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BANK
FEDERAL RESERVE BAN
K OF DALLAS
May 1990
•
•
conOIillC eVlew
CVICW
conOIDlC
ANew
Monetary
Aggregate
F. Koenig
Koenig and
Evan F.
Thomas B.
8. Fomby
Reducing u.s. Oil-Import
Dependence:
A Tarift
Tariff, Subsidy}
Subsidy, or
Gasoline Tax?
Mine K.
K. VOcel
Vucel and
Carol Dahl
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Economic Review
Federal Reserve Bank
of Oallas
Rob,rt H. Bopin
"'_n
OwII_... t:JI/G
William M. W.II. e.
a.t._.,(
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f ........" - - " ' "
co<
H.rv.y Rollnblum
S-~a~'"
G.r.ld P. O'DriICOII, Jr.
vui'tft_"'"
.w......DwwItII(Jt~~
--
W. Michael COlt
Yu","_"'"
Stephen P. A. Brown
"'""11/11
\flu "'_I WId
SoI>oar!tIlIl(>7!jJl
Economi$U
Nalronal and InteffiaflOOal
John I{ HIli
Evan F Koerul!
Robert T Clall
Cala S lOWl'l
Kennelh M EmetV
Josect1 H Haslall
ltnda C Hunt81
MartAWyme
RegIOfliJI and fnergy
W,'I.am C Gruben
Robert W GII""l!I'
MII'Ie K Yucel
Keith R PhillIps
La... L laylor
F,ooa 0 Stga11a
Editon
Rhonda Hams
Diana W Palmer
Virginia M Rogers
The: fCt:lflOffllC RlMew i.! ~Is/'I«I by the
FUr.1 f\eseNe BatIk 01 0.1,. The..eM!<
presstd are thaW of !he lIIJ!hors ard do not
rrfIect!hl! pcJSIhons 01 !/'Ie ftdelal
I\e$er\oe IYrlk of DalIIS or !he ftderJl ReseM
_,ty
System
SublCnpllOOS Ife Md~ tr" 01 cIwve
PIaa sen:I "",,*u fO' .. ng~ and ..vbpie<OPl' ~O(IIS. bid oSSUeI. and Id·
6"e$S
to!he!'\bloc; Af!,," (IepartmIrrt
~11IeseM! 8ri. of o.IIM. S~10011 k, 0.1.
''''''981
IU. T_75222, (21'/651-6289
Andes may blllflfl/1l*1 CII1 the conotl(lll
tNt 1M R;Ua! II CtedlIId .tId !he ReseIItII 0.~ .. prO'llded ..,,,11\, QlP\'ot !he pdlialIB'! COIIlH1lng
the !!plnted II\f!efIaI
Contents
Page 1
ANew
Monetary
Aggregate
Evan F. Koenig and
Thomas 8. Fomby
During the past two dccldes, financial innovations have
proceeded at a r.tpid pace. These innovations h;wc altered the
liquidity of some assets relative to th::11 of others. As a resull ,
traditional measures of the money supply may have become
less reliable as measures of household [iqll idity. Even
sophisticated measures of the money supply, such as the
D ivisia moneta!), aggregates, do not adeq uately adjust for the
effects o f changes in the payments technology.
Koenig and romby propose a measure of the money
supply that avoids some of the sho rtcomings of existing
monetary aggregates The behavior of the new measure
suggests that monetary policy during the late 1970s and early
1980s was s uhstantially less expansionary than (he corresponding traditional and Divisia aggregates might lead o ne
(0 helieve.
Page 17
Reducing u.s. Oil-Import
Dependence:
A Tariff, Subsidy, or
Gasoline Tax?
Mine K. VOcel and
Carol Dahl
l ow oil prices and rising oil imports have caused
growing concern about U.S. vulnerability to Oil-supply
shocks. Mine K. Yucel and Carol Dahl devise a measure of
vulnerability and use it to compare three poliCies that have
been proposed to reduce U.S. vulncr;:lbililY 10 o il-supply
disruptions: a 25-percc nt oi l-import ta riff, a S5-per-barrel
suhsidy to domestic oil producers, and an increase in the
gasoline !;IX from 9 cents 10 25 cents per 8:1I10n.
Yucel and Dahl fi nd that the tariff would make the
United States less vulnerable to disruptions. By increasing
both consumer and producer prices, the tariff lowers consumpLio n while encouraging domesLic production. TIle
increased gasoline tax could either lower o r raise vulnerability. If domestic supply is not very responsive to price
c hanges, the gasoline tax inc reases vulne rability. If domestic
supply is responsive to price c ha nges, the gasoline tax
reduces vulnerability. The subsidy encoul"J.ges increased
consumption and production, leadi ng to a faster depletion of
the resource base. Hence, the subsidy would make thc
Unitcd States more vulnel"J.bJe to o il-supply shocks.
EVan F. Koenig
Thomas 8 . Fomby
Seniof Economist and PolICY Advisor
Federal Reserve Bank of Dallas
Associate ProfeSSOf 01 Economics
Southern MethOdist University
Consultant
Federal Reserve Bank 01 Dallas
ANew Monetary Aggregate
n 1982 the F<..'{\erdllk.~t!I"\·t! Hoard. cil in).,( Ihe
"actll:1I :lnd porcntial dTt:cts o n M I of ongoing
l'h:ll1ge.~ in fin:tndal techno logy and the Wl':lter
:l\'ai lahili tY of a wide \'arit:ry of Illolll'y-likl' imtrument .. :lIld near-monies: dt.:·emph:I... i;o:t,.'{\ the J\H
mont'l;!ry aAAfcg:nc as a guide to polKY' SIIll!1:lrly. in empirical fcse;trch on the dema nd fOf
money and on the rel:ll io nship lX'twl-'Cn growth in
the money :-.upply and growth in o utput or prin.'s.
m:ln}' t.:conomht:-. Il:Ive fou nd it helpfu l to introdUeL' a shift into tht.: p ubli.<;hed 1\ [ I :-.erit.: .... This
shifl is typically placed at or ne:lr l he 1X').(inning or
19tH. coincident with the n:l\ ionw ide Introduct ion
of nCAOIi:lble order of withdr.lwal (NOW )
I
aC('l)tlnT:-.,~
lInle",.. ~O\X' :.!ccounl balance., are pt.:rftXI
.... uh... tiuues for (".Ish and dl'mand dt..'posil<;. sim p ly
adding the three as.sel.. To}(t:lher to obl:tin :1 mea. . urc of lr.msactio n balanct.:s (whidl is <.'on\'cntion:11 pracTice) is no mort.· appropri:lll' th:1I1 adding Ihe nllmber of automobile.... to the nlllnbn of
hk'yde.~ . trains. bo;1\s , blISL'S, and ai rpbnc s 10
oblain a measure of The siock of transportaTion
cCjllipment. A beller approat:h i.~ to Weight thc d ifferent assels by the tf<msaclion sen'ice . . Ihey
yield-jllst as in me<Uiuring the.: .,tock of Ir::tn.<;p<lfI:llion equipment . one would want to wcight different types of equipment d iffere ntl ~' . depending
o n thdr carrying c..lpacil Y and .'> IX'(."",
[n the constn1Ction of:1 moneta ry aggreg:ut:.
a \'arict)' of asset-'weighling ....chcmes haw l)cen
proposed. J\ lost have at least som e int uili \'C apJX·a!. The Didsia :lpproach. however . ...Iands 0111
both for the inTellectu:11 rigor w il h which it has
bel'n dcn:lopt.-d and for the.: :lItcntion it has fL' l'ci\·t.'{l.' The Divisi:l approach l-onCenfr,ltcs on
Economic
R~itw ~May
1990
measuring tllc rute ojgrowlb of the 1Il0ncy supply
r.llhe r lh:m its level. This aggreg~lI e gro wth r.lle i...,
t:lken 10 he :111 avcr.1ge of rht! growlh r.1\("S of
individu:.t l as:-.cls. Tbe Imvt!r the r:lIe of ime.:rcst
p:lid o n an :t.... seL Ihe gfe~lI c r is tht;' weight Ihat
m()\'el1lcnts in the ;L-;.set rccclvc in the Divi:-.ia
meaMlre of the r.lle of change of the mo ney supply. The idt!:t i ... Ih:lI if people remain willing 10
hold :In a.... ~ ( oncring ;\ low pecunia!)' r.lIe o f
return. they must considcr the :Issel t!spt::ci:llly
lIseful a.... a me:.!ns of payment. Accordingl y.
ch:mge... i n ho lding... of assets bearing :1 low rail'
of return p l<lY a more important role in delenn ining movemenb in aggregate IrJ.nsaction balances
than do cha nges in ho ldings of high-yielding
a"''>I;:IS
The authors 'Msh /0 /flank Ed,m A Adams for superb
research aSS'5Umce and Cara
5
Lown. John K ~#iI. and
Kenne/h M Emery for helpful Commenls
Mone/al}' PolICy Repor/ submil/ed /0 CO<lgress on Febru·
ary 10. 1982. as publ,shed In /fIBFederai Reserve au letm.
MarCh 1982 The F8d6raJ Rcserve abandoned Mllargel·
ngen/uelyin 1987 (Heller 1988)
See 8CIX A for definlllOflS
01 M / and rela/ed mone\aty iJ!XIfCQ8/es
SH. for example, Darby. Mascaro. and Marlow (1989).
Rasche (1987J. 5ronfI and T/IorrnOfl (1'J87) and Board 01
Gover"",s (1982)
Wilham Bame". WIth Oilier$. has au/herod a long serIes
of papers on OWlsia rrl<)(Ielary aggrf1{Jalion Sec. lor
examp/6. Barnell and Spondl (1'J82) and UameN. Offenbacher. and Spmdl (1984) Altema/lves 10 OoVlSla aggrer;a11Ofl are descflbed by Spmdt (1985) and Rotemberg
(1989)
The Components and Definitions of Money
As defined by the Federal Reserve
Board, M1-A was the sum of currency held by
the nonbank public and demand deposits at
commercial banks (other than those due to
depository institutions, the U.S. government,
and foreign banks and official institutions),
less cash items in the process of collection
and the Federal Reserve float. M1 is the sum
of the items that were in M I -A plus travelers
checks of nonbank issuers and other checkable deposits (OCOs). OCOs consist of negoliable order of withdrawal (NOW) and automatic transfer service (ATS ) accounts at
depository institutions , credit union share draft
accounts, and demand deposits at thrift institutions. Beginning in January 1983, OCDs
also included Super NOW accounts. Super
NOW accounts paid more generous interest
to depositors than did regular NOW accounts
but had more stringent minimum balance
requirements. After March 1986, with theelimination of Interest rate ceilings on OCD accounts, the distinction between regular NOW
accounts and Super NOW accounts disappeared .
Thc Divi o;i;1 imkx o( growl h in 11K m o ney
.~ uppl y h;I'" two highly :ttlr.tet t\C 1<":;ll u res. Fi rst.
cons truction or the index d(le~ n( II rL·qllin.: de
tailed kllo\\ k'dgL' o r thL: conl l'li>ution \';Irious as~eh make 10 t he hll~ in~ :I ncl o;e ll lll~ of .W)(xl~ and
The definitions used in this article are
somewhat different from those used by the
Federal Reserve Board. Thus, M1 A here refers to the sum of currency held by the non bank , nonthrift public; travelers checks of
nonbank issuers; and household demand deposits. Business and other nonhousehold
demand deposits are excluded Irom the
analysis, on the grounds that the motives for
holding such deposits are substantially differ·
ent from the motives for holding household
deposits (Mahoney 1988). Further, only households have the option of opening NOW accounts. Similarly, for the period during which
a distinction must be made , the OCD account
variable here , N, is a weighted sum of Super
NOW and non-Super NOW OCD balances.
Non-Super NOW OCD balances are given
full weight. while Super NOW balances are
multiplied by the ratio of the opportunity cost
of holding Super NOW balances to the opportunity cost of holding non-Super NOW balances. -Household M1 balances~ are the sum
of MIA and N.
.~L·f\
in:s: t hel't.: ;II'L' nl 1 fu nel io na1 f()"lll~ tl) ~pL'dfy .
no parailletcr.... (0 L:.~lilllah.: .1 S...:cond . the
D ivi~ ia imkx i ~ :U..'t'uralL·: for :ln }' gi\'<.:.'n pay tl1C1llS
t\'Chnolo)-.:r. thc irl(kx':-o l1l()n.' lll ...:nt~ (ully rdkct
; ll1 d
l' h an~L:'" in Ir;l n ~aL'l i(Jf) '-L·1'\·it·L'::;. '
T ilL' acn ll:l('~ 01 thl' Oh l:-o m inde.x i .~ con tinupon t he a~' lIlllpIi O n lilat Ihl' pa} ments tec hnology. whatl'\'er ib rOnll. i ... uncha nging. The
~I..·nt
• /I IS. howeWf. necessNY NI ooe /u'Iow.• Pl'oOt, whctl
.asMts . . 10 t» IfIC4Id«J If! ttw ~Ie IJI)(J lhallhe
~t..w..tyllClmtJgel'''''''In'''COITp:lI'''''assets
(so /hal a $Il71CIIlanwuS doubhng cI aN Ccmponenl assets
resu'IS
1fI"
douOltflrJ 01 /!Ie aggregate}
I Only CO'lI'nllouS-t me [)'v'SUI itggrflfJ<ll<Of! .S fuRy accurare
2
.nae,
OrvrsJ8
()IOvtCICS it /fl"d-order
lhe /fue aggregale (o.e...erl 1976)
/n d,scrcle Mle 11>6
IIpptC»IITlaIO'lIO
l (rO~ and 19l'l<1:-. hO\\\..·\ ·l'r ....;1\\ thL' 'pread of new
typ....~ of 1r.llh.U.:liOll .ll count___ known col/ecthL"ly.h other l hed.... tbk· dep().~l'" (OCD... }-and
of inno\;niol1' Cll kL' alltomatc:d Il'lk'r m:tchint:s.
1l10n\..·~ Illa rket 1ll1l1U:iI l und ~l('l·()llllh . .mel 1ll011t:y
111;l rkel depo'lt aU'ollllto;) dut bcilil .ttL·d th...: tr.msroo-r of \\l'ahh 11110 ~Hld (Jut o r tr.\fl~act i()n h:lianc...:s.
!'t--de ntl Kt"SC o 't' Bank
or Oallas
making s uch balances more e:fficicnl. The evidem
ch:mges in payments technology during the p'lst
two decades suggest that altt..'rnati\'c~ to Divisia
aggregation arc worth exploring.
In this article, w<.' descrihc.: one such alternative approach-an approac h that, li ke the Divisia
index. makes use of m<lrkct inle:r<.'sl r..Ltes to
weight the contributions of individual assets bUI
which, uHl ike the Divi.s i;1 inde:x. m;lkes at least
SOI11<.' provision for !'>hifts in the payme nts tedmology." We find that the Divisia meilSUIl.:! of the
mo ney supply. hecauS<.' its tonsl mctioll fails to
m .. ke: proper allO\vilnce fo r Ih<.' inl'fe:.sing aV;lil.. bility of OCD accounts, significantly dist ort.~ the
pattern of growth of trans:Ktion ha b rKes in the
late 1970s :Ind early 1980s.
NOI surprisingly, in order to relax along one
dimension Ihe assumptions that unde:rlie the
Divisi:. approach. we are forced 10 make more
stringem as... urnptions in other areas. In pa rticula r.
we find it necessary to assllme that Ihe p:lymenls
lechnology ha!i a spt!cific functio nal form. We :oI lso
find it nc,."cessary [ 0 estimate one of the paranU;'h::rs
of this technology econometric.llly
[n the fo llowing scttlon. we review the r.Jtion:lle for Divisia aggregatio n. After noting the
limitations of the Divi!'>ia approach. we propose an
;Ilte rnative aggregation proced ure. Our procedufC
yields a mo netary aggre:gate: thm . dming the late
1970s :md early 1980s, is much less st'n!'>ilive to
Illov<.'mems in OCD habnccs than is either the
Simple-s um or the Divisia me:lsure o f household
~ Il hal:l nces. Results arc rohust with respect to
scveral possible cha nges in our assumptions. The
concluding section of the .. rticle discusses the
need for fun her research.
Divisia aggregation
R\!callthat the r..Lle of change: o f th\! Divisia
index of Ihe money supply is a weighted avemge
of the rates of change of individual as.'>t!lS, with
greatest weight placed on the changes in as..,els
offering the [owe!'>t rates of return Suppose. for
cXllmple, that P.. represents the interest:1 ho usehold loses hy holding a dollar as cash or ir1 a
demand deposit account for a unit tim\! period instead of invc:..'sting the dollar in a hond or other
high-yielding security (BccauS<.' cash .. nd demand
deposits pay no interest. P.. is ...imply equal [0 the
Ero nomic Revlew _ MilY 1990
interest nltc on honds) Sim ilarly. suppose Ihat Pn
represents the interest lost when a household
ke:ep... a dollllr in an OCD account instead of in
bonds. Then, if 0 denotes the Divisia measure of
household M I halances and b it.<; ra te of change,
where M IA is the sum of C'.tsh and ho usehold
demand deposit'>: N denotes OCD account balances; and P.I' defint.."XI as p,,(M l AID) + P.(NlD),
is a meaSure o f the average cost of holding Divisia
money
Equation I can he rearnmged to obtai n
where
and
According to equation 2, the percentage rate of
growth of the Divisia aggregate is a weighted
avemge of the percentage niles of growth of its
individual component assets. The weights, s.. and
s., arc the shares of total "expenditu res" o n transaction services thai are devoted 10 each as.~et.
Only readily ohscrvable price and quantity info rmation is requi red to calculate lJlD by using
eq uation 2.It can be shown that , as long as the payments lechnology is li nea rl y homogcnL"Ous (so
that ;1 doubling of all assets doubles the flow of
transaction services) and is fi xed. movements in
VI D will exactly match those in transaction
services. (Sec Box B)
, The new aggregate makes s/lowarlce lot shihs If) technology rnallend 10 favot ontI form 01 transacl1(lll bal8nce over
Snolhcr. bul II does nol make lJ//oWttfIce lot changes
If)
IOClvlology lila! have a vrnform mf/venr;e Qr'IlIle effi<:oency
oIalilfansaC!1()(I balanc:es
, Dala on pril;e and quantify ,rs
,~aila/)/e
only ar dl$(;rele
lIme Ifllervals ConseqU8t'lIIy. If1lXflCl~. , dlSt:relfi1.11tT1e
apptox:mal1(lll10equation 21S vsed 10 r;onslT\.'C/ rile OrVlSIS
'rlfJregste
,
BoxB
The Accuracy of the Divlsls Aggregate
A payments technology with the property that a doubling of all assets results in a
doubling of financial services is said to be
~homogeneous of degree one ,M or "linearly
homogeneous. Suppose that transaction
services , M, can bewrittenasa linearly homogeneous function, tP(M1A,N ), of cash , demand deposit, and OC D balances. Then the
Divisia aggregate will accurately reflect movements in M. In particular, DID, calculated as in
equation 2, will equal MIM al every point in
time .
R
To see that this equality holds, note first
that by direct differentiation,
M1M = (M1A~.1 ~)M;A I M1A
+(N¢"I ¢)N I N.
where ¢. and ¢In are the partial derivatives of
4'( , ) with respect to M1 A and N. Because tP( , )
is linearly homogeneous, however, ¢(MI A,N )
equals ~.(M1 A . N ) M1A + ~"(M1A . N ) Ntor all
M1 A and N. (This property of linearly homogeneous functions is called Euler's Law.)
Hence.
M1M = [M1A~. / (M1A¢, + N~")jM;A I M1A
+ [ N~" 1(M1 A¢, + N¢")jN1N.
Ul."t::IU"..· (x:[) ;1(U)lIIlI" p :lr illll.'r"',,1 " h ill.'
cl ..h :lI1d d",II1;lIld dl.'P0:-'II:. do nol ./! ... gn...·atcr
than p~. :lnd Ihl.' Di,·bl:1 nll.·:t:.lIrl.' of';h .., pcrc..~nt-
If M I deno/,.,s me sum of cash noosehold demand depas'l,
IIndOCDtJ.1lances IhenMI/M1 ~ W.lMiAIM1A). w(NJNI
whe<e "'. lSdCfNledasMIAI(M1A • N)and w, IS defmooas
N'(MIA • N)Mdequals 1 - w, SlftlC/Calgebrtl esrabl,shes
fhat s. IS grealet Ihan wo,f andOflly l' P, IS (JIBtller than R
•
Suppose, finally, that households allocate
their money between M1 A and Nto minimize
the cost, in forgone interest, of attaining a
given level of transaction services, M. Then
the marginal rate of substitution between M1 A
and N will equal the ratio of the price of M1 A
to the price of N: ' .'4',, :: P,,1P,,, It follows that
Ml A9./(MlA4'. + N¢" l:: p. M1A 1(P. M1A +
p"N) '" s. and , si milarl y, that N¢J" /(MlA¢/I +
N¢J,,) '" p"N l(p/lM1A + p"N ) = sn. Therefore,
M1M=5, (MiA I M1A)+5" (N 1N) =0 1D.
as claimed.
Suppose , now , that M equals 9
(mMl AnN) , where m and n are parameters
that vary through time as financial innovations
occur. Following the steps outlined above,
one can readily show that
MI M = sa(M1A I M1 A +m l m)
+Sn(N I N+h f n)
= 0 10 + 5,(tiI 1m) + 5" (1i! n).
Equation 4 , in the text , is obtained in the
special case in which m equals (1 - a) .. Jt ..... ·)
and n equals a .7'(..... . 1. Thus, financial innovation is capable of destroying the accuracy of
the Divisia aggregate.
.l~'" ).!rl)"th r:n ..· of Ihe: Illon<;:y "uppl)' kqll:llion 2)
pUl" I'clal l\'e!r ).!r"':ltcr \H.'lght on g1"l)wth in ebh
.111d dcm.lI1d d,,·po:-.ib Ih:1I1 dOt;''' "lIupk-:-'UIll ;JR).!l"l·g.ltl(m. " Ike:lll"", OCD b:I!:l nll'" h.I\ .., h\.:~ n
n~illg :11 0\ r;I~ll.·r Ix·r(,,·l1!agl:.' fate thoBl 1.";1,,11 ;111<1
dl.'lll,llld dcpo-..it lubm·..·" (Ch;u1 I ). lhl" dil'f... rencl'
III rl'i;Jli\1:.' \\'l'lghh illl pl i..'s tha t th ... Illoncy :'lIpply
gf(J\\th 1~1l"'.:l~ Clkubtt'd by t ilt: Did"l;! pn)l·l.·
dllt'l.'. h;I' gt:ner.dly hevll below thl.' gr{)\\I il ralt.' of
th ..· "i11l p lc -" LlIl1 IlW;I:-.llfl' of huu:.t;'hold ,\11 hal-
Federal Rese n 'e Ibn k or Oa llas
Chart 1
Chart 2
OGD Account Balances as a Share
of Household M 1 Balances
Alternative Measures of the Rate of Growth
of Household Transaction Balances
Perce nt
Percenl change from 12 monlhs before
50
25
...
20
"
"
"
30
5
20
o, ~----------~~-----------
"
5
o ~~~~~-__~---1973 1975 1977 1979 1981 1983 19 85 1987
-101-______=
1973
1975
1977
""
_ _______________
_
1979
198 1
1983
1985
1987
SOURCE Of PRIMARY OATA
SOI.JRCE OF PRIMARY DATA
Board 01 Governors, Fe<ieral Reserve System
Board 01 Governors, Federal Reserve System
:lOces. On the o th\:r hand. Ix:callsc the rapidly
growing OeD h.lianl"c:-, arc gi\'cn at least sOl1le
\\"l'ight in it:. const rUl"lion. Ihe growth mIt;' of Iht,:
Divisia agg rC~: H e ha ... cxn:cdcd that of M II!. In
pr:lclieC'. the Divisi:1 :Iggregalc has beh:lvc d mllch
morc like hou:oci1old 1\11 th:1O like M IA. (Sec
Chart 2..)
An alternative aggregation procedure
To implement Ollr alternat ive aggreg:l!ion
procedur(', w e ne(:d to a....·;umL· Ihat the p" yments
tcchno logy ha:. " sptX'ifi (' fu nctio n:ll form . We will
assume. in particu lar. Ilwl cash, demand deposits.
and OCD balarKL'S (;ombinc to yield tranS:K't ion
sL·rviccs. M , ;!ccording 10 the fo rmula
OCD halances. at the m;lr~in. relatIve to corresponding scr"icc.~ ~tickk-'{I hy cash and by demand
dcpo.~it s.IC
The p:lr;IIll\:lt.!r 0". o n thl! o lher hand, measures how nearly intl!rchangeablc the I\\'O types of
:\S:OCI babnces arc. It is called Ihe -elasticity of
suhstitution" IX:lwecn M lA and N. When 0" equals
zero. there is no possihility of ..ubstitUling OCD
habnres fo r (.':I~ h o r demand deposit babnces: Ihe
assels must IX! us(.-d in fixed proportio ns and w ill
mow together. in locksto..:p In contr;lst. MIA :lnd
N become perfcct :>ubslitlltc:-. as 0" approaches
infinity. and eq uatio n 3 rl!duces to M .. [(I - a )
MIA + aNJ
Only when, simultaneously, cr is infinite and
ex equals onl!- ha lf is simple-sum aggregation of
OCD ba la nces with cash a nd dema nd de posit
0-1
M = [ (l - a )MIA(o I) " +aN()
0
"
]
{o-'I
.
where a and 0" are nonneg:H i\'c parameters. with
a less th:1O o r equal to I The functional form on
the right-hand sidl! of equation 3 is quilt;' flt;'xihk
and has been lIsed in :>l!wr.11 cmpirical sludit;'s of
Ihe demand for mo ney." If a equals ze ro, OCD
halances yield no tr.msaction services. a nd equ:llion 3 reduces to .11 - MIA The larger is a , lhe
greater are the tr.ms;lction services yielded by
f..conomic Rt:v ie ...· _ May 1990
• See. lor elfample Barnell (1980. (981) and Chetly (1969)
or &:me fifllJnclal 1fIfI(lY811OnS. such as the tt'I/foducbOfl 01
IWlamaled 18I/er maclw1ocs. /'I1CIO'Ie)' market mutual /vndS.
and money market depo$Jt 8CCOt.H'lfS. will/end 10 K>Crease
the marglfllJl ptoductnnly 01 a I types 01 1fan5aC/1Of1 balances. IJ/'lj/ctmly The af}f}feglJ//OfI procodute we develop
fIere ~ not capeOle 01 ClIDturlflg the effec/s of such dlnOViI·
/.Q1S NCI/fIfIf ale /hey captured. however. by the OMsla
and $¥TIpIe·wm ll{X}rcgates
,
balances ju~lifk--d. OnJr when a or a is equal to
zero is it appropriate to ignore OCD halances and
use M lA as a measuft: of {r.msaction services
Divisia aggregation, in (on\r.I~l , is valid for ally a
;lnd a, provided they arc timc-inV;1riant.
Unfortunately, the parJmeter a likely did not
remain constant as OCD ;I(counts spread grddually across the n:llioo. After all, during most of the
decade of the 1970s, thl: only way in which a
household located in , S;ly, Texas could even use
;1n OCD ;lccmmt was through the mail. II The cost
and inconvenicnce ;1.~s(X' iated with making OCO
account dcposits and withdrawals must have
dropped sha rply for such households in 1978when commercial banks were allowcd 10 offer
automatic tr..msfcr service (ATS) accounts-and
again in 1981 - whcn NOW and ATS accounts
1x.'(:<ltllC leg;llly av,libhlt: ,Il all Tcxas depository
institutions. But lowt:r marginal dcposit and withdrawal costs arc equivalL"nt to incrcas<---d marginal
transaction serviccs (Orr 1970; Milbourne 1986).
So, a - the rdativc weight placed on OeD ba lances in the household liquidity function-very
likely incre:lS~:.'(1.
A timt:-varying a drives a wedgt: hetween
the growth r..l1es of ,If and I):
(4)
f,flM=DI D+[a l (l-a)](a-,,,)u / u.
where v is defin<..x1 ;IS a/( I - a), so tlmt ul v
equals [1 / ( 1 - a)1it! a . (Scc Box B for a derivalion.) Thus, whether in(.'fcases in a raise o r lower
the growth rate of M relativc to that o f the Divisia
index depends both on whether a is greater than
o r less than unity and o n whether the current
value of a is greatcr than or less than s".
If a is birge, so [hat Nand M JA are close
substitutes, then :1 small ch,lIlge in the price of
one of the :ISSCIS, relativc to the price of the other,
ought to induce a large reallocation of tmnsaction
balances away fro m the asset that has become
rclatively more expensive. Conversely, if a is
smati, then even a iargt: change in P,. relative to PIt
ought to have very little impact on the allOC'dtion
of trans..ction ha1:lnccs. Forma lly, household cost
minimization implies
(5)
In(N
I MIA)= aln( v)- aln (p,./ P.).
Equation 5 <-,10 be differenced, then estimated
econometrically, treating .dln(v) as a random disturbance with nonzero mean and a as an unknown parJmeh:r. In carrying out this estimation,
we obWined a value of 0.2 141 for a. with standard error 0.1606. (Details are given in (he
Appendix.)
After (J is cstimated, equation 5 can be
turned around and solved for U ::IS a function of
the price ratio, p,/ p". and quantity ralio, NIM I A.
Equivalently, onc ca r' express U as a function of
NI MIA and the ratio of expenditure shares,
s Is .
" "
(6)
1,--).-
U= (sJ s.. )( N I M IA )
We have already seen that thl! quantity ratio,
N/AI lA, was increasing during the tate 19705 and
early 19805 and th,lI the estimated value of the
daslicity of substitution, a, is less than unity.
Chart 3 demonstrJles that sIt has been declining
and, hence. that the mtjo SJ SII has been increasChart 3
Expenditures on Cash and Demand Deposit
Balances as a Share of Total Expenditures
on Household M 1 Balances
Percent
"'r -----.
95
90
85
80
75
70
" Before NI:Jvembef 1978. n/8fes/-beanngc/leckJtlg 8CCO!IflfS
..".." llvadablo only '" the New England starc-s Tho early
fIIs/Of'y oIl'lrer6s /-otIarKIQ c/IecJOOg accounrs is d iSCUSsed
111 Gibson (1975J
6
.5~--------------------------'-1973 1975 1977 1979 198 1 1983 1985 1987
SOURCE OF PRI MARY DATA '
Board 01 Governors. Federal
Reserve SY$rem
Fedf: ral Reserve Ban k o f Oalla$
i n ~. Frolll 1.:<l U:lli(1I) 6. Ih...·n. il !"ollow~ Il w l V has
n ... t.: ...s.~lril}" 1X'1.:11 lrl.: ndi n ~ upward I n olher \\oro ....
Ihl.: m :l r).!in:11 lI~tn ~:K ti o n s...n ·K ...S on ...:It.:d hy OCO
hal:i rK"'s ha\·...• 1X'1.:1l ri ... mg n.: l:l li\·...· to thoS<.: offt.:r...d
hy C:1.~h and ( il.:l11and ( k- ro~it h:I!aI1(t:~ A,!.:ain. I hlS
finding llIak ... ~ ....... n.~·: :1' oeD :K(;Ollnt.~ han' Ix:(;0111 '" :1\":li l:l hk at mor... and Illort..' h ;lIlks :Ind thn!"!
inst itutions. hou",(;holds b:I\·... found il innl':.N ngl y
nJnH'n IL'nl 10 lhl..' Oe D h:II:I11(;L'S 10 fi n:uK...• thL"i r
pllf(: h a~ ...·.~
To j.(L't :I 1ll0 1"1..' p ......("Is ...• notio n of how v ha",
Ix-L'n lx-h:I\'ing throllgh timl· . \\..... I I.~\.'(I equation 6
\() cakul:ttl' th ...· IXlll1 of v impliL'd hy l h...· t.:stim:lt ... d
\·:llu ... of a Th ...· log:lrithm of thi.... path is plOl1l'd in
Ch:lr! -I. Th ... j.!... n",·r:tI t,.... nckncy for V to innl·;ls...·
through th ..., 1970s and It)H()s is apparl'nt l'articlIbrly rapid ).!1"owth in V o{.:cllrr... d in 1')76. when
\0\,\1 : 1 "'T()lI n t.~ Ill·ClIll ...· :1\':libhk throll~houl N...·\\·
En,L:l:md : in bll' 1t)7H. Whl..'ll NOW' :1(TOunt.... heCUll ... kg;! 1 in :\...·w York and ATS :lc('ounIS \\·...·r....
inl rodUH'd : :1I1d in l'ady 1t)~1. \\'h"" n '\OW ac("( )li nts Ix·clm.... a\·:II!all!l.: n:lt i(lIlwidl..'
From t h...• dd"inition of v. a is (:q ual to v'( I +
IJ) I-knn... equat ion 6 (':m Ix- us..."(i to clllumat ... a
fnlm "'"(Illation 3. yiddinj.( a formula for .11 that
d"'IX-Il(b only on a and r....adil y ohs"'I"cd p ric....
~I nd qu:mtily dat:l :
I\ .~
a ;lppro;Kh....s
ar...· lx-rkcI
infinity. so that OCD h aianc...s
~uhstitllle .. for Gtsh and demand de·
po;...it balatK....s. cqu;IIio n 7 b""('omes !II - [p,, /I p" +
" )1,1/ I I I + II' /(" + " )IN. It r ... Ill:l ins tn.lI.... th:1I
.I /IA :lI1d ,\ Il~o\'e ~O,L:L·l'{l",·r. in lo(·kstep. w hen a
eq uab z",·ro. so that. as lx-fori.:, it is :tppropri:ul..' to
u .. . e .11 I tI ;1" :t n ll':I.~ urr.: of liquidity ....... n:ices in this
C:lS\.·.
\X/ e \\"ill ed l Ih ... 1ll0Ile[:IIY aggr... glll ... ohtain ...d from <.:qll:ltion 7 \vh <': 11 a is ., ct cqllal to its
l:. . [i111aled valuL' Ih.... -CES aggregat .....· as eqll;ltiol1
7 i... d<.:rh'... d llnd ...,]" IIle assumplion that tht..'rc is a
C()[lstanl l'bslidty () f suhstituti(lI1 hl.:lwl.:cn asS(..'ls.
Ch:u1 'i-lik ... Chart 2- rlots :.tnnll:tl ratcs of
).t["()\\ III of thl" I)ivisi:l aggr...).tatt..' simpll..'-....ulll
hous... hold 1\ 11 h:lI:IIK ...S. and !IT I A In addit io n . it
plols till" grO\\"lh r,H ... of tIll" CES a,L:grl..'g:lt ...· eakuI:u",'d hy usi n).! tlli.: v;l llll;' of a ohtained from
>
...",tim:lt ing "'qu:ll iotl '3, 0.214 1
In Chan -). til ... l'xt",'nt to which j.(I'( )wth in the
CE..'i :1,L:grl..'gatc par-i llds th:1\ o f ,II lA during the
bl ... 1970", and I.:arly 19HOs is slrikm,L:. In 198 1. for
eX:Il11 p ll..'. th ... growth mtt.'s of til<' C I'"~'i aggn:gatt'
Chart 5
Chan 4
Effects 01 Shifting Technology on the
Marginal Productivity of N Relative
to the Marginal Productivity of M1 A
CES Agg regate and Other Measures
of the Rate of Growth of
Household Transaction Balances
Percent change Irom 12 monlhs before
o
5
"
25
,.
Al l
15
10
,.
- 25
30
'5 L,=--:=c-C~--:=C-~---C=--:~-C~-1973 1975 1977 1979 1981 1983 1985 198 7
SOU RCE Of PRIMARY OATA
Boa rd 04 Governors. Feeler.1 ReS8fVe S~Slem
Eco nomic Kc:vicw - !tf:1 )' 1990
5
o ~------------~f------------5
-10 1-_ _ _ _ _ _ _ _ _ _~--------1973
1975
1977
1979
198 1
1983
1985
1987
SOURCE OF PRIMARY DATA
Boafd o f Goverr"lOls. Feeteral Reserve System.
7
and .11 IAlxllh rlllmm~L whil~ tho.-.c (If s impll. . ~\l1\1 MJ and Di \' i~i;t i\'Il M tr~~ Du ring 1983 a nd
19Wt. simi larly. when till' growlh r:.Hl'S of silllpkMIIIl {\11 and I)i vi~ia .\·11 hOlh In.:nd downward .
gnl\\lil ralL'~ of the CES ;lggreg:ne ;mel .11 111 arc.:
~l:nl'rallr on tht· inc~t!>C E\'cn aftL'r 1 ~ 1. diffl:rI.: n CL'~ IX'I\\ L'Cn the CF.5 series :md Dh'isl;! 'iCril.:s
rem;lin ( illant it'll i\'d~' . if n Ol alwars qualtt:ltiH: ly.
.-.ignifk:'lnt.
Chart 6
Sensitivity of the CES Aggregate
to Alternative Values of the
Elasticity of Substitution
Percent change trom 12 months belore
Sensitivity analysis
In (·on.~tnt l·t in).t our propost·c\ new aggn.:~:He.
WL' assum ...·d that Ihl.: elasticity of subst inn io n 111.:t\\'e~n oeD balances and c,ls h and d~tlland depo.,il h;iI,ll1n's is constant. I low realistic is Ihis
;t",slll11ption~ If the s ubstitutability between OCD
habn(X'S :111d tile lllorc traditional 1r.1I1.'i:It;tion balanl'l~.~ has. indt:ed. changed. the shifl most likely
o (X lIrr..."( 1 in 1981. when NOW accounts h(:came
;lvaibhlL'Il;ltionwide Au·ordingly. \\" rCL" ;(illlalL'd
l'q\I;l\ion 5. a!1owin/>: I h~ pre- I98 1 :lI1d po~ t - l 9HO
\·,lluL· ... of (J 10 differ No ... ignificam shift in the
v:thlL' of a \~;tS detl..'cle(\.l!
H ow important is it th:1I (J he precisely L~st i
mah.:d~ To addre~., thi ... question. we llsl..'d t'quation 7 to clkul:l1 ~ the time p:llh of Ih" growth mte
of thl' CL"i aAArL'gale for three values of the el:lslidl)' of :'\lh~l itution : (J - 0.0535 (one stambrd
error '}('/ml" tltl..' val ue of (J obt:lincd from estimating equ,lIion 'i). (J - 0 214 1 (the ,'alue of (J ohtaim.:d fnml C'slima t in~ equalion 5), and (J o j7'i7 (one st:lIlc!ard error above the valu..: of (J
o ht:linL'd frorn ..:~tim:tting cqtl:!tio n 5).
As Chall 6 ma kes d ear. in any given oneye:II' period. thL' v;llw..: of acan indeed h:t\·c a
substantial impact On the eSlimated growlh ralC of
tll\: Illoney ~llrpl}'. In mid-19tH. for cxamplc.
there is ;t d ilTerence of marl' than 6 percentage
points he tween the annual growth r.Lte of the
mOllq' ... upply Glkul:tted a:,sllming a equlIls
001}; and rill' corresponding growrh nHI..' calcll bt ...""{1 asslimin/>: (J equ:tls 03747. What i.-. most
strik ing and also mOM reassuring. how~\'~r. is Ihal
Ihe l/lla/iwlil'e lx:havior of Ihe CES aggregale is
me d" ' ercncfl bf/rweenlhe pte . 196 1 9fld pasl 1980 el8s·
be 0 (J237. WIth a
stannard errOl 01 0 2635
11C'11l!S 0( su()snMIOf' WIIS eslmBled to
•
1973
1975
1977
1979
1981
1983
1985
1987
SOURCE OF PRIMARY DATA:
Soald of Governors. Federal R_rYe Syslem.
\'ery mud] Ihe ~ame reg.'lrdlC's.~ of Ihe value of a .
In tltl.' Divbia appr<xlCh 10 monda!)' aggreg:lIion , which :t:.... ume... that Ill(' pay men!.~ t(.·dmolORr i~ (,;onst:lIlt. C\'C!)' change in relalive as.-.ct
ho ld ings nm ... t he au ributcd to a ch:tnge in rdative
a ....'iC1 prices. Our estim:lle of equation S indiC".!tcs.
hOw...·vI..T. that mo:.t of the \':Iria tion in Ihe nllio of
OCD balance~ to cash :lnd dcmand dq>osit b"lan(·I..'." is unrdat ...'(i to relm ivc p rice Chllll,gc:S It i.~
pos.~ ih le. though. that relative price changes have
not lx:en appropriately mcasurC'd In particular, it
is I X)s~iblc Ih:1I measuring p" as the (\iffeft.:nCt.:
hetWL'C1l Ihe r:Jt {~ of rcturn on bo nds and the ..IlC
of rl'turn on O CD hal:11lces unc\l.!rMale." the avcr:I).!e co... t of holding OCD balances in rx:riods duri n~ which OCD act'oLlnts were not av ai l:tbl~ in all
st:l1es. A mort.' re:llistic :tppro:tch might be to think
of Pff as det'lining as it Ix'(:ame lega l for b:tnks in
mOfL' and more states to offt:r OCD ,lCcounts 10
their c uSIOllier..
To de tennine how sensitive o ur aggregate is
to IX) ....~ihle lIl i~mcas urc ment of rcl:tti\'e prices, we
ddined a nC'w opportunity cost for OCD halances.
p;'. eq ual 10 ;l weighted ;Ivcnlge of p" :tnd p,, '
The weighl :l\I;lchcd to P.. was set equal to lhc
pro portion of the u .s population living in Slales
wh..:re hank... cou ld kg:t lly offer the prinCipal type
ft:dera l Reserve Ban k o r Dallas
of OCD account-lhe NOW account. The weight
attached to p.. was, s imilarly, set equal to the proponion of the U.S. population living in states
where NOW accounts were illegal. Thus,
falls
as NOW accounts become available in additional
states.
A plot of the CES aggregate constructed by
using
was found to be: virtually indistinguishable from II plot of the CES aggregate :lS constructed origi na lly, usingp~. Apparently, then, the
behavior of the Cl-::S aggregate is insensitive 10
plausihle changes in tht: measurement of relative
asset pnces.
p;
p;
Concluding remarks
Ch:mges over lime in the r.llio o f the
public's OCD babnces to its holdings of cash and
demand deposits cannot be adequately explained
by changcs in relative prices. This finding suggests that thcrc have been significant shifts in the
technology by which households obtain transaction services from cash, demand deposits, and
OCD balances. Simple-sum and Divisia monetary
aggrq:ates, which do nO( make allowance for
changes in the payments technology, may therefore give a misleading pict ure of the direction of
monetary policy.
ntis article has outlined a new aggregation
procedure-a procedure providing specifically for
financial innovations that may tend to fa vor one
asset over another. Applied to data on Cash, demand deposits, and oeD balances, the procedure
yields a monetary aggregate that behaves much
like the household counterpart of MI-A through
the late 1970s and early 1980s (as OCD accounts
oc"'C3me more prevalent) and very differently from
the household counterparts of si mpl ~-sum o r
Divisia r.·l l.
The next step, a critical one, is LO determine
whether the CES aggregate has any closer relationship to innation and real economic activity
than do the Divisia and simple-sum aggregates. In
this regard, it is encour.lging that studies examining the connection between money, prices, and
omput during the late 1970s and early 1980s have
generally found that MI-A has a closer connection
10 innation and real economic activity than does
M I. ]j
.. SH. IOf
tlJlample. Darby, Mascaro. tiM Marlow (1989).
Roley ('985). Haltlt (1964). 8M W6IYIUlgef (1964)
Economic R"kw-May 1990
•
Appendix
Econometric Specification and Estimation of Equation 5
The first-order conditions for maximizing household utility suggest the specification
(A. 1) In(N I MIA),
=Gln( v,) - uln(p" I P. ),.
Assuming that v is an unobserved random
variable with a positive domain. equation A.l
becomes a statistical relationship in which the
elasticity of substitution (a) is a parameter to
be estimated from time series observations
on (NlMl A) and (Pn IP. ). Estimation of a in
(A. 1) can, however. be problematic. First, the
stationarity of the error term, aln(v), ;s in
question and, second, there is reason to believe that (NlM1 A) and (P,,tp. ) are jointly endogenous.
To address the first issue. the time series In(NlMl A) and In(p,/p, ) were plotted and
examined for nonstationarity. The relative
holdings variable. ln(NlM1A). is an increasing
function of time and . thus, appears to be
nonstationary in the mean. The autocorrelation function of In(NlM1 A) is slowly damping.
thus reinforcing the visual pattern of nonstationarity in the mean. Differencing In(NlM1 A)
to the form .1ln(NlM1 A) stabilizes the mean
and produces a quickly damping autocorrelation function. The variance profile of .1ln(NI
Ml A) is roughly of the grouped-heteroscedasticity form (Fomby, Hill, and Johnson 1984,
174-76), the groups being defined for the
periods January 1973-December 1978, January 1979-December 1981. and January
1982-May 1988. There also appears to have
been some intervention (outlier) behavior in
the data at points of change in NOW account
availability. To formalize a judgment on the
nonstationarity of In(NlM1 A), unit root tests of
the Phillips-Perron type (Phillips and Perron
I.
1988) were performed. These tests explicitly
allow for quite general heterogeneity in the
series (the present grouped heteroscedasticity and interventions being a special case).
The tests strongly supported the null hypothesis of a unit rool.
In a similar manner, the relative holding
costs variable In (Pn1pa) was investigated for
possible nonstationarity. A plot of the data indicates a "slow-turning" behavior similar to
that which would be exhibited by a random
walk without drift. The autocorrelation function of In(p,/p. ) is, as expected. slowly damping. Differencing the data generates an autocorrelation function that damps rapidly. The
relative holding costs variable after differencing , Llln(p,,1p. ), exhibits nonstalionarity in
the variance of the grouped form during the
same periods as the grouped heteroscedasticity of .1ln(NlMt A) and , also, exhibits interventions near dates of deregulatory activity.
Again running unit root tests of the
Phillips-Perron type, it appears that. after
proper adjuslment for the heterogeneity arising from grouped heteroscedasticity and deregulatory interventions. the stationary form
of the relative holding costs is .1ln(pnlp~).
Even though In(NlM! A) and In(Pn IP. )
are both apparently first-order nonstationary,
a cointegrating relationship could exist between them. Should cointegration exist. least
squares estimation of equation A.l would
provide a consistent estimate of (J (Stock
1987). When the cointegration tests of Engle
and Yoo (1987) were applied to our data,
however. the null hypothesis of cointegration
was strongly rejected.
Given the apparent first-order nonstationarity of In(NlM1A) and In(Pn ' p.) and the
I'wc ral Kc."K n ·1: IkInk o r Da U;tS
apparent absence of cointegration between
these variables , we conclude that the difference form of equation A. 1 is likely to lead to an
amenable statistical specification with meanstationary errors-namely, a.1ln(u,).
Though mean stationarity in the regression errors may have been achieved by differencing the variables In(NlMl A) and In(p./Pa ) ,
there still remains the problem of jOint endogeneity between the regression variables
.1ln{NIMl A) and dln (p" Ip,.), as well as the
heterogeneity of the errors a.1ln(u,). With the
mean of the errors a.1ln(o,) taken to be
nonzero , the initial regression equation was
(A .2)
d In(N I M1 A), = p, - P, d In(p, I p, ),
+ 810 11 + 820,2
+ 830 ,3 + 84 0 14
°/ +£/.
+ 85
5
In equation A.2 , p, represents the
nonzero mean of adln(o,), /32 is defined as G ,
E, is defined as GJln{ lI,) - /31' and add itive
dumm ies 0 '1 through D,s allow for structural
change at points of NOW account deregulation. In particular,
O/1 = { OI'Omnol:07312
·lOf740landtnefNft8(
O12::: { Olrom73olI07602
11(11" 76 03 and lhelei'le<
ments considered were (individually) the
lagged values of L1In(p,,1p.), dln (NI M1 A), and
dln(p. ) in conjunction with the constant term
and the additive dumm ies 0 ,1' ... , 0 ,5. Auxiliary regressions of the right-hand-side endogenous variable, .dln(p"lp. ), were run on
up to four lags of a potential instrument (always in conjunction with the constant term
and the additive dummies). Using the adjusted R 2 as a criterion for selecting lag length
as wel l as for discriminating between potential
instruments, it was found that the best set of
instruments was the first and second lags of
.1ln{p" 1Pa )' together with the constant term
and the additive dummies.
Because the number of suggested instruments exceeds the number of right-handside variables in equation A.2 , we have the
case of a surplus number of instruments. Of
course , with the availability of a surplus number of instruments, efficient estimation is
achieved through using nonspherical IV estimation , which appropriately adjusts for the
heterogeneity in the errors (Bowden and Turkington 1984, 74). Nevertheless , the spherical
IV estimator will produce consistent residuals, which can provide the basis for properly
specifying the var i anc~ovariance structure
of the I.., for use in subsequent nonsphericaJ
estimation.
The prelim inary consistent residuals, [I
= (dln(NlM1A),+ p,dln(p,lp. ),- 0,0,, ... - b50 IS }' generated by using the spherical
IV estimates, besides reflecting the grouped
heteroscedasticity associated with the regression variables Aln(NI Ml A) and .dln(Pn IPs ),
also indicated substantial temporary interventions. (See Vandaele 1983 for a discussion of intervention modeling and the various
possible types of interventions that frequently
occur in time series data.) The interventions
occurred on the dates 73:01 , 74:01 , 76:03,
78:1" 80:01 , and 81 :01 , coinciding with the
successive dates of deregulation of NOW
p,
011078 10
O13 = { Olrom73
110,18 I I and therea' ler
01\07912
O/4 = { Olrom73
110r 80.0 lapdthereal1er
Olrom73olI08012
O/5 = ( IfOf8tOlandtherea'ter
Still , £ is possibly heteroscedastic, given the
observed grouped heteroscedasticity in the
variables dln(NlMl A) and dln(p, Ip ).,
To obtain conSistent residuals £, from
equation A.2 , spherical instrumental variable
(IV) estimation was implemented (Bowden
and Turkington 1984, 68-69) . The instru-
.
II
accounts.
From this preliminary residual analysis,
a final regression equation was chosen of the
form
(A.3)
,,In(NIM1A), =p,-p" lIn(p"lp.),
+ y, ,I" +
+ Y'3 /
+
y'2/1-1.1
2.'
Y22 / ,-1.2
+ Y2,1,2
+ 123'/-2.2
+ Y3,"3 + Y32
/- 1.3
'
+
Y33 / ,-2.3
+ 141'/4
+
Y42 /_1.4
'
+ r43'1-2.4
+ ys,I/ S + YS2 / -l.5
+ Y53 /1-2.5 + ,Sl'tS
'63'
+ YS2 /1-,.6 +
1-2,6
+ 0,0/1 + 820 12
+ 03 0 13 + 04 0/ 4
+ 05 0 15 +£/.
The only difference between (A.2) and
(A.3) now is the Inclusion of temporary inter·
vention dummies I". .. "
along with the first
and second lags ot each, the lags included to
account for the inertia in the temporary interventions that is indicated by an analysis of the
residuals. Evidently, the money market ad·
justments to NOW account deregulation were
not instantaneous. The intervention dummy
I" takes the value 1 for 73:01 and 0 otherwise.
and are likewise
The dummies
defined according to the intervention dates
74 :01,76 :03,78:11,80:01, and 81 :01.
',6
"2' ',3' "4' "5'
"
"6
To verify the heteroscedasticity in its
error term, equation A.3 was estimated by
using the spherical IV estimator while augmenting the previous list of instruments with
the intervention dummies and their first two
lags as welL Again the resulting residuals
were examined. As expected . the intervention dummies and their lags adjusted tor the
intervention behavior at the IV residuals
(driving the residuals at the corresponding
intervention dates to zero), and the grouped
heteroscedasticity still remained. Auxiliary regressions involving the nonintervention residuals on their lagged values did not indicate
significant autocorrelation. Thus, the heterogeneity in the errors (after adjusting tor interventions) apparently is of the "pure" groupedheteroscedasticity form.
In a final attempt at achieving efficient
instrumental variable estimation , we chose to
use a nonspherical estimator (Bowden and
Turkington 1984,69, eq. 3.3) and to model lhe
variance-covariance structure of the regression error of (A.3) as being of the groupedheteroscedasticityform. The instruments used
were the same as those used in the previous
spherical IV estimation.
Given the assumed validity of equation
A.3 and the specified grouped heteroscedasticity, it follows from the Generalized
Gauss-Markov Theorem (Bowden and Turl<·
ington 1984, 74) that the nonspherical IV
estimator is asymptotically more eHicient than
the spherical IV estimator. The nonspherical
IV point estimates 01 the parameters of equation A.3 and their respective t statistics (in
parentheses) are as follows :
F«kul Kcsc .....·<: 'la nk of Oallas
lIln(NlM1A), ' 0.01813 - 0.21409l1ln(p",p.),
(1.8674) (1.3333)
The basic monthly data were obtained
from the Federal Reserve Board of Governors
and span the period January 1973-May 1988.
+ 0.231571/ 1 + 0.076601
(8.2063)
(2.0497) "' .•
+ 0.0370911-2.1 - 0.037521'2
(1.3184)
(- 1.1108)
- 0.0437011-1.2 - 0.00606/1-2.2
(- 1.2833)
(-0.2052)
+ 0.07080113 + 0.0898511-1.3
(2.6385)
(3 .3366)
+ 0.0350211-2.3 + 0.18897114
(1 .3068)
(4.7413)
+ 0.184721"".4 + 0.16253/1-2.4
(5.0113)
(1.8171)
- 0.192321'5 - 0.01299/1-1.5
(-2.1336)
(-0.1441)
- 0.14996/1-2.5 + 0.336571'6
(-1.6436)
(3.9293)
+ 0.20069/1-1.6 + 0.04383/1-26
(2.3291 )
(0.5099)
+ 0.02550011 - 0 .006890'2
(2.3326)
(-0 .9354)
+ 0.01865013 + 0.01100014
(0 .7080)
- 0.052880'5 +
(-1 .8405)
Economic K..""·ic.... -
M ay 1990
(0.2860)
2/,
.,
References
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103>-56.
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EconomJc Review-May
1990
"
Mine K. VOcel
Carol Dahl
Senior Economist
Federal Reserve Bank 01 Dallas
Associate Professor
Louisiana Stale UniverSity
Reducing U.S. Oil-Import Dependence:
ATariff, Subsidy, or Gasoline Tax?
ntTC;I .,~·d
oil import:- Ita\ l' GH I:-..:d gl'O\\ ing
yL·:II·~. I.ow oil priL:L'''; l'r)COll r;rgt:d nll1~umption. dl'LTl'a~l'd dOrrre~liL: oil pro·
dunion, and It'{! to higher irllport~ BecaUM: ll.S.
or! l'iL-kb arc rciatin'!y m;Hurl', ,Ill' (h:dinc in
durn(',,1\' produl'fioll and l" p lor;Hion \\'il1 n>nlinllC, nt.':ltin,g ;r morl' "l'riou, oil-import prohlt:1ll
ill Ihl' fullll'l'
A di"rupuoll of oil I1l1pOl"b o r ,harp inlTl':r"l" III world oil prin'~ could adn:"I'St:ly :rlfl'('1
11ll' l ' ~ l'Conorn~ 111t.'rdof\:, "ollle oh.-.ern:r:hdil'\ l' Illl' L'nrll'{l SI:IIL', ,hould n:<llll'e import:h~ fcduL:i ng l'On""ulllplion :rnd pfOtL'{'linl-\ till'
(\11I11l'., tic oil indlblry, Thrl'l' rlll'a,un,'" ha\l'lx'1..'n
"u~c"ll'd 10 10\\'1;'1' U.S uri Import.,: o il -import
fl'e~, "uh!'oidlcs 10 dOrlll':-lit' oil pmdul'ef!'o, and;tn
in('rt:a~1;' in Iht: ga-'(llim' 1,1'1: I Initially. Ihl·-.c:
pollne . . \\oul(\ 1I)\\t:r ('ul'1'('nl lInport ... by eithl'r
rl'ducing con'lImption Of inCl'L':hin).t dOI11t"~tic pro·
dll('liot1 Thc tariff would InLTl':hl' pfoduction and
tlt:cn.:ase n)l1~I\lllPti(Jrl. till' . . . ub~idy \\oukl innt:a..;c hOlh pro(\ul'lion :md C011,""I11Pliol). and 11lL'
)o:;I.~olil)e tax would n: dll('(' hOlh production ;mc!
nm . . . umptlon .
BeGlu~ tht' l()n~ 'll'nn d'k'ch of Iht.'Sl· polidc!-o may diffcr from thl' .~h(jr1-tl·rnl cfTt'cts, Wt'
dl'\'i:-cd;r mca .. urc of t·.S. nilncr;lhitity to oil,upply .,h(X'k.., and 1r;1('L'd Ihi" nll':t,,>Ufe O\'t"r linlL'.
\,\'(" nl!l"idcred thrn' ";fl\-'cilk ptllit'ie~ di!'ol'u!-o,';l'd
h~' polil'ymakcr"-:r 2":i-pl'lu'nl im porl t;lriff. a S')flL'r·llarrl'! "uh.. idy to dome"til' oil producer:-. :lnd
;rn in<.:rc:l!-oe in the ).(:t!-oolim' lax from 9 cent:- 10 1":i
ccnl.~ pl'r ~allon-;I nd dcll'nninl.'{l which policy
\\ould m.lkc Ihe l 'nill'{l !'>Iall':- lL'a!'ot \ ulnt'r::rhlc to
oil':-lIprl~' disruplion:- ha"l'd on ollr llle:I.,>Ufe of
I
umn.:rn in rCL:l'n,
F.conomJc Rt,,\'!cw -
M ay
1')90
nrinerabililY . III :In l'ar!il' l papr:r ('{lied and D:lhl
191-19). wc C\'a lualr:d thc t'o"ts of Ihesl' polkit:...; in
Illl' ab..cn<:c 01':1 disruption In lhl.~ :l rtil'k-. \\'l'
<ll'tennillc the henefit.... of the p()lidt:~ in Ihe crSl'
of;t di . . . n..rplion.
A vulnerability measure
\"'e nll';l:-lIfCd Illl' l llllll'{l SI:IIC'>' \·ulner.thility
oil·.'u pply "IIo<:k . . h~ Ih(.' ch:l1lge in l't'onornit'
"elf;rre resulting from ;r l'h:Ulgl' in import . . , Wht.'fl'
11Y.4f(/rt' b dcfinl'{l :\ . . (.'onMrl11ef plus prodtKt'f
:-lIfplu ..., The llle:\"Ufe c.tkulates the C()~I of ;tn oilsupply ~h(X'k for t':lt'h Yl';rr in a 50-yeilr lillle hori'
zon. Thus. the co,1 for l';ll'h },e;lr is Ihc Ch:1I1 ~C in
\\l'lf;1rt: if lhe lii:-rtlplioll had occurred in [h:1I
p:lrticubr year \'ih- cl lnll;l[ed the vulnl'r::rhilily
rnC;l.~url' undef l·tlffl'lll policy and wilh each of
the proposl:'d p01i('il-'~ 10 delerminc wh~lht:r tilt"
new poli<:ie!'o \\Ollle! I'l·duct, the CO"tS of an oil10
We WOIJld "ke 10 man/( Sreph(}(l P A Brown. John K H,II,
Ke,m R Ph,II,ps and Mark Frf)fICh lor helpful convnents and
d'SCUSSIOfIS and Dav,d NBnns lot excellent research
assislance
rile US Senate Fmance CctrmItt!!B protJOSed an oil·
Jt1100II fH II 011 IInpOI'ts WCfO prOfOC/6(J 10 exceed 50 per.
ccnloldlJmand (L8ngIey 1981} Pl'CSldenIGeotge81JSh.1Il
hss csmp8'f1'1. suggested a S1Jl)Ss(1y 10 011 and gas produc ,
ers ReprCsertlill've DanteI Roslenkotl'sk, rf!COfflfT>ende(
ncrCBSUlg lhe CUIT(}(l/ 9o(;f1f11 C~ctS6 tar 011 gasobne by al
leaSi 15 cents pet gallon (Blmba<X1l 1990. 1989} Federal
ResCfV9 C/laIlman Alan arfJCfIspan also argued mal
a
f}BSolJM liJX WOUld do 'less harm' than 0If1ef /eWc$' ($loot
'989)
.7
supply {h:-ruptltlll !
Tht: 1lli,.·;L,urt: of \'ldn ...·I:d)ilily dqx:nd, o n 11K'
dOIllt::-tit· pri!.:...· of 01 1. tht: ~Iur...' of illlport,.. III do1Il...·,..tit· {·on,umptlon . ;md till' da'liciu...·:- of supply
:.nd (kmand durin).: till' di~nlpllon A 10\\ im port
.~hart: \\ould m;lk ...· thi,.· l ·nih..'d ~1 ;Lt ...·, k:-., \·ulnt:r;.hlt: to :10 o il-:-upply ,hoek. :md a hi).:h lIupon
:-han.· \\()uld lllakL' 111'..' t 'nit ...·d Slalt:' m ol"\.'
\,u lnt:r.lhk
\·ulnt:l:th,l ilY j, It:.,:- \\"1lL'n {km:md :md supply l'1;1~lidIK':- art: hl).:h 1\ high (k-mand t:b~lil"ity
1l1t::!n, th;1\ do.~t: :-uh."tllul<::- for oil :11\: :1\ aibhlt: 10
con.,umt:1"'o if ;. :-u ppl)' di,ru plion ocem:-. 1\ high
... uppl y da:-lil"il)" illlplit:.~ Ihal dO!m::-lic pnKll1c...-r:could r...'spond ljl1it·kly 10 a ..... ,]1ply di:-nlplion by
innt::I... ing d(lllll·sli{· (Iii pr<J{iUCli(1I1 In 1)(1111 C;IS...·S.
:1 Illajol" r""(itKtion in for...·ign imports would he
k-,.~ . .u ...lly for 11](.' lInil",'d S[:ucs. B',:C:IU't: Wi,.' cdnl lale till' drL'eh o f ;1 t . . . mpora ry diMuplion. \n·
u ......... sholl-run ",'bsli("t[it:.~ in Iht: mt:a,urL'
How Ihe policies a ffect vulne rability
!'()Iit it::- Ih.u (·han).:...' d()ml'~tic nm~utl1pli(Jn.
dom . . . :-Il(· Pf(){.iu'·llon. or Iht: 10n).:-1\m supply t:bstieilY in :1 ).:h·. . . " yt:ar :llfo.."(·1 ndnl!r.lhlliIY tn Ih:n
y ...·a r To Glkul:tw tht: n llm·r:.th illl} lllL':I.... ur...· \\ t:
Uli lizi,.,(l tht: r ...•... lI lt ' of our fOrL'l"a"lill).: m(xld.
\\ hldl Gdcubt ...,... OIlIpUt p:lIl" for Iht: Or).::lIl iz:tIlOn
of P l'lro!...·UIll Expt.)11ing COlln lrit'.s (OPEC) and 111('
l ·nilt.:d Slalt:', rh l~ Iht: prict: p:1I11 of oi l for the
Ihft't: roli(:i. . . ... and for :I hast: C I ......' (.~('i' I /)e I)(n·
rilled ·· W·ol"/d Oil ,I/odel") \'iI ...' itknl il"it.:d lilt: h:I.~L·
(";I'l!:t~ (·UITl'nl policy. tlK'n impJ...'Illt:nll'd Illl'
Ihrt:t.: policil.'.' 10 dt:[t:1"1l1ill(.' how lilL'Y ch;lIlgL· Ih. . .
pIke :md Olltpul p:IIIl ...
For . . . :[(.:h policy. \\... . . pelformt'd a s~'nsiliviIY
a!l;IJy.~i .. using a \·a fiL·I Y of ~h()rt - rlln dem:lIld :tnd
supply t:1:t~lkitil!."" T IK' sh(Jn- run pri,·c elaslid[it:.~
We mod,/,ed IIle measure lOt /lJe Ihtef) pollocs 10 1flC/vae
subSIdIes 8Ild lax and lar,ff fCo;erlUe5 The appen(Ju. PIe-
sents Iflos procC<Jute
Notdh81.lS ( ' 980, iJIId Hog/lfl (1981' a S5(ll)ll mat the shott·
run elastICity'S OI"le-lenrh me Iong·run elastlClly Btown and
PnoIIops (1 989, hod a lac/Ot 01 one·seveom We C()(>dvclec
a sensolfV'ty 811afysls uSIng laclOts langrog /rom Otl&-lIatf 10
,.
one·t"'f!fIllCtn The lesulls reponed ., rtlIS al/tcle ale With a
laclOl 01 OI1C-lenth
World 011 Model
We use a dynamic optimal control
model set in a partial equilibrium framework to simulate time paths for oil prices,
oil production , and consumption. We
model OPEC as a dominant firm facing
U.S. total demand for oil, less U,S.
domestic production and non -OPEC
imports to the United States. Domestic
producers are profit-maximizing price
takers in the crude oil market. Both the
United States and OPEC own reserves
and maximize the present value of profits over a 50-year time horizon. We
simulate the paths of the variables using
an isoelastic demand function for crude
oil with a price elasticity of -{).9 and an
income elasticity of 0.8. The demand
function was derived from domestic
demand for products and normalized
around 1987 demand. The cost functions lor OPEC and the United States
were also normalized around 1987 production costs for these regions. We assumed that U.S. income would grow 2.5
percent per year. The discount rate was
5 percent. t
For lhemathemat>eal &p9C,he:allOll oIlhe problem and
the spec,foe: Iunc:honal IOfrTlS . see Vocel and Oahl
(1989)
of dt:mand u"'L·d
III our Cl il"ublion of I Ill· \·llln ...·r:Ih ility I11C:I.'-llrl' ar . . . lakl'n 10 Ix· \':triOll ~ fraclion, of
th ...· long-ru n t!""ma nd L'b:-liciI Y. a., .'-l11-t}:c'fL·d by
til\." t:conOlllK .S lil ...·r:llur...· , Tht:,t: t:b~liL"itil!.s do not
vary a\."l"O,:-- poitcii,.·,
Enmomi...." ).:t:nl'r:.III} find Ih ........ !tot1-nm
supplr ...·b .. linly o f oil to lx' \.i,.'I). low. ranging
IX·I\\ ...·L·n () :lnd () I . IIllplyin~ a \ cry ,mall olHplll
rl'''' I")()1l~ 10;1 prit't: dl:tngc (Ilo~:11l 1981. :Ind
Bro:.thll:tll :uld " o~,tn 19WH. Tht, ...mall OUIPU!
rt:~p(Jn.sc.: 1"\.: ... \111:- from \ .... J!. h i~h Ct p:lt·iIY uliliz:llion r:11 ...,... in 011 pr(XIUClion [n til\." ( .;lX' of:1 di,fuplion in Ill1 pOn:-. hO\\ L'\·t:r, thL' prie~' inl'fl':lst: i:-
Fcdcr:al Rcse rve Bank of l)aUas
:111
un~XI)cl1e<11'oh()11-tcrnl
\\ lIldfa ll for till" proonc mit-tlt1 i.:xpt.'ct donK·stit·
produ('l-r.. to dr.lw from pm at~ !'Iockpile!' 10 t:lke
:ldv:tlll:lt-te.: of Ihe.: tl'1ll1'X)r.lry price incrca1>!..' Ht.·nCl'.
the !'iupplr da,>tidty I.:ould Ix: fa irly hiAh,' \'(Ie
clkul:ltt.·d the \\dfare co... t ... of a .. upply shock
u .. mg ;t \'ariety of .. hOt1-rl.ln "upplr d:t~t ici tk:-.
r.tnglllg fmlll 001 to.t Thc ...,.: da .. ticil ies arlO
ohl:tlllL'd hy I~kin~ \':triO\l" fr,II,:l1Im .. of the.: Hlpply
d:t ..tidtil·" Inherent in till' .. irnui:lt ion ...
Base casco L'mk'r l'\lITCIlI policy. oil prin:..
... tart at $20 per h;lrrl'l (1Il 19~ - dollars) and rbl'lo
SKo~6 pCI' h;md in ";0 Yl'ars (CharI )), Simuhlll·d
U.S produ(·tion cb:l inl's fairly ...Iccply d uring I Ill"
"iO-yc;tr linK' horizon (() a houl 19 pcrcent of its
initia l len:1. whik O PEC protilll.'tion is f,lirly .~t:lhk
(Chari 2) Fin:t] OPEC production is on ly <.)2 pl'rn:nt of i1.~ ini ti:ll Icn;:1. rl· ... ult ing fro111 OPEC's \'c ry
high 1e"l'l of rc ...elYC." ('oupk'd wilh rl'l:ttivdr 1()\\
and ... Iahk pr(x]uclion co .. t-.
Thl' u.s im]'Xm .. I!;tfe incfl,::tS!.:.·o; steadily
th roughout Ihe -;O-year tinK' horizon 10 9·, l)Crccnl
duc~r
In .. uch a
(·:hC.
or nm"'llillption :t~ (J , ~
rCM.·f'\'l·~ :lI1d output
dwindle and prod lin ion nl.~h
'o():lf
1111;" welfare
co.. t of an Oll-Sllppl)' (h.. mpl ion. h:lsed on our
Hllnl·r.lhihtr IllC:.... Ufl·. abo innl·:t"<;·... Ihrol1~h time
du(' to IIlL' dedinc tn dOllll· .. tic p roduction :tntl ,ht·
inn!..';I' ...· in IlHlxms (Ch:u1 .H Ch:Uh " and 5 sho\\'
Ihl' pnc(' p;tth:; and dOIllC'li(' production p:lIh:-.
\\'ill1 thl' h:l"C ca:-c :lnd Ihc Ihrce IX)itc-ics analyzed
i n till." anidc
Chart 1
Price Path lor the Base Case
Pll ce IU S dollars)
'00
Chart 2
Output Paths for the Base Case
ProductlOl1.
bollton ba.rels pet year
,
OPEC
2
United State s
oL-~=======:
1987
1997
2007
2017
2027
2037
Tariff. 111(; 2-;-jX!rCl:11I tariff increa'>l'1> thl'
dome''''ic pri(c of oil hy appro.ximaldy 7 )X'rct'nt
to Ihl' carly }'l·:Ir.-.~ T be h ighcr pricc1> lead 10
hi~hcr U.S production. resulting in an earl ier
dcpktion of Ihe l'esouTl'c. h i~ her produclion
costs. and suh"<;'qllenlly a lower produo ion r.IIC in
Ihe fUlllrc. O'·er.lll. lOl al dl'>COllntcd U.s pr<xlucer
profits ovcr the -;0 ye:lr.-. increase hy 118 pt:.·r<.'t'nt.
OPEC. howe\'l'r. i ... wor.-.c off becau:)t; it ahsorbs a
br~t" r ... h:lrc 01 the 1:trill wilh 10lal discounll'd
profits falling hy 29.2 jX!n·cnt.
By Tcdudng t:on .. umption and incrt':lsing
dOIllCSlic Imxlu{·llon. thl' lariff decre:l1>es illlpon
sha res Inili:11 IIUpOI1 ... hares wilh thi: ta riff :lfl'
lower th,11l with th!: b:l.~c ca:-e for about 40 years
(Chart 6), As de.:pletion dfccts reduce dOI11l'stic
production nl';l!' Ihe end of Ihl,; lime hori zon , Ihc
eo
..
• Tho Umle(J SlalC!; llisa has !;/OCkp!lcs of 011 m /he SflaleglC
F'rllroH!um RC!;CfW If tho Icdcral governmenl drew 011
from me StrategIC PeI.cHum Reserve dutmg an 0II-mp0t7
a,srupJlOfI. lho 100ai dotne!;/IC !;VppIy re!;p(J(l5e would be
.e/8t",ely more elastIC
20
oL---________________________
1987
1997
2007
Economic RevieW_ May 1990
2017
2027
2037
• In our model 01 m.oilmatket t'ICJiI-OP£C mpotlS of oil are
IIcpt CO'lSlltnl III tf'/eIf 1967 levels If non-OPEC imporl!;
were II IuncllOfl 01 prICe. /tIefl a U S 18"" WOUld 1e8d /0
samewha/ fItgher domestIC prICes 8fId a smaller decline in
world oil ""e(]S
"
Chart 3
Vulnerability to Oil-Supply Disruptions,
Base Case Scenario
Vulnerabdll~
MeaSUfe
900
800
700
600
500
ElastIC Supply
' 00
300
200
"0
f9 87
1997
2007
2017
2027
2037
d t.'cn:;I ~(;
If) impon ,~h: l rc:-; hecomt;:s mort;: modest.
tari ff .11-.0 lowt:,"" the \ 01:11 o il-impon h il l
1X'C:IlI!'>(.' il de(,:n.:a:-L'''' !hL' \\ o rld p rin' of oil
Wlw n a di,ruption in o il i m pon:- (X'("UP.> ,
ho(h (un!'>u llIcr ;md p rod llCcr p rin's i ncrt.':I~. If
dOIllt.·... ti(· p r<X h K C P.> are vcry unfcspon:-in: 10 the
n it i n oIl Illllx lO _ tha t i:-. if the :-hon-nm :-.upply
is inda:-t K--n m sll me~ bear mo~t o f the price
inn"'-:I'-\.'. PnxllK cr.- arc hell\!r o ff \h ;m constllllt:r..
after :1 disruption 1)(!C:HI ~e pn:x1ucer:-. TCe<:I\'(' a
h igher pr iet.' for IhL'ir n.:b !ivd }' unch:Hlg/;.'<.! kVL'1 o f
out p ut T he highn price:-. :lIld lower d omt:stic
consumption \Villi Ihe 1,lriff dam pen Ihe loss i n
CO!1SUlllcrs' .sllrpll.l .~ duc 10 the sud den disruption
in oil su ppli\!s. T hc o ve l~ tl l wdbr\! co.~ t o f Ihc o ilsu p pl y :-;hod.;. ;t.' ctlcub1Cd by Ollr vul nt:r:thi l ity
IllL': I.~ UI\· , is lower wilh thc I;tri ff th:1I1 wi th the
hast: ca:-e.
On Ihe otlier lwnd , if do mesIie su pply is
n :ry (: la:-;Tic and respo nsive 10 a cut i n imports.
d()[llt::-;tic Oillput L'xp<T nd:. 10 fill the ga p crt:.':lIed h y
rt:duced impons, and consumer p rices risL' l iul;.: .
TIlt."
Chart 4
Effective Consumer Oil Prices,
Expressed as a Ratio to the Base Case
Prices
1.25
1.20
115
1
..==::::::::::::
10 ~"~~~'~11__________~=="
t.051 _______, .. .~::::::::::::::~::;::::
t.CO
t
Base Case
The ptescnl varve calc..-arlOf1 a5S(.mEI$ an eaval ptooatJil.
Ily 01 an OI/-$uppI)' d<$lUpl1Of1 fey each year .wl lhe 5().year
95
tme hotl.lOtl
90
A downward $hdt r!lal IS fIO/ parsllellO the /IlI/,SI demano
funcll()tl would lead 10 SIJC/) a resu/f fey
20
rL' ... ultinl-t in w tin ~ in producers· ...u rp l us and small
los.x·:-. in con:-;ulller.-· , urplu ... Al-t:.li n , thL' wdf:m:
("{):-t i:-; 1;.::-..... with the l ariff tha n \\ il h 1111;.' h:I,t: (';I:-'L',
alt hough IhL' difference l)(!twcen the two li me
patlh I~ ...OI11L'Wh:1I lc:-.~ Ihan in the inda-;til' l':'h e.
Tilt: lotal p fesent ,·:11(11..' of thL' vulnL'mhility
mL':r"'ll ft: O' L'r the enlire IJlne horizon r:- always
1L':-:- w ith tilL' tariff than w ith the hast: (';1'><.' ." The
d,,'crea ~L' TO tht: "ul n\!rab ility Illca ... Uft' range:- from
I I 'i rx.'rn'nt in thc case o f "('ry ind a:-tic Mlpply to
2 I pl..'rccnl \,·hl.:l1 :-u pply h highly d aslic
Subs idy. A S-;-pcr-barrcl :-.ubsidy \0 t!omc:-;lic o il PIl KhKL'TS lowt;:rs prices in the .~h()rt tL'nn
hut 1~ li .'-\.' ., lo ng-It.'rm p rice:-; for oil. Tilt: :-uhsid y
IO\'·L'rs the d fe('live co,~t s To o il pnx lu("\!r:-;. 1hus
d r; I.~ l i (,·a l ly in(TL'asing in iti:11 U, S, oil p n Kl uCli( m .
T hL' role of thL' suh-;idy :IS a ca t ~l lyst \ 0 d OIllL'stic
p roduction (1;.:t.·..e:l.,es with timc ht:("au .~e thL' suh:-;id y j.., (·OT1st:lnt and iI.' d isco untcd value dcc rL':'ls<:s
I hrough (illlL', A., WiTh the ta riff. incr\!:lsed pr<x1ucl ion k a(b to L':l rlief dep ictio n of rc ...o u n::es. h igher
(·o~ [ s for l '.s pnxlucers, and cu n ailed p r<Klun ion
in 1aH.'f years Alt ho ugh sim ilar to the t:triff C:bL'.
thl' :-llh:-Id y m agnific ... these d lt.'ct:-.. Stl rpri,~ ingly .
tIlL' ...uh:-Itl y also i ncrea:-;es O PEC p nxl u('lion in Ihe
l'arly ye<TfS. Innc:l -..cd Li.S p rodu('tio n in tilL' C:l rly
yL':II~ n.'dut:l'''' O PEC's m arket sharc. i ncrt.'a:-.('s
O PEC':-; (kllland d asticilY, and results in higllL'r
O PEC pmdUt""l10n -
a monopolist
Subsidy
851--_,----,-_ _ _,----,-_ __
1987
1997
2007
2017
2027
Fedcl1Il Rcsco 'c Bank
2037
or Dallas
Chart 5
U,S, Production ,
Expressed as a Ratio to the Base Case
'"
Gasoline T'1t
lO': F~2
Base e.se
90
Tan!!
80
7',L,c---~=c---ccc:----c-:=:::::c:~-c"
1987
1997
2007
20 17
2027
2037
\hhollgh th ..· ,uh"id~ 11:,,, 11ll' It}\\',,',,1 irnport
,han: 0 1 th ..· Il1rn' poli(lt·, 1'£11' thl.: fir-I [hr......: ~ ,,':Ir:-o,
,mlx)rt "har..·" q Ul d..I~ h..Tom ...• high ... !' wilh I h..,
"uh"l(h Ih;ln \1 ,Ih "'llh"'r Ill\.' 1;lril)' o r Ih ..• g:l"olin ..·
1.1' 11K' "ul h,(h ..'lln,u!':I).:..·" ("(llhlllllplion h~
IO'\I,'ru1g (,OIl'lHlll.'r pri(I.'" Th ... in«...;,'>1.· i ll dOllll'''It..' "\Ippl~ mor.., 111;111 off..... ,,, Ih ... in<'TI.':" I.· in (on:-OUIllPlioll in Ihl.' "'arly ~"';I r'. Ih ..: rl.'by lo" ... ring
imlxllh. 11011 "'I l'r. l11('r,,';I'I." In 1'101II ('on.,u l11 ]1' ion
and :-upply k'ad [0 a qUit. k ... r dl.'plt.'lion of Ih ...
dom""lic IV'><lUn ... h,t...., .1Ilt.! h igh ... r illlport ... in
rUlli1"\.' r ..';lr, TIll' h)I,,1 (("11.1' o i l import" i:- ;,1,0
high... r \11111 th .. · 'lIh:-oidy 1)l'CltI'... 01':1 higlll'r
\OIt.IIIH: t.f IItll)(1t1'"
TIl\.' :o.1I11." til 111\\ ,,'r, Ih .. · nJ,,1 ()f:lll (Jil-'\Ippl~
di'J'UPlioll for a :o.hnrl lilll ..· if ,hon-run :o.u ppl y h
ind:l"lil' Th ... 101\\.:r i lllport ,h:IIL'.' 111 the l'arir
Y... :II·" hl'lp (ll.'''-'''..';I'I.· Ih .., 11I1!l\.'r:lhilit\' rll ...asu r..: As
i mpOrt:o. Ill(rl.'a'..· III I:ltl.'r Y"':l r, . hOI\ I:\'I.;r. oi lsllpplr di'rUplicl1l' Ix:nml\.' co:o.tl~. 'I'll ..· magll itu(k'
01 t he 10.... in I.·Olhlllll ..·I.... 'lirplu' j" higlH:r \\'il h
tIll: sllh.,i<h' h,,'{';HI'l' of imn:a, ..'<1 <lollll'"ic ('( m,umptioll 1klKl'. ;1 dl:l.'i'l.';i'''· III imptJlb "'qual 10
Ihl.: uriff ('; ' '1.' 1\ ,II 1~"\lh ill hl~hl.:'r ('OIl'UIlK'r
lo,~c', ;lIld Ihc (,(.,,1 (11'.1 dl'l'llp' ion. h"'l.:d 0 11 (lUI'
\\ll ner.,h ilit\ 1Il\.':I,ur..' 1\ ti l hI.: hl~IH:r \\.11 11 th ...
'uh'id~ than II illl Ill ..' t:,rif1
OOIllt.:'11l prll·..·, \1 ill 1101 IIltrt:'a'... 'lIh'I.11l[i;llI~ if demand I' \"'ry d .I~ li t. and ('OlbUIlK'r
Economic Kt:\'lc w -
M :I)'
tm
IO'.' l'" \\ill Ix: \I.:r~ '1ll:11l \'("itl1 Ill\.' lar).!e i nLTea:-.1.:
in dOIll""'K OUtput. Ill\.' :-OUlbld ,... , p:lid 10 domt'!'otil
prod m .... r-. II ill inu-c:l't.: !-!1'.."ll ly. :ll1d Ihl.: policy will
,tI\\;I\'" IX' more co",tlr [h;lll Ihe h:I'I.' l':'~<" III the
,,' 1 l'lll t.f :111 ()il 'lipply dl'rupti()Il 1'11 ..' !()(;iI pr(o'.~1.'1lI \:tlu ..' (If Iht: I'ulm:r.lbilily 1I11_'a.,ur<.: j, ;,I\\:tys
higlll'r ilun tilt.: lM'1: (-;1'>1.' \11111 Ih ... ~U l hid~.
r,,·g;l rd k ..., I I I d:l.,ti('ili ..',
Gasoline lax_ An illlrt:;I'>I.· in th ..• ).,:asoline
1:1:\ from 9 t.:l'nI:-o [0 1; n.:Il'" pl.:r gallon drivt's :1
III.'d).(1.: l X't\\'t'C1l p roduc ..... :111..1 ClUl'llllll.·r pnn;:s,
II ilh I ll\.' i lll..n::I'", III ('On'l lIlll.'r pri('t:~ 1:l r).,:t:r Ih:ln
Ill.... dl.·crt."I"t.: In produccr priCt.:~ Bl'CltI.'e th .... di,.,lOUIlI .... d l.tllIl' of Ill ..· prcKlm·..'r:o.· I.IX lia hility
d"'l'I'''';I'o.:.. lI'ilh lim ..... [II ..· gasolin ... I:IX in dfec\
pO'lpon .... ' ! ,S prodll ~'liol1 T IHI:-o. dOIllI.·.' lic pro,
dud ion tll'dint::-. only in I II .... l.'a d)' y...:,r,."
Til.... g:t,>ol int.: I:IX 101\\'1':- illlPlJll " hare.' o n :r
I ll.... \.'nlirl.· l illlt.: horil.on TIll' I:IX r..·dlll'l:'" both
('( 1II'Ulll pI IOI1 and d()IllI.·:o.lit I)f(Klu""l ioll h~
iIKr..'a .. ing tht.: COlhu nwr pril.'\.· ;lnd dt.:LTt.:a:o.mg [hI.:
pf<KllIc ..'r price Ikclll"l' Ih ..· la~ I')(J'l polle.' produ('\ion. 1I111)()11 ,h;l r~" II ilh Ihl: .l!.L'olint.: tax arc
nOI Ihl' 10\1l'... 1 Ll1 Ih..· ..':\rly 11.',1r-. Frol11 (he Ihird
~1:;lr on, bo\\t.:\·..·r. I Ill' ~a .. olinl: 1;1,'1; ha' [h .... 10\1'(;;"1
illllxm .,h:lre of .tllT hl: Ix)li('ll". JIll hiding Iht' ha"",
Ch..' LOI\ IIUpt'" ~h.II\::-. hO\I..:I ..'r, do nOT 11"'('",:0.~;I ril~' IIllpl)' ;t r.."<.lucl ioll III d,'rl' plloll ('O:-Oh Ch;trl
- ,hem., tit;lt \\'llI_:n ;o.hol1-rll n " upplr b quile ine-
Chart 6
Share of Impons in Domestic Consumption ,
Expressed as a Ratio to the Base Case
Impon Share
1 04
Subsidy
1.02
Gasoline Tax.
92 l---------:----:c':::--~
1987
1997
2007
2017
2027
2037
21
Table 1
How the Policies Change Vulnerability: Total Present Value of the Vulnerability
Measure Expressed as Percentage Change From the Base Case
Short·Run
Supply ElastictUes·
Tariff
.01
.06
.&0
.15
1.5
2.0
3.0
-11 .5
- 11 ,3
-10.9
- 9.4
- 7.0
-5.2
- 2.4
Subsidy
3.2
4.5
6.5
12.3
17.3
19.5
22.0
Gasoline Tax
• .7
7.1
4.'
-.3
-3.6
-4.7
-5 .•
· long·run elastIcities vary between poliCIes and over time The short ·run elasticl~e, shown above a.eaverages tor lhe base case.
The actualelasticitlllS vary in proportIon 10 long· run supply elaslicWes lor Bach Ollhe Ihrea polIcies .
b ..tic (;u"Ound 0 .06>. Ihl.: l-t:.,;olml.: 1;1,. "hid)
1()\\I.:r.-. 1I11f>< )n .. harL·:' Ihn)lIglJ(JUllhL' "iO- ~l·ar tlllll.:
horil.on . Cll} Ix: \\"Ol~l" th.Ul Ihl.: h:I"l' ca"L' \\ Ilh
rl.::'I'lt.:Cl 10 d i"ruptioll (·o ~t:.
If :.hol1 -rlIn "upply i" :1~,.llIlll'd to I'll.' \ I.:r~ ·
llllrl.:"ponsiq:: to priCI.: ch;lngl''' I III I hl' l~lI1gl.: of 0
to 0.6). ;t di.o;ruplio!1 in il11POlb I">n'ol11l.:." co."II~
wl\h Ihl.: g:l.,olill1.: lax. 1,0\\ dOllll""IIC production in
11ll' l':u'ly yl':tr~ (·ollplt.:<] \\'jlh l1nrL'~I)()lbl\1.: Mlppl~
1ll:l kl''' thl' l "ni!(:d Sl;tll.:.~ Tl101"(: \ lIlnL"I~lblt: 10 ~llP
pl y"Il<Kk:. If " hon-fun :'\l ppl~ i~ Tl1on: 1"L':.pon:.i\'1.:
to pnn: ch,mgl'''. howL·n'r. 11lL' di~rtlrll()n in 1111pOlh dlX:" nOI IlllTl.:;I"L' nm"llIllL'r prll"l"" \ 'lTY
I11 l1ch T hL" 10\\"l.:r impo rt "h:lrl''' "lI,d 1()\\L'r CO II "lllllpllOn w!l1l Ihl' g;\ ,~()linL" I:c\ lX:l"(Hlll.: Illl"
d0111111;\11I raL'!o1".". and \"llhll' I~lhilily dCLTl'; I .~l"S \\ IIIl
Illl' g:lsoIi IlL' l:IX.
As
Tahk 1 :-.hows, 11K" lolal prl'SL'!l1 \'al lll' of
vll]nl'I~lh llil r wilh l ilt.: ga:-.olinL· l ax dq"X:nd.~ \"l'l!"
l11uch Oil lill;' sh o!1-run L'b~lK" i ly of ~llpp l }' 1iL'-
GHI,.c domt.::.IK prt.J(luClioll i!'> lo\\cr wit h IIlL' gaso·
linL' 1;1-':, Ihl.: pn x lul'n:'>' rt.:"I)(m:-'L' \0 thL' d i"rupl ion
in 11ll1X)lh IX'(:o1lle:-. a dl'ci .. i\'L' fanor. ThL' g,,"~o l inL'
1:1'1; 1llakL'~ Iht.: l'l1 itcd Stall'..; morl' nl l n{'I~lhk if
~h()r1'l"un ." upply i.~ \'lTy 1J1L'Ia~l i<". fh tht.: ~hort-run
:-.llppl)' 1'1;I.~tlnly incrl'asL·:'>. hl)\\'I.:\L"r. I Ill" :'::I-"1)liI1L'
l a.-.: IO\\'L'r.-. dbnlplion U)"lS .
Summary or poUcies, Chan." 7 and H
." how till.' r:tnkHlg." of Ihl' thrl'L' pol idl''' wilh l"L'·~f)(:cl 10 Ihl" b:I'l" {'ase O\'l'f timL' Till" 1:lrill" dl'arl}'
II
Illakt.:, till" l "l1 lll'd St alL".~ Ie"" \'ul lll'r:l bk 10 0 11 "lIppl~ dl'fliP110lh \\ hL"tlln 11ll" ,.hon -run :,upply
rl"I)(ln~L" i" L'1.I'IIL' Of inl'b"lk. The "ulhldy {'ould
IO\\l"r di,rup"on ("O!'>I~ in IhL' :.horl IL'!"I11 If "upply
\\.I~ \L"r~ I1K"b'lK" OIIll"rwbl',llll' l"(),,1 1)1':1 diSruption i" Illghl'" \\1lh thl' sllh~idr 111:11' \\illl I lll' /):1:'>('
GI.~l' ,"'l111il:l1"iy. 11K' ga"olinL' I:LX IO\\l"I'" dbl'uplion
Chart 7
Vulnerability to Oil-Supply Disruptions ,
Inelastic Short-Run Supply (c.::0,06) .
Expressed as a Ratio to the Base Case
Vulnerab.bly
Measu re
'IS
J-_ ...:Ga::::SOline TaJ
110
105
'OO L-__~~______-.~~=I
Base Case
__
~
95
oor~==::;;;:::~~===:~:
~:':'"~~~:;:
.5.~
1987
1997
2007
2017
2027
2037
Feder a l Rcsc: .....c Sa n k o f Oall;os
Conclusion
Chan 8
Vulnerability to Oil-Supply Disruptions,
Elastic Short-Run Supply (E.",1 .5) ,
Expressed as a Ratio to the Base Case
" 0
, 30,]-______________
"0
"0
1.00
trB~'~.~.~C~.~.~.;;~::==:::;~::::::~~:;:::
.90
Taut!
Gasohn. Till
80"---------------------------1987
1997
2007
20 17
2027
2037
CO:o.l"i for about 20 rC;:lf"S if s uppl y is very eklstic.
Yet. the g:lsoline tax increase."i disll.lption costs if
suppl y is very unrt.'sponsive to price changes.
Table 1 shows the total present value of
o ur vulner.lbilily measure over SO rears with the
diffen.:nt policies and different supply e b sticities
The suh~ id }' d early make"i Ihe U n it(.~ States more
vulnel"<lhle to oil-s upply ..hocks Within the nmge
of shun -run supply elasticities cited in the economics liter.llurc (0-0.1). tht: ~psol ine tax is costly
as wdl. Ollr vulncmbiliry measure indicates thaI
the l:lriff is the most effective tool against supply
disruptions. Ilowever, if short-run su pply elasticities :Ire higher, the cost of a disnlption may be
lessened by the gasoline t:IX. Th<: g:lsoline tax
could even dominate the tariff if short-run supply
is very \:!lastic.
Economic Review-May 1990
Low oil prices ;and rising oil imports ha.ve
increased policymakers' sentime nts for protecting
the oil and g"dS ind ustry. In this a rticle, we 1..'0111·
pared the effl.."'<."!." of Ihree possible measures to
reduce o il impon... : :1 25-pcrcent oil-import tariff. a
55-per-barrel suhsidy to domestic o il producers,
and an increase in the gasoline tax from 9 cents to
25 cents per gallon. One objective o f these policies is to n.:dm:e U.S. vulnerahility to oil-supply
shocks by lowering the coumry·s import dependence through dl..'Creased consumption, increased
production, or both. If policymakers want 10
;lChie\'e import independence by reducing consumption, bOlh the tariff and the gasolint: tax
attain Ih:1I goalthrollgh increast:s in oil prices.
Thl' subsidy dl'<:reascs impC)l1 shares through
inc reased production. bll\ only in the short nm.
Based o n our measure of vulnerability , the
. . ubsidy to dOl11l'sti<: producers will make the
Uniwd States mo re vulnerJble 10 Oil-supply disruptions than lmdcr cu rrent policy The t.a.riff, on
the other hand. lo wers the cost of futu re o ilsupply disruptions. By increasing bolh consumer
and producer prices_ the tariff lowers consumption while e ncoumging domestic production The
present ,·alue or (otal vulnerdhility is consistently
lower with the tariff than with the base G IS<:.
The gasoline lax would make the United
States more vulnerJhle to oil-supply disruptions if
short-nm supply is very inelastic and domestic
producers could nol respond to the cut in im·
ports Howevl'r, if domeslic producers could incro.!ase domestic output by fully utilizing available
Gl pacily and by dntwing down priv;Hc ..tockpiies,
the gasoli ne tax could low(;!r vulnerahility. Tn the
extreme C;lse o f very elastic shari-run supply, the
cost of a disruption with (he gasoline tax could be
lower than with the tariff.
"
Appendix
Measure of Vulnerability
In our microeconomic framework, the
change in welfare caused by a supply disruption is the sum 01 losses or gains in consumers' and producers' surplus . At the margin,
this change can be expressed as the change
in imports multiplied by the infinitesimal change
in price, that IS,
(1 )
(6)
VM is a function of imports, the price of oil,
and the elasticities of supply and demand.
One can similarly calculate the following modifications of VM when the different policies are
in effect.
d W : - MdP : qdP - OdP,
Ad Valorem Taril /:
where q is domestic production, 0 is domestic consumption , M is oil imports, and dP is the
price change .
(2)
M : O(P ) - ",P )
(3)
dM= OpdP-qp dP
(4)
dP :
dM
Op-qp
(7)
Mp
(1 + r)(" q- £,0 )
+ rP"',
where T is the tariff rale, PJ is the domestic
price of oil, and Pw is the world price of oil.
Per- Unit Subsidy :
( 8)
VM -
MpDp S + SF p Dq
S
£ , q p O_c0 Qps '
Op and qp are the partial derivatives of 0 and
q with respect to pnce . Substituting into dW
where 5 is the per-unit subsidy, po is the
demand price, and PSis the supply price of oil.
and rearranging , we obtain the vu lnerability
measure:
Gasoli ne Tax :
(5)
dW
M
VM = - :
.
dM qp - Op
VM can be expressed in terms of elasticities,
Z..
rJ
VM =
(9)
VM _ MP'P' - '/FoP Q
-
£,
qpO_e0 Op s '
where y is the gasoline lax.
1'c;til" r ... 1 H~·st:n·c lbnk "f D:tllas
Re fe rences
(Ca m~
Birnbaum, Jeffrey I L (1990), MRostenkowski Backs
Boos! in Gas Tax, Would Use Defense Cuts to
Trim Dcfic i!' ~ \Vall Slreeljollmal, January 3.
cd. David A. D<..-ese and Joseph S. Nye
- - - (989), MRevenue Hunt: Wilh Tax Rise Talk
langley, Mo nica (1987), "Senate Rejects Plan to
Keep Oil Imports From Exceeding 50% of
Dom(.'Slic Usc,· \Vall 5treetjoumal, July 2.
Reviving, Legislalo rs Line Up Candidates,·
\Vall Slreeljoumal, January S.
Broadman, I larry G . (986), ~The Social Cost of
Imported Oil ,~ E"ergy Policy 14(3): 242- 52.
- - - . and William W. Hogan (988), ·'Is an Oil
Tariff Justified? An American Debate: II. The
Numbers Say Yes,MEllergyjollmaI9(3): 7- 29.
IJrown, Stephen P.A., :tnd Keith R. Phillips (1989),
"Oil Demand :mcl Prices in Ihl! 19905," Federa l
Reserve Bank of Dallas Economic Review,
January, 1-8.
Hogan, William W. ( 981), "Import Management
and Oil Emergencies,' in Energy and Secun'ly,
Econ o mic Review_ M ay 1990
bridge, Mass.: Ballinger Publishing Co.):
26 1-301.
Nordhaus, W . (980), "The Energy Crisis and
Macroeco no mic Policy,M Energyjoumal 1(1):
11-19.
Stout, Hilary (1989), "Fed Chairman Says Gas Tax
Would Be Least Hannful l.evy to Shrink
Ddicil, " \Vall Srreetjoll nw/, February 3.
Yuce!, Mine K., and Carol Dahl (989), "A Dyna mic Comparison of an O il Tariff, a Prod ucer
Subsidy and:t Gasoline Tax ," Federal Reserve
Bank of Dallas Research Paper no. 8912
(Dallas, August).
"
@FedFRASER