View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

S**"

SHADOW OPEN MARKET COMMITTEE

Policy Statement and
Position Papers

March 8-9,1987

PPS 87-01

CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY &
BUSINESS
General Working Paper Series

U N I V E R S I T Y

OF

ROCHESTER

TABLE OF CONTENTS

Table of Contents

i

Shadow Open Market Committee Members

Shadow Open Market Committee Policy Statement

ii

1

Position Papers

11

Economic Outlook and Monetary Policy
Jerry L. Jordan, First Interstate
Bancorp

11

An Update on Velocity Behavior
Robert H. Rasche, Michigan State

25
University

Projected Progress on Deficit Reduction:
Will It Prove Illusory (Again)?
Mickey D. Levy, Fidelity
Bank

Policy Coordination and the Dollar
Karl Brunner, University
of
Rochester




i

39

49

SHADOW OPEN MARKET COMMITTEE MEMBERS

The Committee met from 2:00 p.m. to 7:30 p.m. on

Sunday, March 8,

1987.

PROFESSOR KARL BRUNNER, Director of the Center for Research in Government Policy and Business, William E. Simon Graduate School of
Business Administration, University of Rochester, Rochester, New
York.

PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration, Carnegie-Mellon University, Pittsburgh, Pennsylvania.

MR. H. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann & Company,
Inc., New York, New York.

DR. JERRY L. JORDAN, Senior Vice President and Economist, First Interstate Bancorp, Los Angeles, California.

DR.

MICKEY D. LEVY, Senior Vice President
Fidelity Bank, Philadelphia, Pennsylvania.

and

PROFESSOR WILLIAM POOLE, Department of Economics,
Providence, Rhode Island.

Chief

Brown

PROFESSOR ROBERT H. RASCHE, Department of Economics,
University, East Lansing, Michigan.

DR. ANNA J. SCHWARTZ,
New York.




Economist,

University,

Michigan State

National Bureau of Economic Research, New York,

ii

POLICY STATEMENT
Shadow Open Market Committee
March 9, 1987

Sluggish
economic
nomic

growth

and

large

trade deficits

news for the past 18 months.

conditions as unsatisfactory.

Unfortunately,

present

policies

have

dominated

Many have regarded these
But they are

already

the
eco-

changing.

will not lead to a path of

long-run

stability.
Federal
depreciate

Reserve actions are inflationary.
the

dollar

entail high costs.

and mitigate the

Treasury policies

international

debt

The United States is now a major debtor,

achieve a trade surplus to service this debt.
not eliminate the trade deficit.

to

problem
and must

Faster money growth will

Present fiscal policy will not boost

U.S. productivity, exports and growth over the long run.
Economic

growth will accelerate in 1987 in response

to

powerful

stimulative

actions by the Federal Reserve.

excessive.

As a result, inflation -- and ultimately another recession

-- now

loom on the horizon.

gressively

larger

These actions have

been

Central bank policies that rely on

pro-

swings in monetary expansion will not lead to

sus-

tainable economic growth and stable prices.

We are pressing our allies

to adopt the same mistaken monetary policy.

This will only exacerbate

the problems.

Monetary Policy
The Federal Reserve has returned to the go-stop-go monetary policy
of

the

1970s.

It will produce the same result

now

as

then.

All

measures of money growth increased markedly in the second half of 1986.




1

Federal

Reserve

actions are responsible for increased

money

growth,

lower interest rates and devaluation of the dollar.
This
the

policy has been prompted by the Treasury.

Until

recently,

Treasury seemed to know only one solution to the trade problem

devaluation.
their

--

Federal Reserve spokesmen try to give the impression that

actions are cautious.

They profess concern about the risks

inflation and devaluation of the dollar.

This is misleading.

of

Federal

Reserve actions have fully supported the Treasury's policy of devaluing
the dollar.

In recent months, rapid money growth has been a principal

cause of devaluation.
To

understand the impact of devaluation,

tinguish

it is important to dis-

between real and monetary devaluations.

involves,

devaluation

one, raising domestic prices relative to costs of production

including wages,
prices.

A real

A

real

and, two, raising foreign prices relative to domestic
devaluation

can

have a

lasting

effect

on

trade

patterns.
By contrast,

a monetary devaluation,

raises both prices and costs of production,

achieved through inflation,
including wages.

Monetary

devaluations may have some short-term effect on the trade balance,

but

they have limited long-term effects.
On all sides, there are calls for faster money growth to stimulate
the economy.
from

This is a mistake.

The United States is not

weak growth of domestic demand.

suffering

Domestic demand has been rising

at a 4 percent annual rate for the past two years.

Much of the rising

demand has been satisfied by imports.
To avoid another costly inflation and disinflation,
the

Federal

growth



rate

Reserve

we again urge

to abandon its inflationary policy and

of the monetary base on the path toward
2

set

sustained

the
lower

inflation.
be

We recommend that the rate of growth of the monetary

base

reduced to 7 percent for the four quarters ending i December
?

1987

and

further

reduced

each

year

until

non-inflationary

growth

is

achieved,
There
Reserve.
far

is much speculation about the chairmanship of
This

misses the basic issue.

the

Monetary policy depends to a

greater degree on institutional arrangements than on

ality

of the chairman.

Congress

person-

inflation and disinflation,

not changed with the choice of chairmen.

until

the

The go-stop-go policies that give us alterna-

ting periods of expansion and contraction,
have

Federal

requires the Fed to

deliver

They will

not

change

stable, non-inflationary

monetary growth.

Treasury Policy
Treasury policy is in disarray.
intervene
dollar
means

If the recent Paris agreement to

in the exchange market to prevent further devaluation of the

is

implemented,

the Administration would lose

its

principal

of reducing the trade deficit and slowing the growth of debt

foreigners.

The

Treasury now has no policy to end the trade

to

deficit

and slow the growth of the U.S. liabilities to foreigners.
The

Baker plan for international debt has achieved little and

now moribund.

After more than four years, the Treasury does not have a

policy to bring the international debt problem to an
lending to foreigners,

end.

or new loans from the World Bank,

the debt owed by foreigners,

Additional
would add to

delay a solution and increase the cost to

U.S. taxpayers.




is

3

U.S. Trade and Debt
The

problems of trade and U.S.

nation,

we spend too much relative

spending
shows

is for consumption.

up

indebtedness arise because,
to what we produce.

Most of

The excess of spending over

-- health,

welfare,

The government spends mainly for

most

of

our

production

in the national accounts and impacts both the trade

and the budget deficit.

as a

deficit

consumption

defense spending -- and very little

on

investment.
Privately,
highest

rate we have experienced,

very low rate.
assets
trade

the share of spending for consumption remains near the

and

To maintain spending in excess of production,

borrow abroad.

deficit

while net investment remains

at

we sell

The counterpart of this borrowing is

-- net imports from abroad.

For the

last

a

the

year,

net

imports have remained at about 4 percent of total output -- about $150billion in constant 1982 dollars.
In the past five years,

we have borrowed so much that, instead of

owning net foreign assets of nearly #140-billion at the end of 1981, we
had

net

foreign debts of more than $200-billion at the end

Large

borrowing

will continue even on the most favorable

about

the decline in the trade balance.

of

1986.

assumptions

By the end of the decade

we

will owe foreigners between $600- and $900-billion.
Since our consumption

is high and net investment is low,

this borrowing finances consumption.
rate

of

investment
ments
two

productive investment,

If our borrowing financed a high

as in 1983-1984,

would pay the interest and principal.

would raise living standards.




the returns on
Productive

the

invest-

Since the borrowing of the

years has financed consumption mainly,
4

most of

we are living better

past
now.

But

the debt must be serviced and paid.

At some point,

we

will

be

faced with two options:
Since

our international borrowing is denominated in dollars,

option

would

be

to reduce the real value of the

faster

than

reduce

the real cost of paying interest on the debt.

people now believe

likely.

debt

Increased

by

inflating

inflation

costs

at

home

also.

The precise effect

on

would

Inflation would

impose a large cost on the foreigners who bought the bonds.
experience with inflation and disinflation shows,

one

As recent

there would be large
international monetary

arrangements of another period of U.S. inflation cannot be predicted.
The second option would be to service the debt without

inflating.

This would require producing more than we spend and selling the surplus
abroad

to

pay the interest on the foreign debt.

This

option

would

require a trade surplus for the U.S. large enough to cover net interest
payments abroad.
debt

of

surplus

$600- to
would

indefinitely.
future

Using an interest rate of 8 percent and a net foreign
$900-billion by the end of the

have

to

remain

at

$50- to

decade,

our

trade

$70-billion

per

year

A larger surplus in any year would reduce the debt

interest payments;

and

a smaller surplus would add to the debt and

raise future interest payments.
The change from net imports of $150-billion to net exports of $50to $70-billion would require a major shift in world trade patterns

and

resource use.

Because the debt will remain outstanding, the shift to a

surplus

must

be permanent.

current

or past standards,

$60-billion

A shift of this size,
would be manageable.

large

by

A trade surplus

of

would be less than 2 percent of current real GNP

percent of real GNP in 1990.




though

5

and

1.5

The
the

problem cannot be solved in isolation, however.

only debtor.

serviced.

We are not

Many other countries have debts that also

must be

These debtors, too, must have trade surpluses if they are to

service their debts, currently close to $l-trillion.

This limits our

options.
For example, we cannot expect to solve our problems by increasing
net

exports

to Latin American debtors unless they increase their

net

exports to Europe and Asia. Nor, can we continue to be a net lender to
Latin America to finance their trade and development.
lend

them

Every dollar we

has to be borrowed from the rest of the world or earned by

exporting more than we import.
There is no way to avoid the conclusion that, if the debts accumulated in the seventies and eighties are to be serviced, there must be a
major

change

in trading patterns

trading

relations.

Western

Europe and to Asia.

importers.

The

The

and,

U.S. must

postwar

therefore,

in

economic

become a large net

and

exporter

Western Europe and Asia must become

strategy

of export-led

growth

to

to
net

finance

investment in many countries of Europe, Asia and parts of Latin America
was highly successful.

Standards of living rose.

That strategy must

change to reflect the debtor position of the United States.
The magnitude of the required change is impressive in relation to
exports

and world trade.

billion

and

imported

Last year,

more

the U.S. exported about

than $520-billion

$370-

in constant dollars.

Closing the gap between exports and imports and paying the interest
U.S.

debt

on

would be equivalent to increasing our current exports by 60

percent (in constant dollars) by 1990, or reducing imports by more than
50 percent, or some combination of the two.




6

These amounts are more

than 10 percent of total current world exports and,
vantly,

more

perhaps more rele-

than three times the average trade surpluses

(with

all

countries) of the two principal surplus countries -- Germany and Japan.
Much

of Germany's surplus is earned within the European

Economic

Community, while much of Japan's surplus comes from trade with the U.S.
It becomes clear that these countries must become,
large

net

importers from the U.S.

for the first time,

and other debtor countries if

the

debts are to be serviced.
To

illustrate,

percent

of

their

Japanese

1990 output would provide only

interest payments of the U.S.
about

one-half

and German trade deficits

the

$75-billion

and other major debtors.

amount of expected

interest

equal

to

2

toward

This would be

payments

by

these

to

reach

debtors in 1990.
Many

observers

who

discuss the twin deficits

conclusions that are superficially similar.
sion

They urge monetary expan-

by Germany and Japan to lower interest rates and stimulate demand

for our exports.
to

appear

Others urge monetary expansion by the Federal Reserve

depreciate the dollar or monetary expansion in all three

and perhaps elsewhere.

countries

These are stop gaps, not solutions.

They work

by putting the bandaid of additional demand on a problem that
adjustment

of

costs and prices of exports and

imports.

requires

They

offer

short-term, not long-term, solutions.

Options
The

goal

sustainable
options.




of policy should be to raise standards of living

basis.

Current

policy does not do that.

We have

on

a

four

None offers an easy solution, and only one would raise stan-

7

dards

of living.

Each deals in a different way with the problems

of

trade and debt:
First,

we can continue inflating,

as many now

urge.

would lower the value of the debt and devalue the dollar.
in

the

The decline

value of the debt would transfer wealth from the rest

world but,

of

the

sooner or later, inflation would raise all prices including

interest rates and wages.
tion

Inflation

The rise in wages and other costs of produc-

would offset the effect of the devaluation on trade.

To

reduce

the trade deficit permanently, we must reduce the cost of domesticallyproduced goods relative to foreign goods.
solve

the trade problem but,

Inflation not only does not

by encouraging consumption and

possibly

currency flight, it makes the problem worse.
Second,
and

we

can protect against imports using quotas,

perhaps tariffs.

This would lower spending on imports but

invite retaliation and shrink the amount of world trade.
of

trade

billion
In

would

surcharges

make more difficult the task of

A lower level

squeezing

out

to pay interest on our foreign debt at the end of the

addition to all the other,

restrictions,

we

would

decade.

well-advertised disadvantages of

must add that they are in a real

sense

$60-

trade

counterpro-

ductive when we view the trade and debt problems simultaneously.
Third,

we can devalue the dollar.

the past two years.
prices

A real devaluation, unlike inflation, would raise

relative to costs of production and raise domestic prices rela-

tive to foreign prices.
policy,

would

This method of adjustment, like protectionist

reduce standards of living relative to

perhaps in absolute terms.
avoid

policies

dollar down."




We have done a lot of that in

foreigners

and

We cannot avoid devaluation, but we should

aimed at manipulating exchange rates and "talking
Exchange rates should be allowed to fluctuate freely.
8

the

Fourth,
this,

we can increase productivity.

none easy to accomplish.

There are many ways to do

At the national level, the three most

important policy changes would be:
(1) Without increasing explicit tax revenues,
capital

shift taxation from
spending

and the share of capital spending rises to levels

falls

to consumption so that the share of consumption

substan-

tially above those achieved in the last twenty years;
(2) Reduce government spending,
and,

if

possible,

particularly consumption spending

shift government spending from consumption to

productivity enhancing investments in infrastructure; and
(3)

Make a commitment to maintain these policies -- and

term

pro-growth

after

tax

include

strategy - - t o reduce uncertainty

returns

more

pollution,

to investment.

deregulation,

enforcing

and

Elements

a

about

of

longfuture

this

strategy

of

reducing

less costly means

product liability and ensuring

safety

and

health.
Finally,

we

should

shift

from a policy of lending

to

foreign

debtors to a policy of encouraging repatriation of foreign capital
debt reduction by foreign debtors.
country,

It makes little sense for a debtor

the U.S., to borrow and sell assets to finance loans to Latin

American debtors.
equity

and

Instead, we should encourage Latin Americans to sell

in their large state sectors or to adopt policies that

attract

some of the capital held abroad by their citizens.

Conclusion
The
tive

to

problems of trade and debt require that we produce more relawhat

we spend and that we transfer part

abroad to service the debt.




of

the

difference

The four options take different approaches
9

to the problem.

Inflation does little to solve the trade problem and,

by encouraging consumption, would make the problem more severe. Devaluation

(in real

lowering

terms) and protection would

standards

abroad.

None

of

of

solve

the

to

living

living at home relative

these

options works

to

problem

increase

by

standards

output

and

productivity.
A
the

general

tax increase to reduce the budget deficit would

raise

tax on investment to maintain government spending on consumption.

This is the opposite of a policy to close the gap between spending
production
measures

by

increasing

productivity.

It

is

only

by

and

adopting

that increase output per hour that we can hope to service our

debt while

shifting

output

from domestic

use

to

exports

without

increasing inflation and without permanently reducing our standards
living relative to foreigners,

and perhaps, absolutely.

of

Reductions in

government spending on consumption, higher taxes on private consumption
and

lower taxes on investment and capital would shift resources toward

investment and raise productivity.
Economic

policy

is drifting.

There is no coherent

policy

for

dealing with the problems of trade and debt. The direction of drift is
toward higher inflation and lower living standards.

If we continue in

our current, poorly thought out way, we risk a crisis which will force
changes that are more costly and less orderly than those we urge.




10

ECONOMIC OUTLOOK AND MONETARY POLICY
Jerry L. JORDAN
First Interstate Bancorp

Outlook for 1987
While
U.S.

1987

economy,

will be the fifth year of economic expansion
some

sectors,

regions,

of

the

and industries will be exper-

iencing only the first year of a mild turnaround.

The uneven economic

performance of different regions within the United States and different
countries around the world has been one of the most striking characteristics of the current expansion.
faster

The forecast for 1987 is for somewhat

average real economic growth and for significant

lessening

of

the disparity that has been experienced.
Those regions within the U.S.
strong

growth

that have experienced exceptionally

in the past two years will expand less rapidly

in

the

period ahead, while most of the depressed regions will stop contracting
and

begin

a gradual recovery.

strong in 1986,
year.
out

Some sectors that were

exceptionally

such as housing and motor vehicles, will contract this

The hard-hit agriculture and energy sectors will finally bottom
and

return

start to firm up as the year progresses,
to

sustained

prosperous

conditions

in

but they
the

near

will

not

future.

Exporting industries and import-competing industries stand to show

the

greatest improvement within the manufacturing sectors.
In general, we expect:
-monetary policy to continue to be expansive;
-the Federal budget deficit to decline from $221 billion last year
to a still-quite-large $175 billion or more this year;
-oil prices to average in the mid teens;
-the dollar to fall further;




11

-consumer prices to rise to about 4 1/2% this year;
-interest rates
percent point;

to

rise about one-half to

three-fourths

of

-real GNP growth to be about one percentage point higher than
past two years;

a

the

-employment to continue rising and the unemployment rate to drift
towards the 6% level;
-domestic demand to strengthen in Japan
better markets for U.S. exports; and
-the U.S. trade deficit to begin falling,
real output growth.
In summary,
this year,

and

Europe,

providing

contributing to higher

while U.S. final demand is not expected to strengthen

output growth is forecast to rise more rapidly.

The weaker

performance of the housing and motor-vehicles industries will be offset
by

stronger

electronics,

results
and

in

paper

products,

service industries.

chemicals,

computers,

The disappointingly slow

growth of the past two years is not likely to be repeated.

real

It is more

probable that surprisingly strong growth of final demand will cause our
forecast to be on the low side.

Risks to the Outlook
Last

year

the "surprise" development that dominated the

perfor-

mance of the U.S. economy was the sudden and rapid decline of world oil
prices.

For 1987,

there is a growing risk that the steep descent

of

the

international value of the dollar could force a major policy shift

and

change

policymaker

the

near-term

outlook.

Specifically,

if

were to become concerned about a "cumulative
starting to occur in the foreign exchange

Washington's
process"

"free

fall"

markets,

would

have to chose between risking an international financial

they
crisis

or administering a dose of old fashioned "tight money and credit."




12

or

Our

judgment

is

that

domestic

economic

Federal

Reserve

policymakers

would

subordinate

and political considerations to international

con-

cerns and would accept a recession before they would risk a collapse of
the dollar.

Monetary Policy Options
During the past two years monetary policy has been inappropriately
conducted
falling

with a view to offsetting the adverse real shock effects
energy

prices and depressed

commodity

prices.

The

of

fiscal

impasse, represented by the high growth government spending relative to
national income and the budget deficits,
distortions
tries

in

dollar
U.S.

has given rise to substantial

in the performance of various sectors,
the economy.

regions and indus-

The dislocations associated with

the

strong

followed by weak dollar regimes reflect the inconsistencies
economic

accepted

policies.

the

government,
shocks.
approach

monetary

authorities

have

role of correcting the mistakes of the
as

other

passively
parts

of

well as attempting to mitigate the effects of external

Such

an

the

activist,

judgmental,

and

increases uncertainty on the part of private decisionmakers and

raises

that

of

discretionary
policy

likelihood

formulation and implementation

purely

monetary

the

to

The

of

the central bank will become the

scapegoat

for

whatever is wrong with the economy.
During
campaign
imbalances

the past two years the U.S.

to convince the world press and public opinion that
and

inappropriate
countries.

policymakers have been

being pursued by the

The U.S. position has been:

strong

a

external

disparity of economic performances has been caused

policies

on

by

currency/surplus

when the dollar was strong in

the early 1980s, it was a reflection on our good policies; now that the




13

dollar

is falling it is a reflection of bad policies of

others.

The

clear implication is that whatever is wrong requires policy changes

on

the part of other countries.
The
deficits,

classic

prescription for a country experiencing huge

huge trade deficits, explosive monetary growth and a rapidly

depreciating currency is:

cut government spending,

raise taxes,

reduce monetary growth; none of that is likely to happen.
U.S.

is

increase
their

fiscal

urging other countries to increase
budget deficits,

spending,

ease monetary policies,

way to prosperity" and lower trade surpluses.

and

Instead, the
reduce

taxes,

and seek to "spend
In

a

nutshell,

since the U.S. has embarked on a policy of reinflating, other countries
are being pressured into reinflating right along with us.




14

ECONOMIC AND MONETARY UPDATE
Shadow Open Market Committee

Ul




March, 1987

prepared by:
Jerry L Jordan
First Interstate Economics

1.
Demand vs. Production

Contributions of Different Economic Sectors

(Percent change, 4th quarter to 4th quarter)

(Addition or subtraction from Real 6NP growth, 1986-19871)
Consumer

1985

1986

19871

19881

RealGNP
DEMAND vs. PRODUCTION

(Percent change from prior quarter, annual rate)

(Cumulative changefrom2nd quarter 1984 = 100)

116.0
114.0

J/**/•

REAL DOMESTIC ANAL SALES

s> ,

112.0
110.0
108.0
1060
104.0
102.0
100.0
II

III
1984




IV

I

II
1985

III

IV

I

II

III

1986

IV

I

II

III

19871

IV

I

II

III

19881

IV

1982

1983

1984

1985

1986

1987!

19881

Short-Term Interest Rates

FEDERAL RESERVETRADE-WEIGHTED DOLLAR
Index: 1980:4=100, Quarterly Averages
180.00

(Percent, quarterly averages)
20 T

T

160 00 f

140.00 f

120.00 f

100.00

80.00
4 12 3 4
1980
1981

T i i i i i i i i
2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
1983
1984
1985
1986
1982

12 3 4
1987f

1983

uonsumer rnces




1985

1986

19871

19881

^mm&

Long-Term Interest Rates

(Percent Change, 4th quarter to 4th quarter)
1ST

1984

Mortgage

1982

(Percent, quarterly averages)
20T

15 +

10

30-Yr. Govt Bond

51 I I t I I f I I t I t t I I I I I I I I I I t I t I I I
1982

1983

1984

1985

1986

19871

19881

3.
ST. LOUS AND BOARD MONETARY BASE

GROWTH OF TOTAL BANK RESERVES

QUARTERLY PERCENT CHANGE OVER YEAR AGO

QUARTERLY PERCENT CHANGE OVER YEAR AGO
25.00 T

1. T
10

ST. LOUIS BASE

5.0t

OD

3.0 I t I I t I t t t I t I I t I I I t I I I I I I I I I I
1980:1
1981:1
1982:1
1983:1
1984:1
1985:1
1986:1

BOARD MONETARY BASE AND M1
QUARTERLY PERCENT CHANGE OVER YEAR AGO
20.0

-5.00 •*
66:1

68:1

70:1

72:1

74:1

76:1

78:1

80:1

82:1

84:1

86:1

DOMESTIC FINAL SALES & LAGGED MONETARY BASE
QUARTERLY PERCENT CHANGE OVER YEAR AGO

T

-5.0
-10.0 1 I I I I I I I I I I I I I
1980:1
1981:1
1982:1
1983:1




I I 1 I I I I I 1 I 1 I 1
1984:1
1985:1
1986:1

2 I I I I I I I1 t II I I 1 I I I I I I t I 1 I 1 1 1 1 I t
1980:1
1981:1
1982:1
1983:1
1984:1
1985:1
1986:1
1987:1

4.
Money per Unit of Output and Deflator*

Money per Unit of Output and Deflator*

(Percentage of period average. 1886-1986=100)
450

200

T

(Percentage of period average. 1961 -1986* 100)
T

300 |
250 +
200
Money per unit of output

150 4
100

Deflator

50

0 lllMttHtttMMMtMttttttltMMtMMtUMMIMMtlHtllHttHt«ttimttlttmilttHIMM»ttMtMMt
1886
1898
1908
1916
1926
1936
1946
1956
1966
1976
1986
*M2 proxy end national income measures
of output and deflator

Changes in Money per Unit of Output
and Deflator, 1886-1986

Changes h^Money per Unit of Output
and Deflator, 1961-1986

(Percent change over prior year)

(Percent change over prior year)

Money per unit of output

•20 I I I
1886




1896

IMMMIMIMIIMtMMHIIMMHMMMDMMni
1906
1916
1926
1936
1946

IIMHI
1956
1966

1961
1966
1971
*M? proxy and national income measures
of output and deflator

I
1976

'386

5
Monetary Base per UnR of Output and Prices*

M1 Adjusted per Unit of Output and Prices*

(Percentage of fourth quarter averages,1959-1986=100)

Monetary Base
per Unit of Output

o

40 I I I I I I I I I I 6 i I I t I I I I I I I I I I
1959
1962 196S 1968 1971 1974 1977 1980 1983

40 I I
1986

1959

rQOttm neSfftV Monetary HB90 and RlWr
wetc/rted price indn for grass dornestc purchases

I I

I

I

1962

I
1965

I

I

I
1968

I t I I
1971

I I
1974

I

I

I I
1977

I | |
1980

| |

| |

1983

|
1986

*M1 less one-half of otor checkable dsposfe and Rxedwekjhted price indexforgross domestic purchases

Changes In Monetary Base per Unit of Output
and Price Index, 1960-1986

Changes In M1 Adjusted per Untt of Output
and Price Index, 1960-1986
(Fourth-quarter to fourth-quarter percent change)

(Fourth-quarter to fourth-quarter percent change)
Price Index

\v
-S 1 l l I I t t l I l I l l l I I t t I I I I t I I I I

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986




V

Ml Adjusted per Unftc40u*?ut

.6 I I t l t l I l I I t I I I I l l I I l l I I I » > I
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986

M1 per UnRof Output and Pricesf

Changes hi M1 per Urtt of Output
and Price Index, 1960-1986

(Percentage offourthquarter averages,1959-1986=100)

(Fourth-quarter to fourth-quarter percent change)

14
12

Price Index

10
8

6
4
M1 per Unit of Output

ro

40 I I I I I I I I I I I I I I I 1 I I I 1 1 1 I
1959
1962
1965
1968
1971
1974
1977
1980




111 VM! Rf0(FVW0iMpnc9inoMfaQrottdoinMfc purchssus

l i l t
1983

1986

2{

i

i

i i

i

i i

i i

i i i

i i

i t t

t t

i i

i i

i i t

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986

M1 per Unit of Output and Prices*

Monetary Base per Urft of Output arxl Prices*

(Cumulative percent change fromfourthquarter 1959=1.00)

(Cumulative percent change fromfourthquarter 1959=1.00)

Monetary Base
per Unit of Output

0 501 I 1 1 1 t I t I 1 1 I t 1 t I I 1 I I I 1 I I I 1 1 1
1959
1962 1965 1968 1971 1974 1977 1980 1983 1986
T i w i Htsenrt Monetary Base mo nwd*
wsiohlBd price M M lor gross domestic ptithassi

(Cumulative percent changefromfourthquarter 1959=1.00)

M1 Adjusted
per Unit of Output

0.501 1 1 I 1 1 1 1 1 I 1 i I I 1 I 1 I 1 1 1 1 1 1 1 I 1 1
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986




0.50 1 1 1 1 1 1 I 1 1 1 1 I 1 I 1 I I I I
1959

1962

1965

1968

1971

1974

1977

*M1 and Rxed-weigMed price index tor gross domestic purchases

M l Adjusted per Unit of (>rtput and Prices*

*M 1 less one-hat of other checkable deposits and Fixedweighted price index for gross domestic purchases

M1 per Unit of Output

1 1 1 1 1
1980

1983

1 1 1
1986

8.
MAJOR ECONOMIC INDICATORS

QUARTERLY

I

1966
II

GROSS NATCNAL PRODUCT
(billions of S. annotl rate)
% Change, annual rate

4149.2

REALGNP
(billions of 1982 f. *.t.)
% Change, annual rate

4th QUARTER

417S.6

III
Actual
4240.7

2.6

6.4

1.9

3655.9

3661.4

3686.4

3698.3

I

0.6

2.8

3800.1

3850.0

6.4

5.4

GNP DEFLATOR
(1982-100)
% Change, annual rate
CONSUMER PRICE
INDEX
(1987-100)
% Change, annual rale
f^
CO

39.9

15.1

3.4
3883.4

-0.3 -24.4

1.8

4685.6

4780.6

4875.2

4972.8

8.7

8.4

8.2

3859.8

3601.3

3920.1

3947.3

3.6

3.3

3.0

3989.3

4012.1

4041.3

2.4

2.6

2.3

% Change
'86/85

1987

% Change
'87/'86
1988
Forecast
7.7 4972.8

% Change
'88/87

2.8

3963.9

1986
Actual
4260.6

8.2

3.3

3752.4

Forecast
4589.1

3940.0

7.1

2.9

4.2

4589.1

6.4

3698.3

2.1

3824.0

3.4

3947.3

3.2

3873.8

3.0

3940.0

1.7 4 0 4 1 . 3

2.6

8.2
3786.7
3.7
3907.7

2.5
•0.8

REAL CHANGE i t
NVENTORES
(billions of 1982 $. a.r.)

IV

4494.6

3873.8
3865.7

• 1.8

III

4.0

4407.3

1.3

2.5
3742.0

III

1968
II

3824.0

3721.2
3.6

II

1

8.7

4332.2
6.9

REAL FWAL DOMESTIC SALES
(billions of 1982 1 a.r.)
% Change, annual rate

rv

4260.6

6.2

1987

IV

2.5

3.0

12.0

16.0

11.0

19.0

22.0

26.0

21.0

-24.4

N/A

11.0

N/A

21.0

N/A

115.2

2.1

120.0

4.2

126.0

6.0

330.7

1.3

345.2

4.4

362.8

5.1

113.5

114.0

115.0

115.2

118.4

117.5

118.7

120.0

121.4

122.9

124.4

126.0

2.5

1.8

3.6

0.7

4.3

3.6

4.3

4.5

4.7

4.0

5.0

5.3

327.7

326.3

328.4

330.7

334.4

337.5

341.2

345.2

349.2

353.4

357.9

362.8

1.5

-1.7

2.6

2.8

4.6

3.7

4.5

4.7

4.8

4.9

5.2

5.5

AUTO SALES
(millions, annual rate)

10.7

11.2

13.2

11.8

10.0

11.0

11.2

11.0

11.2

11.0

10.9

10.7

11.4 •

3.7

10.8*

-5.3

11.0*

1.4

HOUSING STARTS
(millions, annual rate)

1.94

1.68

1.76

1.70

1.69

1.77

1.75

1.74

1.72

1.70

1.68

1.66

1.81 •

3.7

1.74*

-4.0

1.89*

-2.7

125.0

124.4

125.0

125.9

126.6

127.9

129.5

131.2

133.0

134.5

135.6

138.7

1.0

-1.9

1.9

3.0

2.4

4.1

5.0

5.5

5.4

4.6

3.5

3.0

99.4

99.6

100.3

101.1

101.8

102.5

103.2

103.9

104.6

105.3

106.1

6.9

7.0

6.6

6.7

6.7

6.6

6.5

6.4

6.2

6.1

296.4

293.1

302.0

309.0

313.0

318.0

327.0

332.0

338.0

11.3

6.9

1.9

INDUSTRIAL
PROOUCTON
(1977.100)
% Change, annual n i t
NGNFARM
EMPLOYMENT
(millions)

UNEMPLOYMENT
RATE (percent)
CORPORATE
OPERATINGPROFITS
(billions of t . annual rale)
% Change over year ago
NET CASH FLOW
(billions of $. annual rate)
% Change CNW year ago

374.3

374.9

384.3

3.7

1.1

0.4

MONETARYBASE
(billions ol S, B.t.)
% Change, annual rate

219.6

224.5

230.2

6.4

9.2

10.5

305.0 ej

1.0

131.2

4.2

136.7

4.1

106.7

101.1

2.4

103.9

2.8

106.7

2.7

6.0

6.0

6.7

N/A

6.4

N/A

6.0

N/A

344.0

350.0

305.0

6.8

327.0

7.2

350.0

7.0

387.0

-0.6

406.0

4.9

428.0

5.4

236.1

9.7

259.8

6.8

277.4

8.0

4.3

6.8

5.3

7.2

7.4

8.0

8.2

7.0

390.0

393.0

398.0

406.0

411.0

417.0

422.0

428.0

-0.6

4.2

4.8

3.6

4.9

5.4

6.1

6.0

5.4

236.1

241.0

246.3

251.6

256.8

261.6

266.6

272.1

277.4

10.7

6.5

9.2

8.9

6.5

8.0

7.5

8.5

8.0

6.6
387.0 e|

NOTE: All quarterly series are seasonally adjusted; % change, annual rate calculated from prior quarter;
calculations based on unrounded data; a.r.. annual rate; e - estimate.




125.9

ual total; N/A - Not applicable.

Prepared by F i r s t I n t e r s t a t e Economics
February 23,1987




AN UPDATE ON VELOCITY BEHAVIOR
Robert H. RASCHE
Michigan State University

Last

November I prepared a rather lengthy paper for the Carnegie-

Rochester Public Policy Conference on the behavior of velocity and
stability

of Ml money demand functions [Rasche (1987)].

updates that research in three ways.

This

the

report

First, I will derive an alterna-

tive interpretation of the short-run money demand functions that appear
in

the

November

velocity

paper.

This interpretation focuses on

changes

determined by the current expected change in the

equilibrium

demand for real cash balances and unanticipated contemporaneous
to

the

various

balances.

This

siderably

determinants

long

from

and

the more

a

equilibrium

conventional

very slow distributed lag

holdings of real cash balances.
just

the

demand

shocks

for

cash

interpretation of the empirical specification is con-

different

emphasized

of

in

specification
responses

of

that
actual

It should be emphasized that this

different way of looking at the regression results

that

is
have

been previously presented, it is not a new set of results.
Second,
ance

I will present the new regression results from a

analysis

of

short-run

money demand

distinct subsamples of the 1953-85 sample.
1975-81

and

1982-85.

significant
identified
increase
cash

"shift
as

in

balances

in

beginning

for

the drift" of

three

The subsamples are 1953-74,

The covariance analysis suggests that
velocity

that

was

in

the interest elasticity of the long-run demand
that has occurred since the

introduction

the

previously

in late 1981 is probably symptomatic

bearing transactions accounts.




specifications

covari-

of

of

for

an
real

interest

The covariance analysis presented here

25

deals

only with the monthly money demand specification of my

November

paper, but the consistent results are obtained for any of the quarterly
specifications.
Third,
during

I will present an analysis of the behavior of Ml velocity

the first 10 months of 1986.

This is the question that is on

everyone's mind, so I will risk addressing the question even though the
data are so preliminary that any conjectures may be purely
artifacts.

The

statistical

reader who is interested only in the question of what

has happened in 1986 should skip directly to section III.
!•

An Alternative
Functions
You

Interpretation

of

the

Estimated

Money

Demand

should recall that the estimated results from annual data are

consistent with an equilibrium log-linear money demand equation with a
unitary real income elasticity of the form:

Aln(M7P)t - a - 3AlriRTBt + Aln(Y/P)t + e
- E[Aln(M7Pt)] + e t

where

the

bars

(1)

over the variables represent annual

corresponding data series.

averages of the

I do a bit of shuffling with the

notation

because the variables that were used in these regressions were
in

the logs of arithmetic

exposition
averages

averages

of monthly data series, while

purposes I will pretend that they are changes in
of the monthly data.

changes

Thus there is an element of

for

geometric
inconsis-

tency in the time aggregation of the data that I am fudging over.
The short-run money demand equations in section IV of the November
paper are of the form:




26

Aln(M/P^ z - a - b J AlnRTB^> i- + cAln(Y/P)
t
t
i=0
n
+ (l-c)(l/n) Z Aln(Y/P). - + cDIFU
1=1
where DIFU
rate.

+U

(2)

is the residual from a (0,1,1) ARIMA model of the inflation

I will assume that it is appropriate to interpret these resid-

uals as:
APt - A P % - P t - vtml

- t . ^ \

- Pt.i - (Pt - t.xv\)

O)

e
where p
the

is the observed inflation rate at t and

expected

t-1.

-p

is a measure of

inflation rate for t based on information

available

A little algebraic manipulation gives an alternative

at

expression

for the short-run demand for money:
n

n

Aln(M/P). - [a - (n+l)b{(l/n) Z AlnRTB^ L.} + {(1/n) Z Aln(Y/P). .}]
z
Z
t i
i=1
'
.1=1
"
- blAlnRTB
C

+ c{Aln(Y/P

n
- (1/n) Z AlnRTB -}
t i
i=1
"
n
- (1/n) Z Aln(Y/P)
i=1

}

+ d(p t - p e t ) + y t

(4)

Now if we ignore the fact that the n in the monthly regressions is
less

than

constructed

a full year

and that

regressions

are not

using geometric averages, equation (4) can be interpreted

as:




the annual

27

n
£Ln(M/P) t - E t l [ A l n ( M / P ) t ] - b(AlnRTBt - (1/n) I A l n R T B ^ }
n
+ c{Aln(Y/P). - (1/n) 2 Aln(Y/P). }
z
c i
i=1
"

+ <Kpt - p e t ) + v t

so

(5)

that the observed change in real money balances is the sum

expected

an

the

change in equilibrium demand for real money balances plus the

effects of current shocks to interest rates,
and

of

unallocated noise component.

appropriate,

real

income,

inflation,

For this interpretation

to

be

the four "shock" terms should not be predictable based on

information available at t-1.

The inflation shock is constructed to be

approximately independent of its own past history, since it is measured
as

the residuals from an ARIMA model.

The other three shocks are not

constrained in any way by the regression.

The first twelve

estimated

autocorrelations of these series are:

Interest Rate
Shock

1
2
3
4
5
6
7
8
9
10
11
12

Real Income
Shock

.41
.00
-.03
-.02
-.18
-.38
-.33
-.11
.02
.02
.05
.15

.01
.03
-.08
-.05
-.08
-.14
-.15
.04
.09
.05
.10
-.04

y

.13
.07
.19
-.09
.06
.09
-.05
.02
.10
-.10
-.03
-.04

so, with the exception of the first, sixth and seventh autocorrelations
in

the interest rate series,




there does not appear to be a tremendous

28

amount of serial correlation in these series.

An interesting test

of

this hypothesis (which I have not yet had the opportunity to construct)
would

be

to treat the "shocks" as a four equation VAR system

test

the

and

to

hypothesis that the coefficient matrix in the VAR model

is

just an identity matrix.
estimate

a

An alternative research strategy would be to

multivariate ARIMA model that involved four

equations

to

determine interest rate, real income, inflation and money demand shocks
jointly.
of

This would also permit Granger-Sims type "causality testing"

the

interest rate,

real income and inflation

shocks

against the

money demand specification.

11-

Some Additional Estimates of the Short-Run Demand for Money
Since I completed the research for the Carnegie-Rochester paper, I

have

done some additional investigation into the nature of the elusive

"shift
This

in the drift" parameter that occurred around the end
research has focused on two questions:

of

1981.

1) attempts to include

a

more comprehensive measure of "transactions" and 2) covariance tests of
the

stability of the short-run money demand specification over various

subsamples of the 1953-85 period.
The first line inquiry has not produced any great new insights.
thought

that I had discovered a useful and apparently unexploited data

series in the Survey
the

number

monthly

I

of

of Current

Business

in the form of monthly data on

shares traded on registered stock

value of all such trades.

exchanges

and

I added either the trading

the

volume

measure, or the real value of trading (deflated by the GNP deflator) to
the
that

annual

money demand specifications to try to

are not measured in GNP.

Unfortunately,

model

transactions

this variable is

pletely insignificant in sample periods that end prior to 1982.




29

comIt has

the

expected

positive coefficient in samples extending through

1985,

when interacted with a dummy variable that is zero before 1982 and
thereafter,

but

this result is equally as unsatisfying as just

one

using

the 1982 dummy variable by itself.
The
All

covariance analysis proved to have a higher marginal product.

of

the regression coefficients were allowed to

values

assume

different

the subsamples mentioned above,

and F tests were

for

check

in

equality of coefficients across

the

residuals

of

unrestricted

the

homoskedasticity

across

the

regressions

subsamples.

used

three

periods.

The

were

examined

for

This

revealed

that

residual variance in the 1953-74 subsample was considerably lower
that
the

of

the later two subsamples,

1975-81

sample.

sample

Thus

period

was virtually identical to that

the

of

the

than

is

in

1982-85

the observed drift in the standard error as the

mixing heteroskedastic errors in changing proportions.
in

the

but that the residual variance

was lengthened from 1974 to 1981 to 1985,

to

sample

attributable

to

The only change

variance of the error process occurs in the mid 1970s and

the

previous conclusion that there is no increase in the residual variation
of

the short-run money demand function (or velocity) in the

fully

supported.

regressions and

These
the

results

are

consistent

for

1980s

the

quarterly regressions (regardless of

is

monthly

the

income

concept used).
The

covariance

analysis also supports the hypothesis

that

the

long-run and short-run income elasticities and the short-run unexpected
inflation

elasticity

of the demand for real cash balances are

across the three subsamples.
the

interest

There is also no evidence of a change in

elasticity between the 1953-74 and

The only significant change in the specification,




stable

30

1975-81

subsamples.

other than the shift

in the constant term that was found in the earlier work is an
in the interest elasticity in the 1982-85subsample.
in

Table 1,

monthly

increase

This is documented

where column 1 repeats the estimates for the

constrained

regressions from the November paper (reestimated on the latest

available data revisions) and column 3 gives the results with a
in the interest elasticity permitted in 1982.
unconstrained
in

It should be noted that

distributed lags were estimated for all three subsamples

the covariance analysis and the lag restrictions identified in

November

paper

were

restrictions.
in

change

column

3

tested

jointly

with

the

covariance

None of the restrictions imposed on the
were

rejected.

This type of analysis

analysis

specifications
has

repeated on quarterly data using the three income concepts:
Sales to Domestic Purchasers;

the

and Personal Income and the

also

been

GNP; Final
conclusions

are identical to those presented here.
An

interpretation

presented

in Figure 1.

of

the estimates in column 3 of

Table

1

It appears that the significant shift in

drift parameter of velocity in 1982 is symptomatic of a rotation

late

1981,

relatively low,
when

interest

the long-run elasticity of the velocity

the

of the

long-run velocity function of the type illustrated in Figure 1.
to

is

Prior

function

was

and that the drift in velocity (the change in velocity
rates were not changing) was positive.

Subsequent

to

late 1981 it appears that the long-run interest elasticity of

velocity

has

velocity

increased,

function

but this has occurred with a rotation of the

so that the current drift in velocity is approximately

zero.

My best explanation for this is that the change in the structure of the
velocity

function

is a result of the relaxation of the zero

rate constraint on transactions deposits.




31

interest

It

should be noted that at least one other piece of research

reached a conclusion that is similar, if not identical, to this.
(1986),

in

Table

1

(p.

16) has estimated a

monthly

money

has
Mehra

demand

equation (equation 2) very similar to the unrestricted distributed

lag

specification

has

reached

an

that

underlies

identical

the results

conclusion

presented

about the change

interest elasticity of money demand in 1981.

here,
in

the

and

long-run

His research differs

in

that it considers only a 1961-85 sample period, and it does not address
the
In

issue of restrictions on the short-run money demand specification.
a

perfect

coincidence,

that

study

chooses

almost

identical

distributed lag lengths to those that I have used.
Mehra

has

also investigated the effect of adding a

nonzero

own

interest rate elasticity of money to his specification of the short-run
money demand equation, though in a highly constrained fashion (equation
3).

He uses the variable Aln(R

- Rm ) where Rm

is a weighted average

of the rates on NOW accounts and SNOW accounts, with weights reflecting
their shares in Ml.
quarterly
AlnR
it

study

A similar variable was used by Taylor (1985) in a

of money demand.

- Aln(l- [Rm /R ]) .

This variable can be rewritten

When the variable is expressed in this form,

is clear that the specification does not introduce any

estimate of the own interest rate elasticity.

If B is the

of the demand for real cash balances with respect to R,

independent
elasticity

the elasticity

of the demand for real cash balances with respect to the own rate,
is

constrained to -gRm/(R-Rm).

which

has

a

This is a highly variable

value of 0 at Rm - 0,

-3 at Rm -

infinity as Rm approaches R from below.
been

any

Further,




testing

as

of the appropriateness

.5R,

and

Rm,

elasticity
approaches

There does not appear to have
of

this

functional

form.

the addition of the constrained own interest elasticity makes
32

no

contribution

the Mgoodness-of-fit" of

to

this work,

estimated

equation.

Based

supporting

the argument that the change in velocity since 1981 is the

result

own

of

on

the Mehra's

interest

there does not seem to be

rate effects in the

demand

for

any

case

real cash

balances.
III. The Behavior of Velocity in 1986
A casual examination of the currently available data suggests that
the behavior

of Ml velocity in 1986 is a real anomaly judged

its history.

I purposefully ignored the events of 1986 in undertaking

the

earlier

independent

research

so that these data would be

test of whatever conclusions

data are now available through October,
personal

consumption

expenditures

November or December).
estimated

were

against

available

reached.

for

Preliminary

1986 (data on the deflator for

have not yet been published

for

These data can be employed in two ways: 1) the

equations from Table 1 can be used to forecast the first ten

months of 1986, and 2) the specifications can be reestimated using
ten additional observations to see if the structure proves unstable
1986.

I have

change

in

confined

an

not yet constructed the instrumental variable for

the Treasury bill rate for 1986, so the analysis here

to OLS estimates.

I do not anticipate that the

the
in
the
is

conclusions

will vary with the estimation technique.
The
second

results of the reestimation test are given in Table

column

of

this

extended through October,
corresponding
tremendous

extension

table reproduces column
1986.
of

surprises here.

1 with

1.

the

The

sample

The fourth column of Table 1 is the

the results in column 3.

There

The parameter estimates are quite

are no
stable

and the estimated residual standard errors are not much different




33

from

the equivalent estimates with the sample ending in 1985.
stability

of

these

However, the

parameters should probably not be

considered

a

particularly strong test of the model, since only ten observations have
been

added

to

the

original

sample

of

391

observations.

interesting are the residuals for the 1986 months.

More

These are given in

Table 2, columns 2 and 4. At first glance, these residuals do not seem
to be terribly out of line.
estimated
look

The only residual that exceeds twice

standard error of the equation is in May,

reveals

1986.

A

the

closer

that there is a systematic behavior in the residuals

in

the run of overpredictions (negative residuals) of velocity starting in
March through at least August. This is also evident in the mean of the
residuals for the first ten months of 1986 which is substantially
than

zero.

specification
1981 [column
The
third

This

pattern

in

the

residuals

is

that allows for an increased interest

reduced

less

in the

elasticity

after

(4)], but is still substantial.

results

of the forecasting test are given in the

columns of Table 2.

In this test, the estimated

first

and

coefficients

from the sample ending in December, 1985 were used with the actual 1986
data for real personal income and Treasury bill rates.
inflation

The unexpected

variable was generated from one period ahead forecasts

the ARIMA model for inflation estimated through December,
predictions

of

inflation

substantially

overestimate

from

1985. These
the

observed

inflation rates in the early months of 1986. The prediction errors for
velocity

in

1986 are quite similar to the residuals of

equations estimated through 1986.

the velocity

The same run of overpredictions

of

monthly velocity changes is observed, and the average forecast error is
negative.




The

equation

that is estimated with only the 1982

34

dummy

variable (column 1) outperforms on average the equation that allows the
change in the interest elasticity of velocity in 1982, for reasons that
are

not

apparent.

Indeed,

this

equation

(column

1)

on

average

outperforms the same specification estimated through 1986!
My
month

conclusion from these experiments is that in

the

to month residual variation in velocity changes,

systematic

behavior

identifiable.

We

that

may,

with

a

lot

of

substantial

there is

data

some

mining

be

should not overlook the fact that these results are

derived from equations that have only four or five estimated parameters
(on samples of over 400 observations).
parsimonious.
estimated

That

equations

is

its

The velocity model is extremely

strength.

But

it

suggests

are not likely to fit every wiggle in

that
the

the
data,

particularly during a period when the economy experiences a substantial
external shock.

Nevertheless,

from these results is that,

the best conclusion that can be

absent drift in short-term interest rates,

the future drift in Ml velocity will be close to zero.
in
been

columns

five and six of Table 1,

reestimated

for

35

This is evident

where the velocity equation

both sample periods with

parameter constrained to zero.




drawn

the

post 1981

has
drift

TABLE 1
Revised Estimates of Monthly Personal Income Velocity Equations
First Differences
Constrained Distributed Lags
Ordinary Least Squares Estimates

53,1-85,12
(1)

53,1-86,10

53,1-85,12
(3)

(2)

53,1-86,10
(4)

53,1-85,12
(5)

53,1-86,10
(6)

Constant

.0307
(.0024)

.0305
(.0025)

.0310
(.0024)

.0309
(.0024)

.0310
(.0024)

.0308
(.0024)

D82

-.0406
(.0070)

-.0504
(.0066)

-.0305
(.0071)

-.0367
(.0068)

-.0310

-.0308

AlnRTB

.0058
(.0006)

.0059
(.0006)

.0053
(.0006)

.0052
(.0006)

.0053
(.0006)

.0053
(.0006)

ALnY/P

.8374
(.0396)

.8514
(.0402)

.8351
(.0385)

.8465
(.0388)

.8351
(.0391)

.8474
(.0388)

.0122
(.0024)

.0134
(.0024)

.0122
(.0023)

.0143
(.0022)

.62
.0434
1.84

.64
.0442
1.78

.62
.0434
1.84

.64
.0442
1.78

D82*ALnRTB
R2
se
d-w




.60
.0448
1.74

.61
.0458
1.66

36




TABLE 2
1986 Velocity Errors
Monthly Velocity Equations
Annual Rates

(2)

(1)
January
February
March

(3)

(*)

.0689
.0046
-.0520

-.0643
-.0119
-.0318

-.0703
-.0096
-.0295

.0652
.0068
-.0689

April
May
June

.0561
-.0933
-.0716

-.0470
-.1245
-.0661

.0444
-.1037
-.0799

-.0365
-.1377
-.0559

July
August
September

-.0494
-.0609
-.0429

-.0775
-.1147
-.0145

-.0677
-.0883
-.0760

-.0566
-.0810
.0236

October

-.0479

-.0537

-.0811

-.0085

Mean

-.0418

-.0476

-.0562

-.0350

Note:
Columns correspond to the columns of Table 1. Columns
1 and 3 are post sample forecasts. Columns 2 and 4 are within
sample residuals.

37




O M I I M

F A !• i B

MO.

I f • 0 - I O • »

T M C l N t

M r

* O .

I t I » • • O •

C I O S S
S t H

fK

S E C T I O M - » O K I O

L l N t

A C C T ' O .

10

1 0 1 M

I

A 0 O A B I

I

•

I « C H

H f A V V

M A O C

IN

USA

PROJECTED PROGRESS ON DEFICIT REDUCTION:
WILL IT PROVE ILLUSORY (AGAIN)?
Mickey D. LEVY
Fidelity Bank

In the Presidents FY1988 Budget
Outlook,

and the CBO's Economic

and

Budget

several important positive trends are projected:

•federal spending growth is significantly slower than recent years
*budget deficits
percent of GNP

shrink

in real and nominal

terms,

and

as

a

*the primary deficit -- deficits excluding net interest outlays -is virtually eliminated within three years
*the federal debt-to-GNP ratio stabilizes and begins to recede
*the President's budget achieves the
deficit targets (see tables 1-2)
Clearly,

some

Gramm-Rudman-Hollings(GRH)

progress on the budget dilemma has

case,

the

but

As is typically

these projections over-estimate the improvement.

occurred,

the

Administration's budget is wildly optimistic.

Unrealistic

budget projections that on paper achieve the overly ambitious goals
GRH

do

not

resolve

the budget

represent sound fiscal policy.
actual

budget

projections.

dilemma,

nor

do

they

of

necessarily

While deficits are scheduled to recede,

outcomes again will be disappointing relative to

these

Unacceptably high deficits will persist until some of the

structural flaws that plague certain spending programs are corrected.
The sharp declines in projected deficits,

even without

enactment

of the President's proposals, occur primarily due to the sharp slowdown
in projected spending growth.
of

GNP

in FY1985,

Federal outlays,

which were 24 percent

are forecast in the President's

current

services

budget to recede from approximately 23 percent of GNP in FY1987 to 21.4
percent




in

FY1990,

while revenues remain unchanged at 19.1

39

percent.

This

pattern of slower spending growth - - a significant shift from the

FY1980-1985
reflects
the

period,

when nominal outlays rose 9 percent

the sharp slowdown in defense spending, lower interest rates,

deficit-reducing

provisions of the Budget Reconciliation

1985 and the sequestration under GRH in 1986.
spending

annually

has been dramatic:

Act

The slowdown in

of

defense

real defense authority in FY1987 will be

approximately 2 percent below FY1985 levels, and the President's budget
calls

for

3

percent annual rise in real defense

FY1988-1990.

From

FY1980-1985,

budget

outlays

real defense outlays rose at

a

in
6.9

percent annual rate.
The President's Budget
Its

projected

proposes even slower total spending growth.

0.9 percent rise is the primary factor that lowers

FY1988 deficit to $107.8 billion,
Most

of

spending

the

President's deficit cutting proposals

programs

negative spending.
A
on

down from $173.2 billion in
involve

the

FY1987.
cuts

in

or sales of government assets which are counted

as

No new general tax increases are proposed.

change in budget accounting gives the impression that

the deficit is larger than what will actually occur.

progress

The 0MB

and

CBO budget projections (including those in tables 1 and 2) and the

GRH

targets

was

placed

include social security (OASDI),
off-budget

even though the program

by the Balanced Budget Act of 1985.

The

surplus

in the social security trust funds -- which

due

rapidly rising payroll tax revenues -- will reduce

the

by

billion in

to

deficit
FY1991.
FY1988

The

approximately

$38

billion in FY1988 and

occurs

mounting

$67

Administration estimates that the on-budget

to be $189.2 billion without proposed legislation,

billion with full enactment of the President's proposals.




40

primarily
total

deficit
and

in

$147.4

What Could Go Wrong?
Spending
for

may

grow more rapidly than the Administration

several reasons.

cuts

and

asset

Many of the Administration's proposed

sales were included in its

already been rejected by Congress.
Second,

there

spending

Budget

FY1987

and

A reversal should not be expected.

In 1985, passage of the Food Security Act (farm bill)

to an unanticipated explosion of agricultural outlays.

the
may

recent budget savings initiatives.

Congressional
Act

With

new spending legislation

Administration's political clout waning,
offset

(HR1),

override
a

municipal

have

are always chances of legislative slippage in the fight

to cut spending.
led

projects

of President Reagan's veto of the Clean

reauthorization

sewage

An obvious example is

treatment

bill which includes
plant

construction

$18

Water

billion

through

the

for

1994.

A

underlying

the

catastrophic health insurance bill is also being debated.
Third,
budget

the

economic projections and assumptions

projections

Administration
rates

may

projects

be

too

table

3).

expectations

prove

correct,

growth

inconsistent

through

1988

In

particular,

sharply declining nominal and

(see

seemingly

optimistic.

Even

with

if

the

real

Administration's

the

interest
inflation

the dramatic declines in real rates

are

its forecast of

GNP

and above 3 1/2

accelerating

percent

Achieving this rapid growth is possible,

growth

real

through

1991.

but it would be significantly

above the average growth rate in recent decades.
The

CBO forecasts less rapid economic growth and higher inflation

than the Administration.
add
rate

Higher than anticipated interest rates would

significantly to net interest costs while slower real
would

reduce revenues.

The CBO estimates that a

GNP
1

growth

percentage

point higher rates beginning January 1987 would increase outlays by $11




41

billion in FY1988 and $23 billion in FY1991,
real

GNP

and that 1 percent slower

growth would add $16 billion to deficits in FY1988

and

$76

billion in FY1991.
The

CBO

proposals,

re-estimates

based

on

its

of

the

own

the

President's

economic

FY1988

projections

and

budget
technical

estimating assumptions, indicate that the deficit will be $26.6 billion
higher

than

the Administration forecasts in FY1988 and $24.3

higher in FY1989.

Similar to recent patterns,

these CBO re-estimates

may prove more accurate than the Administration's.
of

FY1984,

Budget

every

issued

by

have
to

With the exception

President

underestimated the actual fiscal year deficit.

billion

Reagan
These

has

vastly

underestimates

stemmed from overly optimistic economic forecasts and the failure
enact deficit-cutting proposals.

The same pattern will unfold

in

FY1988.

Back-Peddling on GRH
Systematically biased accounting procedures and deceptive
allowed

Congress

and the Administration to suspend GRH's

board sequestration for FY1987.

As a consequence,

tactics

across-the-

the actual deficit

for FY1987 will be approximately $175-185 billion, rather than the $144
billion

GRH

calculations
the

target

which

was

in October 1986.

achievement

of

GRH's

"satisfied"
Of course,

FY1988

deficit

according

to

the

GRH

the $30 billion miss makes
target

of

$108

billion

'The Administration's underestimates, measured as the difference
between the projected deficit in the President's Budget
issued in
February and the actual budget deficit, are: 1982, $83 billion; 1983,
$92 billion; 1985, $17 billion; 1986, $33 billion; and 1987, over $30
billion.
In FY1984, the Administration overestimated the deficit by
$38 billion.




42

virtually
FY1988

impossible.

budget

target,

and

CBO

proposals
Congress

will

has

President's proposals.

estimates indicate that

the

not be nearly enough

President's

to

already rejected a large

achieve

portion

the

of

the

Without deficit-cutting legislation, the FY1988

deficit will be approximately $175 billion.
The widening gap between current deficits and GRH targets has only
accentuated

GRH's

arbitrary;

its

considerations

flaws:

balanced

its

dramatic cuts are

budget goal is

overly

unsupported

by

rigid

and

theoretical

and therefore is an unreliable fiscal policy guideline;

the numerous exemptions from the sequestration process grossly

violate

GRH's original intent that the burden of deficit cutting be distributed
evenly;
the

and so far,

deficit

inconsistent
viability

GRH has elicited many short-term,

dilemma
with,

that

have not

long-run

program

contributed
reform.

quick fixes to

to,
In

or

have

addition,

been
GRH's

is uncertain because of the absence of enforcement power

of

its automatic across-the-board spending cut procedures.
Despite these limitations,
political

guideline

influential

in

for

forcing

GRH has been a surprisingly successful

deficit-cutting
Congress

efforts.

to focus on

the

It

has

deficit

and

provided a valuable incentive for deficit-cutting legislation.
probably

deterred enactment of some new spending

been
has

It has

legislation.

Thus,

simply abandoning GRH would be a mistake.
Faced

with

the

virtually

impossible

arithmetic

exercise

of

reaching the GRH deficit targets, some in Congress are considering ways
to escape GRH's strangle-hold.

House Budget Committee Chairman William

Gray and Senate Budget Committee Chairman Lawton Chiles have

indicated

their

contrast,

the

intent to abandon or ease GRH's deficit targets.
Administration




asserts that the President's Budget
43

In

achieves

the

FY1988

target,

Congress,
attempt
a

and

refuses

Senators

Gramm,

to

budge in its

Rudman,

support

of

and Hollings have

GRH.

In

threatened

to

to restore GRH's automatic spending cut mechanism by attaching

revised plan as an amendment to a new federal debt

that must be considered this spring.
potential

Congressional

action

limit

extension

If successful, they would hinder

to side-step

GRH's

across-the-board

cutting mechanism.
Clearly,
GRH

the Administration's game plan is to attempt to meet the

targets,

albeit

by quick-fix and

selective revenue increases.
has

been

re-enforced

temporary

Recently,

methods,

the Administration's strategy

by Treasury Secretary

Baker's

agreement

finance ministers of major economic allies that the U.S.
efforts to reduce U.S.

budget deficits.

including

with

will continue

The Administration's tactics

have forced Congress into a defensive political posture.
There

are

resolution

two

that

avenues Congress may

raises the GRH deficit targets.

negative political fallout.
FY1988

$108

Congress
projected

billion

would

and

averaged

with

may

enact

This

may

generate

not

be

the

However,

lower

0MB's projection in the GRH

process,

which
the

cuts

must

FY1988

be
GRH

But even if the target is not reached,

GRH's sequestration process is not automatic,

and any across-the-board

would require passage of a joint Congressional resolution,

which

Thus, whatever avenue Congress pursues, across-

the-board cuts should not be expected for FY1988.




the

given the magnitude of the

CBO's realistic budget projection,

seems highly unlikely.

a

disregarded.

agree to use various budgetary gimmicks to

deficit target will not be met.

cuts

It

Second, Congress may acknowledge that the

GRH deficit target should

FY1988 deficit.

required

pursue.

44

Table 1
Budget Projections

Fiscal Years
1988
1989

1990

1991

1069.0
1115.1
1124.0
1086.2

1107.8
1165.4
1184.0
1136.7

1144.4

916.6
910.4
900.0
905.4

976.2
968.2
962.0
969.1

1048.3
1039.7
1050.0
1058.8

1123.2

-173.2
-174.5
-174.0
-176.2

-107.8
-150.1
-169.0
-134.4

-92.8
-146.9
-162.0
-117.1

-59.5
-125.7
-134.0
-77.9

-21.3
-109.0
-35.7

-171.9

-144.0

-108.0

-72.0

-36.0

0.0

48.8
48.8
48.8
48.8

29.2
30.5
30.0
32.2

-0.2
42.1
61.0
26.4

20.8
74.9
90.Q

23.5
89.7
98.0

21.3

45.1

41.9

1986

1987

Outlays
President's Proposal
President's Current Services
CBO Baseline
CBO Estimate of President

989.8
989.8
989.8
989.8

1015.6
1016.8
1008.0
1010.4

1024.3
1060.5
1069.0
1039.8

Receipts
President's Proposal
Current Services
CBO Baseline
CBO Estimate of President

769.1
769.1
769.1
769.1

842.4
842.3
834.0
834.2

Deficit ( )
President's Proposal
Current Services
CBO Baseline
CBO Estimate of President

-220.7
-220.7
-220.7
-220.7

Memo:
GRH Targets
Difference From GRH
President's Proposal
Current Services
CBO Baseline
CBO Estimate of President




45

HA
1247.0
1182.6

NA
1138.0
1146.9

NA

NA
109. Q
35.7

Table 2
Selected Budget Projections

Fiscal Years
1988
1989

1990

1991

2.3
3.6

1.8
3.2

1.1
2.5

NA
1.9

2.6
1.8

0.9
6.1

4.4
5.1

3.6
5.3

3.3
5.3

41.9
41.9

43.2
43.4

42.6
44.2

41.5
44.4

39.9
43.8

NA
42.7

Deficit Projections
President's Budget
CBO Baseline

220.7
220.7

-173.2
-174.0

-107.8
-169.0

-92.8
-162.0

-59.5
-134.0

-21.3
-109.9

Net Interest Outlays
President's Budget
CBO Baseline

136.0
136.0

137.5
135.0

139.0
141.0

141.5
147.0

139.0
152.0

134.8
155.0

Primary Deficit ( )
or Surplus (+)
President's Budget
CBO Baseline

-84.7
-84.7

-35.7
-39.0

+31.2
-28.0

+48.7
-15.0

+79.5
+18.0

+113.5
+45.1

1986

1987

Deficit-to-GNP Ratio
President's Proposal
CBO Baseline

5.3
5.3

3.9
4.0

Spending Growth ( )
%
President's Proposal
CBO Baseline

4.6
4.6

Public Debt-to-GNP Ratio
President's Proposal
CBO Baseline
Projections of Deficits
and Surpluses Excluding
Net Interest Outlays:




i6
»

Table 3
Administration and CBO Economic Projections

1966

1987

1988

1989

1990

1991

Percent change, fourth quarter
over fourth quarter;
Real GNP
Administration
CBO

2.1
2.1

Nominal GNP
Administration
CBO

4.2
4.2

6.
6.

7.3
7.1

CPI-W
Administration
CBO

0.
0.

3.8
4.4

3.6
4.4

Nominal GNP
Administration
CBO

5.2
5.2

6.9
6.0

7.3
6.9

7.2
7.2

6.8
7.4

6.3
7.0

Real GNP
Administration
CBO

2.5
2.5

3.1
2.8

3.5
3.0

3.6
3.0

3.6
3.1

3.5
2.7

GNP Deflator
Administration
CBO

2.6
2.6

3.3
3.2

3.5
3.8

3.5
4.1

3.2
4.2

2.8
4.2

CPI-W
Administration
CBO

1.5
1.5

3.0
3.5

3.6
4.3

3.6
4.3

3.2
4.3

2.8
4.3

6.0
6.0

5.4
5.6

5.6
5.7

5.3
5.6

4.7
5.5

4.2
5.3

7.7
7.7

6.7
7.2

6.6
7.2

6.1
6.6

5.5
6.2

5.0
5.9

3.7
2.9

Percent change, calendar years;

Interest Rates, percent,
Calendar Year Averages;
3-Month T-Bill
Administration

CBO
10-Year Government Bond
Administration

CBO




47




POLICY COORDINATION AND THE DOLLAR
Karl BRUNNER
University of Rochester

The
created

reflexes

of

politicians to problems,

by their past policies,

in

particular

are well conditioned.

This

holds in particular for international financial problems.

those
pattern

Major swings

in the dollar in foreign exchange markets seem reliably associated with
rising demands for "policy coordination".
rang

European and U.S. officials

the alarm bell in 1985 about the persistent rise in

currency

price of the dollar.

while

base

it

"policy

coordination"

course.

an

excuse

at double

the

The

the

U.S.

engage in a

highly

expansionary

monetary

The dollar's foreign exchange rate dropped by 40 percent

against

major

currencies and threatens to

fall

ever

Obviously another round of "policy coordination" is needed.
meetings

1986

rate.

German

of

observed in 1985 essentially offered
to

in

The growth rate of the German

somewhat in 1985 and the first half

proceeded in the U.S.A.

government

more

declined

foreign

"Policy coordination" was required

order to lower the "over valued" dollar.
monetary

the

of

"stabilize"

G-5
the

purported

to

establish

a

consensus

and

further.
The recent

designed

dollar within a target zone preventing further

to

major

declines.
The
we

volatility of the dollar has certainly been remarkable.

And

may reasonably wonder how we could prevent a further fall and

also

lower the volatility of exchange markets.
achieved

by

raising

the level of monetary expansion in

Japan and lowering it in the U.S.A.
and

Japan




suggest

The first objective can

and

The most recent data from Germany

the possible occurrence of

49

Germany

be

such

an

expansionary

shift, whereas the U.S.A. maintains the expansionary stance.
from the Fed some conflicting signals,
about

We obtain

with Volcker expressing concern

the dollar and other governors emphasizing that the

recent

G-5

meeting imposes no relevant constraints on the Fed's policy.
The

second

objective is also achievable

-- "in

principle".

A

suitable combination of fiscal and monetary policy could assure comparatively stable exchange rates.

Financial policies would have to become

thoroughly geared to this requirement however.
to

play

a central role in any meaningful

arrangements.
conditions,

The U.S.A.

exchange

rate

It would in particular have to institute,
stability

fiscal policies.

and

would have

long-run predictability of

stabilizing
as necessary

budgetary

and

Other countries interested in financial stability may

choose an opportunity to peg their currencies to the dollar. A "club of
financial stability" could thus be formed and maintained.
coordination"

may be expected to achieve its purpose.

Such "policy
With a stable,

predictable, non-inflationary policy in the U.S.A., other nations would
simply
order

have
to

to "coordinate" their policies in a

maintain

improbable.

The

the

Administration

second

rates.

But

this

fashion

state

is

in

highly

incentives governing Congressional policies

the first condition.
the

pegged

similar

prevent

The political conception and temptations guiding
destroy on the other hand any opportunity for

condition to emerge.

The conditions responsible for

exchange rates will thus persist.

the

volatile

"Coordinated" interventions by cen-

tral banks in foreign exchange markets barely modify the pattern

under

the circumstances.
The
strategies

inability

to develop any

sensible

long-run

in financial policies does not suspend interest in

coordination".




of the U.S.A.

But

this term

simply covers as a request that
50

"policy
other

countries please proceed with policies agreeable with the predetermined
short-run interests of the U.S.A.

This involved in 1985 a substantial

monetary expansion in the U.S.A. matched with less expansion in Germany
and Japan.
U.S.A.

And it means now that even larger monetary expansion in the

should

Germany

and

be

Japan.

supported

by corresponding

expansion

This kind of "policy coordination" may

some prevailing political pressures.
series

massive

moderate

But it will assure an indefinite

into the future of such "policy coordinations" with a built

longer-run inflationary bias combined with intermittent recessions.




51

in

in

PERCENTAGE CHANGE IN THE GERMAN MONETARY
BASE BETVEEN CORRESPONDING MONTHS
OF ADJACENT YEARS
OBS

VG

1982

1983

#.37297
4.98560
7.89377
8.19072
39754
98090
22758
43457
28732
42240
74546
39542

1984

71472
94640
34717
03113
98390
12925
15999
47023
79725
74438
54830
94834

1985

84405
74458
29846
,36771
.31033
.05687
.83437
99750
83626
04550
33127
,17994

1986

09966
08373
92488
77754
54773
04709
48483
13137
22544
7.40325
8 10449
8.50920

The figure listed under December 1986 meant percentage
December 1985 to December 1986.




52

change

from


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102