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FEDERAL RESERVE BANK OF DALLAS May 1989  •  •  conOIDlC eVlew Money and Inflation in a Deregulated Financial Environment: An Overview w. Michael  Cox and Harvey Rosenblum  Money, Wages, and Factor Scarcity as Predictors of Inflation John K. Hill and Kennelh J . Robinson  l  This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (  Economic Review Federal Reserve Ba nk of Dallas May 1989 Preside nt and Chief Executive Officer Rohcn H Boykll1 First Vice Preside nt a nd Ch ief Operating O fficer William II. Wallace Senior Vice Presidenl and Director of Researc h ll:lfvcy Rosenblum Vice President and Associa te Director o f Research Gerald P. Q'DriscolL Jr. Vice Preside nt and Economic Advisor W. Michael Cox  Economists Nmional (md llllen/ariona! John K. H ill Robert T. Cla ir Evan F. Koenig  ..  Joseph H. Haslag Linda C. I lunter Cam S. Lown Regional and Energy  Slephen P. A. Brown William C. Gnlben William T. Long II )  Keith R Phillips Editors Virginia M Rogers  Janis P. Simmons The Economic Review is published by Ihe Feder.!l Reserve Ban k of  Dallas. TIle views expressed are lhose of the authors and do not necessarily refled the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System. SubSCriptions are available free of charge. Please send requests for single-copy and multiple-copy subscriptions, back issues, and address changes to the Public Affairs Department, Federal Reserve Oank of Dallas, SIal ion K, Dallas, Texas 75222, (214) 65 1-6289. Aniclcs may be reprinted on the condition that the source is cred ited and (he Research Department is provided with a copy of the publication containing (he reprimed material.  j I  Contents Page 1 Over the past decade. the landsca pe o f rhe monetary and banking system of the United States Ius fundamentally and perhaps permanently changed. Cox and Rosenblum survey some of the key macroeconomic questions raised by fjnancial deregulation and innovations. First, they exam ine d1C effects of financial deregulation o n the puhlic's demand for various types o f mom:ys. Second. Lhey investi gate the effects of financial deregulatio n on the process of money supply crea l io n.  Money and Inflation in a Deregulated Financial Environment: An Overview W. Michael Cox and Harvey Rosenblum  Cox and Ro,scnblulll then use the evide nce from studying these issues to reach two basic concl usions. The first is that inflat ion is still a monetary phenomenon-at least once one understands the evolving ant! proper definition of money.  The second is that M2 appears to be the approp ria te monetalY aggregate to target for pursuing long-tenn goals fo r innat ion; bur for purposes of achil~\'ing sho rt-te rm sta bili ty in nominal GN P, sho uld this be considered an impo rtant goa l, targeting the m onet~lIY hase may be more useful.  Page 21 \X/ith the recent brea kd own in the relationship between money and prices, econom ic analYSIS have begun to rely more heavily on non money statistics ",,;he n forecasting inflation . Hill a nd Robi nson exa mine ho\"\' well inflatio n can he predicted from information o n wage gro\vth and factor sca rCity, as measured by the unemployment rate and ca p aCity utilization rate. During the 19805, wage growth and rneasu res of faelor scarcity have predicted infla ti o n mo re accurately than ha ve the monetary aggregates Ml and M2. The nonmo ney statistics suffer the disadvantage of providing less advance notice of an acceleration in inflation. Hill and Ro binso n also use their models to forecast inflation in 1989 and 1990. Forecasts based on recent moveme nts in M2 and wages suggest that the rate o f inflation will decline over the next two years. But forecasts derived from measures of facto r sca rcity po int to a moderate rise in inflation.  Money, Wages, and Factor Scarcity as Predictors of Inflation John K. Hill and Kennelh J. Robinson  W. Michael Cox  Harvey Rosenblum  Vice President and Economic Advisor Federal Reserve Bank of Dallas  Sen ior Vice President and Director of Research Federal Reserve Bank of Dallas  Money and Inflation in a Deregulated Financial Environment: An Overview  M  uch attention has cc ntc n.:d o n thc rcce nt mo netalY and i nlla li o n~l1Y experience of th e United States and o n the role pl ayed hy financia l cI~regula ti on in (h ~ econo mic history of the 1980s,I \',/hi le littl e douht exists thar th ere are many majo r d iffe n.:nces in th e finan cial landscape tod ay as com pared w ith only a few years ago. there is also li ttl e dou ht that an understan ding of l itt:se d ilTe rcnct:s is t:s,~t:nt i a l to l ht: prope r m3nagement of the economy,l Undersra nd ing the likely m~l croeconom ic effecLs o f fi nancial d eregulati o n is clearly impo rtant to the Federal Reserve in v ic \-v of thc direct lin kage to monet~l1y policy. Th e selection of a monetary agg rt:g~l te. of an o perating proct:dure. and of policy ind icators o r guidelines must all be reexamined in lighr of the new and deregula ted fi nancia l en \'i roll melll. T his is ad mi ttedly ~In amhitious cha llenge and one that will requ ire ~u b ~tanri a l resources an d exte nded research--effo r1 ce rt ain ly beyond the scopt: of an y si ng le ,study , T he \vork here p rovid es an overvie w o f th e macroecono m ic effects o f fin<l ncia l deregulatio n and o utli nes Lx ten dLd research in thi s area that we plan o \'er the co m ing mo nths, '; In th is article, we speci fica lly add ress 1hree questions. First, what effect has fi nancial den:gulation had on th e detl1 3fKl for money? Second, has fina ncial deregulat ion significa ntly alt ered the mo ney su ppl y p rocL~s-spLc i fica ll y, thL rdal ionship bctwcen base rno ney and the monewry aggregates? I And th ird , \vh lch measure o f money sho uld the f ed era l ReSLrve LargLt in l hL dereguiatt:d fi nan cial envi ronme nt? As \'Ve review these key q uestio ns, p rov i~ i o ll al ans w ers arc suggested \v hcnever possible,;  Economic Re view- May 1989  Ou r findings at thi s stage shou ld b e v iewed as ten tati ve, Ncverthcless, we find su hstantial suppo rt for several b asic conclusions from rhe mo ne-  H  , We use the term ' fmancial deregulatlOn to refer not only to legislated changes In Ihe regulatory environment that have taken place over the past few years (such as the Depository Institutions Deregula lion and Monetary Control Act) but also to private-sec/or finanCial Innovations , which clearly have equally al/ered the financial landscape. We recognize also thai finanCial deregulation has been somewhat a gradual process rather than an immediate one. See Gilbert (1986, 31) for details of the steps m the phaseout of RegulatIOn ?  0  While we explicitly only conSider the effects of financial deregulatIOn, many other changes have taken place in tfle macroeconomic environment over the past few yearssuch as disinflation, the deposit insurance crisis , Ihe tranSIlion /0 mterstale banking, shocks in oil prices, and cflanges  in lax laws  These changes have altered the underlymg  economics of the banking industry and contributed, at least temporaflly, to the hosl!/e bankmg enVlfonmem, .1  The work reported here draws In part from Cox and Haslag (1989)  • By defimlion, base money (sometimes called the monetary base, or high-powered money) is currency held by the nonbank publiC plus reserves of banks See Table  r for a  complete listmg and descriplion of the components of the M rand M2 monetary aggregates as Vlell as the monetary base, ~  For earlier acknowtedgment of some of Ihe pOlenlial effects of finanCial innovations, see San/omero and Siegel ( 1981), Tatom (1983), and Thornton (1983),  More recently, see  Rolay( 1985); Bradley and Jansen (1986): Chnsllano (1986).Keeley and Zimmerman (1986): Darby, Poole Lmdsey, Ff/edman, and Bazdarich (1987): Roth (l9B7): Stone and Thornton (1987), B. Friedman (1988), Motley (1988), and Wenninger (1988)  1  tary and financial data of the 1980s. First and  get for Fecleral Re~erve policy. But, for purposes of pursuing shol1-term objectives for nominal GNP gn)\vth. hase money now deserves more attention as a potential monetaty t3rget.  111051 impol1ant. bec:JLlst: or financial deregulation.  there appears to h~lve been a permanent shirl in the way in which people distrihute their holdings of wea lth among moneys and other assets. Rut this shirt has heen almost entirely among the COlnponents of the M2 monetary aggregate: to a much lesser extenr, there have been shifts hel\Veen 1\12 and other assels. As a result. there appear~ 10 be  Overview of the policy prohlem faced by the Federal Reserve Before specific qllestions ar<.: considered, \\le \vill first set out the monetary problem faced by rhe Federal Heserve. Ry carefully defining our \"ie\-\' of tl1<.: F<.:deral Reserve's objective and by outlining the \ '~l rious bctors affecting achievemenr of that ohjecti\'e, we intend Lo rut in persJ1ective lhe specific questions addressed in thi~ article" Tn addition. we hope to limit the arnbiguities that mlturally arise \vhen pursuing a relationship between two variables. sllch as money ancl economic actiVity. \'(IhHe Ollf decision to narrow rhe scope of rossihle linkages heI\veen these l\vo variables i~ necessary for tractability. we recognize that there is no unanimollsly accepted view of rhe exact W3Y in 'i-vhich monet3lY policy affcCls the economy. Chart 1 provides a diagrammatica[ overvie\v of the monetary policy problem faced by the Fed-  a stable long-term rclaliollshir bel"'O;Yeen [V12 and the p rice level. which rearfirms the notion that inf1ation is p rimarily a rnOneGlry phenomenon-at least, once you underswnd the cvo[\"ing and proper definition of money. r inancial deregulation also ~lppear~ to have al tered rhe hehavior of 111<.: mulLirle reblionship betweeIl the 1ll0netalY 8ggregates and base rnoney" In particula r, the two primary effects of financ ial deregulation here appear to have heen a slowing in the rme of gro""rth of the M2-w-base money ratio but an increased responsiveness of money supply to tempora r y disturbances in money d<.:mand . Thus, for purposes of pursuing long-tem) goab for Ilomina l GJ\V growth (thaI is. for innaLion), NI2 appears to clominate [)OIh the more naITO\V Ntl and the moneGIJ)" base as <.l t<.lr-  Chart 1  Overview of the Policy Problem of the Federal Reserve Potential Monetary  e / ' - - -_T_a'_g _1S Monetary Policy Inslrumenls  _J  Money Multiplier Process  (  Ultimate Policy Goals  Open Market Operalions  Supply Discount Rate  Reserve Requ irement Ratios  2  of Base Money  -  Individuals' Currency-toeposit Ratio Supply  Banks" Reserve-IoDeposit Ralio  Nominal  of  GNP  Demand  Monetary Aggregates  Prices  Money  for  Real G NP  '>.-1-___. 1  Federal Reserve Bank of Dallas  era l R<::-,er\T, Economic act ivity i~ \'iewed as being affected primarily by the f'\\ 0 ~ides of the money ma rkel-money suppl y and money d emand," O n the u ne s ide, the private sector demands \ ari ous types of m oney~lIrre ncy. bank reserves. demand deposits. other checkable deposib. money market deposit accounts. mo ney  T ab le 1  Components and Definitions of Money  ~B  Bank reserves Currency'  Travelers checks of nonbank issuers  1  Demand deposits2  T Other checkable deposits (OCDs)' Money market deposit accounts (MMDAs) Money market mutual fund (MMMF) balances· Savings and small-denomination time deposits 5 Overnight repurchase agreements and overnight Eurodollars 6  , Currency outside the Treasury, Federal Reserve Banks. and the vaults 01 depository institutions. 1  Demand depoSIts at all commercial banks other than those due to depository institutIons, the U.S. govemment, and foreign banks and official institutions less cash items in the process of collection and Federal Reserve Iloai.  a Consist of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institu tions, credit union share draft accounts, and demand deposits at thrift institutions. 4  ~  2  market mutual funds, and so on.~ On the uthe r side. the Federa l Reserve. together wi th pri\'ate IXlnks and households, dete rmines (through a mechanism described later and known commonly as the money mu lriplier process) the supplies of the \'arious moneys. These supplies include three si mple-SLim monew lY measures- base m o ney and the 1\11 and M2 1110I1e[<l I) ' aggregates. (Sec Table 1 for a Ibting and description of I he various types  of mo ney. including the monetary base and the 1\1 1 and M2 monetary aggregates.) The Federal Reselve's ohjective, broadly speaking. is to achieve some ultimate pol icy goat---defined here as a particular level of nom inal GNP- by manipulati ng ilS policy instru ments. These are open m arkel Olx.'nttio ns. reserve requirement ralios. and the discount rale. 1i Tn choos ing particu lar values for these policy instrume11ls. the Federal Reserve determines a specific magnitude fo r base money in the economy, \vhich, through {he money multiplier process, implies a level for each monetalY aggregate. Fkcaus<.: variations in the priva te sector's demand for money (or moneys) rende r the existing :-,tock o f Ino ney (o r l11oncy~) inadequate or in excess. th e reby affecting the economy's level of nomina l GI\-P . the Federal R<.:scrve may for practi cal reasons choose to adopt an intermediate policy goal, or lllonet31Y target, But also, because of va riability in the money Illuh irlier process, the Federal Reserve must decide whether that mone-  r:lIy target should be a more immediately contro lbble one. ~lIch as base Illoney. or one further separated, such as M 1 or !vI Z. These considerations frame the subject of the sections (hat follo\/v'. To proceed in a useful way. however. we need to cla rify further and  Balances in both taxable and tax-exempt general purpose and broker-dealer MMMFs. Time deposits, including retail repurchase agreements (RPs), In amounts 01 less than $100,000 .  ' OvernIght (and continuing contract) repurchase agreements issued by all commercial banks and overnight Eurodollars issued to U.S. residents by loreign branches of U.S. banks worldwide. NOTE : M2 excludes individual retIrement accounts (IRAs) and Keogh balances held at depoSItory Institutions and money market funds and all balances held by money market funds (except institution-only funds), U.S. and foreign commercial banks, and the U,S. and foreign governments.  Economic Review -  May 1989  6  To center 8rtenrion on the role played by monetary faclors. 81! other influences on eco/lomie activity are Ignored m Chart' and in the accompanying diSCUSSion  • The term ·bank ~ IS used 8S a generic shorthand here, and throughout this study. to refer equally /0 all depository institutions  , We are assuming here, of course, that the cham of the causality runs primarily from base money 10 Ihe monetary aggregates and then to nommal Income. rather than other poSSIble scenanos  naITO\, somewhat t he p o licy problem that we consider. T"./O caveats arc thus !l1ade. T he first cave~lt concerns ou r interpn..:t:uio!l of the use of nominal incom e ~I S a policy objective of the Federal Reserve. 13y ddlnition. nOmi!l~11 incom e is the level of real GN P evaluated at current prices. \X'hile it is reason3hle tha t the Federal Reserve may ha\'e the ability, in the short run , to affeu b0111 real GN P and price~ through expan.\ion or contraction or the money sLlpply. it is generally accepted that signific<l m pennanent effects of monetary po licy on real G~P are nor achievahle. On the contrary. mone talY policy in the long run is seen as affecting only prices. \X1e Ihu,", find it convc.:n ienL to rel<l in nominal income as an o\'emll gmIl of monetary policy. with [he understanding that this va riahle is u~C'd to renect rnovements in berh rea l GNP and p rices in rhe short run hut a:-. a gu ide to controlling innalion in the long run. \X1ilh th is cl arifica tion. we hope that t~ll: n.:ader wil l nor be d istracted as we move sometimes synonymously berwe~n nominal G;\rp and prices in the discussion and challs that follow. The second GIVe~lI co ncerns our definition and selection of variab les to consider as money. \X'har is money? 9 Does money include currency, ha nk reselves, de rmlnd deposits, other checkable dcpo:,ib, money market mu tual funds, money mark et deposit accounts. savings accounts. o r \vila t? Can m oney be measured accurately :lnd useful ly as a simple-sum variable-such a~ i\II, M2, or base money? Or must money be aggregated in some other way to he valid? \'(Ie ~ldJ1li[ at Ihe o u tset thac there is an extensive debatc on this ~ll hject. And. frankly , no co nclusive an$\\'er ha... yet emerged. Thus, for purposes of tractability. for e:lse o f d irect compa rison. and because \ve  g  T()  One could argue /l1at Il1e measures of money conSidered here reflecl more the liquidity concept of money rather than a transactions concept or net wealth concept of money For a discussion of the various concepts of morley and of the Issue of money m a deregulated fmanClal system. see for example. ODriscoll (1985. 1986) and Osborne ( 1985) We consider, as potcnllaltargets. neither indiVIdual monetary components (currency demand deposits, etc.) nor monetary variables other than those of the simplo-sum V8nety. In additron, we do no/ conSider nonmonetary variables, such 8S nommal mcome or tile mlerest rate  4  wish bter to consider mo n et~l1y targets of rhe type historically employed, we choose to narrow the set of possible money measures ro lhose o f the purely simrle-~u m variely. These are M 1, M2, and the monetary base, IfJ In \'iew of lhe central role played separately by bOlh the demanu for and the ~uprly of money in the Federal Reserve's policy p roblem, we tu rn now to focus on each of these in more deta il. Thi~ is followed by an analysis and discliss ion of the issue of choosing a suitable m onetary larget. \Ve hegin our ovelview by looking at the effects th~1t financial deregulation has had on the d emand for the monet<LIY aggregates.  Effect of financial deregulation on demand for the monetary aggregates I n this section , \\'e examine the hehavior of {he demand for ,\ 11 and M2 over the pl:riod 1960-AA. \Ve postpone analysis of the dem and for base money until the money mu ltiplier process is considered , Although it \yould be possible. by separately studying IXlI1ks' dem~lI1d for reserves and housc.:holds· dem and for currency. to exam ine directly the demand for ba~e money also, we choose the ailernative strategy of tre~lfing base money usage a~ a deri£led dernand---<-lerived. that is. frolll the demand for the monetary aggregates and linked hy means or the money multiplier process, \Vle folio .." this strategy because, as shown later! we feel th ~H there is valuable in format iun LO be learn ed from a separate srudy of rhe behavior of the money multiplier process over th e  rcriod 1960-88. A~ Table 1 sho\ys. the task of defining money demand is complicated because there is no single measure of money, A question of central importance, then. is whether there has been a permanent change in the \vay in which people distrihute lhdr holdings of we:I1 rh 3Il10ng moneys and other aSSCb because. at least in part. of fina ncial deregulation. As Chart 2 shows, over the decade there has heen t.remendous growth in the demand for three new financial inSll'umenL.;;olher checkahle deposits (which include NO\'{T and Super KO\X' accounts), money ll1:lrket mutual funds, and money markcl deposi t accounts-all of w hich are no-w fu lly and compctitively inte restbea ring and enjoy checking privileges to some  Feder a l Reserve Ba nk of Dallas  Chart 2  Transactions Balances Billions of dollars  1,600  1,400  1,200  •  MMDAs MMMFs  •  Other checkable deposits  •  Demand deposits  •  Currency  1,000  800  600  400  200  o  '60  '64  '68  '72  '76  '84  '80  '88  SOURCE: Board of Governors , Federal Reserve System .  deg ree. II Such tremendo us g ro\vth in demand has no doubt bee n due largely to the interesrbearing nature of these accounts and to the rates Lhey ofFer compared with those o n alrernative investments. Now that a large part of mo ney is ex plici tl y  interest rates paid o n mo ney compared with those otfered o n alternative assets. It The spread between interest rates paid o n securities and those paiel on IDo ney measu res th e opportunity cost of ho lding money compared with alternative assets.  interest-hearing, will the demand for some. o r  perhaps alL mom:yt-; gro\v mo re rapidly than in the past? \,\,i11 Inoney demand s hrink? Or will it return to previous pan erns o f growth? To in vest igate these questio ns, we \:vill ignore bri efl y rh e  II  Fact that there are various moneys as \vell as various alternative asseb (secu rities, STOck s. real prope rty, etc.) and lhink g~nerically in terms of  involving an agreement bef\.Veen the depOSitor and deposi· tory institution that requires a $2.500 minimum balance ($ t, 000 effective January " 1985) and provides that funds  deposited are eligible to earn more than 5.25 p ercent interest. Beginning in 1986, the distinctiOn bef\.Veen NOW  "money" and '·securities." This allo\vs aLtention Lo be focused on t.he "opportunity cost" co ncept of  accounts and Super NOWs was removed, and all accounts  holding money. At any p oint in time, indi viduals choose [()  hold particular amounts of money Jnd securities relative to their incom e, sLl ch ratios d<.:penc.iing on Econootic Review -  M.IY 1989  NOW accounts were aurhoflzed for all depository Instltu· tions as of January " 1980, and Super NOWs as of January 5, 1983. A Super NOW IS defined as a NOW account  thereafter were classified as NOWs. '2  This choice depends also, of course. on Individuals' tastes and on transactions technology.  5  Chan 3 shows one measure of this opportunity cost-the spread between the interest rare paid on one-year U.S . Trea,sUty securities and the rales paid on checkable deposits (calc ulated on a weighted-average basis)--over the period 1960-88.13 Clearly, the spread berween interest rares paid on chcckahlc de posits and those o n alternative assets has narrowed substamially as a result of fin::lnc ial deregulation. I ~ l3eCJ USC i11lerCSl-hearing checking accou11ls have made money more like bonds, financial deregulal ion co uld have resulted in ;:J. sharp increase in the demand for money re lative to income, leading even to unru ly behavior of the de mand for money. The latte r vvould be the case, for example, if changes in the interest rate d ifferential between money and securities encouraged individua ls to shift more sharply bac k and forth between these fo rms of wealth than previously was  Chart 3  Interest Rates Percem per year  20  16  12  B  4  '64 SOURCE OF PRIMARY DATA : Board of Governors, Federal Reserve System .  .:] The interest rate on checkable deposits referred to here is calculated as a weighted average of the imerest rates paid on demand deposits (that rate being treated as zero), other  Chart 4  checkable deposits (m particular. the average interest rale paid on NOW and Super NOW accounts). money market  The Demand for Money Per Dollar of Income  deposit accounts, and money market mutual funds_ Spe·  (Ratios)  ciflcalfy. ReD =- (OCOICD)ROC [) + (MMDNeD)R'AI~D. +  .800  (MMMF/CD)RMMM~' where RCD is the average Interest rate on checkable depOSits (CO). ROCD Is the interest rate on  other checkable deposits (OeD), RMM [;A is the interest rate on money market depOSit accounts (MMDA). and Ro.IMo.I~ is the interest rare on money markel mutual funds (MMMF) (Before 1982 interesl fale data on NOW and Super NOW  ,566  .400  accounts are unavailable and are estimated.) We explicitly exclude from thiS calculatiOn tho mteresl rale paid on savmgs accounts because those Interest rate data are generally available only in terms of legal maximums (see footnote 36) and not as market rates. Tne spread is calcu· lated as the one·year Treasury security rale less the calcu· lated rate on checkable deposits. '. The spread may be measured with a vanefy of imerest rates Oil moneys and alternative assets. We have chosen fo measure the spread In a way that approximates both {fleop· portunity cost to households of demandmg mterest·bearing checkable deposits and the profit to banks of supplymg those depOSits. It shOuld be pointed out, thoug/l, that the spread behaves very similarly across a vanety of Interest rate comparisons , so the choice here is not critical, See  .283 .200 .14 1  .100 '60  '64  '68  72  76  '80  '84  '88  NOTE: k1 is the MHo·GNP ratio, k2 is the M2·to·GNP ratio, and kT is the MT·to·GNP ratio. See Table 1 for a description of the M1 , M2, and MT monetary aggregates. SOURCES OF PRIMARY OATA : Board of Governors, Federal Reserve System. U.S. Department of Commerce.  footnote 13 for a descflplion of how the interest rate on checkable depOSits is constructed. Also, we recognize that banks implicitly offered pos/liVe rates of relurn on checkable depOSits before financial deregulation To cirCumvont legal prohibition of interesl for example, banks often offered "gifts . •  6  Fe d e ral Reserve Bank of Dalla.<ii  the case. I~ The effects on the demand for mo ney intere~t-bearing checking accounL<.; can he seen by examining the historical behavior of the money- income ratio. Chal1 4 shows thl'ee monetary aggregates-ML ,\112, and a lransaclions aggregate, MT-relative to GNP over the period 1960-8RY' These rati os are denoted as kl , k2, and kT, res pectivel y. Has financial deregulation k:d to a pennanent and radi cal cha nge in the \vay people distribute their ho ldings of wealth among moneys and other assets? Is the demand fo r money now very different from that in the past and perhaps much mo re erratic? As Cha n 4 shows, the demand for 1\111 does appear to have changed dramatically over the past decade. The kl ratio-which fe ll at an average annual rate of roughl y 3 pe rcent from 1960 to 1981-began to grow in the early 1980s ' - While not obvious hom Chart 4, !vi] has also become mu ch less predictable, with the variabiliry in the growth rate of the M1-to-Gl\rp ratio increas ing hy nearly 21ll limes since 19B1. In short there is reason to suspecr a deterioratio n in the stability of the demand for M ·I . This deteriorati o n is even more notable in a broader tra n"i£lClions aggregate, MT--<lefined as the sum of currency. dema nd deposits. other checka bl e deposits. money market mutual funds, and muncy market deposit accounL<.;. I>! In the case of M2 , however, apparently no significant deterioration has been caust.:d by the movement from a regu lated financial environmem to a deregulated 011e. 19 The demand for M2 relative to income has remained remarkabl y stable O\'er this e ntire period, as seen in Chart 4 by the relatively nat line for the k2 ratio (t he !vI2-to-GNP ratio) com pared with the lines for k1 and kT. The finding suggests that the increased ckmand for U'c:lnsactions halances has come largely at the expense of o ther M2 components-in particular, savings and small time cleposib-and o nl y slightly at the expen~e of other assets. Chan') fUlth er supports this finding.lo A closer look at the k2 I<Iriu gives us a beller idea of just how much diffe re nce the emergence o f interest-bearing checkable deposits has made to the de mand fo r M2. Chait 6 compares recent move ments in the k2 rat io with those of the interest rale spread between one-year TreaslI1Y securi ties and checkable deposits. The chan points out o f the emergence of  Econ o m1c Review -  May 1989  two important relatio nships. First, rhe demand for 10 the spread in interest rates. Specifically, as the spread falls. the deJlland for M2 rises. Second and rno re  M2 relati ve to income is closely related  I~  ,6  Preliminary statlslical tests indicate a heightened sensitIVity of money demand to changes m the imerest-rate-spread variabfeover tile period 1983-88 compared with t96o--B 1 ThiS result suggests a potenrlally increased subsfltutability between monoy and allemalive assets (due presumably to the inlerest·bearing nature of money accounts). For evidence on the substitutability among various monetary assets see Gauger and Schroeter (1989) See Table 1 for defmitions of the monetary aggregaces While (mancla! deregulation has been more of a gradual process than an Immediate one. for purposes of comparisons between /he regulated environment and the deregulated one. we need to separate the data into crearly defined periods. The procedure we opted for was to diVide the data into three periods-a period generally characterrzmg a regulated financiaf environment. one charaCle(}Zmg a deregulated environment. and a transition periOd (treated as one year) betwoon/!lese two. Tests were then conducted examining tile behavior of severa! monetary and financial vanables reported here. such as the money-ta-GNP ratios and the M2 money multiplier. to determine the period of maximum {ikeli!lood of a break In the data, The suggested subpenods from those tests were found to be 1960-8/ and 1983--88  '8  This monetary aggregate is sometimes referred toas MI + or M2In response to the prOliferation of new finanCial Instruments offered by both bank and nonbank financial institutions in the second IJa/f of /he 1970s. the Federal Reserve was compelled to redefine the monetary aggregates in 1980 (see Simpson 1980) At that time. it was not known whether (or how) pnor, eXlstmg, and anticipated deregulation of banking would affect the relationships bel\veen the various monetary aggregates and nominal income. inflation. and other realsector and financial variables. Given nearly a decade for these relationships (a evolve and to be measured and understood. we now find M2 emergmg as the most useful monetary aggregate Wilen the monetary aggregates were in IIle process of rodefmition. few economists would have forecast this result. And as deregulation or reregu!afion takes new directions. these relationships may change. Such changes may necessitate the preeminence of another monetary aggregate and/or further redelim/ion of the monetary aggregates as new financiaf instruments are croated With medium-at-exchange or store-or-value properties.  20  Chart 5 excludes one component of M2--overnight repurchase agreements and overnight Eurodollars-which make up approximately only 2'/:lpercenl of M2  7  Chart 5  M2 Components Billions of doUars 3,000  MMMFs 2,500  •  MMDAs  Savings and small time deposits 2,000  •  Other checkable depoSits  •  Demand deposits  •  Currency  1,500  1,000  SOD  o '60  '64  '68  '72  '76  '80  '84  '88  SOURCE ; Board of Governors, Federal Reserve System.  Chart 6  I nterest Rate Spread and Demand for M2 Spread  k2 (Ratio)  Percent per year  68  .62  .56  SOURCES OF PR IMARY DATA : Board of Governors, Federal Re serve System. U.S. Department of Commerce.  8  Federal Reserve Bank of Dallas  impo rtant, the redu ctio n in the spread caused by finan c ial de regulation has no t had a sig nifica nt effect on the demand for [v12. \X:re estimate that deregulario n of the fina ncial e nvironment has reduced the spread in inte rest rates to JIl avera ge of 3. 2 percent fro m 5.9 pe rcent. Tn response, ho wever, the demand fo r M2 per d o llar of income has increased to o nly 62.0 cents fro rn 60.6 cents. That is, the demand fo r M2 per dollar o f incoille has increased by roughl y o nl y 2 pe rcent durin g the period or fina ncial de regulation. 21  Effect of {"mandal deregulation on the money supply process In add itio n to affecting ho useho lds' de mand for the various types of rno ney, financial de regulati o n may have s ignificamly alte red the process of rno ney su p ply creatio n.ll In this section , \ve examine the effect that finan cial deregu latio n has had o n [he relatio nship between th e and base money over the period 1960-88. Particular attention is pa id to the M2 money IllUlriplier-that is, to the relatio nship betwee n hase Illoney and th e 1\12 mo neta lY aggrega te. In the previous secLio n, we exarn ined the historical linkage betw ee n the monetary aggregates and no mina l GNP. As Chart 1 po ints o ut, howeve r. one o th e r linkage is equall y importanr in the o verall connection hetween Federal Heserve policy instruments and po licy goals. It is the linkage he t\",'-een base Illoney (refe rred to a ltern ative ly as the monetary base , or high-powered mone y) a nd th e mo neta !), aggregates-know n comm o nl y as the money mu ltiplier process . By definitio n, base money is the lOlal volum e of cu rre ncy he ld by the no nbank public plus reserves of banks (ad justed fo r changes in reselve req uiren) e nt s).l~ The monetary base is one impo rta nt and useful measure of mo ney because it is the measure ove r which the Federa l Reserve has most immediate contro l. Base money rbes, fo r e xample, as th e Fede ral Reselve eithe r purchases some asset. reduces iL<; l1()Ilmone talY liahilities (thro ugh e ither the o pen market or [he discount window), o r lowe rs rese rve requireme nts of banks . As a practical matle r, open market purchases and sales of government securities are rhe medium most o fte n assoc iated with changes in the base. Indeed , open rnarkd operations are the Economic Review -  May 1989  central to ol with which the Federal Reserve guides mo netary policy o ver th e long run. Because of the fra ctional reserve nature o f banking, an increase in hase mo ney causes a mulripl e increase in each of the n"lonetary aggregates. Consider, for example, the M2 mo net"uy aggrega te and its relati o nship to the mo netary base. Recall that 1\12 consists of currency pl us de posits (demand depos its plus othe r checkahlc depos its plus mo ney market deposit accounts plus money marke t. tnUlll <.t i funds plus savings and small time cleposits), a nd base mo ne y is currency plus bank reselves. z.j Usi ng c to de nme th e ratio at ",,:hich  21  In contrast to M1 money demand, M2 money demand also appears to be more stable. In particular. in statistical tests relating the (log 01 the) level of k t and k2, individuafly, to the interest rate spread (and to a constanl and time), signlflcantfymoreof the variation in k2 is shown as explained In the peflod 1983--88 (compared with the period 1960-8 1) but significantly less for 1<1.  n For an overview of the behavior of the Ml and M2 money multipliers over the period 196(}-87 (and a brief discussion of the role played by the emergence of interest·bearing checking accounts), see Burger (1988). n In practice, there are two measures of the monetary base  the source base and the adjusted monetary base. These measures differ primarily on the basis of whether they adjust for changes In reserve reqUirements. The source base is a simple accounting construct equal to net assets of the Federal Reserve System. The source base rises, tor example, when the Federal Reserve purchases some asset or reduces its nonmonetary liabilities. As a practical matter, the source base is manipulated either througtl an open market purchase or sale of government securi/Jes by the Federal Reserve System or by System lending through the discount window. The adjusted monetary base, on the other hand, additionalfy adjusts the source base to account for the magnitude of reserves freed by a change in reserve requirements. A reduction in reserve requiremen ts, for example. frees bank reserves In an amount that could have been achieved directly through an open market purchase of government securities by the System. Thus, to capture the effects of changes in aI/ three of the System's policy instruments-open market operations, the discount rate, and reserve requirement ratios- we use the adjusted monetary base. In particular, we use the St. Louis adjusted monetary base. See Haslag and Hein (1989) for a more thorougtJdescription of the monetary base and its rela tionshlpto GNP  24  Again, for exposition. weare Ignoring overnight repurchase agreements and overnight Eurodo/{ars.  9  individuals wis h to ho ld currency re lative to M 2 depos its, e as the ratio at wh ich banks ho ld reserves (in excess of th ose requ ired ) relative to M2 de pos its, an d 13 as the monetary base (adjusted fo r reserve req u i re me n ts)~ ir is easy to show that M2 is a mu ltip le o f base money. 25 Spl:cificall y, ule re latio nsh ip is J112 = a2 • H, where a2 = (c + 1)/ (c + e) is the M2 "mo ney mul tipl ier." This equation says simp ly that open market p urchases o r sales of governm ent securiries by the Fede ral Rese rve (as \veJ[ as other operations on basl: money) have an eventual multiple impact on the M2 supply of Illoney, whe re rh e size o f that multiple depends o n the prefe rences of ind ividua ls regarding their hold ings of currency relative 10 deposits (c) and de pends on ba nks· prefe re nces ( e) regarding the amount of rc.';cn 'es to ho ld rdative..: to depos its. To illusrrate th e money mu ltiplier process furthe r, consider the case where the Fede ra l Rese rve wishes to increase the monetary aggn.:gmcs. The Federa l Reselv e, say, purchases gove rnm ent secu rities he ld by banks , whic h increases hank reserves and , thus. base money. Ba nks. in turn. loa n out a portio n of th e additiona l reserves (de pend ing on their choice of e), of w hich individuals redeposit a portion (depend ing o n the ir choice..: or c) , Lhus providing add itio na l de pOSits, of xvhich banks loan o ut a portion, ancl so on . Th is prog ressio n o f rede positing and relending is termed the mo ney multi plier process, because it is through this mechanism that an increase in thl: monetary base has an eventual multiplie r im pact o n any given monct~lly aggregate. I n esse nce, rh e rno ney mu ltiplie r is the transmissio n in the li nkage hetween the e ngine of base  >':  2f;  10  We recognize that not aI/ M2-type deposits are at institutions defmed as "depository mstitutlons " and under the direct superviSion of the Federal Reserve. Examples of these are cash management accounts at money market brokerage firm s. For the sake of exposition. this discussion ignores other types of institutIOnal borrowlI1g and lending costs (loan origination costs , advertising costs, otc.) that might affect banking p rofita bility In addirlon, banks are trea red as lending m Ihe same investment market g eneraHy available to mdividuals. so tile spread shown earlier for indiViduals (the opPOrtunity cost concept) may be used to approximate that pertment to the borro wing and lending decisions faced by banks  mo ney growth and the speed, or growth rate , of the monew ry aggregates. TIlis transmissio n depends on the prefe re nces of both indi vid uals and banks. which. in turn, de pend o n unde rlying econo mic variables (such as tra nsactions techno logy, tastes) and , a lso, o n the sp read between inte rest rates paid o n mo ne y and those on alte rn at ive assets . For pu rposes or seeing the effect that financial deregulat io n has had o n the mo ney su pply process, \ve must unde rsta nd nexl the ro le that the inte rest ra t L sp read plays in banks' cho ice of the excess reserve -to-depos it ratio. On the one hand, de posits he ld as reselv es !"elve a d irect econ o mic function to banks in that they allow banks to meet unanti cipated cash drai ns! manage the efficient allocati o n of bank liab ili ties a nd assets over time, and satisfy reserve reqUirements witho ut bo rrowing at the discount wi ndow. On th e othe r h3 nd , though , the spread reJlccrs the pOle..:nt ial net un it pro fit to banks from bo rrowi ng funds in th e deposit ma rket and investing those fu nds e lsewhere (draw ing clown reserves) .& A dec rease in the spread , then , is 3pt {Q increase banks' chosen excess reserve-to-de posit Idtio as it lo,\ve rs th e econom ic be nefit LO banks or lend ing Chart 7  Currency Relative to M2 Deposits , Excess Reserves Relative to M2 Deposits, and the M2 Money Multiplier .2  C, .  (RatiO)  (Ratios)  12  .1 4  11  ,10  10  ,07  9  B  .0009  7  .0002  6  '60  '64  '6B  '72  '76  'BO  'B4  .00005  'BB  NOTE : c is currency relative to M2 deposits, e is excess reserves relative to M2 deposits, and a2 is the M2 money multiplier. SOURCE : Board of Governors, Federal Reserve System.  Federal Reserve Bank of Dallas  depo~it~ instead of retai ning those deposits as reselTes. Chan - ~ ho\"\ls the behavior of the exces~ re~ervL'-lO-uer)osi t rat io and rhe M2 mo ney l11 ultiplier over thL' period 196O--R8. I\ s that chart revcal't, the excess reserve-to-deposit ratio, v.:hich  rell Meadily through the period 196O--HO, began to le\el off in the early 1980s and has in recenr years sho wn signs even o f growth . Apparently, the emergence of inreresr-bearing checkabi<.: del1osiL<; and the implied narrowing of the spread between borrowing and lending rates of bank s have hac! a signi fi cant impact o n bank~· chosen resclVe-lOdeposit ratio.-z~Ole also, though. in y ie\"\' of the relatively small magnitude of the excess rescrve-to-deposit ratio, that Ih is effect on the NI2 money multi plier ha., not been the predominant one. Even more significantly impacting the 1\12 money multiplier ha-.; heen the emergence o f a new patlL'rn of beha\'ior for the currency-tn-deposit ratio. A...r;; Ch~1I1 7 shows, the currency-to-M2 dq)()s it ratio . wh ich fdl at an average annual rate of 1.4 percent over  the period 1960-8 1, has aItered its long-term course and in recC'1lL )"<..:ar:-; has p. r UlllH ~If ;] 11 average ~Illn ual rate of 0.3 percenL Such an increase Chart 8  The Demand for Base Money Per Dollar of Income  d er<..:gula tion .  Chart 8 shows the implications of t.hese n.:suit., for the demand for ha~e 1l10 ne),. Renecting a  (Ratio)  .09  .08  .07  in relative currency hold ings m ight have been expected . in part, g iven rhe genera l decline in interest rate" o n ~lI te rnali\'c i n veS1.ment~ on:r the decade (enco uraging hou~ehold s to :,ubstitutt! o ut of th<..:se interest-bearing instrume nts and into cash). StilL the increase would Hot ha ve o<..:cn predicted frOI11 the em ergence or interest-bearing deposit accounts. Tndeed, one might have expected that financial deregulatio n would reduce the currency-to-deposit ralio as households rt:'cluced t.heir cash halances and sought the attracti veness of intercst-bearing checking aCColllltS. 1fl The basic lesson to be lea rn ed from studying the new and pu zzling behavior of the curren cy-todeposit ratio, then. is that there remains a good deal of un cenainry about the way in which financial deregu latio n has affected the money multipli <..: r proccss. l9 Kon etheless, the lYI2 money multiplier has departed from it.s eMahlished pattern of 2.l-percent ave rage an nual growth over the period L%0--81 and has slowed to vi rTu ally no growth (with some s igns, in t~lC l , of declining ove r the past three to fou r years). Furthermore. the v~lrbb ilily in the gn)\vth rate of the M2 l110ney Illultiplier has increased sharply ove r th e p~lst few years.·\(1 And as a result, the transmission mechanism from th e Federal Reservc's operating variable-base moneY-[Q (he ultimate monetary target(s}-the moneta lY agg regatc(s)-has I)<..:<..:n made potentially less certa in because of financial  } "  "  .06  •  ....1:'  .05  IL J  , =~  ,. This result JS strongly supported by slatis/Jca! analySIS mdicatmg a highly statJstJcally Significant rcllJllon bCMecn the interest-rate-spread variable introduced here and both the excess reserve-ta-deposit ratio and the M2 money muiliplier. 'f/  Of course, there is also the potential effect that deregulation has had, through heightened fmancial fragllily. Of) /fle currency-fa-deposit ratio  n See Burger (1988) for a discussion of thc rcccnt behavior of  .04 '60  tfle currency-ta-deposit ratio '64  '68  '72  '76  '80  '84  NOTE : kB is the monetary base-to-GN P ratio . SOURCES OF PRIMARY DATA: Board of Governors , Federal Reserve System. U.S. Department of Commerce.  Ec..:()n o m ic Review -  May 1989  '88  Specifically. the vaflance In the annualized quarterly growth rate of !fIe M2 money multiplier has increased Irom an average 010. 18 percentage pomt over the period 1960-80 to 0 26 percentage point over 'he period 1982-88  11  higher demand for both bank reserves and currency rel~l tive to Nl2 depos its and currency, the base-lO-Gl\P (kR) ratio has depaned in recent years from its historically decl ining pattern. Specifically, \vhile the k~ ratio fell at an average annual rate of 2.3 rercent over the period 1960-81, this ratio has grown over the past six years at an average annual rate of nearly 0.6 percent.  The Federal Reserve's money target in the new itnancial environment We tllrn now 10 the issue of eSlahlishing targets to gu ide monelary policy. In the past, repeated arguments have been rnade for targeting M 1 and NI2 and, more recenLly, for the monetary baseY Arguments have also been made thaI the Federal Heserve should target both interest rates and nominal income. Practical!y speaking, these are too many targets to consider \v ithin the scope of this article. For simplification and [or case of d irect comparison. then, \"\'e consider only three potential Federdl Reserve targets. These are base money. M1 , and M2-alt, notably. monetary largets. in this section. we :,et out a simple rule fu r monetary targeting and then eV3iuare the implications of applying three alternative targets to follow thar rule. \Xle 3dmit at the outset that our choice of a targeting procedure is potentially overly simple. Nonetheless, it serves as <'1 useful device for comparing the me rits o[ al[ernative targets, ~vhile also providing a va luab le benchmark against which to judge more sophisticated targeting procedu res. \'\!e should also indicate that, whereas our discLlssion to this point has been cast in terms o[ levels of variables, for purposes of cons idering alten13tive targets by which to achieve both s holt-te rm and long-term goa ls, it is rnu ch  J'  For early hlslorical support for the choice of M2 as the appropriate monetary aggregate to larget. see Friedman and Schwartz (1963) More recenlly. see McMillin and Fackler  (1984). Judd and Trehan (1987). M. Fnedman (1988). Mehra( /988). and Wenninger( 1988) Supportfortargetmg the monetary base may be found. for example, In Fama  (1983). Andersen (1 975). Andersen and Karnosky (1977). McCallum (1987. 1988). Hall (1988). Neal (1988). and Shadow Open Markel Committee (1985 ).  12  more meaningful to conduct the a nalysis henceforth in terlllS of rates of gro\vth. Is 1here some monetalY variable thar the Feci<.:ral Reselve can target in an effort to control nomin3i G.:.JP gro\vth and, if so, what is that va riahle? To IIwestigate this question. we must first define our use o f the term "lllonet~lIy targeti ng procedure." Should the procedure he one of allowing the, varia hie lO grow within certain prespecified ranges; should there be some "feedback" rule for money growth from ohserving nominal G~P. interest rates, or some other policy indicalor; should the Federal Resetve adopt. say, a constant growth rat e rule for the monet.a!), variable in question, as has heen frequemly suggested; or should some other t3rgeting procedure be followed? Given the complexities of this problem and in view of our dL'sire to focus on the merits of pur~uing alternative monetaty targets (rathe r t.han al(ernati\'e targeting procedures), we adopt the simplest monet~lIy targeting procedure-a constant growth rate rule. That is, whichever of the three monetary variables t.he Federal Reserve targeL"i, a constant growth rate i~ presumed to be adopted for that vari3ble. This is accomplished for base money hy direct control of the Federal Reserve halance sheet. Achievement of a constant growth rate for each of tJ,e monetary aggregates ~vould admittedly he more difficult (if not impossihle in the very shOit run) because of rhe influence of private forces on the money mUltiplier process. Nevettheless. this ru le is ac hievahle in principle (certainly. at least approximately) by raising or lov.:ering the growth rare of the monetary base to offset movemenL"i in either of the money multipliers. \X'e r)lust also specify whethe r the Federal Reserve's ohjective is to achieve a desired nominal GNP goal in the sholt run (a goal for real GNP and the price level combined), in the long run (a goa l for prices), or hoth. There is no necessary reason why a goal of minimizing temporaty disturhances in nominal GNP would call for the same monetalY target 3S would a goal of preventing deviations from a desired permanent path for numinal GNP (infl3tion). This is an important distinction and one that we feel should not be ignored. Our approach, thus, is to assume that tJ,e Federal Reserve is concern ed ahout each type of Federal Reserve HilOk of Dallas  Table 2  Trend Growth and Deviations from Trend Growth in a2 and the k Ratios (Annual averages , in percentage points)  Deviation from trend growth  Trend growth  k1  k2  a2  kB  k1  k2  a2  kB  1960-81  -3.18  -0.18  2.12  -2.30  1.75  2.55  2.32  1.87  1983-88  1.13  0.25  -0.29  0.55  5 .15  2.99  1.79  2.28  NOTE : a2 is the M2 money multiplier calculated as the ratio 01 M2 to base money. kl is the Ml -Io-GNP ratio , k2 is the M2-to-GNP ratio, and kB IS the base money-Io-GNP ratIo. See footnote 17 for an explanation of the  choice of periods over which these variables are compared. SOURCES OF PRIMARY DATA : Board 01 Governors. Federal Reserve System. U.S. Department of Commerce.  d isturbance to norn inal G:-..IP growth-sholt and  long fun-and to eval uate rhe relative m e riL<, of pur:-.uing d iffe r-em moneta .), targets in terms of thei r abilities to achie\'e ho/b shoJ1-ru n an cl longrun desired rares of Gl'\P gro\vrh. In tiUI11, then. the prohlem \\e ~re consideri ng b one w here (he Federal Resen:e w ishes to contro l nom inal G'\l) gro\\Th as m llch as possible. both in the long fll n and in the short fu n , by adopting a consta nt grm-:v th ra te rule fo r dther ~Il • •\ 12, or the monetary base. \'\fhat are rhe n..:Iafive merits of target ing each of these money va riables to achie\'e rhis goal? As Table 2 shows. the ans~\'e r \0 this question is not im mediately srraighlfonvard hecause there arc genera lly twa types of shocks that may occur (and havc histori ca ll y Occu fnxl) [ 0 money dema nd and to m o ney supply growth, each of wh ich affccts nom inal GNP g rowt h d iffe n..:ntly. B ro~\(Jl y s pea ki ng, these two types o f shocks are lem pOr~lI)' shocks and perma nen t shock s. Consid er first the case of permanent shocks to rhe growt h ren e in money dema nel or money supp ly. Exam ples o f these shocks are shown in Chal1s 4, 6, and 7 and Table 2, \\ here arguably permanent shifts have occ urred in tht: gro\'\'1h r~l(es of the kl ratio, the k2 rat io. and a2 (t he M2 money m ultiplier) over the past decade. A~ sho \vn in Table 2. over the past fe\"\·- yea rs (he a\'e r~lge ann ual rate o f gro\"\-th i n k I has risen to Eco n o m ic Review -  May 1989  1.1 percent from -3.2 percent previo usly-a ~hift of 4.3 re rcentage po inL, . Thus ( by our calc ulations), cOl1lin uing ro target .'vI1 over this periodthat is. con tinuing to allow M 1 to g row at i t") 1960-8 1 average annua l \ ·~t1 u e-wou l d have lightened nom ina l GN P gro\\ th [Q under 2.ti percenl from its actual average of nearl y 6.3 percent. Ta rgeting the monetary base. in turn. would have tigh tened nom inal Gl\'P growt h to 3. 1 percent, becau se o f the sha rp downw ard shift (a shift o f 2.tI percentage points) in th e trend rate o f growth of th e [..,12 money multi plier. Targeting M2, o n the other ha nel . wo uld have produced ~l l m ost no d iscernible effect o n the growth rate of nom ina l GNP. as the k 2 ratio remained stable thro ughout this period (a trend shift o f o nl y 0.4 perce nrage po int). On the basi~ of rhese reSUIL'i and fo r purposes o f achievi ng lo ng-tt:nn ohjecti ves for nomina l GN P growl h (inflation), a r ol icy o f targeting \,12 wou ld then be im plied . Chalt s 9, ] 0, and 1 1 further underscore this pOinL·'S1 \'(Ihile M l has been led astray by the  .JOi  In Charts 9. 10. and 1 I. thelmes depicting thelevelofpflces have been adjusted by addmg respective constant rales of growth quarterly These constants are calculated. In each case, as the average quarterly growth rate of real GNP plus the averago quarterly growth rale of the mdividual money· to-GNP ratio over the period 1960--88  newfound attrac..:ti\·encss of int(.'re~t - beari ng depo~­ its (Ch ~1I1 9) an d \"hile the reb tionship between the monetary h3se and price:'> has been imlx lired by the effe([s of fin~lI1cbl d ereguhll ion o n the rno ney multiplier process (C hart 10), Ihe relationship between Nil and prices (Ch:1I1 11) has n:mai ned remarkahly s rabl e.~·~ T here has been a pe rmanen t change in the way in wh ich people dblrinute their holdings o f wea lth bet\veen moneys and other asset::, beGluse o f fimll1Cial deregu lalion. bill this sh ift has bcen almost em ircly among the compunents of M2 and not between j\12 and other assets. It b fo r this reason that tile long-term relationship nenYeen 1\1 2 and pri ce~ has not been Sign ifica ntly damaged hy financial deregulat io n. Consider now the implicllions of a:mporar), ~h{)c ks to Illone) demand and 1110nc), !m ppl y growth. shown in T able 2 as de\'i_Hions from the trend rates of growth for each of th e peri()d~ 1960-8 1 and 19H3--88> What :I re the effects of these Iype::; of mo ne.:tary shocks o n nominal GNP growth? T o amiWer this questio n , recogni7.e first tl1a1 money supply adjusts partially and <-lutornatically 10 mee.:t disturlKlnces in mone.:y d ema nd. ConSider, fo r eX:llnpi<.:, the case of an increa.'ie in Illoney dem and. An increase in the demand for money rela tive to Oliler :lSSeb cause!) a w idening of the ~ pre~ld between interest rates o n d epOSits a nd those on <liternat i\"e investments. thereby inducing hanks to make more loans. which. through l he money multiplier process described abo\'e, i ncrea~es the money supply. Parl of this autom;l(i c adjustrnent process \Va.') in place before.: fi n:lIlcial deregulat io n because inlerest rates o n alternative assets could respond to change."i in the d ema nd for money : but now, deposit intere:-; t rates abo G ln respo nd. ~'h i c h aids in the automatic ad justment of mo ney supply to accommod ate shifts in money demand. In short, the.:re arc funciame.:nt:ll economic reasons why h o u ~eho l ds' de ma nd for M2 per  dolbr o f income (k 2) and the M2 money multipl ier (a2) wou ld historicall y be signifiGlntly co rrelated- indeed. even more correlated in a deregulated finan cial em·ironment. \'{Ihile potentiall y tenta tive. our estimates co nfirm that the stalistical co rrei:1tion between the quarterly gro~vth  Chart 9  M 1 and Prices (Indexes, 1981:04 . 100)  200  150  100  50  '64  >68  '72  '76  >80  >84  >88  SOURCES OF PRIMARY DATA: Board of Governors, Federal Reserve System. U.S. Depanmenl of Commerce.  Chart 10  Base Money and Prices (Indexes, 1981 :04 = 100)  200  150  100  50 Our choice to represent {he relationship betwoen monoy and prices m lelms of levels m Charts 9. 10. and 11 . and In the accompanying dl$c(lssion. IS statistically supported by evidence that the level of prices is CO-Integrated (allhe /0. percent level or greater) With each of the variables M1. M2. and the monetary base  14  >64  '68  '72  '76  '80  '84  >88  SOURCES OF PRIMARY DATA: Board of Governors, Federal Reserve System . U.S. Depanment of Commerce.  F<.'"rlCr.lJ Reserve Bank of  rates of k2 and a2 has increased Lo 0.72 over the period 19R3--R8 frOIll 0.49 ciuring the period 196O---B 1. \'\fha t impl ications does this hold for the cho ice of an appropriate monetary aggregate with w hich to achieve short-term stability in nominal Gf\P gro~'1:h? I3ccause a policy of targeting the monetary base allows the mo ney multiplier to reInai n freely flexible and available to help equilibrate the money market- tha t is. to ab sorb disturbar1Ces in money demand o r money supply-such a policy potentially lessens the transm issio n of those clbturhances to nominal GNP growth in Lhe economy. ·~ A policy of ta rgeting M2. on the mhe!" hand, ignores the benefits of the automatic equilibrating mechanism offered by the moncy mull.ipl ier process. thereby alluwing those disturbances to he lr.:lnsmitted mo re fully to nominal GNP in the economy. In sum, then, there are n1erits to targeting M2 and the monetary base and rela ti ve ly lirtle merit to targeting (vII. The m erits of I.argeling NI2 lie primarily with the fact that the M2-to-GNP ratio has proven quite sta hle h istorically; thus. targeting M2 grO'\\1h is a relatively simple way of achievi ng long-lLTm goa ls for inflation. The mcriL<; of ta rgeting base money, on the ot her h ~lncl, lie primarily with the stabilizing nature of th e money mult iplier  Chart 11  M2 and Prices  process; monet3 ty aggregates ca n adjust to acco mmodate partiall y any temporary shocks ro money demand. The borrom line. then, is thar. if th e Federa l Reserve is concerned primarily with controlling inflation, a constant gro\-vth rul e for M2 ma y be rh e more reasonable policy to pursue. If the goal is more one of remporary stahility in nominal GNP growth, then such a ta rgeti ng rule for the monetary base is likely preferred. especially in a deregulated financial envi ronment. In either case. there is good reason to argue [hal M"I has much of its reliability a,') a monetary target.  Conclusions and projections Over the past decade. the banking and moneta ry system of rhe United States has fund amentally and perhaps irrevocably cha nged. There are clea rl y many major differences in the financia l environment today as compa red w ith on ly a few years ago. Perh ap.s th e greatest of these diffc:rences is the way in which people hold money and wea lth. 5'> As recently 3S 10 years ago. incliviclLl~lls Llsed chiefly currency and demand deposiL<; for transaclions balances. while they preferred savings accounts. interest-bea ring securiti es) and other assets as stores of value. In thi:-, o ld, rcgul::.nccl financial environment. checkable bank deposits were prohibited from pa ying interest t and rates on savings d eposits \,..-cre limited to a ma...xim um of 5Y2 percenl.·~  (Indexes. 1981:04 = 100)  200 ."14  See Santomero and Siegel (1981) for theoretical examinafion of fhe effects of financial deregulation on the slability of  150  the macroeconomy b  See Santoni (1987) for an exposic/on of the relaCionshlp be{''Ieen naC/ooal wealth and M 1 money demand over the  100  periOd 1960--86 "Ifi  The 55-percent legal maximum became effective January  " 1984 Before thatrime (and overthe period with which thiS  50  study is concerned), the legal maximums wer8 as follows: January 1, 1957- December 31, 1961. 3percenl; January 1, 1962-January 20, 1970, 4 percent: January 21. 197ChJune '64  '68  72  76  '80  '84  SOURCES OF PRIMARY DATA: Board of Governors, Federal Reserve System. U.S. Department of Commerce.  Economic RevieW-May 1989  '88  30. 1973. 45 percent: Ju/y I, 1973....June 30. 1979. 5 percent: July 1, 1979-December 31, 1983, 5.25 percent, andbegmnmgJanuary 1.1984, 5.5percent. Notea/sothar transferability between savings and checkmg depOSits was severely restricted by regulation.  15  Induced hy inflatio n and high interest rares in the late 1970s, howeve r, finan ci al innovations, such as rno ney market ITIurual funcis , began to change lhe way in \-vhich people hold money and ~vealrh. And \\'ith the subsequenl enacltnent of the Deposito ry Institutions Deregulation and Monetary Camral Act of 19~O, 3 new era of money and banking was o ffic i~lll y ushered in. The act guaranteed full rite of pass~lge to a new and deregulared financial world and cod ified changes in the nature of money that had evolved over the prior ciecade. In shon, a la rge pa It of what is ca lled "money" became explicitly intere.'>lbearing and, thu s, much mo re like bonds and other earning ass<.:b th~1J1 previously. The emergence o f a ne\-v market-determined "price" for checkahle deposits h~IS h3d, and will continue to have, impo rLant effect..s on th e econo rny, For one. the naITO\\ ing of the: inu,.:rest rate ~pread between "funds bOlTo\'v ed and funds lent'" by dep os itory institutions implies potentially funda menta l changes in banking profitability, ban k failure rates, the cornposition of b3nk loan po n folios, and so o n . These microeconom ic, or stru crural, ramifications of financial deregulatiun arc irnportanl to th e economy, and rhey are important to the Federal Rt;'SClve beca use th ey bear direct ly on the function of supelvis ion and regulation. Uut financial de regulation also has important macroeconomic effects on the level and stabiliry of prices, interest rates, and GNP in the ecunomy. This article provides an ovelview o f some key que~tions reg~lrding the impact of financial deregulation on the macroecono m y, \X1e have four ba sic conclusions. 1. Financial deregulation docs appe~lr to k lve caused a permanent shift in th e way in which people distrihure their holdings of weJlth among moneys and other assets. But this shift has been almost enrirely among the compo nents of the tvl2 ll10netcuy aggregate and not between NI2 and other assets.  J'  16  2. There appears to he a stable relat ionship hetween M2 and the price level. This stability reaffirms the norian that inflation is primarily a mo nerary' phenomenon once one understands Lil(: evolv ing and proper definitio n of money. 3. Financial deregulation appears to have altered rhe rela tionship between the monet::I1Y aggregates and the Federal Reserve's primary instrument of monetary control- base mo ney. In particular. financial deregulation has apparemly slowed the r3re of growth of the M2-to-base rnoney ratio but has yiel ded an increased responsiveness of money supply to ten1pOr~l1y disturbances in money demand. LI. Thus, for purpose,',. of pu r~ui ng long-term guab for nominal GNP growth (goa ls for inflation), .1'\'12 appe:1rs to ciomi nate hoth the more narro\\' Ml and the monetary has<.: as a target fo r Federal Resen.·e policy. But for purposes of pursu ing short-term goa ls for nominal GNP growth , base money is likely th<.: preferred target, especiall y, in the deregulated financial envi ronmen t. Based o n these findings, v..'hat can we po int to as reducing inflation in the United States during the early 1980s, and what projecti o ns C3n be mad e about the nation's future co urse of inflation? T he work here indicates thaL the inflatio nary era  of rhe lare j 970$ can be linked largely  10  exces-  sive grow th in the M2 monetary aggregate during tha t period,-~- furthermore , lhe decelerati o n in in Oat ion d u ring the earl y 1 9~Os appears to be d u e largely to deceleration in {he rate of tv12 money gro~·"( h and e m he cred ited only a liule to financial dcregu l ~j[ io n o r innova tio ns in the payments mech:Jnism. 1:3eca use financial de regulation has not signifi ca ntly altered the long-term relationship between ?vI2 money and prices. the future course for inflation will co ntinue to depend largely on the cou rse of M2 money growth, \v hich (he Federal Reselve is o bliged to restrain for pri ce stability.  M2 grew at an annual rate of 10 (0 13 percent for a to· quarter period ending In (he fourth quarFer of 1978 This was followed by a buildup in inllation averagmg 8 ro 10 percent ar an annuai rate over an 1 I-quarter penod endmg in the fourth quarter of 1981  Federal Reserve Ban.k of Dallas  References Andersen. Leonall C. (975), "Selection of a MonetalY Aggregare for Economic Stabili zation." FLde ra l Reserve Hank of St. Louis Review, October, 9- 1'). Andersen, Leonall c., and Denis S. Karnosky (1977). "Some Considerat ions in rhe Use o f Moneta ry AggregatL's for the I mplementation of j\:l onet~IlY l.>olicYt" Federal Reserve Bank o f St. Louis Review, Septemher, 2-7. BO;1rd of Governors of the Federal Rese rve System (1977). 'The Impact of the Payment of Interest o n DLmand Oeposils," Staff Study (\Xlashington, D,C.: Board of GovLrnors, 31 JanuaJY)· Bradley, .~1ich acl D., and Oennis \XI. Jansen (1986). 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(1988), "McCa llum's Base Growth Rul e: Results fo r the United States, \'(Test Germany, Japan, and Canada," PAS \'\forking Pap er Seri es, no. 11, U.S. Department of State ( \'(Ta shing ton , D .C.: U.S. D epanme nt o f Slale, 13urea u o f Economic and Business Affairs, Planning and Economic Analysis Staff, December).  Oarhy, M ichael R., William Poole, David E. LincLst.'y, Millon Friedman, and Michael j. Bazdarich (1987), ' Recent I3dJavior or the Ve locity of iVlo ney,"Contemporal:V Policy isslles 5 (january): 1-33. Economic Review -  May 1989  It Did and Why Tt Passed Away,' Federa l Reselve Bank of St. Lou is Review, February,  22-37.  Ha ll man, Jeffrey J" Richard D. Poner, and D avid H. Sm all (989), M2 per Un it of Potential GNP 17  ClS an A}lc/Jor /or Ihe Price Leoel. St aff Stud ies. no. 157 ( \\fashingto n , D.C : 130a rd o f Governo rs o f th e Federal Reserve System . Ap ri l).  Has lag. Jose ph II .. and Scott E. I-ki n Cl989). "Reser ve.: Relj ui remenrs. th e Monerary Base , and Economic Activi ty, " Federal Reserve Ba nk of Dallas t :coll omic Reuiew, M arch , J- 15.  of the H o use COlllmittee o n Bank ing, Finance  and Urban Affairs, 100th Cong. , 2e1 sess., Committee Pri nt 100-5.  O 'Dri.,coIL Gerald P. , J r. Cl9S5), "Money in a Deregulated Financial System," feder:l l Reserve Ba nk of Dallas F.cOl1o mic Review. May, 1-12. - - - (986) . "Deregula tio n and Monetary  Judd, John P .. and Rha ral Tre han (1987). "Pol1folio Substitu tion and the Relia bility of Ml, M2 a nd M3 as MonetaIY Policy Ind icators." Federal Re.:serve Ran k of Sa n Francisco l::co nomic Redell ', Su mmer, 5- 29. Keeley, Michael C, ::Ind G<l lY C. Zimm erman (986), " Deposi t Rate Dereg ula tio n and the Oe llland fo r T ra nsactions Media." Federal RLserve Bank of Sa n Franc isco t:CO Jl omic Nevieu ). Su mmer, 17-62 .  McCall um, Be nn ell T. (1987), "The Case fo r Rules in the Conduct of M onetary Poli cy: A Concrete Exa m p le." Federal Reser ve Bank of Ri chmond F.co1lom ic Review, September/ October, 10-1R.  - - - (] 98FO, "Hobusrness Properties o f a Rule for Monetary Pol icy," Ca rneg ie-Rochester Coufe rence Series 0 1/ Pll blic Policy 29,1 73---203. N1cMillin , \VI. Douglas, and James S. Fackl er ( 984). "lvloneralY vs. Cred it Aggrega le~: A n Eva luation o f Ivlonela lY Po li cy T argets," SOlltbern J::cO Il 0miC/ Oll /,Jl ClI 50 (Janua ry): 7 ] ]- 23.  Meh ra , Y as h P. (1988), "T he Fo recast Perfo rm ance of A lternati ve Models o f Infla tio n. " Federal Reserve BJnk of Hichmo nd Eco ll om ;c Neview,  Septembe r/ October. 10-18. Mo tl ey, Brian (1988). "Sho uld M2 13e Redefined' " Federa l Reserve B::lt1 k of San Fra ncisco 1:;con omic Revieu '. \'\7inler, 3.?- 51. Neal, Stephen L.  (J 988), RejJ0I1 on the CO llcillct 0/  IHo n eta1}, Po/icy, p rep ared b y the SulKomrnit-  l ee o n Domestic M o netary Po licy fo r th e u St: 18  Heform ," Federa l Reserve Bank Eco nom ic Reviell !. July. 19-3 1.  or D allas  Osborne, Dale K. (985). "What Is Money To day'" Fed eral Reserve Bank of Dallas Eco nomic Redell'. January, 1- 15. R ~l sc h e. Rohert  H. (1989). "Some Evidence on the Elu, ive 1982 Shift in Velocity Drift," in  Shadow Open Market Comm ittee, "Po licy Sta te ment an d Position Papers," Public Po licy \Vurk ing Paper Series, no. PPS 89-01. UniverSity o f Rochester (Rochester. K.Y.: Un ive rsi ty of Rochester. Brad ley Policy Research Center.  19- 20 Ma rch), 41--49. Roley. V. Vance (1985) , "Money Demand PrediCtability," jOllrnal o!l\1oney, Credit, a lld lJc/llkil/g 17 (November. pt. 2} 6]] --41. Ro th. H mva rd L. (987). "H as Deregula[ion Ru ined Nil as a Po licy Guide?" Fedel"3l H.eserve Rank or Kan sas City Econ omic I?euiew, June,  21- 37 Sa ntome ro. An thony M .. and Jerem y J Siegel 09fll ) , "Ra nk Reg ul alion and Macro-Economic Stability. '· AmeriC(l I' Econom i c Review  71 (Ma rch} 39- 53. Santoni, G. J. Cl987). "Changes in Wealth and the Ve locity of Money," Federal Reserve Bank of Sl. Louis Review. March . 16-26. SllJd o\,\; O pen Ma rket Committee (1 985- ), "Po licy Sta te m ent and Positi o n Papers," Pub lic Pol icy \'Vork ing Paper Series. L ni versity o f Rochester (Rochester. N .Y.: Uni ve.: rsity of Roche.:ster, l3radlLY Po licy Research Center). Fede ral Reserve Bank of D4Ill:as  Siegel, Diane F. (1986), "The Relationship of Money and Income: The Breakdowns in the 70s and 80s. " Federal Reserve Bank of Chicago Ecollomic Perspectives, Ju ly/ August, 3-15. Simpson, Thomas D. (J 980) , "Th e Redefined MonetalY Aggregates, " Federal ResenJe Bulletill 66 (Febru,,,y) 97- 11 4. Stockton , David J., and James E. Glassman (1987), "An Eva luation of the Forecast Pcrfonn ancc of Alternative Models of Inllation," Review of i::coHomics mid Statistics 69 (FeotlJary): 108-17.  Thornton, Daniel L (983), "Why Docs Velocity Matter'-- Federal Reserve Bank of St. Louis Review, December, 5- 13. Tobin, James (969), "A General Equilibrium Approach to Monetary Theory," joul7lal of MOlley, Credit, and Banking 1 (Febru aIY): 15-29. Tobin, James, and W illiam C. llrainard (963), "Financial Intenned iaries and lhe Effective ness of Monetary Controls. " America n Economic Review 53 (M ay , Papers and Proceedings,  1962); 383-400. Wenni nger, Jo hn (1988), "Money Demand-Some  Slone. Courtenay c., and Daniel L Thornton (1987), "Solvi ng the 19805' Velocity Puzzle: A  Long-Run PropeI1ies ," Feder.:!l Reserve Bank  of j'\ew York Quarterly Review, Spring, 23-40.  Progress Repon ." Federal ReseIVe Bank of Sr.  Louis NelJiew. August/Sep[emher, 5- 23. Tatom, John A. (1983), "Was the 1982 Velociry D ecline U nusual?" Federal Reserve Bank of 51.  Louis I?eview, August/September. 5- 15.  Econo mic Review -  M ay 1989  19  John K. Hill  Kenneth J. Robinson  Senio r Economist and Policy Advisor Fede ral Reserve Bank of Dallas  Economist, Financial Industry Studies Department Federal Reserve Bank of Dallas  Money, Wages, and Factor Scarcity as Predictors of Inflation  I  n the monetarist vie\\, inHalion b causeu by money growth in excess of growth in real money demand. But to say that money is the  source of innation docs not guarantee that infla-  tion can be predicted well from past changes in the money supply. This point became especially clear during the middle 1980s, w hen rapid money growth failed (Q produce significant inflation heca lise of a coincident shift in asset demands toward monLy. especially comronenrs of the M 1  monetary aggregate. \'(Iith rhe breakdown in the reimionship between money and prices, there has heen considerable imerest in the usc of other statistics to forecast inflation. Among other variables, previous studies have considered the gap between actual output and potenlial output, changes in commodity prices. movements in the foreign exchange v:.l iue of the dollar, and growth in private and puolic debt. 1 These studies generally conclude that it is easy to improve upon the forecast performance of M1, especially over the decade of the 1980s. Thc forcxast superiority of nonl11oney variables is less clear, however, whcn money b defined as M2, ~l broader aggregate. In this article, \Ve evaluate the usefulness of wage growth and measures of factor scarcity as predictors of intl ation. An analysis of wages predicL'i inflation from information on growth in the tolal compensation of n<>nagricul tu ral employees. An analysis of factor scarciry predicts inOation using two measure.s of inpur scarcity: (]) the difference between the unemployment rale and an estimate of the natural rate of unemployment (me.lsuring labor sca rcity) and (2) {he capacity utilization rate (measuring capital scarcity). Fo r Econ omic Review -  M ay 1989  purposes of comparison, we at!;() consider twO monetary aggregates as p redictors of inflation, Ml and M2. The forecasting methods derive from an analysis of inflation in U.S. consumer prices over the period 1960-S0. Each method is evaluated on the basis of how well if has predicred inflation during the 1980s and how much advance notice it gives of an impending change in inflation. We find that inOation forecasts from wage gr()\vth and factor scarCity have been substantially mo re accurate than forecasts based Oil M1 gro\v1h and have also been more accurate [han those based on M2 gro\vLh . \'V'e do find, however, that Ml and M2 give greater advance warning of innation. Alternative innation forecasts are made for 1989 and 1990. The results offer mixed signals about the future course of inflatioll. Forecasts derived from recent I1l0vel11l:nts in rhe unemployment rate and capacity utilization rate suggest a  Most of the research on thiS article was conducted while Robinson was in the Research Department at the Federal Reserve Bank of Dallas , Stockton and Glassman ( 1987) and Me!lra (1988) examine the predictive accuracy of an augmented Phillips curve model whose principal explanarory vaflable is the gap between actual output and potential output. Recent studIes of commodity prices as predictors of mflation include Boughton and Branson (1988) and Furlong (1989). Roth (1986) evaluates the performance of several composite leadmg mdicators of inflatiOn. Including the following explanatory variables movements in the foreign eXChange valuo of the dollar. growth in private and public deb!. the ratio of employment to population. and the percentage of purchasing agents experiencing slower deliveries.  21  Chart 1  The Inflation Transm ission Process  Excess  Excess Growth  ..... moderate rise in intlarion over the next {wo years. In conrrast, forecasts dc.:rived from recent M2  growlh and wage grov.rth point toward a significant slow'ing in the rate of inflation.  The inflation transmission process Chart -1 p rovides a simrlifieti description of the inflation process. lnllation begins v,:ilh excess  To simplify the exposition. we have ignored the feedback loop that runs from product-price Inflation , and its effect on inflatIOnary expectations. /0 factor-pnce inflatIOn For pur· poses of (his arlie!e. II is only necessary 10 know that forecasts of Inflation in consumer prices can be improved by making use of poor mformallon on wage growth and factor scarcity 3  Alchian and Allen (1972. 95 97) provide an instructive example of how an increase in final demand often f,rsl pulls up the prices of labor, raw materials, and goods m early stages of production.  In their example, businessmen wall until  costs go up before raising prices This practice creates the !ffusion of cos/-pus/) Inflation. • The forecasts are based on actual values of M 1 growth but predicted values of inflation, unless those values wore known at tile beginning of the forecast period  22  Rise in  Demand for Products  Money  Product Prices  Rise in  Factor  Faclor  Scarcity  Prices  money gro\vth-that is, an increase in the money stock lhaL exceeds the addilional amount the rublic would choose to hold at constanr prices. This excess can happen either because the money supply is growing raridly or because money de mand is weak. \Vhichever is the reason, through its effect on spending and interest rares, th e excess in money grov.!th produces an aggrega le excess in the demand for goods and services. The excess in demand, rhen, has a direct effect on producl prices. 13ut there is also an indirect effect--one that operates through facror markers and the costs of produclion. Bt.'GlUSt.' high product dt.'mand, finns are encouraged 10 hire more workers and order more I'mv materials. creating shorrages of laho r and olher factors of production. These shorlagt:s lead to a rise in factor prices. The increase in factor prices is eventually passed through to product prices. completing the inflationary prnct:ss. l It is clear from Charr 1 th3t {here are severa l \vays of gaining information on the Future course of inflation, Money growrh irself \-vill prove to be a good preclicror of inflation. provided that monetary excesses are more rh e resu lt changes in money supply than changes in money demand. If  or  or  Fed e ra l Reserve Bank o f Dallas  Table 1  Chart 2  Inflation in 15 Selected Countries, 1960-80  Money Growth and Inflal ion: An International Comparison  Average annual rates (Percent)  Brazil Iceland Peru Colombia South Korea Yugoslavia Philippines Mexico Japan France Canada United States Venezuela Switzerland West Germany  37.3 21 .9 19.4 16.0 15.0 13.7 10.0 9.4 7.3 6.8 5.3 5.3 4.6 4.1 3.8  SOURCE OF PRIMARY DATA: International Monetary Fund .  Inflation (Percent)  40  30  20  10  o  10  20  30  40  Ml growth less real GNP growth (Percent)  .Each of the 15 countries listed in Table 1 is represented by a point in Chart 2. The height of each point along the vertical axis is the average annual rate of inflation over the 1960-80 period . The length of each point along the horizontal axis is the difference between the average growth rate of M1 and the average growth rate of real GNP over the same period. If inflation can be projected without error by taking the difference between M1 growth and real GNP growth, then all the points will line up along the straight line in the chart. While short of being perfect , the theory worked well over the sample period.  inflation [ends [Q manifest itself firs t in the costs of production, then informarion on factor sca rc ity and factor prices will also prove helpfu l in predict ing inflation . ~  Money growth as a predictor o f inflation Money growth has been a h istorically relia b le predictor of infl ation, both in the United Stales and in mhe r nations of the world. Th is can be seen from a n internat ional comparison of inflation and NIl growth rates. Table 1 shows a sample of 15 countries a nd their ave rage annu<.t1 rates of inflation over the period 1960--80. The countries were selected to represe nt a hroad range of inflation experiences . Inflation occ urs whenever rnoney supply grows fa ster rhan real ll1om:y demand . Tf the dema nd for Ml grows in Economic Review - May 1989  line with the general level of economic activity, the rate of inflation can he projected as the difference between the growth rd le of M1 and the growth rate of real GNP (gross nationa l product). As Chart 2 shows, this sirnple theolY worked we ll in predicting intlation over the sample period. The usually stahle relationsh ip betvveen Ml and the price level weakened considerably d uring the 19805. This was especially true in the Uni ted St3(eS, w he re disinflation a nd a deregu lation of the interest payable on c hec kab le depos its altered the character of Ml de mand. These resu lts came across clearly in our o\vn analysis. A statistical mode l relating current inflation to past values of 1\111 growth was estimated using U.S. dat.a fo r the 1960--80 period (see the box). The model then was used to co nstruct a sequence of two-year forecasts for 1981-82, 1983--84, 1985-86, and 1987-88. I The results, p resented in Chart 3, 23  Estimation of Forecast Models We eslimated four models to forecast inflation. The models correspond to the four explanatory variables discussed in the text: M1 growth , M2 growth , wage growth , and a composite measure of factor scarcity. Labor scarcity is measured by the difference between the actual unemployment rate and the natural rate of unemploymenl, and capital scarcity is measured by the capacity utilization rate. ' The models were estimated using quarterly data from the period 1960-80. To ensure that the data were stationary, the autocorrelation functions of all series were examined. The dependent variable in the regressions is the rate of inflation , as measured by the consumer price index. The independent variables include lags of the inflation rate, which allows past inflation rates to playa role in predicting future inflation. Akaike's final prediction error (FPE) was used to obtain the number of lags of inflation to include in the estimation equation. The FPE criterion was also used to obtain the proper lag lengths of the other independent variables. This procedure led to the following prediction equations :  ,  (1 )  INF, ~  a. o+ L  U" INF,_,  1'=1  , (3)  INF, ~ Yo +  L Y" INF, ., 1",1  ,  +  L Y"  WAGE,_, '  1=1  R 2~ .7 9; SSE ~ 236.6.  and  (4)  ,  INF, ~  ° + L 0" 0  INF"  1",1  4  +L  1=1  °  2,  01F, _,  4  +L  O" CAP,_; ,  i ~'  R '~ .85; SSE ~ 173.1.  where INF is the inflation rate and M1 G, M2G, and WAGE represent growth rates of M1 , M2, and wages, respectively. OIF is the difference between the unemployment rate and the natural rate of unemployment , and CAP is the capacity utilization rate . The Box-Pierce Q statistics indicated that the residuals from these equations were white noise.  8  +  L  u" M1G,_"  j =d  R '~ .85 ; SSE ~ 155. 5.  ,  (2)  INF, ~  Po+ L P,; INF,_; (,...1  , The growth rates of all the variables were caiculated using first  differences of the logarithms. All variables were seasonally adjusted and, except lor the natural rate of unemployment were obtained from CITIBASE, the C.libank data set. Wages were measured by the average hourly compensation 01 a:1 nonagricultural employees, The natural rate of unemployment is from Gordon (t 984). Capacity utilization refers only to manufacturing Industries.  9  +  L P2; M2G '_I'  '0'  R '~ .83; SSE ~ 178. 6.  24  Federal Reserve Bank of Dallas  Chart 3  Chart 4  M1 Growth and Inflation  M2 Growth and Inflation  (An nualized rate s)  (Annualized rates)  Percent  16  Infiation  12  - Actual -  8  Predicted using M2 growth  4  o ·4  '81  '82  '83  '84  '85  '86  '87  '88  SOURCES OF PRIMARY DATA : Board of Governors,  ·4  '81  '82  '83  Federal Reserve System.  Money continues to play an es.sential role in uelerm ining th e price level. Information un M1  growth failed to predict inflation accurately during the 1981-88 period b<..:cause of significant changes  in money demand. Thus, what o rdinarily would have seemed like excessive money growth was  not excessive at all bul, radler, was very mllch in line \-"" ith the public 's demand for .~11. Financial deregulation is thought to have had a much sm aller effect on the demand fo r .M2 than on the demand for Ml. ~ One wou ld SUSp<XL [h<':J1 , that the relation sh ip of inflation to M2 growth that existed in prior decades might con tinue 10 app ly during the 1980s. Thi s seems LO be (he GISC. Shown in Cha rt 4 Jre a series of t~vo­ yea r inflation forecasts dcriv<.:d from the historical rclalion.ship between M2 and inflation. During the 1980.s, inflation forecast.s ba sed on 1\,12 have been much morc accurate than those hased on Ml. The average forecast error for the M2 model was 3.1 percentage roinL<;-less than half the error of the M 1 model. Economic Review -  May 1 9 89  '85  '86  '87  '88  Federal Reserve System.  U .S. Bureau of Labor Statistics.  clearly show th e tendency for NIl to overprcclict inflatio n during the 19ROs. The mean foreC;:lsl erro r-that is. the average difference between projected infl ~l tio n and actual infla tion-was 6.7 percentage points.  '84  SOURCES OF PR IMARY DATA: Board of Governors, U.s. Bure au of Labor Statistics.  Wage growth as a predictor of inflation \'V'ith (he breakdown in the relmionship hetween Ml and the price level, there has been more interest in nol only other moneta ry aggregmes but also o ther kind s of econom ic varia hIes as predictors of inflation. One of the more popular va ri ahles is wage growth. Increases in wages arc not [he root cause of inflation . But if inflation tends to manifest itself first in wages, then \-vages ca n selve as a leading indicator of inflation. To evaluate the usefulness of wage growth as J. predictor of inflation, we explained current inflation hy using past va lues of growth in the tota l co mpensa tion of nonagricu ltural employecs. {t  5  For example, see the article by Cox and Rosenblum In thiS Economic ReView  5  As an alternative measure of wages. we consIdered the se-  ries on average hourly earnings of manufacturing workers The Ill-sample forecasts derived from (his measure were slightly less accurate, however, (han those based on the compensation measure Anotherof(en-watchedbaromeler of wage pressures is the employment cost index. Unfortunately, this series is only available beginning with 1976 and. therefore, could not be considered.  25  The analysis revealed that info rm ation on wage growth co mribu tes, in a statistically significant way ~ to [he predictio n of future inflation rates. Sho'wil in Chait 5 are intlati on forecasts made w ith the wage mo del. During thL 1980s, wage growth has proven more accurate as a predictor of inflation than has M2 growth. Th e average forecast error for the wage model was l .B perce nrage points-more than a full percentage p o int l o~ver than the average error ror the NIl model. Although they have proven accurate in recent yea rs , inflatio n forecasts based o n wage growth provide relatively lillk: advance warn ing. /\lm ost three-founhs o f the final elTecr o n inIlarion of a given \'}.lage incre~l se is rea li zed after six quarters. T he effect or money growth . o n the o ther hand, is much m o re protracted. Only 20 percem of the final effect of !VI2 groMh (and 40 percent of the effect of M 1 growth ) is reali zed :1rte r six qualters.  Chart 5  Wage Growth and Inflation (Annualized rates) Percent  16  12  4  o -4  '81  '82  '83  '84  '85  '86  '87  '88  SOURCE OF PRIMARY DATA: U.S. Bureau of Labor Statistics.  Factor scarcity as a predictor of inflation Two other nonmoney statistic." that are watched closely as signs or innationary pressures are the unem ployment rate and the ca jxlcity utilization rate . ThL presumption is thaI increases in intlation are preceded by a tig htening o f labor markets and greater use o f plant G11X1City. To evaluate thi s rh esi!-i, we est i m~lteJ :1 model relating currenr inflatio n to two measures of fa cto r sca r~ city: the d iffe rence between the civilian unemploym ent fate and Gord on's (19Rl) estim ate of the natural rate of unernploymenr ~lI1d (2) the Federal Reserve Board 's industrial ca pacity utiliza-  en  r The natural rate of unemployment is in/ended /0 measure only the unemployment thaI 1$ frictional or structural in nature. It excludes any unemployment arising from cyclical fluctuations in aggregate labor demand In most studies the natural rate IS assumed to depend primarily on demographic faclors. sue!) as Ihe age and racial distribution of the population, and mslllu/ionai factors. including minimum wages and unemployment Insurance. Recently however Rissman (1986) has argued Ihat the natural rate IS affected by long-term changes in the industflal dls/flbu/lon of em· ployment and Ihat. when Ihese effects are accounted fOf, the na/ural rale exhlbils substanllally more variabilrry than previously beheved See Carlson (1988) for an Introduction to /he concept and determinants of tile natural rate  26  rion rare. In measu ri ng labor market tightness, we follow cOI1\'cntional theory by adjusting the observed unempl oyment rate for changes in th e natural rale.- Gordon's series o n the natural rate is relatively co nservative , with a range o f less than 1 percenwge po int over our sa mple period. Cha it 6 shows the results of inflati on foreGistS made w ith the fa ctor-sca rcity rnode!. The fo recasts were slightly more accurat e than those from the wage-gro\vth model. Th e average forecast error of the factor-sca rciry model was 1.5 percentage poi nts. This co mparcs w ith an average error o f 1.8 percentage poims in the wage mode!. Roughly 50 percent of the ultimate erfect o n innation or changes in the unemployment rate o r changes in the capaCity utilizati o n rate occurs within the first si x quarters. Thu.o.;, thei r effect on inJlation is Illore immediate than that of M2 but is more delayed {han that of \vages.  Comparison of aJternative predictors of inflation \Xle now review th e pe rformance of the alte rnative methods of predicting in llation. The first colu mn in Table 2 shows th e average forecast error made by each model over the 1981-88 pe-  Ft=<.Iera1 Reservt= Bank o f Dallas  rioel. !\:11 proved to be com pletel y unreliabl e as a predic tor of inflation. The broader money aggregale, M2, was much Illore accurate. '\vith less th an  Chart 6  Factor Scarcity and Inflation (Annualized rales)  half the average forecast error of Ml. But the  Percent 16 , .....' ..........  12  8  4  o -4  '83  '85  '84  '86  '87  '88  SOURCES OF P RIM ARY DATA: Board of Governors,  Federal Reserve System. U.S. Bureau of labor Statistics.  Table 2  Comparison of Alternative Pred ictors of Inflation Average  Percent  forecast error. 1981-88 1  effect after six quarters  M1 growth  6.7  43  M2 growth  3,'  ,9  Wage growth  1.8  74  Factor scarcity  , ,5  5,  In percentage points. SOURCES OF PRIMARY DATA: Board of Governors, Federal Reserve System.  I  U.S. Bu reau of Labor Statistics.  models thal were most succc~s rlli in predicting inflation during the period were those based on wage growth and measures of factor scarcity. The Llcto r-sca rcity model had only 50 percent of the a\·crage t'rror of the ,\112 model, ::md the \vage modd on ly 60 percent of the c:: rror of the M2 model. To be useful as a pred ictor of inllation, an econom ic variable not only muM forecast accurately hut also ~hou l cl provide ~ignificant advance notice of a change in i nflat ion. The numbers in the second column of Table 2 indicate how much of the fimtl l.{fecr on inllation of a given increase in an l'xplanarory va ri able is rea lil'.ed wit hin the fir:3t six qU3rlers. The huger the number is, the less the advance warning given by the variable. Our rc~ults indicalc that wages and measures of [actor scarcity provide less advance notice of a change in inflation than do the moneLal)1 aggregates. This is especially tru e of wages. Threefo unhs of the effect on in ll ation of a given increase in wage growth is fe lt w ithjn the first six quarters. In contrast. only 20 to 40 percent of the effect of money gro\vth occu rs within the f irst six quarter;').  Inflation forecasts for 1989 and 1990 Table 3 shows alternative innation forecasts for 19R9 and 1990'" Somc of th e forecasLs rel y heavily on e\·ems that have already taken place. This is especially true of the 1%9 rorecast derivcd from past va lues of M2 growth . Some additional information on future events must be supplied, hov,:ever. rn the case of th e M2 model. \ve assume that !VI2 grows at a 6-p~ rcenr annual rate. For the other models, we assume Lhat wage growth, unemployment, and capacity utilizaLion remain at the values they achieved during the Lhird qU~1I1er of 1988. The natural rate o f unem-  ~ Because of irs recent unrellabiliry, no inflatIOn forecas ts  were generated from the M I model  Economic RC\' icw -  ~1<ly  19H9  27  Table 3  Alternative Inflation Forecasts (Annual rates, in percent)  actual  1989 forecast  1990 forecast  M2 growth  4.4  3.2  2.3  Wage growth  4.4  3.4  3. 5  Factor scarcity  4.4  5.5  6.3  1988  SOURCES OF PRIMARY DATA : Board of Governors, Federal Aeserve System. U.S. Bureau of Labor Statistics.  rioYI11c.:nt b assumed ro be "1.5 p<.:rcel1l. The models give very differem impressio ns about the future CQur:-.e of inflation. Gro\vlh in  j\·12 over the past sevc:ral year:-- has slowcd enough lO project a ')igniricLlllt decline in lhe rate of intla-  tion-by as much a:-. 2 full percentage  point~  over  the next two years. An31)'~is of recent wage growth alo;;o indicates that the rate of innation will decl ine. The faCIOr-::iGIn..:ity model. on the other hand, paims [o\\'ard an increase in innation during oUlh 19H9 and 1990. The.:;e projc.:ctions reflecl. of cour~e, the significant decline in the unempio)" ment r~l re and rise in the capaCity utilization rate  that look ['lace in 1987 and 1988. With such a ,,\'ide \ 'ari~mce in the (on:casts, the l ,~, inflation experience o\'er the nexi t\\'O year'! is certain to prove valuable in a:-,sessing the merib of the alterna tive pn.:dictor."i  or inn~ltion,  Policy implications In the 1980s, \\ 'age growth and I1lCasun.:s of factor scarcity have predicted inflal ion more accu-  i  rately than have the monetary aggregates t-.fl and )\12. If non money stati.')tics are to serve a;;; guides or indicator \'ariables for moneIary policy, ho\ve\'er, they rnust also pro\'ide considerable advance notice of :.In : l ccele r~ltion in i nflation, On this count, they are less satisfactolY. Thi ~ is especially true of \yages . .\Ion:menb in \yages during 1988 arc much more re\'ealing about inil<"'ion in 1989 than they arc ahout infbtioI1 in 1990. Unfortunately, monctary policy made during 1988, when Lhe infofm:nion on t\"ages \Va~ availahle. is likely to han: the majority of it., effect in 1990 and beyond, with relati\'ely lillie erfect on inl1mion in 19R9. 13y lhis argument. inform~ltion o n f<lClOr scarci ty could pro\"(= more helpful to poli cymakers, becau,',c its rL'l:lIionship ro inflarion b more delayed. The principal difficulty ~' ith rnea:;urcs of factor scarcity is thar the} lllar not always accuralely reileel the degree of scarcity in productive capacit). Thl'on:tical measures of labor market tightness. for example. require kno\yledge of an unob~er\, ~lble \'ariable-the natural rate of unemployment. OUf own findings lend a certain surPOl1 10 Gordon'S method of estimating the natural rate, Out hCGllI"ie the natural rate is unobservable, there b always the pOlential for selious d isagreement (weI' what the measured unemployment r:.lle is actually saying about labor market lightne~s.')  r·mil money demand becorm:s more stahle. or at lea~t more mo netary policy must be conducted in an ecleclic fashion. \yith an ;.l!)~ortment of ::-,t:llistks being used to a~se~s the innmionary climate, lnforl11 ~l\io n on \vage grow t.h :Ind factor ~('arcity can he u."icful in (his regard. lJUl beGlu'ie of .;;hort lead time!> and potential Ineasurelllent problems, neither of the~e variables should be relied upon exdusively as :1 gu ide for monetary poli cy.  Recently, the capacity utilization rate has beon critiCized as  a series whose moaning may be changmg  1115 argued that  compulerizatlon and roslructur;ngs have mado U. S. mdustry more eWcient. With the result that bUSInesses are able to expand output furrher beforo facing production bottlenecks and delivery backlogs See tho report by Stout (1988)  28  Fede ral Reserve Rank o f Dallas  References Alehian, Armen A., and William R. Allen (1972), University Economics: Elements o/lnqlli1Y, 3d ed. (Belmont, Calif.: Wadsworth Publishing).  Mehra, Yash P. (1988) , 'The Forecast Perfonnance of Alternative Models of Inflation," Federal Reserve Bank of Richmond Economic Review,  Sq)[cmbcr/Ocrober, 10--18. BOllghwn, Jam es 1\11.. and Will iam H. Branson (1988), "Conunodity Prices as a Leading Indicator of Inflation, " N RF.R \\forking Paper Series, no. 2750 (Cambridge, Mass.: National Bureau of Economic Research).  Rissman, Ellen R. (986), "What Is the Natural Rate of Unemployment?" Federal Reserve Bank of Chicago Economic Perspectives, September/ October. 3-17 .  Carlson, Kcith M. (1988), "How Much Lower Can the Unemployment Rate Go?" Federal Reserve Bank of St . Louis Review, July/August, 44-57.  Roth, Howard L. (1986), "Leading [ndicators of Inflation, " Fedcral Reselve Bank of Kansas City  Cox, W. Michael. and Ilarvey Rosenblum (1989),  Stockton, David]., and James E. Glassman (1987),  "MonLY and Inflation in a Oeregulated Financial Environment: An Overview," thi s Economic Review, 1- 19.  furlong. Frederick T. (989), "Commodity Prices as a Guide for Moneta,y Policy," Federal Reserve Bank of San Francisco Economic  Review, Winter, 21-38. Gordon, Robcn J. (J 984), Macroeconomics, 3d cd. ( Boston: Little, Brown).  Economic Review -  May 1989  Economic Review, Noven1ber, 3-20.  "An Evaluation of the Forecast Perfonnance of Alternative Models of Inflation," Review qf  Economics and Statislics69 (February): 108--17. Stout, Hilary (1988), "Key Economic Statistic Comes Under Fire ," Wall Street journal, 13 December, Southwest edition, A2.  FEDERAL RESERVE BANK OF DALLAS STATION K, DALLAS , TEXAS 75222  BULK RATE U.s. POSTAGE  PAID ADDRESS CORRECTION REOUESTED  PERMIT NO. 151