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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 (FedHistory@dal.frb.org)

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 pa.sl
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 aggregat.es
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 largel.ing 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 rnonet.ar), 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 Dall..ls

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 rJ.tc 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 1o.st
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

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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 predict.able. 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.

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