy coordination.
I.
A third paper examined domestic policy interaction
between independent monetary and fiscal
authorities.
Financial intermediaries and their role in the
economy comprised the second topic discussed at
the conference. The course of financial innovation
and deregulation over the last decade in the U. S. has
brought to prominence several important policy
issues related to banking regulation and the responsibility of the Federal Reserve to maintain the stability of the financial system. Five papers presented
at the conference addressed issues related to the role
of financial intermediaries in the economy, specifically those important to the debate over the appropriate scope of and need for financial regulation and
ways of reforming our current regulatory system.
This article contains a brief survey of the papers
presented at the 1986 Fall Academic Conference
with an emphasis on their policy implications.
Copies of any of the individual papers may be
requested by writing to Public Information, Federal
Reserve Bank of San Francisco, 101 Market Street,
San Francisco, California 94105.
Policy Coordination
Recent developments in the analysis of macroeconomic policy have emphasized the role played
by expectations about future policy actions. In particular, the impact of current policy on the economy
can be influenced by the private sector's expectations about future policy. The influence of expectations raises two issues: first, whether we can under-
stand the effects of current economic policy without
an explicit understanding of how policy is likely to
be determined in the future; second, whether policymakers can influence the economy by announcing
that they will take certain actions in the future.
These issues are particularly important when trying to understand economic policy in the presence
of two or more independent policy authorities.
Recent concern in two areas highlight the timely
relevance of research on the interactions among
policy authorities. In this nation, where authority
for fiscal and monetary policy resides in separate
institutions, some authors have expressed concern
* Senior Economists, Federal Reserve Bank of San
Francisco. The authors would like to thank H.
Robert Heller, Dale Henderson, Alan Hess, Warren
Weber,and Thomas Willett for helpful comments on
an earlier draft.
31
over the extent to which the Federal Reserve might
be forced by fiscal inaction to monetize the growing
federal debt. On the international scene, where
policy decisions taken by one country can affect the
policy choices open to other countries, much attention has been placed on recent attempts by the U. S.
to reduce the American trade deficit by persuading
Japan and W. Germany to stimulate their economies.
the monetary base for the central bank and the
cyclically adjusted fiscal deficit net of interest for
tile fiscal authority. In the second stage, each policy
authority attempts to achieve the best trade-off
between keeping its policy instrument close to the
value that achieves its macroeconomic objectives
anci minimizing deviations of the stock of public
debt from a desired target.
The second stage of this game is made interesting
by the dynamic government budget constraint that
links the debt to the actions of the monetary and
fiscal authorities. The fiscal policymaker can lower
the debt held by the public by choosing to run a
budget surplus, but this course of action may conflict with the fiscal stance necessary to achieve the
reference path. The monetary authority can reduce
the debt held by the public by monetizing it, but this
choice may conflict with the path of the monetary
base necessary to achieve goals such as price stability.
The solution to this game yields a set of equations
that describe the behavior of the monetary base, the
noncyclical fiscal deficit, and the stock of debt held
by the public. The heart of the authors' theory lies in
the restrictions the theory implies for the coefficients in the equations for the base, the deficit, and
the debt. Most importantly, these coefficients
depend on the parameters characterizing the weight
each policymaker gives to achieving its desired
value for the debt.
If the fiscal authority cares about achieving its
target for debt, while the monetary authority does
not, then the monetary authority will set its instrument to achieve its macroeconomic objective without regard to the debt and the fiscal authority will be
forced to give up its desired reference path in order
to keep the total debt near the desired target. Conversely, if the monetary authority cares about the
debt target and the fiscal authority does not, the
monetary authority will be forced to sacrifice such
macro goals as low inflation, for example, in order
to achieve the target level of the debt. These two
alternative outcomes represent the extremes in
which one policymaker or the other dominates. The
actual outcome will depend on the relative weight
each authority places on its policy objectives.
A chief purpose of the Tabellini and La Via paper
is to provide a framework for empirical analysis that
might allow these weights to be estimated. The
Money, Deficit and Public Debt:
An Empirical Investigation
by Guido Tabellini and Vincenzo La Via
The paper by Guido Tabellini of UCLA and
Vincenzo La Via of the World Bank entitled
"Money, Deficit and Public Debt: An Empirical
Investigation" focuses on the joint behavior of
domestic monetary and fiscal authorities. Recent
theoretical work has emphasized that the relationship between macroeconomic variables, such as real
interest rates and the current budget deficit, will
depend critically on the expectations the public
holds about the course of future budget deficits.
These expectations will, in tum, depend on future
monetary and fiscal policy. Therefore, to analyze the
impact of current and projected federal budget deficits, for example, it would be necessary to forecast
how the Federal Reserve and the Congress are likely
to act in the future. Specifically, will the Federal
Reserve eventually generate renewed inflation by
monetizing future deficits, or will Congress be
forced eventually to raise taxes to reduce the debt?
To forecast future monetary and fiscal policy, it is
necessary to understand how relatively independent
policy authorities will interact. Such interaction
may be particularly complex when, as seems likely,
the policy authorities have conflicting objectives. In
such an environment, Tabellini and La Via take the
view that "future policies must be viewed as the
equilibrium outcome of a dynamic game between
the two authorities."
The game that the authors model separates the
strategic interaction of the monetary and fiscal
authorities into two stages. In the first stage, each
authority chooses an optimal path for the policy
instrument under its control in order to achieve its
macroeconomic objectives without considering the
choices being made by the other authority. The
policy instruments in the United States consist of
32
framework would· then allow a conclusion to be
drawn as to whether U.S. policy is best characterized as a game in which the monetary authority
dominates or one in which the fiscal authority
dominates.
The main finding ofthe paper is that the burden of
stabilizing public debt during the period 1955-1985
fell on the fiscal authority. The authors conclude that
"there is no evidence of debt monetization on the
part of the monetary authorities, while instead there
is strong evidence that fiscal deficits were reduced
when the stock of public debt inherited from the past
increased." In other words, the evidence suggests
that the Federal Reserve has not, in the past, tended
to monetize government debt. Other findings are
that both fiscal and monetary policy tend to be more
expansionary under Democratic administrations,
and that there is evidence of a political business
cycle in both monetary and fiscal policy related to
national elections.
ences of· the monetary and fiscal authorities. To
Sheffrin, it seemed unlikely that such preference
parameters would remain unchanged as the personalities of the individuals determining policy
changed. TabeUini noted that an attempt was made
to. test for parameter stability over the sample
period, and that dummy variables were included in
the empirical analysis to capture the effects of
changes in the chairmanship of the Federal Reserve.
The results suggested monetary policy was most
restrictive under William Martin's chairmanship.
Noncooperative Monetary Policies
in Interdependent Economies
by Matthew Canzoneri and Dale Henderson
Tabellini and La Via examine only the Nash
equilibrium to their dynamic policy game; they do
not consider how the outcomes might be affected if
the monetary and fiscal authorities can coordinate
their policies or build reputations for "good"
behavior. The role of such reputation building is one
of the central foci of the Conference's second paper,
"Noncooperative Monetary Policies in Interdependent Economies: Time Inconsistency and Reputation" by Matthew Canzoneri and Dale Henderson,
both of Georgetown University. The paper represents a chapter from the authors' forthcoming book,
Noncooperative Monetary Policies in Interdependent Countries.
Like Tabellini and La Via, Canzoneri and Henderson employ a game-theoretic framework to study
the interaction of two policy authorities. However,
Canzoneri and Henderson shift the focus from the
domestic interaction of monetary and fiscal
authorities to the international context in which the
different policymakers are the monetary authorities
in different countries. The authors argue that one
can obtain misleading conclusions from models
with only one active policy authority and illustrate
their argument with an example. In their example, a
requirement that policy be pre-committed to certain
actions necessarily leads to better outcomes when
only one policymaker is active but may lead to
worse outcomes when two policymakers are active.
Canzoneri and Henderson note that if the current
behavior of private agents depends on their expectations of the future, credible announcements about
future policy instrument settings may provide pol-
Comments by Steve Sheffrin
Steve Sheffrin of the University of California at
Davis raised three issues in his comments on the
Tabellini and La Via paper. First, he questioned the
division ofthe policy game into two separate stages.
In particular, he felt that it seems unreasonable to
expect policy authorities to act in the first stage as if
they were totally unaware of the second stage of the
game. Tabellini agreed that this separation was
somewhat artificial, but argued that it allowed the
analysis to be greatly simplified.
Second, Sheffrin expressed concern about the use
of the cyclically adjusted federal budget deficit as
the fiscal policy instrument. He claimed the use of
the deficit ignores the choice between spending
changes and tax changes.! In addition, the use of a
cyclically adjusted deficit was not introduced into
macroeconomic policy discussions until the 1960s
so he believed that its use in the empirical work as a
measure of the fiscal policy instrument for the entire
1955-1983 period may be inappropriate.
Finally, Sheffrin questioned whether Tabellini
and La Via had really succeeded in estimating
structural parameters that can be used as guides to
understanding future policy. In particular, he
referred to parameters estimated by Tabellini and La
Via which they describe as representing the prefer33
the monetary policymakers in the two countries also
respond symmetrically, their commitments to
change next period's money supplies are counterproductive. Their symmetric pre-commitments
have no effect on this period's employment and CPls
because. the pre-commitments leave the expected
real exchange rate unchanged. The only effects of
the pre-commitments are undesirable changes in the
next period's CPls. According to this model, each
policymaker makes a counterproductive commitment to change next period's money supply because
if he did not, the other policymaker would make a
commitment that would leave him in an even worse
position.
In his presentation at the Conference, Henderson
developed a four-way classification of policy
according to whether cooperative or noncooperative
behavior and pre-commitment or no pre-commitment are involved. He then argued that two combinations - noncooperative behavior with no precommitment and cooperative behavior with precommitment - were the most relevant options for
future study. In most cases, cooperation among
policy authorities, together with pre-commitment to
future policy, is likely to yield the best results since,
as Richard Sweeney of Claremont McKenna College, the paper's discussant, pointed out, cooperation maximizes the economic pie and pre-commitment maximizes the number of instruments
available to the policy authorities.
Canzoneri and Henderson also consider what
happens when the policymakers interact in an
infinite sequence of two-period games. In this situation, the policymakers can establish reputations for
good behavior. Over an infinite succession of twoperiod games, noncooperative behavior without
pre-commitment may result in what can usefully be
called the efficient outcome, that is, the outcome
that would result with cooperative behavior and precommitment in a single two-period game. The inefficient outcome is the outcome that would result
with noncooperative behavior and no pre-commitment in a single two-period game.
In playing the succession of games, each policymaker thinks that if he does not cheat, the other
policymaker will continue to choose the policy
associated with the efficient outcome, and that if he
does cheat, the other policymaker will revert to the
icy authorities with an extra instrument for affecting
the current values of their target variables. Thus, the
ability to pre-commit to future actions increases the
number of effective policy instruments available to
policymakers. The authors examine the role of precommitment within the context of a two-country
model in which monetary policies in the two countries can be either cooperative or noncooperative.
As a framework for their analysis, the authors use
a model in which each monetary authority cares
about employment and price volatility in its own
country. The price the authority cares about,
however, corresponds to the Consumer Price Index
(CPI) - an average of the price of home goods and
the home price of foreign goods - which is affected
by monetary policy actions in the other country
through the real exchange rate.
For example, a rise in the home country's money
supply raises the price of home output and further
raises the home CPI by causing the home country
currency to depreciate in real terms. This depreciation comes about because an increase in the home
money supply lowers real wages, given that nominal
wages are predetermined by contracts, thereby
causing home output to rise and creating an excess
supply of domestic output. The home currency must
depreciate in real terms to raise demand for domestic output and restore equilibrium in the market for
home output. While a domestic monetary expansion
raises the home CPI, the associated real depreciation of the home currency lowers the foreign CPI.
In the Canzoneri and Henderson model, credible
announcements about future monetary policies
affect current CPls because they affect expected real
exchange rates. This connection depends critically
on the assumption that wage contracts last for more
than one period. 2 The existence of multi-period
wage contracts imparts a short-run rigidity to wages
that allows announced monetary policy actions to
have real effects.
Canzoneri and Henderson then show how precommitting to future policy actions in the absence of
cooperation among policymakers can be undesirable. They cite the case of a symmetric disturbance
in which each policymaker will consider responding with the two tools available: the current money
supply and a commitment for next period's money
supply. Since Canzoneri and Henderson assume that
34
policy associated with the inefficient outcome for
some number of two-period games in the future,
perhaps forever. Each policymaker would choose
the policy associated with the efficient· outcome
only if the future reward for not cheating were high
enough. The Canzoneri and Henderson analysis
suggests that when reputation building is possible,
the outcomes of noncooperative behavior without
pre-commitment may not be inefficient.
tems· by comparing the fluctuations in output,
prices, imports, and exports under each system. His
results seem to indicate that economic fluctuations
would be smaller under a flexible exchange rate
system.
Taylor's evaluation of the exchange rate regime
focuses only on aggregate supply disturbances. At
this stage of the research project, Taylor has not
fUlly evaluated the two exchange rate systems in the
face of aggregate spending and financial market
disturbances. Also, he makes very specific assumptionsabout monetary policy and fiscal policy to
compare fixed and flexible exchange rates. Under
both systems, he holds fiscal policy constant. Under
the flexible rate system, he assumes that all seven
countries in the model hold constant the rate of
growth of their money supplies. In contrast, under
the fixed rate system, he assumes that the U.S.
holds its money growth rate constant while the other
six countries allow whatever money supply movements are necessary to keep their exchange rates
fixed.
Taylor compares these alternative exchange rate
systems using a model characterized by two important features. First, the aggregate wage level is
modelled as determined by the existence of multiperiod, overlapping contracts of the type studied by
Taylor in earlier work. 3 The wage equations are
estimated for the United States, and the wage equations in the other six countries are then assumed to
be the same as that for the U.S. Second, the model
assumes perfect capital mobility as reflected in its
requirement that deviation from uncovered interest
parity be zero on average. This requirement means
that the differential between interest rates in each
country must equal the expected change in the
exchange rate. In Taylor's model, therefore, this
interest rate parity condition and the wage equations
are two channels through which expectations of the
future influence the economy's current equilibrium.
The presence of expectations of future variables,
together with the assumption that these expectations
are rational, greatly complicates the derivation of
the policy simulations. Within Taylor's model, the
solution for the current period depends on expectations of next period's equilibrium, which depends
on· expectations of the following period's equilibrium, and so on. Hence, to simulate the model for
Comments by Richard Sweeney
In discussing Canzoneri and Henderson's paper,
Richard Sweeney felt that actual experience with
policy coordination suggests that policy authorities
have usually tried to get other countries to follow
bad policies. In addition, policy authorities may
have preferences that differ from those of private
agents - a point of view emphasized in recent
theories of public choice.
An Econometric Evaluation of
International Monetary Policy Rules
by John Taylor
Whereas the Henderson and Canzoneri paper
provided a theoretical framework for analyzing policy coordination, the purpose of the conference's
third paper, "An Econometric Evaluation of International Monetary Policy Rules: Fixed versus Flexible Exchange Rates" by John Taylor of Stanford
University, was to report on a model designed to
evaluate alternative policy regimes empirically. This
paper represents part of an ongoing research project
by Taylor that involves the estimation of a rational
expectations model of seven industrial countries the U.S., Canada, France, Germany, Italy, Japan
and the United Kingdom. Taylor strongly argued
that even if agreement were reached on the theoretical effects of disturbances in open economies, estimates of the empirical magnitudes involved would
remain crucial for actual policy analysis.
Taylor attempts in his paper "to evaluate and
compare flexible versus fixed exchange rate systems
using a rational expectations policy evaluation technique ..." The estimated multi-country model he
uses is subjected to random shocks, first under the
assumption of flexible exchange rates and then
under the assumption of fixed exchange rates. He
then evaluates the two different exchange rate sys-
35
Comments by Roger Craine
even one quarter requires that the model be solved
into the distant future to ensure that the expectations
of the future are consistent with the actual future
behavior implied by the model.
In addition to providing a comparison of alternative exchange rate regimes in the face of supply
shocks, Taylor's paper also reports the estimated
effects of unanticipated U.S. monetary and fiscal
policy changes. He examines the effects of these
policy changes under both fixed and flexible
exchange rates.
Under flexible exchange rates, Taylor shows that
a U.S. monetary expansion raises U.S. real output
during the first year of the expansion; output then
returns to its baseline level over the next two years,
reflecting the long-run neutrality of money. The
dollar depreciates in response to the monetary
expansion in this simulation, but the effects of U .S.
monetary expansion on other countries are small.
The rise in domestic output raises U.S. demand for
imports, which causes some output expansion in
the other countries, but this foreign expansion is
dampened by the dollar depreciation that shifts
demand to U. S. output.
According to Taylor, when a fixed exchange rate
regime is in operation, a similar U.S. monetary
expansion produces a large expansion in the other
countries. In contrast to the flexible exchange rate
case, the other countries must keep their currencies
from appreciating relative to the dollar under fixed
exchange rates. To do so they must let their money
supplies expand. These induced monetary expansions lead to the greater output effects Taylor finds
with fixed rates.
Taylor finds a similar contrast in the effects of a
U.S. fiscal expansion under fixed and flexible
exchange rates. Under flexible exchange rates, he
finds that an increase in U.S. government expenditures produces a dollar appreciation and a trade
deficit for the U.S. that leads to some real expansion
in the other countries in the short-run. In contrast,
under a fixed exchange rate system, he finds that a
U.S. fiscal expansion leads to a sharp contraction
abroad as the other countries are forced to reduce
their money growth to keep exchange rates from
changing. While these results agree qualitatively
with standard open economy theoretical models,
Taylor's research yields estimates of the quantitative
magnitudes involved.
Roger Craine from the University of California,
Berkeley, was the discussant of Taylor's paper.
Craine applauded Taylor's approach to policy evaluation in which the behavior of a model representing an economy or policy regime is studied while it
is disturbed by random shocks.
Craine did, however, question whether the
parameters of Taylor's model would remain
unaffected by a shift in the exchange rate regime. In
his empirical work, Taylor does account for changes
in the way expectations of the future are formed
when the exchange rate regime shifts, but other
aspects of the model, such as the average length of
wage contracts, are assumed to remain unchanged.
One method for testing the stability of the model
over exchange rate regime shifts was suggested by
Craine. Since the model was estimated over a period
of flexible exchange rates with data from the period
1971 to 1985 used in the estimation, Craine noted it
should be possible to use the model to "forecast"
backward. One could then see if the model is able to
fit the period of fixed exchange rates prior to 1971 .
First Day Panel Discussion
The first day of the Conference concluded with a
panel discussion on policy coordination. Panel
members were Peter B. Clark, Acting Division
Chief of the International Monetary Fund (IMF),
Professor Robert W. Clower of the University of
South Carolina, H. Robert Heller, member of the
Board of Governors of the Federal Reserve System,
and Professor Thomas Willett of Claremont Graduate School.
Peter Clark began the discussion by reviewing the
role played by the IMF in international policy coordination. He explained that the role is played at two
levels. First, at the bilateral level, the IMF focuses
on the policies of one country in relation to the rest
of the world. Since most countries are "small", the
focus at this level is on the impact of external factors
on the country's domestic economy. For "large"
countries such as the U.S., IMF discussions focus
on the impact of that country's domestic policy on
the rest of the world. Clark cites discussions with
U. S. policymakers over the impact of fiscal deficits
on world interest rates as an example of the difficulties inherent in policy coordination when policy36
makers hold different views about the true workings
of the world economy.
Second, at the global level, the IMF focuses on
multilateral coordination of policy and provides a
forum through which countries can exchange information on economic forecasts and policy assumptions. Clark's example of an issue addressed at this
multilateral level was the problem of managing
world aggregate demand in the face of declining
world fiscal deficits.
Robert Clower emphasized that, in the absence of
a better understanding of how economies work at
the macro level, discussions of policy coordination
are of little value. Such coordination requires forecasts of where economies are headed, but he stated
that economists are simply not capable of providing
believable forecasting models of real economies. In
this situation, Clower believes, policies are usually
based on "faith, hope, and bias."
Clower also argued that there is little short-run
connection between demand, supply, and price in
most markets. He felt that economists need to
understand better how markets work before they
worry about policy coordination.
In his remarks, Robert Heller praised the line of
research presented in John Taylor's paper for its
attempt to quantify some of the issues that are
relevant for an evaluation of policy coordination.
Heller drew a contrast between automatic regimes,
such as the gold standard, and discretionary regimes, such as that which currently characterizes
the international economy. He said that coordination was determined by rules in automatic regimes,
and described discretionary regimes as characterized by "coordination by conference."
Heller argued that the desirability of flexible
exchange rates will depend on the cost ofreallocating resources within each country. He believed that
small countries would tend to favor a fixed exchange
rate system because rate adjustments are likely to be
expensive for them. In contrast, he thought the large
industrial economies would favor flexible exchange
rates. Heller argued that a hierarchy of views exists.
Among the U. S., Japan and Germany, for example,
coordination may rely primarily on flexible
exchange rates. Among Germany, France, and the
U.K., greater reliance may be placed on fixed
exchange rates within Europe and flexible rate.s with
therestofthe world. In tum, each of these countries
is likely to have a group of smaller nations, often
former colonies, that fix their exchange rates against
the larger country's currency.
Tom Willett emphasized that the disagreement
among policymakers over the correct model of the
world economy has played a major role in limiting
past attempts to coordinate policy. He cited the
recent revival of the locomotive argument, in which
the U.S. wants Japan and W. Germany to expand
more rapidly and thereby pull up the U.S. growth
rate. Willett believed that one's view of the desirability and even effectiveness of such coordination
depends on whether a Keynesian or monetarist
model provides the more accurate view of economic
movements.
Willett felt that the post-war record of avoiding
"beggar-thy-neighbor" policies was fairly good.
However, he also felt that recent discussions on
coordinating policy to reduce exchange rate fluctuations have been misdirected. He believes that
exchange rate stability, by itself, is not an appropriate objective of policy. International considerations
can be important for monetary and fiscal policy
formulations, but Willett stated the objective of
policy coordination should be to promote overall
economic stability and that this objective does not
always correspond to a constant exchange rate.
When macroeconomic policies themselves contribute to economic instability, he suggested that
attempts to peg exchange rates within target zones
may promote further instability.
37
II.
Financial Intermediaries and the Economy
Many policymakers believe that financial intermediaries (that is, banks and thrifts) playa central
and· special role in the macroeconomy that is different from that played by other firms. This belief
underlies the notion that maintaining the stability of
financial intermediaries is key to ensuring a stable
real sector and avoiding the economic downturns
frequently associated with financial panics caused
by bank failures. However, there has been a longstanding debate in the academic economics literatureabout just what it is that differentiates financial
intermediaries from other firms, or even if they are
different.
Some economists argue that banks' role in the
macroeconomy is not inherently different from
other firms even though banks undoubtedly provide
valuable services. Proponents of this view believe
that banking regulation is unnecessary and that an
unregulated banking industry would be stable. To
the extent banks currently have a special role,
adherents of this view believe that this special role is
a result of regulation, not a reason for regulation.
Others argue that banks are "special" because of
externalities involved in the provision of payment
and/or credit intermediation services. As a result,
banking regulation is necessary to ensure the stability of the banking industry and the real economy.
At a minimum, proponents of this view argue that
some sort of federal protection is needed - in the
form of either explicit or implicit deposit insurance
- to prevent a systemic collapse of banking. Once
such a guarantee is in place, they note that other
sorts of regulations are needed to keep bank risktaking in check.
Amore complete understanding of the economic
roles of banks and the influence of banks on the
macroeconomy might have far-reaching implications for the regulation of the financial system and
might well contribute to our understanding of the
causes and effects of business cycles. Moreover,
such understanding might have important implications for monetary policy.
The papers presented during the second session
of the Conference contribute to our knowledge of
these issues by analyzing the economic functions of
banks (depository institutions), the relationship
between banks and the macroeconomy, and the role
of banking regulation.
CflallengesinDeposit Insurance Reform
A Speech by Robert Parry
lrrapresentation entitled, "Challenges in
Deposit Insurance Reform," Robert Parry, President
of. the Federal Reserve Bank in San Francisco,
addressed one of the more pressing issues in bank
regulation:refoffil of the deposit insurance system.
He focused on how deposit insurance could be
reformed in such a way as to eliminate the incentives
it currently provides for excessive risk-taking while
still preserving the ability of deposit insurance to
prevent bank runs.
His topic is especially important in light of the
rapid pace of financial innovation in recent years.
Currently, bank regulation and supervision are the
primary means used to keep bank risk-taking in
check. Such oversight is needed because a virtual
100 percent deposit insurance guarantee essentially
eliminates depositor surveillance - the mechanism
through which market forces would restrict risktaking in an unregUlated environment. (In an unregulated environment, banks with more risky portfolios would have to pay higher interest rates on
deposits.)
Ifbanks were allowed to participate in the changing financial environment, it would be necessary to
reduce restrictive regulation and maximize reliance
on market incentives to keep risk-taking in check.
The question then is whether it is possible to
increase reliance on private market forces while still
maintaining depositor protection to prevent bank
runs.
Although Parry did not directly address the
broader question of whether the banking industry
would be stable in the absence of deposit insurance,
he argued that there are ways of keeping the good
features of deposit insurance - its ability to prevent
runs
while at the same time minimizing the
incentives it provides for excessive risk-taking. In
particular, he argued for protecting the deposit
insurance funds by shifting all of the risk of bank
losses to bank equity holders.
He pointed out that although other approaches,
38
Some Evidence on the Uniqueness
of Bank loans
by Chris James
such as shifting risk to depositors, would increase
market discipline, they would not provide protection
against bank runs. In contrast, shifting risk to bank
capital holders would simultaneously protect depositors and the insurance fund while eliminating the
incentives for excessive risk-taking inherent in our
current system.
To protect the. insurance fund by . !jhifting risk to
capital holders, Parry proposed using market value
accounting and closing banks befOre their market
value could fall below zero when closure would
result in losses to the insurance fund. He noted that
such a policy might not be easy to implement, but
that the costs of carrying it out would be less than the
losses to the deposit insurance funds of not doing so.
Moreover, failure to reform deposit insurance might
result either in an expansion of the scope of insurance and the scope of regulation if banks were
allowed to expand into new areas, or such severe
bank regulations.that many traditional banking
functions would be undertaken outside the banking
industry.
.Although the discussion did not resolve thequestion of whether there is an inherent need for deposit
insurance, a conference paper by Chris James ofthe
University of Oregon shed additional light on one
aspect of the issue: whether bank loans are special.
James'paper, entitled "Some Evidence on the
Uniqueness of Bank Loans," dealt with the questionsof whether banks loans are somehow special
and different from other types of credit. That is,
whether bank loans are imperfect substitutes for
other types of loans, such as public debt offerings.
The answer to this question has two important
policy implications. First, if the credit intermediation services of banks were special, regulatory policies, such as 100 percent reserve requirements, that
restrict the degree of bank-provided credit intermediation could be expected to have adverse consequences for the real economy. Second, if bank
loans were special, a regulatory policy that ensured
a stable provision of bank credit could have beneficial real economic effects.
In addition, monetary policy might have real
effects even in a classical general equilibrium
framework if bank loans were special. For example,
if restrictive monetary policy reduced the degree of
bank-provided financial·intermediation, real economic. activity as well as prices would decline.
Thus, the James paper is of potential importance for
both. regulatory policy and monetary policy.
James examines two types of evidence supporting
the uniqueness of bank loans. First, he analyzes the
incidence of the reserve tax on bank certificates of
deposit (CDs) to determine whether bank borrowers
orban!< depositors bear the reserve tax on CDs.
Second, he compares the stock-price announcement
effects of new bank credit with those of private
placements and public straight debt offerings for a
group of pUblicly traded banks.
James finds no evidence that bank depositors bear
the reserve tax on CDs. First, James finds that CD
rates do not differ significantly from other domestic
open market rates with similar maturities. Second,
when the reserve taxwas increased between November 1978 and July 1980, there was no statistically
significant decrease in the rate on CDs relative to the
Discussion
The general discussion following Parry's speech
focused mainly on the issue of whether deposit
insurance was necessary - the implication being
that if it were not needed, the easiest way to reform
deposit insurance would be to eliminate it.
However, there was little disagreement that if
deposit protection were necessary, then some type
of reform of deposit insurance is required.
Discussion then turned to the lender-of-last-resort
function of the Federal Reserve as a potential
replacement for deposit insurance. Some discussants pointed out that if the lender-of-Iast-resort
function were used to prevent runs at failing (or
failed) banks, the function would have the exact
same incentives for excessive risk-taking as our
current deposit insurance system. The lender-oflast-resort function would in effect maintain the
federal guarantee of deposits and the undesirable
incentives of deposit insurance for excessive risktaking.
39
Comments by David Pyle
David· Pyle of the University of California at
Berkeley raised the following issues in his discusSioflof.the· James paper. First, .he • questionectthe
reliability ofthe eviden~e regarding the incidence of
the reserve tax on CDs. He thought that pooling the
data over a long period, as James did, might have
problems because ofchanges in interest rate spreads
that • might ·have occurred because of factors. not
related to the reserve tax. He argued that, on statistical grounds , using shorter· observation periods
around the times of the actual changes in the reserve
tax would be superior to pooling the data over the
longer period.
Moreover, even if the findings of no change in the
interest-rate spread held up, Pyle questioned
whether one could conclude, as James does, that
bank borrowers necessarily bear the reserve tax. For
example, it is possible that bank owners might bear
the tax if banking were not competitive - perhaps
because of regulatory restrictions and subsidies.
Because of this possibility, Pyle suggested examining the effects of the reserve tax on bank net worth
by analyzing the stock-price responses when
changes in the reserve requirements on CDs were
announced.
Second, Pyle was highly supportive of James'
analysis of the effects of different types of financing
on stock price returns. He noted that James' finding
that issues of straight debt used to refinance bank
loans had a statistically significant negative effect
on stock prices was strikingly different from previous findings by other researchers. The new finding provides a basis for arguing, as James does, that
the inability of other researchers to find such an
effect was due to their inability to discriminate
among different uses of debt.
Pyle also asked whether the loan approval process
itself (which presumably conveys information) or
the actual takedown of loans accounts for the positive stock-price effect, and urged James to pursue
this .line of research further.
rate on commercial paper or Treasury bills as might
be expected if deposit holders bore the reserve tax.
These findings would seem to be compelling
evidence that depositors do not bear the reserve tax
andthat CD deposits are perfect substitutes for other
types of open-market instruments. More importandy, if the banking sector were competitive, these
findings imply that bank borrowers must bear the
reserve tax in the form of higher loan rates. If so,
bank loans would be special in the sense that borrowers are willing to pay higher rates for them.
James also finds evidence supporting the uniqueness of bank loans in a comparison of the stock price
responses of borrowing firms to the announcements
of new bank loan agreements, private placements of
debt (primarily with insurance companies), and
public straight debt offerings.
James argues that bank loans might be special
because they convey information to the market
about the soundness of the borrowing firm. That is,
the bank may have information about the firm that
outside investors do not. 4 If so, one might expect
announcements of bank loans to be associated with
positive stock price effects while public debt offerings or private placements of debt would have no
such effect.
As expected, James finds a positive stock-price
response associated with the announcement of a
bank loan that is larger than the stock-price
responses observed for private placements and public straight debt offerings. In addition, the larger
stock-price response associated with bank loan
announcements does not appear to be attributable to
any characteristic of the debt contract such as maturity, size of the loan, or differences in the type of
borrower using each type of borrowing agreement.
James concludes that the stock-price evidence
together with the incidence of the reserve tax on
bank borrowers suggests that there must be something special or unique about bank loans. An
implication of this view is that bank loans may
provide a mechanism for reducing monitoring costs
and agency costs and avoiding information asymmetries and the underinvestment problem associated with such asymmetries. Unfortunately, James'
results offer no completely satisfactory explanation
of the particular unique service or attribute of bank
loans.
40
Explaining the Demand for
Free Bank Notes
on the coins imposed costs on the.use of specie that
approximatedthe expected losses on banknotes due
tobarlk failures.· Moreover, banknotes may have
been more convenient than coin for large transactionS.
Second, in Minnesota,. where. banknotes of the
"railroad" banks eventually· were redeemed· at far
below par because their backing was very poor,
banknotes •appear to have been exchanged at well
below par and treated as small-denomination
securities, not par-valued money_ Rolnick and
Weber point out that the notion that freebanknotes
were priced as risky securities rather than as safe
currency implies that the public was able to judge
the quality of the underlying assets. This view is
much different from the conventional one that the
public accepted banknotes at par regardless of the
quality ofthe bank's assets presumably because they
were either naive or misinformed.
If the acceptance of banknotes below par were
characteristic of other states during the free banking
era, the traditional literature may have misinterpreted the true economic function of some banks.
According to Rolnick and Weber, banks may have
acted more like mutual funds offering denomination
intermediation than issuers of a par-value medium
of exchange.
by Arthur Rolnick and Warren Weber
Although the James paper suggests that bank
credit is special, it leaves open the question of
whether banks' payment services might also. be
special. The paper by Arthur Rolnick and Warren
Weber of the Federal Reserve Bank of Minneapolis,
entitled "Explaining the Demand for Free Bank
Notes," deals with this issue by examining a historical period during which banks were allowed to
issue currency. (Warren Weber presented the paper.)
This subject is at the heart of an understanding of
the nature of money and the demand for noninterestbearing and possibly risky, privately issued money.
It also bears on whether bank regulation is necessary to ensure the provision of a stable medium of
exchange.
The paper presented at the Conference is one of a
series by Rolnick and Weber (1983,1984) that reexamines the "free banking" era from 1837 to
1863, during which banks were permitted to issue
their own banknotes (that is, currency). In these
papers, they challenge the traditional view of the
free banking era that characterized the era as chaotic, with widespread fraudulent "wildcat" banking, large numbers of bank failures, large losses to
banknote holders, and frequent banking panics. The
experiences of that era are often cited as evidence
that strong government regulation of banking is
necessary for banking and monetary stability, and
that banks should not be allowed to issue their own
banknotes.
The specific question addressed in the conference
paper is why privately issued, risky banknotes were
demanded as a medium of exchange when relatively
safe specie (gold and silver coins) were available. 5
Rolnick and Weber have two answers to this question. First, banknotes issued in the states of New
York, Wisconsin and Indiana were in fact not very
risky because their backing (the assets banks
acquired by issuing banknotes) was sufficiently
strong. Although banknotes apparently circulated at
par in these states, as did specie, the service return
on banknotes may well have equalled that of specie
even though some banks failed to payoff banlalotes
at par (although the losses were very small). The
reason for comparable service returns was that wear
Comments by Tom Cargill
One unresolved but very important question mentioned by Tom Cargill ofthe University of Nevada'at
Reno in his discussion of Rolnick and Weber's paper
is whether nonpar-valued banknotes such as those
issued by the railroad banks actually circulated as a
medium of exchange. If not, Cargill questioned
whether silver and gold coins were used more than
banknotes in Minnesota than in the other states.
If nonpar-valued banknotes did circulate as a
medium of exchange, Cargill stated that a banking
system in which bank deposits are equity shares (as
are money market mutual fund shares) may be more
feasible than is· normally thought possible. This
conclusion is important because such a banking
system is not subject to runs and it may be that
banking has developed along a different line
because of unnecessary restrictions. If so, one avenue to solving the bank run problem while eliminating .the deposit insurance guarantee would be to
41
allow (or perhaps require) banks to offer equity
share deposits rather than par-valued deposits.
Cargill also raised the question of why Minnesota's. experiences differed from those of New
York, Indiana, and Wisconsin even though the
ostensible regulatory environments were the same.
For example, he asked whether the railroad banks in
Minnesota were explicitly tolerated by state officials
or the result of clever exploitations of loopholes by
bankers?
In discussing the paper, Cargill also pointed out a
limitation of the paper's applicability to current
problems. He noted that banks during the free
banking era operated in a commodity-based monetary system (gold was the numeraire) in which there
would have been much less reason for concern with
banks' issuance of currency than in our current
system where currency itself is the numeraire.
Cargill applauded the authors for dispelling a
number of common myths about the free banking
era. He stressed that the paper's importance goes far
beyond that of an interesting piece of historical
research. In particular, he cited the paper's important implications for the rationalization of government regulation of financial institutions as well as its
implications for the type of regulations that might
enhance financial efficiency.
Perhaps most importantly, Cargill believed the
paper debunks the idea that restrictive government
regulation is necessary because the public cannot
distinguish between good and bad banks. (The
traditional argument is that such regulation is
needed because the banking system would be
destabilized by the contagion of bank runs if the
public were unable to distinguish good from bad
banks.)
to the 1980s if they had hedged their portfolios and
thus provided only intermediation services, and (2)
is there something special about S&L deposits that
clluses households to continue to hold relatively
stlll>Ieatnounts of them even in the face of relatively
large cha.n.ges in the differential between the rate
paid on such deposits and the rate on substitute
assets?
'fheanswers to these questions have several
potentially important public policy implications.
First, ifS&Lscan earn a pure intermediation profit
distinct from a profit resulting from assuming interest-rate risk, they must be providing a valuable
economic function that somehow differs from the
similar function performed by primary financial
markets (for example, securities markets).
Second, if thrifts' economic functions are somehow special, part of the reason might be that thrifts'
or other depositories' deposit-taking and loan origination services differ from similar functions
provided by primary financial markets. Thus, like
Chris James' paper, which deals with the question of
whether bank loans are special, Hess' paper deals
with the issue of whether the financial intermediation process is special.
Hess finds that the S&L intermediation profit
margin has been positive since 1950 and has
exhibited a strong upward trend since its trough in
1965. This intermediation profit margin contrasts
with the actual profit margin of thrifts, which
declined sharply and even became negative when
interest rates rose in the early 1980s. Thus, Hess
argues that had thrifts eliminated their duration
imbalance, the sharp rise in interest rates in the early
1980s would not have caused so many of them to
fail.
In a statistical analysis of the intermediation
profit margin, Hess finds that both trend growth and
deviations from trend growth are due mainly to the
difference between the rate on one-year U.S. government securities and the average rate paid on S&L
deposits. The differential increases whenever open
market rates rise, thus increasing thrifts' intermediationprofit margin.
'fhese findings lead Hess to ask whether S&Ls
lose market share to substitute assets when the rate
differential and hence their intermediation profit
margin increases. If such an effect were large
The Intermediation Profit Margin and
Market Share of S&Ls
by Alan Hess
Alan Hess of the University of Washington, in his
paper entitled "The Intermediation Profit Margin
and Market Share of Savings and Loan Associations," deals with the question of just what economic functions savings and loan associations
(S&Ls) provide. He addresses two interrelated
aspects of the question: (1) could S&Ls have earned
a positive profit margin in the period from the 1950s
42
adjustable rate mortgages, and securitized mortgage pools, are all relatively recent developments.
Even now, with these instruments available, some
thrifts choose not to use them to immunize themselves againstinterest rate risk. One.reason for their
choice might be. the underpricing of FSLIC deposit
insurance, which provides an incentive for thrifts to
assume more interest-rate risk than is socially optimal;
enough, aggregate industry income could actually
fall when the intermediation profit margin increased
because the size of the S&L industry would decline.
Such a result would suggest that S&L deposits have
a numberofclose substitutes and that they are notin
any sense special.
In fact, Hess's results are quite the opposite. He
finds that the substitutability of S&L deposits with
other assets is very small, and interprets this finding
as evidence that the S&Ls reduce information and!
or transactions costs to depositors. This reduction in
information costs, in tum, reduces depositors' portfolio substitution in response to interest rate differentials. Thus, when market interest rates rise
relative to S&L deposit rates, the intermediation
profit margin increases on a one-to-one basis while
S&L's market shares fall only slightly. The net effect
of these two forces on the aggregate industry intermediation profit margin is to increase industry
profits when interest rates rise - a pattern opposite
that observedwhen S&Ls do not hedge their interest
rate risk.
Agency Cost, Collateral,
and<Business Fluctuations
by Ben Bernanke and Mark Gertler
The final paper by Ben Bernanke of Princeton and
Mark Gertler of the University of Wisconsin,
entitled "Agency Cost, Collateral and Business
Fluctuations, " provides a theoretical explanation of
the microeconomic foundations of banking and the
connection between banking and the macroeconomy. (The paper was presented by Ben Bernanke.)
The paper focuses on special aspects of bank credit
and thus is related to Chris James' paper on whether
bank credit is special.
Bernanke and Gertler's paper has important
implications for public policy since it highlights the
interrelationships between the bank intermediation
process and the real economy. In fact, Bernanke
argues in another related paper (Bernanke, 1983)
that the collapse of bank-provided intermediation
services was a major contributing factor to the
length and severity of the Great Depression. The
results· of the Conference paper also suggest that
financial problems can have important effects at the
macro level.
The two economists' analysis starts at the micro
level with assumptions about informational structures regarding the outcome of investment projects,
and shows that the "institutions" of debt and bankruptcy will·arise. Bernanke and Gertler then show
how a financial structure with both debt and bankruptcy leads to a connection between the financial
and real parts of the economy.
Their paper is divided into two basic parts. In the
first part, the authors provide a static partial equilibriumanalysis of the financing of physical investments. In this analysis, investments are of such a
large size that no single individual has sufficient
resources to finance them. As a result, investments
Comments by Herb Kaufman
Herb Kaufman of Arizona State University discussed the paper. He wondered if the estimated
interest elasticities of demand for deposits were
sensitive to the estimation procedure, arguing that a
multi-equation approach might produce different
estimates.
Kaufman then discussed three other points: (l)
the optimal number of thrift institutions, (2) their
ability to immunize their portfolios, and (3) the
underpricing of FSLIC insurance.
Kaufman agreed with Hess's point that fewer
S&Ls would have failed if they had been able to
immunize themselves from interest rate risk in the
early 1980s. But he suggested that the optimal
number of thrifts might have declined in the early
1980s due to changes in the economy, and that, as a
result, some thrifts would have failed anyway. For
example, he pointed out that some banks failed even
though they were more or less immunized against
interest rate risk.
Kaufman also noted that, until recently, market
instruments were inadequate for thrifts to immunize
themselves against interest rate risk. Instruments
that hedge against interest rate risk, such as futures,
43
are typically financed by both "inside" and "outside" funds - that is, equity and debt. This method
of financing leads to a standard agency problem
with divergent incentives between borrowers (firms)
and Jenders«debt holders). The key proposition
Bernanke and Gertler establish is that the more
collateral (equity) that the borrowers or insiders
bring to a project, the lower are the agency costs and
the more efficient will be the investment process.
The authors show that the existence of asymmetric information (the insider-equity holders have
more information about the project's outcome than
the outsider-lenders) leads to an optimal contract for
outside financing that takes the form of a debt
contract. A debt contract is one in which the insider
announces the return to the project, say x. If the
actual return were greater than or equal to x, the
outsider would receive x, and if the actual return
were less than x, the firm would go bankrupt and the
outsider would receive all the remaining assets.
According to Bernanke and Gertler, there is a
social loss or agency cost associated with bankruptcy because the lenders must audit a bankrupt
firm to ensure that they receive all of the remaining
assets of the firm. Bringing more collateral to the
project lowers agency costs because the more collateral the insider brings to the project, ceteris paribus,
the lower the probability of bankruptcy and the
lower the expected auditing cost.
An implication of this analysis is that there is a
connection between the financial arrangements in
the economy and the real investment undertaken.
For example, in a world in which there is a great deal
of bankruptcy and default, the efficiency of physical
investment will be lower.
In the second part of the paper, the authors embed
their micro financial model into a macro model to
examine its business cycle implications. In this
macro model, output is in the demand-for-investment .function because, according to the model,
when firms do well and output is high, collateral
also is high and high collateral lowers the cost of
borrowing. Thus, as real income rises, saving
increases but investment demand also increases
because of the "financial-solvency" effect. Income
therefore has to increase more to balance the
demand for investment with savings.
The. integration of a financial sector into the
macro model leads to a more "persistent" business
cycle with greater amplitudes. The intuition behind
this result is that if productivity rises, for example,
borrowerswilLbecome more solvent since they will
h/:lvemore collateral, and therefore agency costs
will be lower and investment demand would be
stimulated (due to lower borrowing costs). Moreover,. since .more investment occurs, the effects
persist over time. (The story works in a similar way
ina. recession when collateral declines, borrowing
costs increase, and investment decreases.)
A final point of Bernanke and Gertler's paper is
that· financial shocks themselves can be causes of
business cycles. For example, a large unanticipated
deflation would redistribute wealth away from borrowers to lenders, given that debt contracts are
written in nominal terms. This wealth redistribution
lowers collateral and makes the borrowing class less
creditworthy, which in tum reduces the amount of
financial intermediation and physical investment.
This unanticipated deflation can have an adverse
effect on real output.
One major limitation of the paper noted by Bernanke is that the model applies best to privately held
firms. If firms could easily issue additional equity,
for example, they would have no need for debt
financing and the conclusions of the paper would
not hold. Bernanke suggested one answer to this
criticism is that there may be similar agency costs in
publicly held firms, costs that preclude them from
using equity issuance as a means of raising new
funds.
Bernanke and Gertler's paper has potentially farreaching policy implications. For one, it suggests
that . to the extent public policy can enhance the
stability of the financial system, the real economy
wilIbenefit. It also suggests that unanticipated
deflations caused, for example, by contractionary
m9netl:lfY policy, can have an adverse effect on the
re.al ~conomy.
comments by Aris Protopapadakis
Aris Protopapadakis of the Claremont Graduate
School,. in his discussion of the paper, praised the
paper as excellent and urged the authors to continue
their. research. He did suggest that the authors
44
consider adding risk-aversion to the model since the
structure of the model precludes initially identical
persons from holding identical portfolios (some
persons hold debt while others hold equity).
Protopapadakis thought the main weakness of the
paper, which was acknowledged in the paper's conclusion, is that it is somewhat hard to see how its
findings apply to publicly held corporations.
Although he thought that some of the elements of
the paper might apply, he questioned whether it was
possible to show that stock contracts as well as debt
contracts would arise as a means of attracting outside funds.
FOOTNOTES
REFERENCES
1. See Tom Sargent, Federal Reserve Bank of San Francisco Economic Review, Fall 1986.
Bernanke, Ben S. "Nonmonetary Effects of the Financial
Crises in the Propagation of the Great Depression,"
American Economic Review, Vol. 73, June 1983.
Fama, Eugene. "What's Different About Banks?", Journal
of Monetary Economics, Vol. 10, 1985.
Fischer, Stanley. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Ruler," Journal
of Political Economy, Vol. 85, Feb. 1977.
Rolnick, Arthur J. and Warren Weber. "New Evidence on
the Free Banking Era," American Economic Review,
Vol. 73, No.5, December 1983.
_ _ . "Causes of Free Bank Failures: A Detailed Examination," Journal of Monetary Economics, Vol. 4, October 1984.
Sargent, Thomas. "Interpreting the Reagan Deficits,"
Federal Reserve Bank of San Francisco Economic
Review, Fall 1986.
Taylor, John B. "Aggregate Dynamics and Staggered
Contracts," Journal of Political Economy, Vol. 88, Feb.
1980.
2. The role of multiperiod wage contracts for the effectiveness of monetary policy is studied by Fischer [1977],
Taylor [1980], and the conference paper by Taylor discussed below.
3. See, for example, Taylor (1980).
4. Although James does not focus on this explanation, it
may be that banks obtain inside information about firms
through their deposit relationships. If so, the special nature
of bank loans cannot be separated from the special nature
of deposits.
(5. Although Rolnick and Weber provide an interesting
explanation of why there was a demand for banknotes,
there also are interesting questions regarding what factors
limited their supply. For example, if (noninterest-bearing)
banknotes could be used to buy (interest-bearing) state
bonds (which could be deposited in turn for more banknotes) as the authors argue, seemingly a bank owner
would buy an unlimited amount of bonds, thus infinitely
leveraging original capital and earning an unlimited profit.
45
Brian Motley*
This paper examines the hypothesis that although household consumption is affected by the share of the national income that is spent by
government, it does not depend on whether government obtains command
of its share by taxation or by borrowing. Estimates of annual consumptionfunctions using alternative measures ofincome and wealth that differ
in their treatment ofgovernment spending, borrowing, and debt, do not in
general support this hypothesis. Changes in government tax revenues
have a stronger influence on consumption than changes in government
spending. However, there is some support for the hypothesis that
increases in government debt do not stimulate consumption spending,
suggesting that households recognize that debt interest payments must be
financed out offuture taxes.
In the last five years, as tax rates have been
lowered with no corresponding reduction in federal
outlays, the budget deficit of the federal government
has increased sharply. By most conventional measures, fiscal policy has been strongly expansionary
over this period. Since the tax reductions added to
households' disposable incomes, they presumably
enabled households to spend more on consumption,
causing aggregate demand to be stronger than otherwise. However, this presumption that a policy of
lowering taxes is stimulative rests on the assumption
that consumers determine their levels of spending
on the basis of their current after-tax incomes and do
not take account of the huge increase in the amount
of outstanding federal debt that results from the tax
reduction.
In recent years, several economists have argued
that households realize that the existence of government debt means that taxes will be higher in the
future, and that they take account of this future tax
liability when making their current saving and consumption decisions. This argument implies that tax
cuts that are not accompanied by equal reductions in
government outlays will not affect consumption,
because households will view the tax cuts as necessarily temporary; taxes will have to be higher in the
future to service the higher level of government
debt. From this view, recent fiscal policy may not
have been particularly expansionary despite the
existence of unprecedented federal deficits.
This paper seeks to throw light on the interaction
of government deficit spending and household consumption using newly available data on the assets
and liabilities of the private and government sectors
of the economy. These balance sheet data,
assembled by the Federal Reserve as a supplement
to the Flow of Funds Accounts, show how the
savings of each sector of the economy are translated
into changes in their net wealth. Using these data in
conjunction with the flow of funds and national
income accounts, it is possible to construct alternative measures of private income and wealth that
differ in their treatment of government borrowing
and debt. The paper uses these alternative measures
to estimate equations to explain household con-
* Senior Economist, Federal Reserve Bank of San
Francisco. Jean Bursan and John Nielsen provided
valuable research assistance.
47
sUlllption, with a view to discovering whether
changes in govelllment borrowing and debt affect
household spending decisions.
The first section of the paper reviews the theory of
household consumption behavior with particular
emphasis on the role of the government debt. The
argument that households recognize that additional
government borrowing today will require higher
taxes in the future, and that they take this into
account when making their consumption and saving
decisions, is described as the "Ricardian" view,
I.
after the nineteenth century English economist,
David Ricardo. The alternative view, that households largely ignore the future tax burden implied
bYtheexistence of an outstanding federal debt, is
described as the Keynesian hypothesis.' The second
section of the paper derives the estimating equations
that permit.an empirical comparison between these
alternative theories, and describes the statistical
data used. The empirical results are presented in the
third section. The fourth section provides a brief
summary and suggests some conclusions.
Theory
Ricardian Challenge
Until about ten years ago, it was an article of faith
among most economists that governments could
influence the aggregate demand for goods and services in the economy by altering either their expenditures or their tax revenues. Increased government
outlays were presumed to contribute directly to
aggregate demand, while lower taxes - by adding
to the disposable income of the private sector were thought to stimulate private demand indirectly.
This view of the effects of fiscal changes underlay
the major Kennedy-Johnson tax cut of 1964, the tenpercent surcharge on personal taxes applied in
1968, and the series of smaller tax changes in the
early 1970s - all of which were designed specifically to offset cyclical fluctuations in the economy.
In recent years, a number of economists 4 have
challenged this argument and, as a result, cast doubt
upon whether changes in fiscal policy have any
significant influence on aggregate demand. 5 These
economists argue that the method by which government expenditures are financed is not relevant to
their effect on aggregate demand. Their argument
derives from the assertion that eventually all government outlays must be paid for out of tax revenues.
Suppose, they say, that the government cuts taxes
in a given year but leaves its expenditures - except
payments of interest and principal on the government debt - unchanged both in that year and in all
future years. To pay its bills, the government must
borrow by issuing government bonds to the private
sector. However, by issuing more debt, the government puts itself in a position wherein it must raise
taxes sometime in the future to meet the resulting
higher payments of interest on the debt. For this
reason, the government cannot reduce taxes permanently while maintaining its outlays on goods and
services unchanged.
The government might attempt to avoid increasing taxes by financing higher future interest payments by additional borrowing. In such a case, the
government's debt would rise at the same rate as the
interest rate that it pays, even if the government were
to meet all of its other expenditures (both current
and future) fully out of tax revenues. Such a policy
cannot be sustained in the long run if the interest rate
exceeds the growth rate of GNP, because the interest
payments on the debt will grow faster than (and
eventually will consume the whole of) GNP. Even if
Keynesian Approach
The view that aggregate demand may be "managed" through fiscal policy, usually identified with
Keynesian economics, rested on the assumption that
the method by which government spending is
financed - by levying taxes or by borrowing in the
financial markets 2 - is important in determining its
impact on aggregate demand. Increasing government spending without raising taxes, or reducing
tax revenues without cutting expenditures both were
assumed to stimulate total demand, whereas equal
changes in expenditure and taxes were thought to
have much smaller effects. 3 In effect, this Keynesian approach to fiscal policy held that an increase in
the amount of the government's expenditures
financed by borrowing - "deficit financing" rather than by levying taxes - "tax financing" would significantly stimulate aggregate demand.
48
and thus may not be closely related to the household's income in that particular year.
The assertion that tax changes that do not reflect
changes in present or future government outlays
should have no net effect on private expenditures is a
logical extension of this life-cycle argument. Consider, for example, a typical household faced with a
tax increase after it has mapped out a long-term plan
for consumption. In formulating its plan, the household will have taken account of its best estimates of
future income and tax payments. The plan will be
"optimal" in the sense that no further changes in
consumption (in the form of reducing consumption
in some years in order to increase it in other years)
will add to the household's lifetime welfare.
Under such circumstances, a tax change that
increases the household's current tax payments but
lowers future payments by an equivalent amount
will not cause it to alter its consumption plan
because it has no effect on the household's ability to
finance any particular consumption plan. The additional current taxes can be paid by borrowing and
the lower future taxes will provide the funds needed
to repay this loan. Since the original consumption
plan was optimal and is still possible, the household
has no reason to change it.
the interest rate were less than the economy's
growth rate, the debt might still grow faster than
GNP if the noninterest portion of the budget were to
remain in deficit.
Alternatively, the government might seek to avoid
raising taxes by financing future deficits through the
creation of new money and thereby cause inflation.
Although this financing method avoids higher
explicit taxes, it imposes what is in effect an "inflation tax" on those groups in the society that are
unable to protect themselves against the effects of
rising prices.
The inevitable conclusion of both financing alternatives is that a reduction in current taxes must be
repaid by higher taxes sometime in the future. 6
Thus, in present value terms, tax changes do not
alter the liability of the private sector to pay taxes to
the government; they only affect the timing of those
payments, with tax cuts delaying them into the
future and tax increases hastening them into the
present.
This line of argument implies that tax changes
will have no effect on the aggregate demand for
goods and services when two conditions are satisfied. First, private spenders should recognize that
such changes alter only the timing of tax payments
and not their eventual amount and, second, they
should be able and willing to offset such alterations
in timing by appropriate amounts of borrowing or
lending. The modem theory of consumer behavior
argues that these conditions do indeed hold.
Ricardian Equivalence
Thus, the proposition that tax changes have no
effect on household consumption plans follows
directly from the modem life-cycle theory of consumption behavior. In fact, the proposition has a
much longer history and originally was put forward
by David Ricardo more than a hundred and fifty
years ago. 7 For this reason, the modem proponents
of this argument describe it as the Ricardian equivalence theorem.
Ricardian equivalence also implies that a household will reduce its current consumption if government spending increases today or is expected to
increase in the future, even if there is no change in
current taxes. The household will cut current consumption because it recognizes that additional government outlays must be financed eventually by
higher taxes, and hence that its after-tax income will
be reduced in the long run.
Two principal arguments have been advanced
against the Ricardian approach. 8 The first is that
households are myopic; they do not foresee the
Consumption Theory
Since Milton Friedman developed the permanent
income hypothesis of consumption and Modigliani
and Brumberg the life-cycle approach in the
mid-1950s, most economists have accepted the
notion that households plan their consumption (in
broad outline although not, of course, in detail) over
a relatively long time horizon. The typical household seeks to "smooth out" over its life-cycle the
effects on its living standards of variations in its
income. The household does this by borrowing
during periods when its current income is low,
saving and repaying debt during its prime earning
years, and living off its accumulated assets during
retirement. Thus, a household's consumption in any
given year depends on its estimate of the total
resources it will have over its complete life-cycle,
49
higher taxes necessitated in the future when current
taxes are lowered without a change in the government's current and prospective non-interest expenditures. Put somewhat differently, myopia means
that, in estimating the resources they have available
for consumption, households regard their holdings
of government securities as part of their wealth, and
the interest on those securities as part of their
income, but ignore their corresponding liability as
taxpayers to finance the payments of interest and
principal on the securities. 9
Economists describe this myopia as "fiscal illusion". Households suffering from fiscal illusion will
regard a current tax cut as adding to their resources
available for consumption, and ignore the higher
taxes that will subtract from those resources in the
future. Interestingly, Ricardo himself appears to
have taken this view. While proposing Ricardian
equivalence as a theoretical possibility, he argued
that, in practice, households put more weight on
current tax changes than future ones. 10 In particular,
Ricardo proposed that wars should be financed by
current taxes rather than by borrowing, since placing the full tax burden on the present generation
would dissuade governments from engaging in
war.] 1
A particular case of this argument is the situation
where the higher future taxes will not faU on the
present generation of households (those who
receive the tax cut) but on their descendants. In this
case, Ricardian equivalence implies that members
of the present generation will add to their bequests
in order to offset the higher taxes that will fall on
their children. Critics (including, as we have seen,
Ricardo himself) suggest that households either are
not this farsighted or do not care enough about
(possibly unborn) future generations to provide
them with larger bequests to offset those generations' taxes.
A second argument against the Ricardian equivalence hypothesis is that households may be unable
to offset the effects of a tax increase because their
ability to borrow is limited. For example, a household faced with higher current taxes may wish to
borrow in order to avoid a cut in its current consumption but be unable to do so because no lender is
willing to make the loan. As a result, a tax increase
may compel the household to reduce its consump-
tion even though it recognizes that its taxes will be
lower in the future. Conversely, a household that
already is constrained by its ability to borrow - and
so is consuming less than it would if it were free to
borrow more - may take advantage of a tax cut to
add to its current consumption even though it recognizes that its tax payments will be higher later. 12
Formal Models
The Keynesian and Ricardian models of consumption behavior agree that households' consumption and saving decisions depend on the levels of
their income 13 and wealth, but differ in the concepts
of income and wealth to which the typical household pays attention.
In the traditional Keynesian approach, consumption is made to depend on income after taxes. while
wealth is defined to include the value of households'
holdings of government securities, without subtracting the capitalized value of the future taxes needed
to service those securities. Thus, under the Keynesian approach:
C
where
a
+
bYK
+
CWK
(1)
T
(1 a)
K+D
(1b)
y
In equation I a, Y represents national income and T
is net payments of taxes to government;14 the
income of the private sector, yK, is income minus
taxes. In equation I b, K represents the stock of
tangible and equity capital owned by the private
sector at the beginning of the year, and D represents
the stock of privately held government debt outstanding. ls
In contrast, the Ricardian approach implies that
income should be defined as national income less
government expenditures on goods and services 16
since this difference represents the portion of the
national product that is available to the private
sector for consumption. Ricardian equivalence
means that the method (taxation or borrowing) by
which the government obtains command over the
share of the national income that government spends
does not affect the amount of their share that households spend. The Ricardian approach also implies
that the definition of private wealth should not
50
recall that the national income is equal to the sum of
consumption, investment and government expenditures on goods and services,
include the private sector's holdings of government
securities since these are precisely offset by households' liability to pay future taxes. Thus, under the
Ricardian approach:
Y
C
where
yR
a' + b'YR + C'WR
=
C+I+G
(3)
(2)
Y-G
(2a)
K
(2b)
Also, investment is equal to the change in the stock
of tangible assets in the economy, and the government deficit is equal to the change in the stock of
government debt outstanding,
In equation 2, the income variable, YR, is defined as
national income less government spending on goods
and services, excluding government spending on
transfer and interest payments, and wealth, WR,
excludes the private sector's holdings of government securities.
In conducting empirical tests of these alternative
models of household behavior, it is important to
choose definitions of income and wealth that treat
the government's taxing and borrowing activities in
the same way. If, for example, households regard
their holdings of government debt as part of their
wealth (the Keynesian view), then they also should
regard taxes but not government borrowings as
reductions from their income. In contrast, if households were to take the Ricardian view that all
government expenditures represent claims against
their incomes (whether these expenditures are
financed by taxes or by borrowing), then they should
not regard their holdings of government bonds as
part of their wealth.
The definitions of income and wealth in the
preceding equations are consistent in this sense.
This consistency implies that, for either pair of
definitions, private disposable income less consumption (that is, saving) during a year is equal to
the annual change in private wealth. 17 To see this,
I
(4)
G-T
(5)
In the Keynesian case, the private sector's disposable income is equal to national income less the
taxes the private sector pays to the government.
Hence,
yK - C
(Y - T) - C
~K
+
=I+
(G - T)
~D
(6)
where ~ WK represents the change in Keynesian
wealth over the year.
In the Ricardian case, by contrast, private disposable income is defined as the national income less
government expenditures. Hence,
yR - C
(Y - G) - C
=
I
~K
~WR
(7)
where A.WR represents the change in 'Ricardian'
wealth over the year.
51
II.
The Empirical Model
consume more and save less. These considerations
suggest that consumption should depend on the
level of wealth, after accounting for changes caused
by the three factors named. Equations I and 2
therefore should be modified to yield estimating
equations of the general form:
The approach used in this paper to test whether
the Keynesian or the Ricardian approach to the role
of government better explains average household
consumption behavior is to estimate a series of
annual consumption functions that use as explanatory variables different measure of real, or inflationadjusted, income and wealth. The measures differ in
the way in which government taxes, expenditure,
and debt are treated.
To ensure that the definitions of income and
wealth are consistent among the equations, they are
made to satisfy accounting identities of the type
illustrated in equations 6 and 7 in the preceding
section. Consumption is defined as real personal
consumption expenditures (in constant 1982 prices)
on nondurable goods and services. Purchases of
durable consumption goods are regarded as part of
gross saving, and the stock of household durables as
part of gross wealth. These definitions are used in
the Federal Reserve's Flow of Funds Accounts and
National Balance Sheets.
Ct
=
a
+
where Y t
=
+
bY t
c[W t - Dept
(8)
+
Rev t - Inft]
Real gross private sector income in
year t
Wt = Real gross private wealth at the
beginning of year t
Dept
=
Depreciation of tangible assets in
year t
Rev t = Asset revaluations due to changes in
asset prices during year t
Inft
Income and Wealth
In the theoretical discussion of the previous section, it was assumed that consumption during a
given year depends on the level of private wealth at
the beginning of the year, and that the change in
wealth from the beginning of one year to the beginning of the next is equal to gross private saving
during the year. In reality, there are three other
factors that contribute to the year-to-year change in
the real value of private wealth. They18 are (i)
physical depreciation of tangible assets, (ii) changes
in the values of assets due to changes in asset prices,
and (iii) changes in the real value of wealth as a
result of inflation in the prices of consumer goods.
These factors also should influence households'
consumption decisions. If the real value of their
wealth is reduced during the year by the physical
depreciation of their stocks of tangible assets or as a
result of increases in the prices of consumer goods,
households are likely to want to save more and
consume less. In contrast, if increases in asset prices
were to add to the market values of their wealth over
the year, households would be likely to want to
=
Decrease in real value of wealth due
to inflation during year t.
The definitions of income, Y t, and wealth, W p in
this equation will be different between the Keynesian and Ricardian cases. The differences in the
definition of wealth in tum will imply different
definitions of the inflation variable. In the Keynesian
case, the inflation variable, Inft, will include the
change in the real value of the government debt due
to inflation;19 in the Ricardian case, it will not.
Equation 8 assumes that aU changes in real wealth
have the same effects on household consumption. In
particular, differences in the level of wealth at the
beginning of the year, W p have the same impact on
consumption as do changes in real wealth during the
year due to depreciation, changes in asset prices,
and general inflation (Dept, Rev t, and Inft). Clearly,
this is a very strong assumption.
Influence of Depreciation
Most studies ofthe consumption function take for
granted that consumption decisions are made on the
basis of income net ofdepreciation rather than gross
income. Implicitly, this amounts to assuming that
52
that only changes in the real, inflation-adjusted,
value of the government debt should have an effect
on household consumption. 21 Additions to the nominal debt (that is, budget deficits) that represent only
the effect of inflation, should not influence private
consumption behavior. 22 This argument means that
reductions in the real value of the public debt due to
inflation should reduce consumption in the Keynesian model. Such reductions should have no effect
in the Ricardian model because inflation simultaneously reduces the real burden of the taxes
required to service the debt.
Equation 8 permits a comparison of these hypotheses. In the Keynesian version of the equation, but
not the Ricardian version, the "inflation loss" term,
Inft , includes the effect of inflation on the real value
of the government debt. However, as in the case of
asset revaluations, the effect on consumption of
inflation-induced losses of real wealth may be different (probably smaller) from the effect of other
wealth changes. Hence, the estimated equations
include a separate term representing inflationcaused losses of real wealth.
households regard the making good of depreciation
on their tangible assets as having some sort of prior
claim on their current gross income before it is used
for consumption. Equation 8 represents an alternative hypothesis that although households recognize
that physical depreciation of their homes and stocks
of consumer durables reduces their wealth (and so
their lifetime consumption), they do not necessarily
regard the making good of this depreciation as
having a prior claim on their gross incomes in the
year in which it actually occurs. On this hypothesis,
consumption decisions are related to wealth net of
depreciation rather than to income net of depreciation.
These alternative hypotheses may be tested by
including gross income, gross wealth, and depreciation as separate explanatory variables in the equation. The coefficient on depreciation is expected to
be negative. If consumption were related to income
net of depreciation, the coefficients on the income
and depreciation variables would be equal but of
opposite signs. If wealth net of depreciation were
the key variable, as equation 8 assumes, there would
be equal and opposite-signed coefficients on the
wealth and depreciation variables.
Interest Rate
In addition to the income and wealth variables,
the estimated equations also include as an explanatory variable a measure of the real, inflationadjusted,' after-tax, short-term interest rate. That
measure represents the terms on which households
are able to substitute between current and future
consumption. This real interest rate is constructed
as a quarterly series and then aggregated into an
annual rate.
The yield on six-month commercial paper is used
as a measure of the pre-tax, nominal, short-term
interest rate facing consumers. The after-tax rate is
estimated by multiplying this yield by (l - Rtax),
where Rtax is an estimate of the marginal tax rate
paid by individuals. 23 The real yield in each quarter
is derived by subtracting from the nominal yield a
measure of the expected rate of inflation in the prices
of consumer goods. The expected inflation rate in
each quarter is proxied by the actual inflation rate
over the five-quarter period centered in that quarter. 24
Asset Revaluations
Several studies have found that increases in the
market value of household asset holdings tend to
stimulate consumption expenditures. 20 In equation
8, such revaluations have the same impact on current consumption as do other changes in gross
wealth. However, some changes in asset values may
occur toward the end of a year and so have less effect
on that year's consumption. Also, households may
regard some revaluations as transitory (rather than
permanent increases or decreases in their lifetime
resources), and may not alter their consumption in
response. For these reasons, the effect of the
revaluation variable on consumption may be smaller
than that of the wealth variable. To allow for this
possibility, the equations estimated below include
the revaluation variables, Rev t , as a separate term.
Inflation
With regard to the effect of inflation, a number of
economists in the Keynesian tradition have argued
53
gross national product received by the private (nongovernment) sector29 after both federal and state and
local government taxes and transfers. Similarly, the
wealtl1 variable 30 is defined to include the private
sector's holdings ofboth federal and state and local
gQYernment debt as well as of tangible and equity
assets .. Thus, equation 9 becomes
Estimating Equations
These modifications to the simple theoretical
model described in the last section yield an estimating equation of the fonn:
Ct
=
a
+ b. Yt + c. Wt
+ d.Dept + f.Rev t
+ g.Inft + h.Rt
(9)
30 + al' (GNPt-Tt-TtSLG)
where Rt = real, after-tax, short-tenn interest rate
+ a2.(K t +Dt+D tsLG) + ....
This equation represents a generalization of equation 8. Again, the definitions ofY t, W t and Inft will
be different in the Keynesian and Ricardian cases.
The coefficients on income and wealth are both
expected to be positive. The coefficient on the
revaluation variable (f in equation 9) is expected to
be positive and of approximately the same order of
magnitude as, or smaller than, that on the wealth
variable. Similarly, the coefficient on the inflationloss variable (g in equation 9) is expected to be
negative, but again of approximately the same order
of magnitude as, or smaller than, that on wealth.
Data for each of the variables (except the interest
rate) were assembled using the recently revised
National Income and Product Accounts constructed
by the Department of Commerce and the corresppnding Flow of Funds Accounts and National
Balance Sheets25 prepared by the Federal Reserve.
The data used are annual series from 1953 to 1985.
Care was taken to ensure that, with only very minor
exceptions, the data26 satisfied the condition that:
where T represents tax and nontax payments to each
level of government, net of all government transfer
and interest payments.
In the second equation, the private and state and
local government sectors are consolidated. The
income variable is defined as the portion of GNP
accruing to the private and state and local government sectors less those governments' expenditures
on goods and services whether financed by net taxes
or borrowing. This income variable includes transfer payments received from the federal government
(including grants-in-aid to state and local governments) and is net of all federal taxes. Payments and
receipts of taxes and transfer payments between the
private and state and local government sectors are
netted out. Wealth is defined to exclude the private
sector's holdings of state and local government debt
but to include holdings of federal government debt.
Thus,
Ct
=
30 + al·(GNPt - Tt - GtSLG)
+ a2·(Kt + Dl) + ....
(11)
(12)
This equation is a hybrid between the Keynesian and
Ricardian approaches. Households are Ricardian
with respect to local and state government taxes and
debt, but Keynesian with respect to the federal
government.
Finally, in the third equation, all tax and transfer
payments (including inter-sector transfers between
the .federal and state and local governments) are
netted out. Hence, the income variable represents
the whole of GNP (except for the small portion that
accrues to foreigners) less expenditures on goods
and services by governments at all levels. Wealth
consists only of the stocks of tangible capital, land,
All data are put on a per capita basis and are deflated
by the implicit deflator for personal consumption
expenditures on nondurable goods and services.
To allow for the possibility that private households may treat state and local governments differently from the federal government,27 the income
and wealth data were constructed for three alternate
levels of consolidation. In each case, the revaluation
and inflation-loss variables were defined so as to be
consistent with the definitions of the corresponding
income and wealth variables. 28
In the first or Keynesian consumption equation,
the income variable is defined as the portion of the
54
and foreign assets less that portion that is owned
directly or indirectly by foreigners. Thus,
Ct =
ao
+
This equation is a fully Ricardian one, since wealth
excludes the private sector's holdings of governmentdebt whereas private income is defined by
subtracting from GNP all government expenditures
whether financed by taxes or borrowing.
a l · (GNPt-Gt-GtsLG)
az.(Kt )
+ ....
(13)
III.
Empirical Results
is, in them, wealth is defined net of depreciation.
In each equation in Table I, both income and net
wealth are found to have significant positive effects
on consumption expenditures, regardless of the
measure used. The coefficients on the revaluation
variables also are positive, implying that households
respond to increases in the market value of their net
assets by adding to their consumption. The smaller
coefficients on this variable compared to those on
Table I reports the results of estimating consumption equations using the three alternative measures
of income and wealth defined in equations 11, 12,
and 13 in the preceding section. Each equation also
includes the real after-tax interest rate and the
revaluation and inflation variables; the last is
defined to be consistent with the definitions of
income and wealth.
In preliminary estimates of these equations, the
coefficients on the depreciation variable (Dept in
equation 9) were found to be positive and statistically significant. As explained above, theory predicts that these coefficients should be negative.
Indeed, virtually all past estimates of consumption
functions have simply assumed that consumption
depends on income net of depreciation, and therefore have implicitly imposed the restriction that the
coefficient on depreciation is equal but opposite in
sign to that on gross income. Since the depreciation
variable has a steady upward trend over the sample
period, with little year-to-year variation, one possible explanation of its positive coefficient is that the
depreciation variable is acting as a proxy for an
upward trend in consumption caused by some omitted variable.
When an explicit trend variable 31 was added to
the equation, the estimated coefficients on the
depreciation variable were negative in all three
equations. The hypothesis that consumption is
related to wealth net of depreciation could not be
rejected. Imposing this restriction yielded a better
fit (lower standard errors of the equations) than the
alternative restriction that consumption depends on
income net of depreciation.
This result suggests, in contrast to the conventional assumption, that households treat depreciation of their tangible assets as reducing their wealth
rather than current income. Hence the equations
reported in Table I incorporate this restriction; that
TABLE
1
Consumption Equations Using Three
Alternative Measures of Income and Wealth
Dependent Variable: Per Capita Consumption
Expenditures on Nondurables and
Services ($ 1982)
Alternative IncomelWealth Variables
Regressor
Constant
Trend
After-Tax Real
Interest Rate
Per Capita Real
Income
Per Capita Net
Wealth
Asset Revaluation
Inflation Loss
SEE
R2
Rho
55
Keynesian
Hybrid
Ricardian
0.306
(1.13)
0.306
(4.55)
-0.009
(0.68)
0.339
(6.65)
0.037
(4.87)
0.014
(2.28)
-0.015
(1.002
-0.099
(0.30)
0.289
(3.63)
0.008)
(0.47)
0.328
(5.68)
0.039
(4.27)
0.016
(2.35)
0.012
(0.66)
0.621
(2.52)
0.553
(9.52)
-0.031
(1.90)
0.183
(3.50)
0.048
(4.90)
0.021
(2.85)
-0.058
(2.82)
0.063
0.997
0.244
(l.20)
0.072
0.995
0.302
(1.52)
0.082
0.993
0.360
(1.85)
the wealth variable suggest either that households
do notreact to such revaluations within the year or
that they treat a part of any addition to the market
value of their assets in a given year as transitory.
Reductions in the real value of wealth resulting from
inflation are estimated to reduce consumption,
although this negative effect is not statistically significant.
Inspectionof the standard errors of the equations
in Table I shows that the hybrid and Ricardian
equations that consolidate the private and government sectors provide a less satisfactory fit to the
data. Although the difference is not particularly
large, it casts some doubt on the Ricardian approach
since it suggests that households do not regard taxes
and government borrowing as fully equivalent
methods of financing government expenditures.
For a sharper test of this result, estimated equations that include the differences between the
various alternative measures of income and wealth
as additional explanatory variables are reported in
Table 2. In these equations, private income is
defined as the gross national product minus the net
taxes that the private sector pays, and private wealth
includes the stocks of both federal and state and
local government debt outstanding. These are the
same definitions of income and wealth used in the
first equation in Table 1.
The first equation in Table 2 adds the differences
between these income and wealth variables and the
corresponding measures when the private and state
and local government sectors are consolidated. In
the case of income, the difference is equal to the
current deficit of the state and local government
sector; in the case of wealth, it is equal to the state
and local government debt.32 Thus,
Ct =
TABLE
Consumption Equations inclUding
Differences between Alternative Measures
of Income and Wealth
Dependent Variable Per Capita Consumption
Expenditures on Nondurables and
Services ($ 1982)
Regressor
Constant
After-Tax Real
Interest Rate
Per Capita Real
Income
Per Capita Net
Wealth
Asset Revaluation
Inflation Loss
State/Local Govt
Deficit
State/Local Govt
Debt
Federal Deficit
III
0.687
(1. 76)
0.019
(1.44)
0.475
(13.58)
0.033
(3.48)
0.014
(1.58)
-0.012
(0.17)
0.669
(1.34)
0.024
(1.68)
0.502
(16.51)
0.027
(3.21)
0.014
(1.38)
0.012
(0.16)
0.277
(2.84)
-0.008
(0.19)
Inflation Loss
Adjustment
Revaluation
Adjustment
5.81
(1.56)
0.543
(0.50)
0.091
(0.56)
0.215
(2.20)
-0.016
(0.27)
0.431
(0.44)
0.087
(0.50)
SEE
0.085
0.995
0.148
(0.92)
0.075
0.997
0.226
(1.04)
0.078
0.996
0.256
(1.19)
Total Govt. Debt
R2
Rho
a2·(Kt +Dt+Dt SLG)
+ .....
II
Total Govt. Deficit
all.(GtSLG - TtSLG)
a22·(Dt SLG)
0.671
(2.092
0.043
(2.34)
0.514
(12.16)
0.027
(2.15)
0.026
(2.09)
-0.033
(0.85)
-0.126
(0.25)
-0.309
(1.52)
Federal Debt
an + aj.(GNPt-TtsLG-Tt)
+
+
+
2
(14)
If (as the Ricardian approach assumes) households.treat state and local government expenditures
as claims against their own incomes, regardless of
how these outlays are financed, and if they do not
regard their holdings of state and local government
56
debt as part of their net worth because they imply a
corresponding liability to pay future taxes, we
would expect 33
The .first of these hypotheses is decisively rejected;
in the second equation in Table 2, all is significantly
positive rather than negative, implying that a
decrease in federal taxes has a strong positive effect
onconsumption. The equation neither confirms nor
rejects the second hypothesis, since althougha22 is
negative and not significantly different from -a2' it
also is not significantly different from zero.
Fil1ally, in the third eq\lation of Table 2, the
implications of consolidating the state and local and
federal governments are .examined. This equation
includes the combined deficit of the federal and state
and local government sectors and the total government debt. Thus,
In contrast, if households do not consolidate the
spending. and borrowing of state and local governments with tbeir own (as the Keynesian model
assumes), we would expect all = a22 = O.
Unfortunately, the results in this first equation are
inconclusive as neither of these pairs of hypotheses
may be rejected at conventional probability levels.
However, a22 is negative and significant at a 14
percent probability level, which would imply that
increases in state and local government debt have a
smaller wealth effect on household consumption
than do increases in other forms of wealth. This
provides some support for the Ricardian approach.
In the second equation in Table 2, the income and
wealth variables are the same as in the first equation,
but the federal deficit and federal debt are included
as additional variables. Thus, this equation assumes
that households do not consolidate the debt and
income of state and local governments with their
own, and allows us to examine whether they do
consolidate those of the federal government. Thus,
Ct =
+ al·(GNPt-TtSLG-Tt)
+ all·(GtSLG+Gt-TtSLG-Tt)
+ a2·(K t +DtSLG+Dt)
+ a22.(D tSLG+ Dt) + ....
(16)
As in the other equations, the Ricardian hypothesis
implies34 that all = - a j and a22 = - a2'
In this equation, the coefficients on the wealth
variable and on the stock of government debt (a2 and
a22) are not significantly different in absolute value,
as required by the Ricardian hypothesis. But since
a22 also is not significantly different from zero, the
first result is inconclusive. As in the second equation,all is positive and significant, implying that
tax increases have a strongly negative effect on
consumption.
The results in Table I with regard to the effects of
asset revaluations and inflation on consumption
decisions are not altered in Table 2. Additions to the
nominal value of wealth resulting from increases in
asset prices tend to encourage household consumption, whereas reductions in its real value due to
inflation tend to discourage spending.
C t = an + al·(GNPt-TtSLG-Tt)
+ ajj.(Gt-Tt)
+ a2.(Kt + DtSLG+ Dt)
+ a22.(Dt) + ....
an
(IS)
Ifhouseholds were to treat federal expenditures as
reductions from their spendable incomes, regardless of whether these are financed by taxation or
bond issuance, we would expect all = - al < O.
Similarly, if they were to regard federal debt as
involving a future tax burden and therefore not
representing net wealth, we expect a22 = - a2 < O.
57
IV.
Summary and Conclusions
private sector wealth, but this finding does not
depend on whether private wealth is defined to
include or to exclude the stock of government debt.
However,the overall fit of the equations is reduced
when wealth is defined to exclude government debt.
In addition, contrary to the predictions of the
Ricardian approach, the results indicate that, in the
current year, consumption responds strongly to
changes in government taxes. Decreases in federal
government tax collections cause households to add
to their household consumption, even if these
decreases are not accompanied by cuts in government spending.
Nevertheless, although a federal tax reduction
tends to stimulate the current year's consumption,
the Ricardian hypothesis that the resulting higher
level of government debt has no positive wealth
effect on household outlays in subsequent years
cannot be rejected at conventional levels of statistical significance. Proponents of the Ricardian view
might interpret this result as indicating that households recognize and pay attention to the tax burdens
associated with higher levels of federal debt once
that debt has been issued. However, the alternate,
Keynesian, view also is not rejected by the estimated equations.
The approach adopted in this paper has the advantage that income and wealth are treated in a consistent fashion. However, it must be recognized that
some issues emphasized by earlier studies of the
Ricardian equivalence hypothesis have been
ignored. The most important of these are the
assumptions that current income and current government expenditures are adequate proxies for the
long-run or "permanent" levels of these variables.
In particular, the finding that changes in current
taxes have a strong effect on consumption may be
sensitive to the assumption that current government outlays provide a good forecast of future
outlays. On the one hand, if the Ricardian hypothesis were correct, consumption would depend on the
permanent level of government spending. In such a
case, if the current level of government expenditures
were a poor proxy for its permanent level, the
equations would be mis-specified. On the other
this article has examined two views of the effect
of government spending on household consumption. In what may be characterized as the Keynesian
approa.ch, households consider reductions in government taxes as additions to their income and
wealth, and therefore, such tax changes have a
stimulative effect on consumption. This approach
also assumes that additions to government spending
adddirecdy to aggregate demand.
The Ricardian approach says that households
would discount the stimulation of additional government spending or reduced taxes because they
recognize that government expenditures reduce the
spendable resources at their command regardless of
how those expenditures are financed. When government spending is financed by current taxation,
household income is reduced immediately. When it
is financed by debt issuance, the need to extract
taxes in the present is reduced but additional taxes
will have to be levied in the future to finance the
payment of interest and principal.
Thus, the Ricardian approach suggests that recent
tax reductions would have little permanent effect on
household spending since they do not reflect reductions in government outlays but only a switch from
tax financing to debt issuance.
This issue has been examined in a number of
earlier studies, several of which have found that the
Ricardian hypothesis could not be rejected by the
data. Several of these papers have stressed the
argument that Ricardian households would pay
attention to the permanent rather than the current
level of government spending even though the concept of permanent government spending is difficult
to measure empirically.
In this paper, the implications of this hypothesis
for the definitions of both income and wealth have
been treated simultaneously. In addition, this paper
is the first to use national balance sheet data on
private holdings of tangible and financial assets to
examine this issue.
Overall, the results here do not support the Ricardian hypothesis. 35 Although they are somewhat
mixed, all the equations reported in this paper find
that consumption is affected by the level of real
58
hand, given the difficulty of pr~dicting government
outlays, it seems unlikely that an alternative proxy
would be superior.
Subject to these limitations, the results presented
here· have implications for the .conduct of fiscal
policy. They suggest that while the immediate
effects of deficit financing on householdconsumption and savings decisions are reasonably clear-cut,
the long-run effects are more uncertain. In the short
run, reductions in taxes tend to stimulate household
ou(lays as a larger sh~ of the GNP reaches the
hands of •the private sector. In the longer run,
however, •when .deficit spending. shows uP. in the
fOnn of a larger federal debt, it is uncertain whether
taxpayers will treat that debt as an addition to their
wealth justifying permanently higher expenditure
levels.
59
FOOTNOTES
1. These are convenient but not wholly accurate labels.
Oavid Ricardo clearly had some doubts about the hypothe$is that today bears his name. The theory of consumption
that! describe as Keynesian in this paper reflects the views
Of$everaleconomists besides John Maynard Keynes, and
might. more accurately be labeled the "mainstream"
approach.
2. ".lnaelC:lition to levying taxes and borrowing, the government also has the option of financing its expenditures by
creating new money. However, the choice between issuing new debt or new money is a matter of monetary, rather
than fiscal, policy. In the United States, this decision is
made by the Federal Reserve rather than the Treasury or
the Congress. In order to focus attention on fiscal policy, I
shall assume that monetary policy is constant
in the
sense that there is no change in the rate of money creation
-:- so that taxing and borrowing are the only alternative
finanCing methods available.
3. Most economists in the Keynesian tradition argued that
the effect on aggregate demand of an equal increase in
both government expenditures and tax revenues would be
small but not zero. This proposition is known as the 'balanced budget multiplier theorem'.
4. An early treatment of this argument can be found in
Martin J. Bailey, National Income and the Price Level,
McGraw-Hili Book Co., 1962, pp 71-81. Much of the recent
interest in the argument stems from Robert J. Barro, "Are
Government Bonds Net Wealth?" Journal of Political
Economy 82 Nov-Dec 1974.
'
" .
.
5. It always was recognized that the expansionary effects
of defiCit finanCing might be partially offset ("crowded out")
by a rise in interest rates if monetary policy did not accommodate the increased demand for money associated with
rising levels of nominal income. For a detailed discussion
of crowding out, see Alan S. Blinder and Robert M. Solow,
"Does Fiscal Policy Matter", Journal of Public Economics,
1973. However, the recent challenges to fiscal policy do
not rely on this crowding out argument, but instead deny
that budget deficits per se stimulate aggregate demand.
.
.
6. Conversely, If current taxes are increased With no
change in the government's non-interest outlays, the government debt will be lower in the future than it otherwise
would have been, and hence future taxes also will be lower
because the required payments of debt interest will be
reduced.
7. David Ricardo, Funding System, 1820. Reprinted in P.
Sraffa (Editor) The Works and Correspondence of David
Ricardo Vol IV 1951 p. 143.
'.'..
.
,
8. For a non-t~?hnlcal diSCUSSion of these Issues, see
Phillip Cagan, The Effects of Government DefiCits on
Aggregate Demand and FinanCial Markets: A Wlde- Ran 9,Ing ReView of the Literature and Current Policy Issues ,
Proceedmgs of the SIxth West Coast AcademIc/Federal
Reserve EconomIc Research Semmar, Federal Reserve
Bank of San FranCISco, November 1983, pp 99-106.
9. Thus one of the first modern articles describing the
Ricardian equivalence theorem was Robert J. Barro, "Are
Government Bonds Net Wealth?", Journal of Political
Economy, 82, Nov-Dec, 1974.
10. "It would be difficult to convince a man ... that a
perpetual payment of 50 pounds per annum was equally
burdensome with a single tax of 1000 pounds. He would
have some vague notion that the 50 pounds per annum
vvould be paid by posterity, and would not be paid by
him.. ". That an annual tax of.5O pounds is not deemed the
same in amount as 1000 pounds ready money, must have
beElnobserved by everybody." David Ricardo, Funding
System, p. 187.ln modern terms, It seems clear that In this
pa$sage Ricardo. IS ~uggestlng that most persons are
afflicted by fiscal IllUSion.
11. "When the pressure of the war is felt at once, without
mitigation, we shall be less disposed wantonly to engage
in an expensive contest, and if engaged in it, we shall be
sooner disposed to get out of it, unless it be a contest for
some great national interest." Ricardo, Gp. cit., p. 186.
12. A third argument against the equivalence theorem is
that it assumes that private agents are able to borrow and
lend at the same interest rate as the government, whereas,
in fact, the private sector rate generally is higher. This
means that when the government lowers taxes without
reducing its expenditures, the value of the securities that it
must issue exceeds the present value (to the private
sector) of the resulting future tax burden, because the
latter IS discounted back to the present at a higher rate of
Interest than the seCUrities Yield. Hence such a poliCy
action adds to the total wealth of the private sector and so
encourages a higher level of consumption. The second
argument made in the text really is an extreme case of this
point, since if a household is totally unable to borrow, this
means that the 'borrowing rate' it faces is infinitely large.
.
13. Most economists, regardless of whether they accept
the Ricardian equivalence hypotheSIS, argue that ~onsumptl~n depends on some measure of long-run or permanent Income, rather than on current Income, because
household plans aremade over a relatively long hOrizon. In
thiS paper, my focus IS on the role of government spending,
taxing and borrOWing In the consumption deCISion and
hence the distinction between current and permanent
Income IS Ignored.
.
14. T represents net tax payments after deducting all
government transfers to households, Including payments
of interest on the public debt.
15. The wealth of individual households also includes
privately-issued financial assets. But for the economy as a
whole, holdings of private financial claims are .exactly
offset by the corresponding private finanCial liabilities, so
that aggregate private wealth includes only tangible
assets and financial claims on the government (plus net
claims on foreigners, which are ignored in this equation).
Throughout this paper I assume that it is aggregate wealth
that matters so that it is legitimate to 'net out' private
financial assets against private liabilities. This assumption
amounts to ignoring the effects of the distribution of assets
and liabilities among households. Similarly, the use of
national income rather than personal income as the
income variable assumes that the distribution of income
between households and corporations (that is, the distribution of profits between dividends and retained earnings) does not affect consumption.
60
tent data set, these estimates were not used in this paper.
16. As pointed out earlier, Ricardian equivalence implies
that households should take account of any expected
future changes in government spending, since these will
imply future changes in taxes. Some studies of the equivalence hypothesis have made consumption depend on
"permanent" or long-rungovernrnent spending, though
finding a suitable empirical proxy for this concept is not
easy. See, forexample,John J. Seater and Roberto S.
Mariano, "New tests of the life cycle and tax discounting
hypotheses", Journal of Monetary Economics, Volume 15,
No.2, March 1985. In this paper I essentially assume that
current government spending is the best availableforecast of future spending.
17. In the simple examples shown in the following equations, it is assumed that current saving is the only source of
increases in real wealth. Other sources of change in real
wealth
changes in the nominal prices of assets, the
effects of inflation, and the depreciation of tangible assets
- are ignored. These factors are discussed below and are
incorporated in the empirical work. The examples also
ignore foreign investment.
18. To show precisely how each of these factors enters the
year-to-year change in the real value of wealth, let At
represent the real stock of assets at date t, qt the average
price of these assets, d the rate of physical depreciation of
assets, and S, the flow of nominal saving in the year
beginning at date t. Then
qt+1 At+1 = qt+1At
dqt+1At + S,
20. For an example, see Flint Brayton and Eileen
Mauskopl, 'The Federal Reserve Board MPS quarterly
economic model of the US economy', Economic Modelling, ,Volume 2, Number
July 1985, pp 182-186, and
pp 222-226.
21, See Brian Horrigan and Aris Protopapadakis, 'Federal
Peficits: A Faulty Gauge of Government's Impact on FinanciaIMarkets', Business Review, Federal Reserve Bank of
Philadelphia, March/April 1982; and Robert Eisner, How
Real is the Federal Deficit?, Free Press, New York, 1986.
22. Suppose there is no inflation, the government debt
out$tanding is $100, the interest rate is 5 percent$othat
the government's annual interest expense is $5, and this
expense is fully paid out of taxes so there is no, budget
de!.i.cit. The inflation rate now rises to 10 Percent and ,as a
res\.llt the interest rate increases to 15 percent and the
annual interest expense to $15. If the government does not
raise taxes but instead borrow$$1 a year, this will have no
effect on the real value of the government debt because
the added borrowing will exactly offset the inflationinduced decline in the real value of the previously-existing
debt. Relying on this argument, these economists suggest
that budget deficits resulting from inflation-induced
increases in interest rates will have no effect on private
demand.
°
23. The source of this estimate is Robert J Barro and
Chaipat Shakosakul, "Measuring the Average Marginal
Tax Rate from the Individual Income Tax", Journal of
Business, October 1983.
= q,A,
dqt+1At + (qt+1 - qt)At + St
This equation says that the nominal value of assets at date
t + 1 is equal to their nominal value at date t, minus the
physical depreciation occurring during the year beginning
at date t, plus the revaluations due to changes in asset
prices over that year and plus nominal gross saving in the
year.
24. Thus, the expected inflation rate in any quarter is being
proxied by an average of the actually realized inflation rate
before and after that quarter.
25. The national balance sheet data contain estimates of
the annual depreciation on private tangible assets (including consumer durables) and of the revaluation of tangible,
equity and foreign assets due to changes in asset prices.
The 'loss' of real wealth due to inflation is calculated by
multiplying the real value of wealth at the beginning of the
year, less depreciation and plus asset revaluations, by the
rate of consumer inflation during the year. In the "Keynesian" equations, real wealth includes, and in the Ricardian
equations it excludes, the stock of government debt.
If Pt is the price of consumption goods in the year beginning at date t, this equation may be written in real terms as
q'+l A'+l IP, =
{[q,A,
dq'+lA, + (q'+1 - q,)A,]lp, .. ,}
- {[q,A,
dq,+,A,
+ (q,+, - q,)A,Jlp,.,}-{(p,-p,_,)lp,)
+ S,lPt
The left side of this expression represents the real value of
wealth at the end of year t (date t + 1). The first term in
braces on the right side represents the value, deflated by
year t - 1 prices, of the asset stock at date t, minus the
physical depreciation and plus the nominal valuation
changes occurring in the year beginning at that date. The
second term represents the change in the real value of
these assets that results from the change in the general
price level (that is, inflation) in year t, while the third term is
gross real saving.
19. In principle, the revaluation variable should also be
different in the two cases, since in the Keynesian case it
should include, and in the Ricardian case it should
exclude, changes in the value of the government debt due
to variations in the prices of government securities.
However, the national balance sheet data that are used in
this study do not include estimates of revaluations of the
government debt. Unofficial estimates of such revaluations
do exist; however, in the interest of using a single consis-
26. Full details of the definitions of the variables used are
shown in a Statistical Appendix, available from the author.
27. The federal government sector is defined to include
both the Federal Reserve Banks and the Sponsored Credit
Agencies and Mortgage Pools, as well as the general
government. This means that the undistributed profits of
these bodies are included in the income of the federal
government rather than the private sector as is done in the
national income accounts. The government sectors are
defined to exclude, and the private sector is defined to
include, the operations of both federal and state and local
government employee pension funds.
28. The depreciation variable is the same regardless of
the level of consolidation. This is because the national
balance sheets do not include the tangible assets of
governments and thus all depreciation is on privatelyowned tangibles.
61
29. The private sector includes both households and pri-
Since the average growth rates of both income and wealth
overthesample period are quite close to that of consumption, similar results would be obtained .if the trends in either
ofthesevariables were used (although the coefficients on
the trend variable itself would be different because the
levels ofthese variables are different).
vatebusiness. Hence, the gross income of the private
sector .includes all corporate profits (except the retained
profits of the Federal Reserve. Banks) __ whether or not
these are distributed to households in the form of dividends ~ and is measured before allowance for depreciation of tangible assets owned by households and business.
$2. This equation also includes avariablethat represents
the inflation loss onthe public's holdings of state and local
government debt. This variable is extremely small but is
incllld~dtoensure that the variablesinthe equation contin~etosatisfytheaccounting identity in equation (10). .It is
not statistically significant at conventional probability levels. Since holdings of government debt are valued at par in
the balance sheet data,there is no variable representing
nominal revaluations of the public's holdings of state and
local government debt.
30.•Private wealth includes the assets of both households
and business. In. the published balance sheets qf the
priyatesector, the. assets of corporate businesses are
valued. at their replacement cost, and the holdings of
corporate equities by households andmutual funds, which
represent claims to these corporate assets, are netted out.
In the measure of private wealth used here, household
equity-holdings are not netted out; instead, the value of
corporate business assets is represented by the value of
corporate equities held by the household sector, either
directly or viamutual funds. Correspondingly, revaluations
of corporate assets are represented by changes in equity
values rather than in the replacement values of the underlying assets. Full details of these adjustments made to the
published data are given in the Appendix. Preliminary tests
indicated that this method of valuation yielded estimated
equations that explained the levels of consumption more
closely than equations using the published data.
33. Note that when a 11 '" -- a1 and a22 = - a2' equation
(14) is identical to equation (12). That is, the second or
'hybrid'equation in Table 1, defined income and wealth so
as to impose these restrictions.
34. When a 11 = -a1 and a22 = -a2, equation (16) is
identical to equation (13). That is, the third or 'fully Ricardian' equation in Table 1, defined income and wealth so as
to impose these restrictions.
35. Recall, however, that Ricardo himself was dubious of
the hypothesis which today bears his name.
31. This variable was constructed by estimating a loglinear regression of consumption on time and using the
fitted values. That is Trend = Exp[FitLcon], where FitLcon
represents the fitted values of the equation:
Log(Consn) = a
+
b.Time
62
@FedFRASER