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Second Quarter 1992
~ 992



conOIIDC eVleW
Ca eoftb
77Je Case
ing M2
John V Duca

Monetary Policy in a
Small open
Open Economy:
The Case ofSingapore
John H.
H. Wood

iona/ Ejects

Agricultural 11
Rona D.
0 Slgalla

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (

Economic Review
Federal Reserve Bank of Dallas
RolMrt D. MeT • • r, Jr.

TCHlW J. S'''''''li,

Hlrvey Rosentllilila

s-v... ~Ittd/)lonr"'~
W. Mtc....1/lwrIcI(o
Coli d IIe-.tI

G,r"d P. O'Driscoll, Jr,

I'u Ita _ _ Ect1tortc_

Stephln P. .l. Brown

Zsolt 8e<:si
Robel'll Clair
John V Coca
Kenneth M Emery
Robert W Gilmer
David M Gould
Wi lliam C Gruben
Joseph H Haslag
Evan F Koenig

O'AmM Onnenl
Kent! R Ptulilps
FIOI'Ia 0 S.galla

llJi l TayIa'
JoIw1 H Welch
""" A \YyM<
Kevlll J. Yeats
MII'I81( Vocel

IIn••reh AIIociatH
ProfesslJI Nalllan S Balke

Southern Methodist UniYersiry
ProfessDf JolYllltyanl
Rice UmvefSlf)'
Professor Thomas B Fomby

Soolhern Methodist University
ProfesSOl' Scon Freeman
UnivefSiryof Texas
Professor John H Wood
Wake Forest Uniwrslry

Rhonda Harm
Carol O'Neil
Virginia M Rogefs
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Page 1

The Case of the
Missing M2
John V. Duca

Since the third quarter of 1990. the growth of M2 in the

United States has been weaker than econometric models predicted. Jo hn V. Duca assesses w hether this shortfall in M2
grO\vth is associated with inflows into bond and equity mutual
funds or the thrift resolution process.
Duca finds that while, to some degree, bond funds are
good substitutes for M2, rood and (.'q uity funds do nm account
for the shortfall. Most of the missing M2, he concludes, appears
to be related to activity of the Resolution Trust Corporation.
Duea reasons thai resolution procedures can depress M2 in
ways nOi reflected in standard models, such as by forc ing an
early call of small time deposits and by impllrting the fisk of
prepayment to small lime deposits

Page 25

Monetary Policy in a
Small Open Economy:
The Case ofSingapore
John H, Wood

John H. Wood studies Singapore, a small open economy
dedicated to growth through both Sowing and the attraction
of foreign investment. He finds that the monetary authority'S
supporting role is the provision of a stable monetary e nvironment, particularly a stable domestic price level. Singapore's
monetary authority has unusual freedom from domestic
constraints in fulfilling this role because of the government's
conservative fiscal policy, control of labor relations, and
disinclination to support unprofitable enterprises. Singapore
has controlled its inflation by ad justing to changing world
conditio ns. The record indicates that low inflation has been
maintained by means of a money growth n ile.

Page 43

Regional Effects
Agricultural Trade
Fiona D. Sigal1a

Fiona O. Sigalla explores the impact of free international
trade in agriculture on individual states and the components
of their agricultura l sectors. Full mullilalcraltrade liberalization would lower the cost of food and increase gross national
product by encouraging reallocation of resources to more
productive uses, Sigalla argues. She finds that free trade would
ha ve litlle o r no effect on income in six Siaies and that gross
agricultura l income wou ld risc in six other states. Agricultural
income would decline by 7 percent or morc in fourteen stales
and by at least 2 perccm in the remaining twenty-four states,
She concludes that trade liberalization would reduce
agricultural income in most states, but the small s ize of the
agriculrural sector would lead 10 relatively small income losses
that could be offset by gains in other sectors of the economy.

John V. Duca
Senior Economist and Policy Advisor
Federal Reserve Bank of Dallas

The Case of the Missing M2


or more than a year, the M2 monetary aggregate has been unusually weak. For example,
the Federal Reserve Board staff model of M2,
referred to as the FRE M2 model, overpredicted
M2 growth by an average of 1.8 percentage points
over 1990:3-91:4, and an M2 model developed at
the Federal Reserve Bank of San Francisco overpredicted M2 growth in late 1990 (Furlong and
Trehan 1990) Figure 1 presents results from estimating M2 growth with the FRB M2 model, where
the estimated shortfall in M2 growth is the gap
between estimated M2 growth and actual M2 growth.
This study assesses two competing explanations for this phenomenon. One is that the missing
M2 merely reflects substitution by households into
bond and equity mutual funds, which are very
liquid (Farrell and Mc amee 1991) Indeed, coincident with the missing M2 have been runoffs in
small time deposits, unusual weakness in money
market mutual funds and large inflows into bond
and equity mutual funds. The other explanation is
that the missing M2 reflects households' reaction
to the activities of the Resolution Trust Corporation (RTC). Indeed, the missing M2 has coincided
with the effOltS of the RTC to resolve failed thrifts.
The shortfall in estimated M2, or missing M2,
has policy implications because monetary aggregates are often used as indicators of economic
activity. From the equation of exchange,

where M = money, V = velOCity (gross national
product 1M), Y = transactions (usually measured
by inflation-adjusted GNP), and P = the price
level People typically reduce their money holdings as the spread between the rates that they
can earn on nondeposit assets (for example, US.
TreasUlY securities) rises over rates paid on deposits.
As a result, when this spread, or opportunity cost,
Economic Review -

second Quarter 1992

Figure 1

Estimated Shortfall in M2 Growth



~ ...










of money rises, the velocity of money rises because
people hold lower average money balances to
conduct their transactions.
If velocity is very predictable, then nominal
GNP (P x Y) can be inferred from money and
interest rates. This inference is important for
policy-making because estimates of prices and
inflation-adjusted GNP typically are available after
a considerable lag, whereas interest rate and
money supply data are available more quickly If
money demand-the relationship between

I would like to thank, without implicating. Steven Prue and
Matthew Turner for providing excellent research assistance, and Richard G Anderson, W. Michael Cox, Kenneth
M Emery, Evan F. Koenig, Harvey Rosenblum. David Small,
Pat White. and Kevin Yeats for their suggestions during the
progress of this research

money, interest rates, and nominal GNP-is
stable, then policymakers can use current money
supply and interest rate data to roughly estimate
current nominal GNP.
At one time, the demand for the Ml monetary aggregate was stable, and for this reason, Ml
was used as an indicator of economic activity.
However, there was a "missing money" period
during the mid-1970s when Ml was unusually
weak and suggested that nominal income was
much lower than it actually was. Moreover, the
link between Ml, interest rates, and nominal GNP
has become looser since the deregulation of
deposits in the early 1980s. In particular, substantial shifts of deposits between those classified
within Ml and those classified within the broader
M2 monetary aggregate have resulted from deposit
deregulation. l For these reasons, Ml has been
used less and less as an indicator of nominal GNP.
Evidence that the demand for M2 is more
predictable than the demand for Ml is mounting
(Hetzel and Mehra 1989, and Moore, Porter, and
Small 1990). Not surprisingly, economists and
policymakers increasingly are turning to M2 as an
indicator of economic activity and as a guide to
long-run price developments (Hallman, Porter,
and Small 1991). However, in recent quarters M2
growth has been unusually weak.
Using the FRB M2 model, this study documents the missing M2 evident since 1990 and
finds that RTC activity, rather than inflows into
bond and equity funds, appears to account for
much of M2's recent weakness. In essence, the
RTC's method of resolving failed institutions has
lowered the perceived return on thrift deposits in
ways not typically explained by models of M2. In
response, investors have shifted from M2 deposits
to other assets, including but not limited to bond
and equity mutual funds.
This study is organized as follows. I first
describe what bond funds are, explain how they


Ml includes currency, demand deposits, and other checkable deposits (NOW accounts) M2 includes Ml, passbook
savings deposits, small time deposits, MMMFs, money
market deposits accounts, overnight Eurodollars, and overnight repurchase agreements

may theoretically affect M2, and show that bond
fund effects cannot account for the missing M2.
Then I describe the activities of the RTC, explain
how RTC activity may theoretically affect M2, and
show how these activities appear to account for
most of the missing M2. I conclude by summarizing
the findings and discussing their policy implications.

Bond funds and the missing M2
This section begins with a review of the characteristics of bond and equity funds and then presents
several theories on how bond and equity funds
could be depressing M2 by becoming more attractive relative to M2 deposits. Next, I describe how
bond fund adjustments to M2 were made and use
the FRE M2 model to show that the missing M2 does
not mainly owe to bond and equity fund effects.
Characteristics of bond and equity funds.
Developed in the mid-1970s, bond funds are
mutual shares of bond portfolios. Bond funds are
a good substitute for direct bond holdings because bond funds typically are more liquid and
more diversified than are direct bond holdings.
Bond funds also substitute for M2 deposits. One
reason is that many bond funds are in mutual
fund families that allow investors to shift their
assets among bond, equity, and checkable money
market mutual funds (MMMFs) at little or no cost.
Indeed, some market analysts have suspected that
the 1991 slowdown in MMMF growth owes to
shifts into bond and equity funds (Figures 2 and 3).
Bond funds also provide investors with credit
lines and credit cards. Thus, rather than putting
one's savings into a small time deposit, an investor might choose to use a bond fund that permits
one to either tap a credit line or shift funds into a
MMMF when the need to write a check arises.
Similarly, equity mutual funds potentially
substitute for both direct holdings of equity and
for other assets, such as M2 balances. However,
equity funds differ from M2 balances in one
important way that bond funds do not. Specifically, equity funds carry a substantial degree of
investment risk, which makes them much less
substitutable for M2 deposits than bond funds.
Moreover, in contrast to bond funds, available
data do not allow one to easily measure shifts
from directly held equities to equity funds. For
these reasons, this study focuses more on bond
Federal Reserve Bank of Dallas

Figure 2

Figure 3

Bond and Equity Fund Net Changes

Money Fund Net Changes

Billions of dollars

Billions of dollars








..r ·

/ \



! : Eqully Fund


















-40 +--,---r--,------,-----,----,----,---.--,---,

SOURCES: Investment Company Institute and Federal Reserve Board.

fund rather than equity fund effects
Bond and equity mutual funds since the mid1970s. At this point, it is useful to review the
history of bond and equity funds. As shown in
figure 4, equity funds grew moderately over the
late 1970s and early 1980s. During the stock
market boom of the mid-1980s, equity funds
surged, reflecting higher prices of existing shares
and inflows spurred by substantial price appreciation. Equity funds fell sharply during the stock
market crash of 1987 and then recovered to precrash levels by late 1989. More recently, equity
funds have grown rapidly as investors have
reacted to declining yields on short-term debt
securities and small time deposits,
As illustrated in Figure 5, bond funds grew
modestly over the late 1970s and early 1980s,
These funds then grew rapidly during 1985-86,
were almost flat over 1987-89, and then grew
rapidly in early 1991. Over 1985:1-86:4, household
bond funds (seasonally adjusted-SA, Investment
Company Institute data) rose by $143,4 billion,
which is much greater than the $80.4 billion
increase in overall holdings of government securities (less savings bonds), tax exempt securities,
and corporate bonds (Flow of Funds data, NSA).
These data suggest that much of the mid-1980s
surge in bond funds reflected shifts from directly
Economic Review -

Second Quarter 1992

held bonds to bond mutual funds. This hypothesis
is consistent with tax incentives that encouraged
households to shift funds from long-term financial
assets to individual retirement accounts (IRAs), for
which mutual funds are more suitable.
Beginning in 1987 when the Tax RefOffil Act
of 1986 severely restricted the eligibility requirements for IRAs, bond fund holdings changed little
for the remainder of the decade. Although bond
fund inflows have recently accelerated, the current
spurt differs from that of the mid-1980s. Over
1990:3-91:2, bond funds (SA) held by households
rose $32,5 billion, while household holdings of
government securities (less savings bonds), tax
exempt securities, and corporate bonds increased
by $100,5 billion. Thus, the surge in bond funds
during the early 1990s mainly reflected shifts away
from nonbond assets (that is, M2 deposits), rather
than shifts away from direct bond holdings.
Indeed, the most recent surge in bond funds
appears to reflect shifts from M2 deposits, particularly small time deposits, which fell sharply in 1991.
In addition, because the costs of transferring assets
between bonds and MMMFs within an asset
management account are small, one would expect
that some substitution between M2 and bonds
would occur more specifically between bond and
money market funds. Consistent with this view,

Figure 4

Figure 5

Household Equity Funds

Household Bond Mutual Funds

Billions of dollars

Billions of dollars








.: Subl;1,rut!O(l 'mm
....: Direct Bond HOld'I'1llS

o -1-"""I"'-r=:;=:;:::::;:=;=;=:=;,~l"""-'4··:.:.:··:....··r--r-"""T'"~-r--.---.
'75 '76 '77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91

'75 '76 '77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91

SOURCES: Investment Company Institute and Federal Reserve Board.

SOURCES: Investment Company Institute and Federal Reserve Board

bond inflows over 1990-91 have coincided with
some weakness in MMMFs outflows, as shown
earlier in Figure 3. Although bond funds are still
small relative to the stock of M2, their rapid
growth in 1990 and 1991 may account for some
of the recent unusual weakness in M2 growth as
suggested by press reports (Clements 1991).

households and firms must choose between
holding their assets in money or bonds. Bonds are
attractive because their yield exceeds that on
money This yield diflerential is called the opportu111~y cost qf money. On the other hand, if the need
to purchase a good arises, a household or business
must pay the cost of transferring assets from bonds
to money In the Baumol-Tobin model, people
balance these considerations by holding some
money and some bonds. Not surprisingly, the
demand for money in this model is lower if the
opportunity cost of money rises, if spending falls,
or if the cost of converting bonds into money falls
Within this framework, the recent popularity
of bond funds can be attributed to two main
factors First, there has been a reduction in the
costs of transferring assets from bonds (now bond
funds) into transactions accounts, on which
households can write checks 2 A second factor is
the recent large spread of long-term interest rates
over short-term rates, often referred to as a steep
yield curve. The expected return on bond funds
reflects long-term interest rates, rather than shortterm interest rates as with small time deposits. As
a result, the recent decline in short-term interest
rates relative to long-term interest rates has been
accompanied by a fall in M2 deposit rates relative
to yields on bond funds.\

Why bond funds may affect M2:
a theoretical framework
This discussion of why bond funds may theoretically affect M2 relies on the model of money
demand developed by William Baumol (1952) and
James Tobin (956). This framework stresses that



Ross Milbourne (1986) developed a model to analyze the
impact of certaIn financial innovations on the demand for
different monetary aggregates His model gives a more
complete treatment of how a decline in the costs of transferring assets from bonds to money can decrease the demand
for money
The maturities of most small time deposits are less than 1
year and typically range up to 2-1/2 and 5 years The
effective maturities of bond funds primarily fall into the
range from 3 to 10 years

Federal Reserve Bank of Dallas

Theoretical aspects of the empirical
analysis of bond fund effects
Shifts from M2 to bond funds, however, likely
require high spreads of long-term over short-term
rates because such shifts entail fixed costs to households. These costs include commission (load) fees,
time needed to gain information on mutual funds,
and fixed annual fees (typically $75 to $100). In
addition, mutual fund family accounts that allow
shifts among bond, equity, and checkable money
market mutual funds have minimum required investments (typically $10,000) that usually are much higher
than those of simple bond fund accounts. j As a
result, M2 may not be affected much over the short
term by a modest decline in the cost of shifting from
bond to money market funds or by a modest rise in
the spread between bond and small time deposit
yields. It is thus plausible that M2 will be substantially affected only by large or persistent changes in
transfer costs or the slope of the yield curve.
The data are generally consistent with this
view. Although the cost of shifting assets between
bond and money market funds generally fell in the
late 1980s and early 1990s, bond funds have only
risen noticeably during two periods since 1982periods when the yield curve has been very steep.
As shown in Figures 6 and 7, the growth rate of
bond funds adjusted for inflation has only been
substantial during the periods 1985-86 and 199091,5 However, of these two periods, the mid-1980s
surge was much larger relative to the slope of the
yield curve, and partly reflected shifts from direct
bond holdings to IRAs/401Ks invested in bond
funds when tax requirements were more generous.
Further evidence that bond fund growth has not
consistently reflected spreads between short-term
and long-term rates is that bond fund growth was
weak in 1987 despite a fairly large yield spread.
This weakness likely reflected the enactment of the
Tax Reform Act of 1986, which greatly curtailed the
number of households eligible to contribute to IRAs
and which imposed much more restrictive limits on
the amounts of 401K contributions.
Thus, including the spread between rates on
long-term and short-term Treasury securities in M2
regressions is unlikely to detect surges in bond funds
that result from changes in the tax code and the
unusually fast growth of new instmments during
periods of innovation. 6 In the past, these sorts of
Economic Review -

Second Quarter 1992

empirical difficulties have been handled by expanding the definition of M2 (such as adding MMMFs
and money market deposit accounts [MMDAs] to
M2), rather than by solely relying on adjusting the
opportunity cost terms in money demand models.
Indeed, Figure 8 illustrates the importance of
including past innovations, such as MMMFs and
MMDAs, in M2. 7 Taking this approach, I compare
the behavior of M2 with that of M2 plus adjustments for bond and equity mutual funds.

Theoretical aspects of measuring
bond fund effects
The institutional characteristics of bond
funds suggest that they are substitutes for directly
holding bonds and for M2 balances.
Substitution between bond funds and direct
bond fund holdings. Bond funds offer three
main advantages over directly held bonds. First,
bond funds enable an investor to acquire shares
in a well-diversified portfolio with only a modest
investment. Portfolio diversification partially
protects investors by enabling them to not be
overly exposed to the risk that the value of a
particular firm's bonds will fall greatly. A second
advantage is that bond funds in mutual fund
families are more liquid than directly held bonds.
That is, bond funds can be converted into checkable assets such as MMMFs more quickly and with
less expense than can directly held bonds.
A third incentive to hold bond funds rather
than bonds relates to taxes. During the mid-1980s,
U.S. tax laws created incentives for households to
open individual retirement (IRA) and Keogh





Minimum balances to open just a bond mutual fund account
are as low as $500-$1,000, but do not allow shifting into
money market mutual funds
The GNP deflator was used to adjust bond funds for inflation
Indeed, the spread between yields on 10- and I-year
Treasury securities was insignificant when added to the M2
models used in this study.
For a discussion of how and why the definition of M2 has
evolved over time, see the study by W. Michael Cox and
Harvey Rosenblum (1989)

Figure 6

Figure 7

Growth in Real Bond Funds

Yield Spreads







Annualized Real Growth Rate
of Bond Funds






- 5 +---.--,--,--,....---,r----,----,----,---,---,











SOURCES: Investment Company Institute and Federal Reserve Board

accounts for which bond and equity funds were
better savings instruments than directly held
bonds. Mutual funds can be more attractive tax
shelters because many funds complete and
provide all of the tax-related accounting information for investors and bond funds allow investors
to make the maximum annual IRA contribution,
$2,000-$4,000, which is less than the $10,000
minimum denomination of most bonds. H
The major drawback of bond funds is that
for rich investors, the costs of directly investing in
bonds may be less than bond fund fees. Nevertheless, bond funds are a more attractive means of

The maximum contribution is $2,000 lor most eligible indl'
viduals and $4.000 lor most eligible families
• In practice. many institutions do not penalize households
significantly if they must prematurely withdraw small time
deposits in an emergency


Of $354 billion in bond funds in September 1991. $146
billion was invested in muniCipal bonds, $123 billion in U S
government securities (including U S government-guaranteed, mortgage-backed securities), $25 billion in junk bonds,
and $50 billion in mixed bond funds (primarily, Treasury.
municipal, collateralized mortgage obligations. and high
grade corporate bonds)

holding bonds for many investors.
Substitution between bond funds and M2.
Several characteristics of bond funds suggest that
they are also substitutes for M2. To evaluate the
"moneyness" of bond funds, however, it is helpful
first to review the salient features of M2 deposits.
M2 deposits generally share three important
characteristics. First, because they are federally
insured, investors need not wony about the risk that
their M2 deposits may fall in nominal value. By contrast, many corporate bonds (especially noninvestment grade or junk bonds) pose default risk to
investors because the fim1s may not be able to pay
back investors. A second characteristic of M2
deposits is that they generally have smaller minimum
denominations than many bonds and commercial
paper issues, which typically come in $10,000 increment,;, As a result, many more households are able to
invest in M2 deposit'; than in bonds. Another important feature of M2 deposits is that households can
either write checks on many M2 deposits or shift
noncheckable M2 deposits into checkable accounts. 9
How do bond funds compare with M2
deposit';? First, many bond funds typically have little
or no credit risk because they are heavily invested
in U.S. government-guaranteed, mortgage-backed
securities and high-grade corporate bonds. 10 As a
result, bond funds are relatively safe and can substiFederal Reserve Bank of DaUas

tute for small time deposits. Second, many bond
funds have minimum investment sizes less than
$10,000 and do not require households to invest
in $10,000 increments. Third, many bond funds
enhance the liquidity of investors by offering checkwriting privileges, credit lines, and credit cards.
Fourth, many bond fund holdings are in mutual
fund families, which allow investors to readily shift
assets across bond, equity, and checkable money
market mutual funds at very low transactions
costs. II This last feature heightens the extent to
which investors shift funds between bond or equity
funds and MMMFs when relative rates of return
between these assets change. Indeed, the missing
M2 has been accompanied by weakness in MMMFs,
as well as in small time deposits.
Bond funds differ from M2 deposits in
several ways. First, unlike M2 accounts bond
funds are marked-ta-market, meaning that a
change in interest rates affects an investor's
balances by altering market price of these assets.
Bonds bear a fL'{ed coupon and, thus, indirectly
so do bond funds. When long-term interest rates
rise, therefore, the prices of existing bonds fall,
allowing the yield to rise. Thus, the market value
of bond funds falls as long-term rates rise. For this
reason, bond funds pose interest rate (price) risk.
A second way that bond funds differ from
M2 deposits concerns taxes. Because of the
marked-to-market feature of bond funds, investors
must consider the capital gains tax consequences
of shifting out of bond funds into money market
funds. These tax considerations entail costs that
may hamper substitution between bond funds
and money market funds.
A third difference is that bond funds include
many IRA and Keogh accounts, which are excluded
from M2 because their tax-deferred status reduces
their liquidity. Finally, annual fixed fees and
minimum balance requirements for bond funds
effectively limit the relevance of these instruments
to more affluent households (One reason is that
many less well-off households may find that these
fixed fees are large relative to the interest income
on the amounts that they can invest.)
Overall, the characteristics and recent behavior of bond funds imply that while they are not
perfect substitutes for M2 deposits, their degree of
substitutability may be substantial. Expanding M2 to
include bond funds would internalize such substituEconomic Review -

second Quarter 1992

Figure 8

Selected M2 Components
Billions of dollars

Money Market Mutual Funds
Money Market Deposit Accounts




Other Checkable Deposits
Savings and Smali Time Deposits


Demand Deposits



tion effects, and thus, at least theoretically, might
make M2 more stable. However, including bond
funds in M2 could create several complications.
First, many bond fund assets have substituted for
direct bond holdings. Second, the marked-to-market
valuation of bond funds would introduce an
interest rate sensitivity that is not a direct "money
demand" effect. For example, a rise in bond yields
would cause bond fund balances to fall through
marked-to-market valuation. It is unclear to what
extent households would replenish their bond-fund
holdings following such a change in bond prices.
Finally because they are long-term investments, the
degree of substitution between bond funds and
equity may exceed that between M2 deposits and
equity. This implies that putting bond funds in M2
may make M2 less stable as investors shift between
stocks and bond funds.


Mutual fund families usually allow investors a limited number offree transfers among money market. bond, and equity
funds within the same family (Donoghue's Mutual Funds
Almanac, 1987-1988, 16-17) Recently, Citibank has enabled households to easily shift funds among MMOA,
checking, MMMF, bond mutual funds. and equity mutual
funds. thereby increasing the substitutability of bond (and
equity) funds with liquid M2 deposits

Empirical analysis of bond
and equity fund effects on M2
This section creates bond and equity fund
series that are used to adjust M2 for bond and
equity fund effects. First, estimates of total household bond and equity fund holding are presented.
Then, these data are adjusted for substitution
between bond funds and direct bond holdings.
Data and variables. Bond and equity fund data
since 1975 are available from the Investment
Company Institute (ICI). Federal Reserve Board
staff has classified mutual fund holdings into
several asset groupings that can be categorized
into bond, equity, and mixed bond and equity
funds (Duca 1992a). In general, the mixed funds
tend to hold more equity than bonds, and for this
reason, mixed funds are treated as equity funds. 12
One difficulty with the ICI data is that they
aggregate holdings by households and institutions,
whereas MMMFs held by institutions are not in M2,
but in M3 It was assumed that 75 percent of all
bond funds were owned by individuals on grounds
that the share of bond and equity funds held by
households has remained around 75 percent
according to available year-end data for 1983-90.
These monthly bond and total mutual fund outstandings were then seasonally adjusted with an
X'll procedure.


Mixed funds also include Investment Company Institute
mutual fund categories whose definitions with respect to
bonds and equities have changed over time using data
organized by Pat White of the Federal Reserve Board staff.


Adding total household bond and equity funds to M2
produced an aggregale Ihat was even less explainable
than BEFM2 and M2 Note that because equity funds and
directly held equity rose together during the 1980s, it was
impossible to adjust equity funds for substitution away from
directly held equities along the lines that adjustments to
bond funds were made

" Furthermore, in a survey conducted by National Securities
& Research Corp during the summer of 1991, more than 90
percent of surveyed mutual funds indicated that net inflows
from households came partially at the expense of MMMFs
and bank deposits, while 50 percent indicated that some of
the net inflows came from substitution out of insurance
company assets (Clements 1991, C9)

Because bond funds are substitutes for direct
bond holdings and M2 deposits, we must distinguish between these substitution possibilities to
assess the impact of bond funds on M2. For
example, to the extent that the mid-1980s surge in
bond funds likely reflected shifts away from
directly held bonds, M2 is unaffected. For this
reason, a bond fund series was added to M2 that
adjusts bond funds for shifts with direct bond
holdings ("SBFM2", see Appendix A for details).
In addition, two other adjusted M2 series were
created, One adds total household bond funds to
M2 (BFM2), and the other adds equity and substitution adjusted bond funds to M2 (BEFM2).1:\ Each
of these three expanded M2 aggregates have
grown faster than M2 since 1990:2. However, it
important to note that the estimated growth rates
of the three expanded M2 aggregates would likely
be higher than that of M2 because the opportunity
cost of the bond and equity funds added is lower
than that of M2 deposits.
Estimating whether bond and equity funds
account for the missing M2. Using the FRB M2
model as a benchmark, this subsection estimates
M2 and M2 adjusted for bond and equity mutual
funds Three adjusted M2 series were evaluated:
these used total household bond funds (BFM2),
substitution adjusted bond funds (SBFM2), and
equity plus substitution adjusted bond funds
(BEFM2). This approach was taken because the
riskiness of equity returns may make equity funds
less substitutable for M2 deposits than are bond
funds. The bond and equity adjustments also enable
one to assess the advantage of internalizing any
substitution between these two types of funds.
The procedure used in creating these series
implicitly makes the strong assumption that any
estimated changes in bond or equity funds
completely represented substitution effects with
M2 deposits. This strong assumption is consistent
with results from the Federal Reserve's August
1991 Survey of Senior Financial Officers. Of the
large banks in this survey who characterized retail
deposit growth as unusually weak between May
and July 1991, the most frequently cited reason
for this weakness were "returns on noncleposit
instruments, such as bond funds or Treasury
securities II Nevertheless, because of the strong
implicit substitution assumption, the mutual fund
adjustments are best viewed as yielding upper
Federal Reserve Bank of Dallas

Table 1

Selected Results of Estimating M2 Growth Rates, 1976:1-91:4


Bond Fund

Bond and Equity
Fund Adj. M2

Simple Bond
Fund Adj. M2

log(M2,_,)-log( GNPAVt_,)





long-run OC elasticity





Selected Variables

S.S.E. (Quarterly, not
a percentage)





R2 (corrected)





- 58816





** Significant at the 99-percent confidence level.
(t statistics in parentheses)
GNPAV = (GNP, + GNPt _,)/2, measure of permanent income used as a long-run proxy for transactions.


Opportunity cost of M2, defined as the spread between the 3-month Treasury bill rate and the average
interest rate paid on M2 balances.

NOTE: A negative coefficient on [log(M2,_,)-log(GNPAV/-l)] implies that M2 balances adjust (error correct) toward
their desired levels.

hound estinutes of the imp:ICl of hond and equit\'
funds on .\12 grcm-th.
Sl'IeCled~tatistic~ rlom l·.~timating the FHB"s :\12
mOl1e1 ;lIld mutual fund d;IU ;Ire presccnted in Tahle
I (Sl'C Duci 1992a for morc dcuil.~J. The sample
IXTiod hegins in 1976: 1 heclllsl' mutual fund (ktu
sun in It),;:;:1 and heclusl' the FHB crror-correction
mOlk'1 uses a fe,,- lag.~ dlhl' dl'Jwndent \-ari;lhk'.
The FI{B \12 eCllution lontain.~ \ :lriahles that contlol
ror the \ olul1lc of spending \\ ith G'\I' and IXTson:t1
consuillption cxpenditurL's. :lIld for the opportunity
cost or I)olding monl'} \\ith the sprl'ad hl't\\'l'en;1
markl't intl...e.~t ratl' (tIll' six-Illonth Treasury hill
r:lte) ;l11d the average ratl' earned on NI2 halances_
Ch;II\~L'S in the l"O.~t of shil'ting het.\\'l-cn money ami
othLT :lSSl'tS are not in tllis model hecausc they :lrl'
not Ille:lsured across timl' in practicl'
Economic Review -

Second Quarter 1992

The FRB 1\12 Illodel is an "error-correction"
model ,,-hich track~ hoth the long-run ;lJ1d shortrun responsl'S of 1\12 to changes in spending and
in its opportunity cost (for further discussion sec
Moore, Porter, :lIld Small 1990 amI the hox titled
"'/h(> i'arm 0/ the /V12 f(~'..!,ressiol1 :'vlode/" J. The m:\ in
aclvantage of this approach is that it betkr estimates short-run and long-run mO\Tments than
othcr approaclll'.~ 0\\ ing to its econometric form
;lJ1d the expertise of tile Federal Reselye Board
staff in modeling ,\12, the FRB model is considc.Tl'c!
slatl' of thl' art. For tllis re:lson. it i~ L\.~l'd to
document and is moclified to account for till'
missing T\'12. Although the four different M2 series
are estimated with the same type of model. they
differ in the 11<)\\ the opportunity cost or Illoney is
nW:lsun.'d Com eptu:t1h-. the FRB model Ille;lsurl's

The Form of the M2 Regression Model
The M2 model developed by the Federal Reserve Board staff has this form:


+I,a;[ln(Y;_,) -In(Y;_i_lll

+/3,ln(OCt _1 )
+/32[ln(OC,) -In(OCt _,)]
+am [ln(M(-1) -In(Mt _ 2))
+ojRegulation dummy
variables, where:
In = the natural log of a
M t = M2 at time


[In(M)-ln(MHll = the growth rate of M2 at
time t.
C = a constant.

EC = estimated coefficient on
the error correction term.



transactions (often
measured by GNP or

OC = the opportunity cost of
a;s = estimated short-run
effects of transactions.

am = estimated short-run effect
of previous M2 growth.
/31 = estimated long-run effect
of OC on M2 growth.
/32 = estimated short-run effect
of OC on M2 growth.


O's = estimated effects of
changes in regulations.
Also, note that the first difference of the log of
a variable is the growth rate of that variable.
More detailed variable definitions are provided in the tables.
Before examining regression results, a
brief review of key assumptions and each
component of the model is helpful. Because
of its error-correction specification, this model
can estimate the short-run and long-run
effects of economic variables on M2 growth
and, in particular, how M2 growth responds to
previous deviations of the level of M2 from its
long-term determinants. Over the long term, it
is assumed that the growth rate of M2 matches
that of GNP. This assumption is justified on
grounds that the long-run velocity of M2 (that
is, the ratio of GNP to M2) appears constant.
(Forevidence, see Hallman, Porter, and Small
Of the components, the estimated "errorcorrection" coefficient, EC, is expected to
have a negative sign. The reason is that the
difference between the log-level of M2 and
that of GNP is expected to converge to the
log of the inverse of M2's long-term velocity
(adjusted for M2's opportunity cost). For example, suppose that In(M2(-1) is above the
long-term level associated with In(GNPH )
and In(OCt_J In this case, one would expect
M2 to fall until [In(Mt_ 1)-ln(YH)] declines to its
long-run level holding all other variables constant. As the magnitude of EC rises, this
adjustment, or error-correction occurs at a
faster speed.
Another variable in the model, In(OCH ),
measures the long-run effect of a change in
M2's opportunity cost. Because M2 holdings
are likely to fall as its opportunity cost rises,
this term is expected to have a negative sign.

(Continued on the next page)

Federal Reserve Bank of DalJas

The Form of the M2 Regression Model-Continued

Dividing the coefficient on In(OCt_ 1) by EC
yields the long-run elasticity of M2 with respect to its opportunity cost. This statistic is
very useful. For example, an elasticity of -5
percent indicates that a once-and-for-all (permanent) 100-percent rise in the opportunity
cost of M2 will eventually cause M2 to fall 5
percent from its initial level.
Because M2 responds differently in the
short run than in the long run, several other
types of variables are included. First, lags of
the growth rate of transactions are included,
which the Board model measures with the
growth rate of personal consumption expenditures. These variables are expected to have
positive signs, as a rise in transactions would
tend to boost the need to hold assets in the
form of M2.
Second, the lag of last period's M2 growth
rate is included. This variable helps control for
momentum in how people adjust their M2
balances and is expected to have a positive

M 2\ opportun it y cost ~IS the differencc het ween ~l
rish-free m~lrket inll'rest rate ~lnd the aver~lge raIl'
on ~12 h;IL!!1ll'~ For con,~i,~tency. the \\'eigh\nl
~Ivl'r;lge \ il'ill.~ on 11lL' ~ldjusted "12 series \\ lTl'
cllcuLltnl tel rl'llL'Ct tIll' risk<ldjusted return on
mutu~t1 rumls ;lIld that em !\12 deposil.~ Thl'riskadjustnl relLirn O!1 !1111tual fU!1ds \\~l.~ set equ;t!to
the three-l11onth Tre;l.~ury hill rate on ground.~ th;ll
these funds likt'l) ) ielcl Ihe market r~lte of l'l'tUIll
on ~Issels 11;1\ ing silllilal market. credit and
prepa \'Illent risks.
Looking al the fult:>. the K's of the IWo
hond fund ;Idjusled sC'lles are sOl1le\Vh~11 hetter
than thosl' or 1\12. wilh the suhstitution-hond
~ldjustL'd series \'il'leling the hest fit B' contr~ISI.
the hond ;lIld equil\ fuml adjusted !1HlLkl \ il'ids
a \\ or.~e I it Ih;111 the regular ;\12 model. likeh
rdlelling \h;1I equil~ funds ~lre much less suh,~\i­
tuuhle for \12 than ;Irc hond funds,
Economic Review -Second Quarter 1992

sign. Note that because it is assumed that the
velocity of M2 is constant over the long-run
(controlling for M2's opportunity cost), M2 and
transactions (GNP or consumption) will grow
at the same long-run rate. To be consistent
with this assumption, the sum of the coefficient
on lagged M2 growth and the coefficients on
the lags of the growth rate of consumption are
constrained to equal 1.
Third, the current growth rate of M2's
opportunity cost is included to measure the
initial effect of a change in M2's opportunity
cost. As with the sign of In(OC/-1)' it is expected to have a negative sign.
Finally, several dummy variables are
included to control for the impact of changes
in bank and thrift regulations that unusually
affected M2 holdings. These variables control
for the introduction of MMDAs in late 1982,
deposit rate deregulation in early 1983, and
the imposition of credit controls in 1980:2.
(See Table 1 for more details.)

Tahle 2 presents in-sample rcsiduals for the
suhsample period 1990:5-()1:!J. The ~um of
,~qu;lr(xl errors (S.S,1:'.. a nlt'~ISUrl' or unexplained
mO\'ements) of the su h,~t iIu lie llhl dj usted and
simple hond adjusted 1\12 ,~erie,~ ;Ire 2() percent
and 29 percent ImH'r m tT thi,~ period than the
S.S E, o! the unadjusled \12~erie,~, respectively
The hond and equit\ adjusll'd \12 Illodel also
produces a l()\\Tr S.S,E m IT Illi,~ ,~uhsample
period (9 percent !m\Tr) I h;\ n I he FIW ~ [2 model.
()ne measurc of the missing i\12 is the average
growth rate shortfall or an 1\-12 series over 1990:3() 1:4. I{esults indicate lhal ;Illcling suhSlilulionadjusted bond funds accounls for 27 percent of
the Illis,~ing. '12; adding loul hond funds. for 28
percent of the missing M2; ;l1ld ;ldding equity and
,~uhstitution-adjustcdhond fumls, for 4;) percent
of the missing ,\[2 or C()UI.~e, ea(h mutual fund

:ldJu tment Imphcitl

Illakes the sl rong assuillption

Table 2

In-Sample M2 Growth Rate Errors Over 1990:3-91 :4,1976:1-91 :4)
(Percent, Seasonally Adjusted Annual Rate, Negative Entries Reflect Weaker-Than-Predicted M2 Growth)



Bond Fund






1991 :1
1991 :2
1991 :3
1991 :4














26% lower

9% lower

29% lower

Bond and Equity
Fund Adj. M2

Simple Bond
Fund Adj. M2

Growth Rate Residuals, 1990:3-91 :4:


Percentage of
Missing M2 explained
S.S.E. over 1990:3-91 :4,
(Quarterly rate):
Relative to FRS S.S.E.


that all portfolio suhstitution invo!\'ing hond and
stock funds are compll'ldy internalized \\ ithin
their l'XIXtndl'd ddinitions of M2. For this reason.
these estimates are hl'st vil'\vl'd as up!1l'r hounds.
E\'l'n \\ ith this qualification in mind. hond ami
equity funds can potentially account for only a
small part of the missing 1\12.
This result likdy reflects three things First.
tlll' "missing Nl2" hl'gan appearing in 1<)<)()::).
whereas hond ami equity fund inllows \Vl'rl' not
suhstantial until the spring of 1<)<) I. Second. if :\'12
is hl'coming !l'ss attractive to investors 11l'causl' of
trouhll's in the thrift industry. hond ami equity
mutual funds are not the only altl'rn~ltivl's to
holding 1\12 Third. even though simply adding
hond and equity funds to Nl2 may .Sl'l'm to
account for much of tlll' missing Nl2 in 1<)<) I. such
a calculation is misleading One reason is that

one-fourth of hond and equity funds are held hy
institutions. Another is that heclusl' these assets
ha\'e I(m er 0pp0rTunit\' costs than 1\12 dl'])()sits.
adding them to :\12 in a logically consistent
l1unner means that the opportunity cost of this
ne\v aggregate is 100\'l'r than that of :\12. and thus
tl1l' demand for the ne\v aggregate should he
SOI11l'\\ hat higher. I kncl'. l'\ en though the growth
of adju.sted 1\12 may he higher than that of 1\12. so
i.s tlll' estimall'd gnm th of the adjusted series

RTC activity and the missing M2
In this section. I re\ iew the activities of the
Resolution Corporation and descrihl' two
\\ ays these acti\ ities may create a missing Nl2
phenomenon I also present RTC variahll's that
~Ire added to the FRB Nl2 modd ami estimation
Federal Reserve Bank of Dallas

results that show that RTC effects appear to
account for the missing M2.
The RTC was created in 1989 by Congress
under the Financial Institutions Reform, Recovery,
and Enforcement Act to close bankrupt thrifts.
Through early January 1992, the RTC had resolved
535 thrifts, which entailed handling insured
deposits and selling assets seized. The most
impoltant RTC activities with respect to M2 are
those relating to the resolution of deposits.
Between 1989 and early 1992, the RTC had sold
or paid off about $1H3 billion in insured deposits.
When the RTC resolves deposits at a bankrupt
thrift, it either pays insured depositors directly and
closes their accounts or sells the deposits to
another institution that has the right to reset
deposit rates after providing a two-week notice.
RTC closings of insolvent thrifts can create a
missing M2 phenomenon by affecting M2 in two
related ways that are not reflected in standard
money demand variables. Ji First, when closing a
thrift, the RTC's actions force depositors to
reassess their M2 balances because the RTC either
pays depositors directly and closes their accounts
or sells the deposits to another institution that has
the right to reset deposit rates after proViding a
two-week notice. For this reason, the M2 balances
of depositors at failed thrifts are likely to more
quickly adjust to changes in M2 opportunity costs
than they would be in more normal circumstances According to industry sources, most cases
where small time rates are reset involve
"brokered" small time deposits.1 6
As a result of actual "calls" of small time
accounts, the short-term adjustment of M2 to
changes in its opportunity cost may not be
adequately estimated using an error-correction
model with conventional money demand variables. This effect on the speed of adjustment can,
theoretically, either boost or depress M2 growth.
However, such an effect could be creating a
missing M2 problem in the early 1990s because
small time accounts initiated at bankrupt thrifts
during the late 19HOs are being prematurely
"called" in a period of lower interest rates As a
result, the decline in small time deposit rates and
the pace of nominal activity (GNP) since the late
1980s can lead to a much quicker adjustment in
small time and M2 balances than in the pre-RTC
days. Empirically, this "call" effect may be tracked
Economic Review -

Second Quarter 1992

in an M2 model by the volume of deposits at
newly resolved institutions as either an independent variable that is implicitly interacted with one
or more oppol1unity cost variables or an extra
variable that is directly interacted with M2's
opportunity cost.
A second way the resolution process can
create a missing M2 phenomenon is by creating
uncel1ainty about deposit yields, which depresses
the demand for M2. Depositors, especially those
who shop for higher-than-normal yields (often
through brokers), face a repricing risk that arises
because the high yield earned on deposits (fully
covered by deposit insurance) at a troubled thrift
either may be lowered (repriced) by a purchasing
institutions or will no longer be in effect if the
RTC directly reimburses depositors. This risk is
similar to the "call" risk posed by many corporate
bonds, because in an environment of falling
interest rates, many firms would exercise their
option of paying off old bonds having high
interest rates with new bonds having lower
interest costs. For this reason, investors in corporate bonds often do not expect to earn the posted
interest rate on a bond for the full period of stated
maturity even if they did not expect the corporate
bond issuer to default.!:'
As a result of increased uncel1ainty over
nominal deposit yields, conventional measures of




See Ouca (1992a) for why two other RTC-based explana·
tions for the missing M2 are not plausible
These accounts are arranged by brokers for inveslors who
shop for high yields and do not entail much of a relationship
between banks and depositors Industry sources indicate
that nonbrokered. small time accounts that are sold by the
RTC are much less lIkely to have their rates reset because
the purchasing institutions want to acquire a custorJ?er
relationship with "nonbrokered" depositors. who are less
apt to switch to a competitor
For example. interest rates on mortgage-backed securities
that are government guaranteed exceed yields on comparable maturity Treasury bonds The reason is that investors
demand a higher rate on such mortgage-backed securities
because some of these bonds would be retired early if
households refinance their mortgages at lower interest
rates. which would force investors to reinvest funds in an
environment of lower rates


M2's opportunity cost do not consistently track its
true opportunity cost. For example, if a credit-risk
free market rate exceeds the stated average yield
on M2 balances by a given amount in an environment of RTC resolutions, the same spread in a
pre-RTC environment would not mean that the
true opportunity cost of M2 was identical in hoth
periods Indeed, in this example, when investors
factor in the call risk posed by the RTC, the tme
opportunity cost of M2 is higher in the RTC
environment. Thus, current spreads between the
average rate paid on M2 balances have understated M2's opportunity cost since the RTC
became very active. By understating the apparent
opportunity cost of M2 in this way, most M2
models have overestimated M2 growth, thereby
giving rise to a missing M2 phenomenon.

Empirical analysis of RTC effects on M2
Data and variables. This subsection describes how
to test for RTC effects and the variables used in
such testing. Empirically, the call risk created by
thrift resolutions is difficult to measure hecause
people are adapting to a new environment, and
markets have had little experience in measuring this
call risk However, the effects may be loosely
proxied by the volume of deposit<; at newly resolved
thrifts. Many depositors may not become aware of
this new risk until the RTC resolves their deposits
or those of people they know because, with deposit
insurance, the depositors may falsely assume they
only need to know posted deposit rates.
To assess the impact of RTC activity on M2,
the FRB M2 model was modified in three ways.
The first (model 2) adds a variable measuring the
change in the quarterly average mnning sum of
deposits at resolved thrifts (RTCDEP) The second
and third (models 3 and 4) add terms (RTCOC and
RTCDOC), which respectively interact RTGDEP
with an M2 oppottunity cost term and the first
difference of this variable to see if RTC activity
affects the long-run or short-run elasticity of M2



The qualitative results with respect to the three RTC variables were similar using a longer sample period (1964 1914)

with respect to its opportunity cost. See Table 3
for data on RTCDEP and Appendix B for details
on these three variables.
I should note that since 1989:3, the variable
R1'CDEP has generally been larger than the estimated shortfall in M2 growth produced by the FRB
M2 model. This evidence implies that RTC resolution activity may account for the missing M2.
The estimated impact of RTC effects on M2.
The impact of RTC activity was assessed by
estimating four versions of the FRB model over
the period 1976:1-91:4. To compare RTC and
mutual fund results, the sample period begins in
1976: 1. I~ Because RTC did not begin closing thrifts
until 1989:3, the RTC variables (Table 3) all take
the value zero before 1989:3. As a result, variation
in the RTC proxies occurs in only ten quarters,
which makes it unfeasible to conduct simulations
with RTC variables. Thus, the results should be
viewed with caution given that results based on a
short-period may not stand the test of time.
Selected statistics from estimating several
models are proVided in Table 4 (see Duca 1992a
for more details). Results from model 2, indicate
that R1'CDEP is negatively and significantly related
to M2 growth. The negative but insignificant
coefficient on RTCOC in model 3 implies that the
sensitivity of M2 to its opportunity cost is not
significantly heightened by RTC activity. In model
4, RTCDOC is statistically significant, but has a
positive, rather than the hypothesized negative,
sign. Consistent with the significance levels of
RTGDEP, RTCOC, and RTCDOC, the full-sample R 2
of model 2 (0828) is better than that of the FRB
model (0.780), while those of models 3 and 4
(0.787 and 0.794) are only slightly better. In
addition, M2 adjusts (error-corrects) to desired
levels at faster estimated speeds in models 2, 3,
and 4 (25 per-cent, 20 percent, and 22 percent per
quarter, respectively) than in the FRB model 09
percent per quarter). This is considered a good
result because models with higher speeds of
adjustment tend to model the desired stock of
money better than those having lower speeds.
Although the R2 of model 2 is somewhat
better than that of the FRB model, any improvement in full-sample fit is limited by the short
interval during which the RTC has been active.
Thus, any RTC effect is likely to be reflected in
recent years. This point is borne out by the inFederal Reserve Bank of Dallas

Table 3

Changes in Quarterly Average Levels of Cumulated Deposits at Resolved Thrifts
(In Billions)

Simple Quarterly Total of
Newly Resolved Deposits 1












1991 :1
1991 :2
1991 :4








change in the quarterly average volume of cumulated deposits at resolved thrift institutions. Main
proxy for RTC effects on M2.


measure of the quarterly average volume of cumulated deposits at resolved thrift institutions (used to
create RTCDEP)


quarterly average volume of deposits at newly resolved thrifts that occurred within that quarter.

Note that because resolutions tend to occur in the third month of the quarter,
i) the quarterly average of newly resolved deposits (ORTC) is much smaller than the simple sum of newly
resolved deposits during an entire quarter (the last column), and
ii) the potential impact of RTC activity during quarter t on M2 is mainly felt in quarter t +1, owing to quarteraveraging effects For this reason, the average size of RTCDEP tends to be larger than that of QRTC, and
RTCDEP sometimes surges in the quarter following a surge in QRTC.

sample errors rrom thl' Illodels during the period
since the RTC has IKTn :Il'l i\ e (Tah/e 5), O\'Cr
1<)<)0:3-91:4. till' .'i.S.I·:.·s or models 2. 3, :lI1d 'j :lrl'
'12 percent Icl\\er, 2 percent lower, and 12 I1lTu::'nt
higher than that or till' I:I~B Illodel. respel'li\'L'h'. In
:Iddition. if the missing ,\12 is mcasured 1)\' the
:I\'l'rage e.stimatl'cI grCl\\ II) r:ltl' .shortfaJl (WlT
1()()0:3-<) 1: J. then till' Inc \ :lriahle.s in mo(k,ls 2.
3. and -f accounl ror :->3 J1lTlent. 3--' percent. :lI1d
H percent or till' mi.s.sing \12. respectiH'1\
Tahles f :\I1d ') suggest se\ eral conclusions
First, lllodl'1s 3 :lI1d ·1 indicate that the neither the
Economic Review -

Second Quarter 1992

long-run nor the short-run responsi\cl1l:ss of 1\:12
to ch:lnges in its me:lsured opportunity cost arc
signihcmtly heightened hy Inc activity (the
coefficient on R1'Cf )oe h:IS the wrong sign).
Second. model :.2 procluces the lK'st full-sample ht,
:I nd error-corrects raster I ha n models 3 and L
Third. model 2 accounls ror much more of the
missing .\12 th:111 eithlT mOlk'l 3 or modcl .j, The
performance or model 2 i.s consi.stent \yith the
h> j1othesc.s that IrI'C :lllions create a missing M2
plwnomcnon dircl'lly hy crl'aling an early "call"
on high-yielding small tillle deposits in a period of

Table 4

Selected Results of Estimating M2 Growth Rates, 1976:1-91:4
Selected Variables

FRS Model

Model 2

Model 3




Model 4





- 00083*


long-run OC elasticity





S.S.E. (Quarterly, not
a percentage)





R2 (corrected)





** Significant at the 95-percent confidence level.
** Significant at the 99-percent confidence level
(I statistics in parentheses)

(GNP, + GNP,_,)/2, measure of permanent income used as a long-run proxy for transactions.


Opportunity cost of M2, defined as the spread between the 3-month Treasury bill rate and the
average interest rate paid on M2 balances.


measure of quarter-to-quarter change in the quarterly average volume of cumulated deposits at
resolved thrift institutions


variable interacting RTCDEP and 10g(OC/-l)' controls for whether the long-run opportunity cost
elasticity of M2 is sensitive to RTCDEP.


interacts RTCDEP and del(log(OC)). controls for whether the short-run opportunity cost elasticity of
M2 is sensitive to RTCDEP.

NOTE: A negative coefficient on [log(M2H )-log(GNPAVH )) implies that M2 balances adjust (error correct) toward
their desired levels

1()\\'l'l illlele,~1 r:lll'S :l1ld indirl,etly h) l're:lting a

cd I risk on 01 her. nO(-Yl'I-ca lied dl'posilS
'" Another reassuring aspoct 01 mo(fel 2/s that Its cocll/clOnts
on non-RTC vanab/es (not shown) are more SIIIIIi,if tu those
obtall1ed by est/matll1g the IRB mcnic/up /hroug/1 1OlROl4
than are thosc ob/atncei by esIII11"IlI1g the FRrJ moclc!
through 1991 4 Olthese variables the must notewortilyarc
Ihc error correction long-rUII opportul1lly cos! and sllOrlrun consumption terms

Ci\l'n tlut Illock'i 2 is prdl'l';thle to the othl'l'
In'C-lll( Jdil'il'd :\12 11 \(KIl'1s. the \ :triahle !nCfJf;p ~'as
alkll'cl :\.~ :1 ~ep:lr:lll' regre,~,~or to l';lch of the bond
:ltllll'quit\' !"und :lcljustl'd :\[2 1ll00Icls. I ·) Hl'sults
illdiclIl' Ilut NrC/ )/:'1' is signi!"ic1I11 in all three
Illockls. of l1lL·Sl'. I hl' subs( itution-hond acljusted
Federal Reserve Bank of Dallas

Table 5

In-Sample M2 Growth Rate Errors Over 1990:3-91 :4,1976:1-91:4
(Percent, Seasonally Adjusted Annual Rate, Negative Entries Reflect Weaker-Than-Predicted M2 Growth)


FRS Model

Model 2

Model 3

Model 4




- 91


1991 :1
1991 :2
1991 :4














42% lower

2% lower

12% higher

Growth Rate Residuals, 1990:3-91:4:


Percentage of
Missing M2 explained
S.S.E over 1990:3-91:4,
(Quarterly rate):


Relative to FRS S.S.E

*Not particularly meaningful given the ""Incorrectly" signed coefficient on RTCDOC in model 4

model out performs aII the others in tl'II11S of fullsampil' I it. :IS shmyn in T:lhle 6. With rl'spL'Cf to till'
missing \12. the :l\er:lgl' :\12 gro\\·th r:lle shortf:dl
0\"(.'1' I ()(XU-() I :-1 is 0.2 I percentagL' points \\ ilh the
"uhstitutiIJl1-hond adjusted modL'!. O.2() percentagl'
points \\ itll tot:d honll lund,,,_ and :1 sOlllewlwl
smaller 0,10 percent:lge points with the equity and
suhstitutioll-hond adjustlllL'nts Simi!:II' to the mutual
und regrl',ssions th:ll e'-:lludL'd RTC dTl'llS. tlK'se
findings indicate lhat adding suhstitution :ldjusted
hond funds yields till' most expl:tin:lhle monetary
:lggreg:lte. hut that :Iddillg in equit) runds SL'e!11S to
:lccount for' ,sOIl1e\\ h:lt l110re of thL' mi,,,,sing ]\[2.

SUlllmary and policy implications
The closing of lhrifts In' the Inc can plausihh' depres,s \12 h\' :1<.lu:dh forcing cd!.s of high\'iL'id ,,,111:111 tiIl1L' depo,sits in :111 L'11I ironment or
Economic Rt.·view -

Second Quarter 1992

Icm L'r illlerest rates :lI1d hy creating call risk for
other SIl1:111 time deposil.s. The volume of deposits
at ne\\ I) resoh'ed thrifts can he corrL'iated \\'ith
unexplained ~Yeakness in \12 growth not only
heC:lllse roll-m'er dTecl.S are tracked hy this
variahil'. hut also hel':IU,Se knowil'dge of the risk
to nominal rate returns Il1ay !11ove \\'ith the level
or ETC :ICli\ it\· as more households experience
the,se ri,sk,s IIrst-hand.
Consistent ~'ith these possihle effects.
regn:ssion :1Il:dysis imliC:ltes that Il10st of the
missing .\12 appears to he associ:IIL'd with thrirt
reso]utiol1S Although SOJlle of tlK' mi,ssing ,\12
may IK' rl'llC'crecl in suhstitution h) households
Irom retail deposits to\yard hond and equity
mutual I"unds. it is unck'ar to what extent these
shifts sll'm from RTC policies that can plausihly
redul'l' the :lttr:lCti\ L'ness 01" :\12 deposits or from :1
,steepening \ il:'ld cun e. ;\loreo\"lT. hond and


Table 6
Selected Results from Combining RTC and Bond and Equity Fund Effects, 1976:1-91:4
(Runs add RTCDEP to M2 and bond and equity fund adjusted M2 models in Table 1)


Bond Fund
Adj. M2

Bond and Equity
Fund Adj. M2

Simple Bond
Fund Adj. M2





- 19011 **


- 00034**




Long-run OC elasticity



- 077


Selected Variables

S.S.E. (Quarterly, not
a percentage)





R2 (corrected)





** Significant at the 95-percent confidence level.
** Significant at the 99-percent confidence level.
(t statistics in parentheses)

Growth Rate Residuals, 1990:3-91:4:
(avg. FRS error














42% lower

66% lower

62% lower

64% lower


Percentage of
Missing M2 explained
S.S E. over 1990:3-91 :4,
(Quarterly rate)'


Relative to FRS S.S.E.

equity mutual funds do not appear to ~Il'u)unl for
more than a small part of the missing M2.
\"Xfhile the results indiclle th;11 equity funds
are not good substitutes for M2, [ find Ihat bond
funds are a good substitute for M2 balancc.~ on
two grounds. First, the characteristics of bond
funds are similar to those of M2 balanccs. Second.
because a bond fund adjusted M2 aggregatl' is
more explainable than 1\12, it appears that ;In

expanded aggregate intern~t1izes substitution
helwel'n homl funds ~lJ1d Nl2, These results suggest
that the Feder;t1 Ikservt' may need to monitor
an M2 monclary ~Iggrt'gate that is expanded to
include some hond funds, Neverlhdess, findings
indiCltl' lhal in considering an expanded M2
aggrl'g~lll', il is empirically imporunt to differenti~Ile bond fund inllows associated wilh shifts out
of dircTI bond holdings from those out of M2,
Federal Reserve Bank of Dallas

This study suggests that the case of the
missing M2 is similar to two previous episodes of
missing money; all three instances appear to be
linked to regulations. The first case of missing
money-weak Ml and demand deposit growth in
the mid-1970s-was identified by Stephen Goldfeld
(1976) and has been linked to two factors. One
stemmed from businesses' switching from demand
deposits to overnight repurchase agreements
spurred by high interest rates and the prohibition
on interest on business deposits (Tinsley, Garrett,
and Friar, 1981). The other factor stemmed from
declines in compensating balances (zero-interest
bearing accounts of firms that partially compensate banks for providing services and loans) that
owed to shifts away from bank loans to commercial
paper. These shifts in business credit sources
were induced by banks' rationing credit during
a period of Regulation Q-induced disintermediation and passing along the higher cost of reserve
requirements during a period of high interest rates
(Duca 1992a).
During the late 1970s and early 1980s, a
missing M2 phenomenon appeared as high
market interest rates, coupled with Regulation Q
ceilings on deposit rates, drove households away
from deposits toward money market mutual
funds. This case of the missing money was solved
by later adding MMMFs (and MMDAs) to M2,

Economic Review-second Quarter 1992

which internalized any substitution between
MMMFs and other M2 components. The current
missing money episode can also be interpreted as
reflecting the changing impact of regulations.
Specifically, the RTC's actions can be viewed as
removing the deposit insurance subsidy indirectly
paid by taxpayers to investors holding high
yielding accounts at troubled thrifts.
Although results link the missing M2 to RTC
activity, the short subsample period of RTC
activity makes this study's findings subject to
qualification. The reason is that without a long
track record, it is possible that some other development that happened at the same time as RTC
resolutions could be the real cause of M2 weakness. Nevertheless, the results suggest that until its
completion, the thrift resolution process could
continue to create a missing M2 phenomenon.
These findings do not imply that the RTC is
incorrectly resolving bankrupt thrifts. Rather, the
results simply suggest that RTC activity is affecting
M2 growth in ways not captured in conventional
econometric models of M2. An important implication of this study is that if economists are to infer
the general pace of economic activity from M2,
M2 may need to be viewed in conjunction not
only with spreads between deposit and market
interest rates, but also with the pace at which the
RTC resolves troubled thrifts.


Appendix A
Constructing a Substitution Adjusted Bond Fund Series
This appendix describes how a bond
fund series was adjusted for inflows from
directly held bonds. This series, BF, was then
added to M2 to construct one of the two bond
fund adjusted M2 series that are assessed.
As described at the end of this appendix, all
three bond and equity fund adjusted series
were converted into quarter average equivalents (using the same procedure) because
M2 growth is typically measured on a quarter
average basis.
BF was calculated as the difference
between bond fund outstandings and cumulative bond fund inflows attributable to shifts
away from direct bond holdings (BFS). BFS
was calculated in two steps. First, direct bond
fund holdings are estimated. Using the Federal Reserve Board's flow of funds data, total
household bond holdings (BT) were defined
to equal the sum of the household sector's
corporate bonds, government securities (excluding savings bonds), and tax-exempt securities. Note that household assets in
commercial paper or in money market mutual
funds were not counted as bond holdings, but
that owing to data limitations, this figure includes Treasury bill holdings. Direct holdings
of bonds ("BO," Le., nonmutual funds) were
estimated as the difference between total
household bond holdings (BT) less total estimated bond fund holdings (TBF).
The second step entailed estimating the
extent to which direct bond holdings fell as a
result of substitution toward bond funds. This
was done as follows. If bond fund holdings
rose while direct bond holdings fell, then bond
fund holdings attributable to substitution be-


tween bond assets equaled the minimum of
the size of the decline in direct bond holdings
and the increase in bond funds. Given data
limitations, bond fund holdings attributable to
substitution between bond assets were conservatively calculated as equaling the cumulative sum of such measured substitutions:

BFSr = ISUBt_i'



where SUBt
TBFH ]) ,




BOt]' [TBFt -

if (TBFr - TBF,.) > 0 and (BOt - BO,.)<O, and

= 0, otherwise.

This measure likely understates substitution
from directly held bonds to bond funds because it does not account for the extent to
which direct bond holdings would have grown
in the absence of bond funds. However, the
relatively sluggish growth of total bond holdings in the mid-1980s implies that the degree
to which BFS underestimates these shifts is
Next, bond funds substituting for M2
(BFU) were calculated as the difference between total household bond funds (TBF) and
BFS (see Figure 4):





Finally, this bond fund component was converted from an end-day-of-quarter number to

(Continued on the next page)

Federal Reserve Bank of Dallas

Appendix A
Constructing a Substitution Adjusted Bond Fund Series-Continued

a quarterly average number to create an
adjustment (BF) that was comparable to quarterly average M2 data. This was done by

In creating the two other mutual fund
adjusted M2 series, total household bond
funds were added to M2 (BFM2), and equity
and substitution adjusted bond funds were
added to M2 (BEFM2). As with BFM2, these
adjustments were converted into quarter average equivalents following equation 4a. 1 Note
that although bond fund data are available on
a monthly (end-day-of-month) basis, the adjustments in equation 4a had to be calculated

Economic Review -

Second Quarter 1992

on an end-month-of-quarter basis because
the flow of funds data used are end-month-ofquarter data. To compare the M2 series adjusted with substitution adjusted bond fund
data (SBFM2) with the other two bond and
equity fund series, the two other series were
converted into quarter averages using the
method in equation 4a even though monthly
data are available. The qualitative nature of
the results was unchanged when BFM2 and
BEFM2 were constructed by averaging
monthly data instead of using just end-monthof-quarter data points.

These quarterly adjustments are averages of constructed month
average data Monthly averages for each month t were created
by averaging end-day-of-month outstandings for months t and


Appendix B
Formulas Used in Measuring the Impact on M2 of Deposits at Resolved Thrifts

RTCDEP was calculated in several steps
to create a variable comparable to the way M2
growth rates are typically calculated. Two specific considerations were taken into account.
First, the growth rate of M2 usually is measured based on quarterly averages of month
average balances. For this reason, a onceand-for-all deposit runoff in the first month of
a quarter depresses M2 growth that quarter
by a greater magnitude than does a comparable decline in the third month. Second, due
to quarter-averaging, inflows occurring in quarter t-1 are likely to have a greater impact on
the quarterly M2 growth rate in the following
quarter (t). Thus, resolutions of deposits that
occur in one quarter can affect the growth rate
of the following quarter. For this reason, the
impact of deposit resolutions on quarterly
M2 growth is best measured if the variable
RTCDEP is defined as the change in the
quarterly average level of current and prior
RTC resolutions rather than by the contemporaneous volume of deposits at newly
resolved thrifts.
Reflecting these considerations,
RTCDEP and RTCOC were constructed in
several steps using available monthly data on
total deposits at thrifts resolved by RTC.l
First, the monthly volume of deposits at newly
closed thrifts (RTC) was converted into a
contemporaneous month-average effect by
dividing it by 2 (MRTC). Next, these monthly
data were converted into quarterly average
flows (QRTC). This was done by weighting
each contemporaneous month-average flow
by one-third, and then adding the weighted
monthly averages to two-thirds of RTC from
the first month and one-third of RTC from the
second month of each quarter. In the third
step, a quarterly average cumulated stock of
resolved deposits (RTCDEPO) was created


by adding the cumulated sum of resolved
deposits in prior quarters (CUMRTC) with the
quarterly average level of newly resolved
deposits (QRTC). Next, RTCDEP was calculated as the first difference in RTCDEPo.
Fifth, RTCOC was created by multiplying
RTCDEP with the lagged opportunity cost of
M2 deposits (OC) defined as the difference
between the three-month Treasury bill rate
and the weighted-average return on M2 balances. 2 Finally, RTCDOC was created by
multiplying RTCDEPwith the contemporaneous first difference of M2's opportunity cost



deposits at thrifts newly
resolved during a month.
month average of newly
resolved deposits.
quarterly average of newly
resolved deposits.
cumulated sum of deposits
resolved in prior quarters.
quarterly average cumulated
stock of resolved deposits.
change in quarterly average
cumulated stock of resolved
RTCDEP interacted with the
opportunity cost of M2.
spread between 3-month
T-bill rate and average yield
on M2 balances.

Subscript m denotes month m.
Subscript q denotes quarter q.
Subscript g denotes first, second. or third
month of quarter.

(Continued on the next page)

Federal Reserve Bank of Dallas

Appendix B
Formulas Used in Measuring the Impact on M2 of Deposits
at Resolved Thrifts-Continued






RTCm /2







_ RTCOEPq x M20C q

+ (1 13) MRTCg=2
+ (1/3)MRTCg=3
+ (2/3)RTCg~1 + (1/3)RTCg=2
= (5/6)RTCg~1 +


+ (1/6)RTCg=3


L,[RTCg~l.q=1 + RTCg=2.q=t



Economic Review -

Second Quarter 1992

The author owes a special debt to Richard Anderson of the
Federal Reserve Board staff, who compiled these monthly





This was done in order to compare results with the Fed's error
correction model of M2, which lags the log-level OC term by one


Baumol, William (952), "The Transactions Demand
for Cash: An Inventory Theoretic Approach,"
QuarterlyJournal ofEconomics 66 (November): 545-56.

Milbourne, Ross (986), "Financial Innovation and
the Demand for Liquid Assets," Journal of
Money, Credit, and Banking 18 (November):

Clements, Jonathan (991), "Bond Fund Sales
Climb to Record Level in July," Wall Street
Journal (July 31): Cl and C9.

Miller, Merton H., and Daniel Orr (966), "A Model
of the Demand for Money by Firms," Quarterly
Journal ofEconomics 80 (August): 413-35.

Cox, W. Michael, and Harvey Rosenblum (989),
"Money and Inflation in a Deregulated Environment: An Overview," Federal Reserve Bank
of Dallas Economic Review, May, 1-19.

Moore, George R, Richard D. Porter, and David
H. Small (990), "Modeling the Disaggregated
Demands for Ml and M2 in the 1980's: the
U.S. Experience," in Financial Sectors in Open

Duca, John V. 0992a), "The Case of the Missing
M2," Federal Reserve Bank of Dallas Research
Paper, no. 9202, March
- - - 0992b), "U.S. Business Credit Sources,
Demand Deposits, and the 'Missing Money,'"
Journal ofBanking and Finance (forthcoming, July).
Farrell, Christopher, and Mike McNamee (991),
"Does the Shrinking Money Supply Spell
Trouble?" Business Week (October 28): 116.
Furlong, Fred, and Bharat Trehan (990), "Interpreting Recent Money Growth," Federal

Economies: Empirical Analysis and Policy
Issues, edited by P. Hooper, K.H. Johnson,
D L Kohn, D.E. Lindsey, RD. Porter, and R
Tryon, (Washington, D.C.: Board of Governors of the Federal Reserve System, 21-105).
Orr, Daniel (970), Cash Management and the
Demandfor Money (New York: Praeger).
Senior Financial Officer Survey (991), Board of
Governors of the Federal Reserve System,
Photocopy, August.
The Donoghue Organization (987), Donoghue's
Mutual Funds Almanac, 1987-1988 (Holliston,
Massachusetts: Donoghues).

Reserve Bank of San Francisco Weekly Letter
(September 28): 1-3.
Goldfeld, Stephen M. (976), "The Case of the
Missing Money," Brookings Papers on Economic Activity 7(3): 683-730.
Hallman, Jeffrey J., Richard D. Porter, and David
H. Small (991), "Is the Price Level Tied to the
M2 Monetary Aggregate in the Long Run?"
American Economic Review 81 (September):

Tinsley, PA, B. Garrett, and M.E. Friar (981),
"An Expose of Disguised Deposits," Journal
ofEconometrics 15 (January): 117-37.
Tobin, James (956), "The Interest Elasticity of the
Transactions Demand for Cash," Review of
Economics and Statistics 38 (August): 241-47.

Hetzel, Robert L., and Yash P. Mehra (989), "The
Behavior of Money Demand in the 1980s,"

Journal ofMoney, Credit, and Banking 21
(November): 455-63.


Federal Reserve Bank of Dallas

John H. Wood
R.J. Reynolds Professor of Economics
Wake Forest University and
Research Associate
Federal Reserve Bank of Dallas

Monetary Policy in a Small Open Economy:
The Case of Singapore
uring the past quarter century, Singapore has
combined the fastest growth with the lowest
innation of any industrial economy. J This record
has been accompanied by conservative monetary
~tnd fiscal policies, as well as free trade and unrestricted capital nows, reminiscent of nineteenthcentUlY liberalism. The primary concern of this
article is Singapore's monetary policy, which is
interesting and perhaps instructive in several ways.
First, Singapore is the best avaibble example of the
small open economy that occupies a central place
in international trade theory: it has few protective
tariffs or exchange controls and is too small to
innuence the prices of internationally traded goods.
Second. the constancy with which the Singapore
monetalY authorities have pursued price stability
for 170 years, as a colony and as an independent
state, may be unique. Third, because Singapore's
monetary officials have been forthright in articulating their method" and objectives, we are provided
with a rare opportunity to evaluate the success, or
otherwise, of the policies of a central bank.
A country's economic policies are political
variables subject to many innuences and cannot be
understood without knowledge of their history and
the institutional framework within which they arc
conducted. The first section of this ~ll1icle traces the
hist()Jy of Singapore's monetary institutions and
policies from its establishment as a British trading
post in IH19. These institutions and policies have
changed less than in most countries. and the present
commitment to stable prices may be attributed to the
belief that past economic successes have in large
P~llt been due to Singapore's record of price stability.
The second section presents the structure of the
economy and government wage. fiscal, and trade


Economic Review - Second Quarter 1992

rolicies-the real background that sets the requirements and limitations of monetary policy. We will
see that the Singapore monetary authority has been
spared most of the internal constraints, such as
.government deficits and aggressive unions, that have
plagued central banks in other countries, giving it the
freedom ~lS well a'i the desire to pursue price stability.
Singapore's recent monetary policy is examined
in the third section. The authorities have continued
to adapt to changes in world monetalY conditions.
As a colony and during the first few years after independence from Great Britain in 1963, Singapore
aimed at rrice stability and a stable exchange rate

I am gratelul to the following people for helpful discussions
and stalislical assistance Jared Enzler and Thomas Shammugaratnan of the Monetary Authority of Singapore, Tilak
Abeysinghe, Basant Kapur, K J Ngiam, Peter Smith, S H
Tung, and Raymond Wong of the National University of
Singapore, Allin Cottrell of Wake Forest Universify; David
Gould, Evan Koenig, and Gerald ODriscoll of the Federal
Reserve Bank of Dallas, and Robert Emery of the Board of
Governors of the Federal Reserve System All errors are my
, Between 1965 and 1990, the average annual growth rate of
Singapore's per capita real gross national product (GNP)
was 72 percent, compared with 6 7 percent and 6 4 percent for South Korea and Taiwan, Singapore's closest
competitors Singapore's average rate of consumer price
inflation was 3 6 percent, compared with 4 2 percent for
Wesl Germany, which had the second-lowest inflation, 56
percent for the United States. and 6 7 percent for Organization for Economic Cooperation and Development (OECD)
countries (based on data from World Bank Development
Report 1990, International Financial Statistics. and Financial Statislics: Taiwan District, The Republic of China)


by tying its currency to that of a larger country on
the gold standard---the United Kingdom until its
devaluation in 1967 and then the United States until
it left gold in the early 1970s. Since then, Singapore
has continued to achieve low inflation through
close control of its money stock and letting its
exchange rate rise relative to most of the inflationary
outside world. Some possible lessons of the Singapore experience are considered in the last section.

The evolution of monetary attitudes
and institutions
What made Singapore different in the
1960s from most other countries ofSoutheast
Asia was that she had no xenophobic hangoverfrom colonialism. The statue qf the
founder ofSingapore, Sir Stamford Rajjles,
still stands in the heart of the city to remind
Singaporeans q{his vision in 1819 q{Singapore becoming, on the basis qffree competition, the emporium ofthe East. on the route
between India and China There were then
120 people on the island. They lived bjl fishing Within jIve years of its foundinp" there
were 5,000 traders, British, Arab, Chinese,
Indian, and others drawn in by this principle
offree and equal competition
Had the Dutch who governed the then
Netherlands t:ast Indies accorded these same
ground rules for trade and commerce in the
Indonesian Archipelago, Singapore mip,ht
never have got started. These were ou r origins
So we have never sufferedFom any illhibitions in borrOWing capital, know-how, managers, engineers, and marketing capabilities
-Prime Minister K. Y. Lee (978)

Singapore's colonial heritage also includes the
determination to select the monetalY institutions
most conducive to price stability. The development


Dollar is a variation of the German word thaler. a sixteenth-

century coin struck from Bohemian silver Thaler and its
variations came to be generally applied to silver coins The
Spanish peso. or piece of eight. was known in the Englishspeaking world as the dollar, and the name was extended
to the similar U S silver coin minted in t 792

of those institutions and their relationship to the
present framework are discussed below.
The silver standard and the Currency Board
system. In 1819, the island of Singapore, lion
ofthe sea, at the tip of the Malay peninsula (see
the map) was acquired by the British East India
Company from a local sultan. Singapore was joined
with two ports on the west coast of Malaya, Pinang
and Malacca, in a single administrdtive unit called
the Straits Settlements. The liberal economic environment extended to acceptance of the competitive,
full-bodied currency then in general use in the
East-Spanish and Mexican silver dollars. More than
2 billion of these coins were minted by the Spanish
from Mexican silver between 1535 and 1821, and
1.5 billion were minted by the Mexican government
during the remainder of the nineteenth century.
They "were the most widely circulated coins in
history, [perhaps] closer than any other to being a
truly international currency" (Chiang 1967, 1-2).2
Government monetary involvement was
limited to minting subsidiary coins until 1899, when
private note issues were terminated and a Board
of Commissioners of Currency was established to
issue paper currency in exchange for silver coin
and to redeem this currency in coin on request.
The operations of the Currency Board were patterned after boards established in other British
and French colonies. Fifty percent of the value of
its notes were held in silver and the remainder
was invested in British government securities, the
income from which defrayed the expenses of the
Board and supplemented the reserve until it
attained 110 percent of the note issue. Additional
sums were paid into the general revenues of the
colony. The reliance on sterling was finally broken
by the British devaluation of 1967, but Singapore's
currency continues to be more than fully backed
by gold and foreign exchange (there was a shift
from a silver to a gold standard in 1906).
Straits Settlements notes came to be widely
used in British Borneo, Sumatra, the independent
sultanate of Brunei, and the Malay peninsula,
which had come under British control although
administered separately from the Straits Settlements. In 1938, the Settlements joined the nine
Malay States and Brunei in a currency union, the
Straits dollar became the Malayan dollar, and the
Currency Board distributed its profits in line with
currency use in the various parts of the union
Federal Reserve Bank of Dallas




• lJl'lZN>u











S ••
So ulh





S ••



I cfJ'j·





The gold exchange standard. Germany, the
United States. and several other countries adopted
the gold standard in the last third of the nineteenth centUlY, and these increases in the demand
for gold. combined with silver discoveries, caused
a depreciation of silver relative to gold. The value
of the Straits silver dollar in the London market
fell from 60 pence (a quarter of a pound sterling.
\vhich \\"as fixed to golcl ancl until decimalization
in 1971 had 20 shillings of 12 pence each) in 1H72
to 31 pence in 1H93 5 The Inclian silver rupee
Economic Review -

Second Quarter 1992

, Britain had been on the gotd standard since the earty
eighteenth century The gotd standard was based on the
willingness of banks and governments to exchange their
note and deposit liabilities for fixed amounts of gold, for
example, the Bank Charter Act of 1844 required the Bank of
England to purchase with notes all gotd offered for 38875
per ounce of standard gold and to sell gold for 3 89375 per
standard ounce


suffered similarly India and the Straits Settlements
traded predominantly with gold standard countries,
and both were liable for substantial payments to
London fixed in gold. Foreign investment was discouraged, inflation instigated labor disputes, and
the resulting agitation for the gold standard eventually overcame the opposition of those who argued
that a depreciating currency stimulated exports.
India was first to develop what came to be
called the gold exchange standard. Silver coins
continued to circulate, and the local currency was
not easily redeemable in gold, but gold was
"available for payments of international indebtedness at an approximately constant rate [that is,
within the gold points] in terms of the national
currency" (Keynes 1913, 30). The reserve was kept
abroad, partly in gold but mainly in British government securities. The system benefited India and
Great Britain. India earned interest by investing
resources that otherwise would have been circulating as full value gold or silver coin, and the market
for British securities was enlarged. Because the
reserve was held principally in British securities,
the system was referred to as the sterling exchange
standard. A similar system established by the
United States in the Philippines in 1903 was called
the dollar exchange standard. In addition to maintaining an adequate gold reserve, the local government's main tasks were to insure that silver and
other subsidiary coins were worth less melted
down than their nominal values so that they would
remain in existence and that the quantities of notes
and coin in circulation were such that their value
in the foreign exchange markets did not fluctuate.
The Indian system was extended to the Straits
Settlements in 1906 at the rate of one Straits silver
dollar to 28 pence, which was maintained by Singapore until it left the pound to keep parity with gold
and the U.S. dollar when Britain devalued in 1967.
Currency Board or central bank? The Federation of Malaya became independent in 1957, and
Singapore gained internal self-government in 1959.
In 1959, Malaya established a central bank that
performed various regulatory functions and served
as the government's banker. But the central bank



Drake (1969,27), with a quotation from Gunaskera (1954)

did not issue currency. That remained the responsibility of the Currency Board. Singapore and
British Borneo joined Malaya to form Malaysia in
1963, and in 1965 Singapore left Malaysia, but the
currency union continued until 1967. Currency
boards were widely admired by the colonial
peoples for whom they had been established:
From this history of monetary developments one point stands out, namely the overriding importance of commercial relations
with the outside world. It was through international trade that modem money came to
Malaya. It was the safeguarding of international trade and investment which motivated
the currency reformers and provided Malaya
with a monetary system which was simple,
inexpensive and "ideally suited to a period of
colonial expansion and capital migration." 4

However, Malaysia felt the time had come
for a more active monetary policy. In correspondence with the Singapore Ministry of Finance,
the Malaysian central bank agreed that "the
Currency Board system has not restrained orderly
development so far" but expressed concern that
its continuation might interfere with desirable
monetary actions in the future.
[S]hould the economy deteriorate and
should the Malaysian and Singapore Governments he ohliged to maintain levels of expenditure in spite of deteriorating revenues, the
Currency Board system will certainly he a
serious restraining factor in the orderly
development of Malaysia and Singapore
because of the rigidities of the system which
prevents the use of foreign exchange reserves
other than for hacking the currency .
The Board cannot in any way influence
the money supply and, even in normal times,
it is powerless to make credit available to
meet the growing needs of an expanding
economy, nor can it influence the cost of
credit in the country The system cannot in
any way influence the country's economy
when it is subjected to pressures due to
swings in the country's halance of payments.
Its rigidity imposes an undue hardship on
the economy in periods of crisis. A deflaFederal Reserve Bank of Dallas

tionary situation caused by a deficit in the
balance of payments .. can be accentuated by
a contraction in the supply of money at a
time when the proper remedy for such a
situation would be an increase in the money
supply and a lowering of the cost of credit in
the country. '
The Singapore Minister of Finance responded,
[IJt must be remembered that the
present stability of the Malaysian dollar .is
due in quite large measure to the in-built
financial discipline which a Currency Board
system imposes. The main point to ask is
whether the Currency Board system has
restrained orderly development in Malaysia
and Singapore to date. The point [of our
earlier letter] is that taking into account the
effects of sudden separation of Singapore
from Malaysia, it may be more prudent for
both our countries to continue with a known
trusted existing currency system, rather than
to introduce structural changes now. (;

These differences could not be bridged, and
in 1967 Malaysia and Singapore began to issue
separate currencies. The old currency board was
extinguished, and Singapore and Brunei established
a new one Currency boards had existed in nearly
fifty British, French, and American colonies. But
by 1970, among those gaining independence only
Singapore had elected to keep that system."
Perhaps Singapore's decision to preserve its monetary constitution was as much as anything a signal
of its continued commitment to price and exchange
rate stability.H However, the simultaneous achievement of these goals is possible only as long as
other countries pursue the same ends. Growing
world inflation, the increasing frequency of exchange
rate realignments, and finally, in the early 1970s,
the end of the Bretton Woods system rendered
Singapore's 1967 decision obsolete. Henceforth,
Singapore would have to choose between the conflicting goals of price and exchange rate stability.
The Monetary Authority of Singapore (MAS).
The Currency Board still exists, but effectively as
a department of the MAS, which was established
in 1971 with all the formal powers and responsibilities possessed by modern central banks. 9 In
Economic Review -

Second Quarter 1992

practice, however, purchases and sales of foreign
exchange are its only significant instrument of
monetary policy. Open market operations in
government securities on a significant scale have
not been possible because of the absence of a
good secondary market. 10 Most government
securities are held by the Central Provident Fund
(the government pension fund) and other institutions that tend to hold them to maturity. There is
no active discount rate policy because it is
believed that interest rates are determined externally. Of the three traditional instruments of
monetary policy, this leaves the reserve requirement ratio on bank deposits, which in the face of
large capital inflows was raised in 1973 from 5
percent to 9 percent and then lowered during
1974-75 to 6 percent, where it has remained.
Figure 1 shows that most MAS actions are
purchases of foreign exchange to offset drains
caused by government surpluses. 11 In the third
section, the exchange rate and the money stock
are sometimes treated, for convenience, as
alternative instruments of monetary policy. But
the exchange rate and money are only proximate
instruments; some might call them intennediate
targets. The immediate instrument is always
operations in foreign exchange.


From letters of January 10. 1966, and April 8, 1966, reproduced in Annexes A 6 and B 4 to Republic of Singapore,
White Paper on Currency (1967)





Republic of Singapore, White Paper on Currency (1967),
Annex B 3, March 21, 1966
The only other currency board still in existence is that of
Hong Kong, which is still a colony
It should be noted that Malaysia's inflation rate since 1965
has been almost as low as Singapore's
The chairman of the MAS is normally also the chairman of
the Board of Commissioners of Currency
However, the government has encouraged greater activity
in the Treasury bill market since 1986 See Emery (1991,

" Also see Moreno's (1988) Chart 1, "Sources of Reserve


The economic framework: the real
background to monetary policy
In Singapore, weji>Und that the best
fiscal and monetmy policy to underpin a
major investment promotion effort is to turn
a deaf ear to the seductive appeals 0/ the New
Hconomics, which preaches that economic
growth can be achieved hy over-spending
and manipulating the supply of money..
!W!e havefound that the old:lashioned
conservative policy 0/ halancing the government budget-in fact of hud/{eting for a
substantial surplus on CU1Tent account to
jlnance development expel/Clitllre---produces
the hest results in the long run.

Figure 1

Sources of High-Powered Money:
MAS Purchases of Foreign Assets Less Changes
in Government Deposits and Other Liabilities
Billions of Singapore dollars




Foralgn A!SelS,-' "


,. '.,





.. ,.

\ .'

., I

HIgh·Powe,eIH.40noy '.'

-Minister of Finance K S Goh (1973)

Singapore may be the world's most open
economy. 12 There are few exchange controls or
protective tariffs, and the government has sought
to provide an attractive climate for foreign investment. 15 It has one of the world's largest and
busiest ports (the location of its massive deepwater port on the main sea lane between East Asia
and the Middle East and Europe is its greatest
natural advantage) and one of the largest refinery
centers It is a major financial center, trailing only
London, New York, and Hong Kong in the
number of commercial banks (35), and it is the
center of the Asian Dollar Market, with 190 financial institutions soliciting nonresident deposits.
Singapore's foreign trade in relation to the size of
its economy leads the world (Table j),
The continuation of the colonial free trade
regime and commitment to monetary stability
have undoubtedly been important factors in Singapore's economic success. Its leaders were educated
in England shortly after World War II, but they




Singapore is rivaled by only Hong Kong lor this distinction
Most exchange controls were dropped in 1978, but the
authorities have retained the right to interfere in some
cases For example, banks intending to extend loans in
Singapore dollars for more than S$500, 000 to nonresidents
or residents lor use outside Singapore must obtain the
approval 01 the MAS See Emery (1991, 211)

73 '74 75 76 '77 78 79 '80 '81 '82 '83

84 '85 '86 87 '88 '89

SOURCE: International Financial Statistics,

were unaffected by popular Keynesianism, believing that growth is hest achieved by an open
economy, foreign investment, domestic saving, and
fiscal and monetalY conservatism. However, Singapore is not a laissezfaire state, The government
sets economic goals and unhesitatingly interferes
with market forces to achieve those goals, Some
of those government activities and their implications for monetary policy are discussed below,
Land use and the pattern of production. Singapore has approximately the area and population
of the city of Chicago, and government is most
obvious in its regulation of land use, The space
required for roads is limited by a 225 percent tax
on new car purchases (recently supplemented by
quotas), cremation is encouraged, outlying villages
have heen razed and their inhabitants moved to
the high-rise housing blocks that dominate the
Singapore landscape, and agriculture has been
reduced. Cheap food is available from nearby
agricultural economies, and "[rlecognising that
[Singapore's] comparative advantage lies in less
land intensive activities like trade, manufacturing,
and provision of services, the government has
over the years steadily reduced both the number
of farms and the area they occupy... " (Lim 1988,
Federal Reserve Bank of Dallas

Table 1

International Trade-GOP Ratios for Selected Countries, 1984
Hong Kong
South Korea
New Zealand
West Germany
United States

Total Trade/GOP






















NOTE: GDP is gross domestic product
SOURCE: Lim (1988, 5).

()()) lkt \\'CTn 19()"; and 19H9 the share of agrillil[urc' ;\I1cl fishing in gross domestic produc t (C; 1)1')
fell Imm .0, I percent to 0.3 percent. '\c'arh HO
pc'rcent 01 the land is gO\'ernment-m\ ned. ;1 .suh.stanti;i1 part of \\ hich i.s nll\\ \'acant in anticijxltion
of commc'!'cial and industrial de\ e!opl1wnt h;,
Iligh-lc'ch foreign firms \'arious ta\. incc'nti\ es
"promotc' thc' of foreign technolog\." ;\I1d thc'
gmTrnl1Wl1t h;l.s provided a superh il1fLl.structure
;\I1cl ;\ "responsihle trade union movement" (Lim
19HH, 2";71, hut otlll'r\vise firms receive little
g( )\en1l1Wl1t protection or assistance. There i.s no
room for ;\cti\'ities. foreign-owned or Singaporean.
tllat rc'quire tariff protection, suhsidies. or help
from tlw central hank in the form of 10\\ interc'st
r;llc's ()r other policies likely to cause inlbtion or ;\
c!c'plTciating e\.change rate. E\en puhlic utilitie.s
;\I1d otlll'r go\'c'!'nment enterprises earn profits.
Fiscal policy. The gO\ ernment enforce.ssuhsL\nti;i1
pri\ atc' s;\\ ing ;\I1d manages a .surplu.s on its ()\\ n
acc ount. I, Tlw most striking aspect of tlw top
portion o( Tahle 2 is the high rate of im estmc'l1t~
morc' than \0 percent of GDP during the FrOs ;\I1d
19HOs S;\\'ing also exceeds -10 percent of inCOlllC.
:\]ost pri\';ltesa\ ing is through the Centr;i1 I'rm ident Fund (CPFl. a mandatory plan undc'!' \\'hich
Economic Review -

Second Quarter 1992

c'mplo\'C'!'s and employees contrihute speciCied
proportions of \\ages for the future use of emplon'T.s. \\'ithdra\\'ab are permitted onh- for home
purdnse (the main use). retiremenl income. home
rc'pair. and hospital expenses Current contrihution r~\tes are 1H percent and 22 ]wrcent of wages
for employers and employees. re.spectively.
Wage policy. The government's attitude toward
wages Ius heen inf1uenced hy the conflicting desires
for intern~ltional competitiveness (hy means of low
wages), long-term growth (implying high wage.s to
I()rce out low-wage industries), and economic
stahility <calling for f1exihle \vagesl. An example of
the second inf1uence was the "\\ age correcti\'e
polic;, " launched in 1979 in comhination \vith an
"industrial restructuring program" .to promote .skillintc'nsi\ e. high-value-added industries" (Lim 19HH.
I \0). Because reductions in unemplo\'ment and in lahor-force paJ1icipation had heen
e\.hausl<:.'d as sources of gnl\\th. increased empha.sis \\ as placed on "qualitati\'e imprm el1wnt in

Figure 1 shows the effect of thiS surplus on bank reserves


Table 2

Gross Domestic Product and Related Data
(Millions of Current SS, Unless Indicated Otherwise)




Private consumption
Government consumption
Gross fixed capital formation
Change in inventories
Net exports of goods and services









Gross domestic product





Gross domestic product (1985 prices)





Population at mid-year (thousands)





Per capita real GOP (thousands 1985 S$)





Employment (thousands)





Unemployment rate (percent)













Area (square miles)'
Per capita GOP (US$)
United States
West Germany
South Korea
, Increase due to landfills.

SOURCES: Singapore data are from Economic Survey of Singapore Per capita GDP (US$) data are from International Monetary
Fund, International Financial Statistics

lahour ~l1ld access to modern technology" (Lim 191'11'1,
139)," Tax incentives vvere introduced .. to promote
investments in more technologically sophisticated
industl ies and to emphasise rescarch :lnd development" (Lim 1981'1, 2";7l. The wagc-corrective
policy was an attempt hy the government-as a
large employer and regulator of CPF contrihutions
and through its intluence on priv'atc ~',age hargaining-to reinforce these incentives and phase
out Imv quality Iahour intensi\'c industries" hy
raising \\ ages and other labor costs (Lim 1988. 2'')7),

Between 1970 and 1985 the labor-force participation rate
rose Irom 55 percent to 66 percent, entirely due to the rise
in lemale participation from 30 percent to 48 percent


Some ohservers have argued that this policy
\vas applied too vigorously, that the rise in real vV~lges
hetween 1979 and 1984 (8.7 percent pCI' annum,
compared with a productivity growth r~lte of +6
percent) was partly responsihle for the 198";-1'16
recession, and since that time thc gO\'crnmcnt has
stepped up efforts to make lahor costs morc
Ile"ihle. Adjustments in employer CPf contrihutions
havc heen ~111 important pan of this policy. heing
rcduced from 2S percenr to 10 percent in 198() and
gradu~t1ly heing raised in line ~'ith economic e"lxlnsion. Furthermore. in recent years many companies
h~l\ e fo!lmved the. ational \Vages Councih recommended "flexihle vvage policy" hy limiting wage
incrc~lses to 2 percent to 4 percent but giving brger
YC~lr-end honuses linked to company perform~lI1ce
(Daniel 1(89), Tahle 3 compares wage supplements
Federal Reserve Bank of Dallas

Table 3

Average Hourly Compensation of Manufacturing
Production Workers, 1985 (US$)



Ratio of Additional
to Wage

United States
United Kingdom
Hong Kong
South Korea




SOURCE: US Department of Labor. Bureau of Labor Statistics, Office of Productivity and
Technology. June 1986; reproduced in Lim (1988, 185)

in Sing:lpore \\ iththos<: of othc'r countriL'.s. TIl<:
bl'gL'St componL'nh of the 'i'i-perc<:nt figur<: for
I ()H'i \\ ere tilL' eillployer.s' 2'1 pL'rcent CI'F contrihution :Ind honus :lI1d \\'age suppk'mellls totaling
15 ]XTLent ThL' I'ormer is n()\\ IH pern'nt. hut tIlL'
bilLT Ius rroh:lhh- grown In I ')W). g()\ LTnnll'nt
\\ orkers reu:i\'L,d :1 Chrisll1las honus equi\':t1ent to
.z.-'i 11lonths .'<1 LilY. :l1ld Ill:ll1\" pri\· tl >1'
\\ (>rklTs recei\ nl much me 1I L'
The gO\ LTnlllent conlinllL:s to put prL'ssure
on lo\\-\\,:tgc industries In addition to limiting the
nUl1lhLTs of unskilled foreign \\ orkers that finns
nl:!\ L'mp]o\'. :1 jiJll'~!!,1/ /{'(Jr/..,('/\ lely \\ :IS introducL'd
in !()S-. TIll' ilHlIllhh- iL'n' is adjusted in rcsronsL'
to L'conomic conditions. hut in II)')() it r:l1lged from
SS2'i() 10 S~:\()(). dcpending on the imlu.stl'\ (tIll'
Sing:lporL' dolLll' w:ts \\ orth :\hou[ '1'1 I' S cenls I,
Fin:t1h. it is \\orth pointing OU[ th:1l bhor 1:1\\
:tnd union cooper:ltion :lIl' imporL:tnt conlrihutors
to \\:Ige tle:\ihilit\ TIll' Eillpl()\mc'nt Alt or 196H
"enjoins upon thl' lahour 1110\ cment more disciplinl'."ainl in \\ :lgL' \wgoti:llion :lI1d. genL'r:t1h'. a
grL':ller :1\\':trL'nL'.S.S of the soci:t1 respon.sihility of
org:lJli/.ed Llhoul' in the 1:lrger fr:l1lle\\ ork of the
Il:Ition:d inlLTc'st ' (Coil 1(r21 TIll' Industl i:t1 I{d:lliOilS
,\l·t of the s:\l11e \ Glr reduced the scopc of colkTti\ L' hargaining h) gi\ ing "full discretion:lr) PO\\ l't'S
to m:lJlagemcnl in 1l1:ltters or pro\1lotion. tr:lnsfer.
rel'J'uitl11ent. clisllliss:t1.\\el1lent. :\s.signment ()f

Review -

Second Quarter 1992

duties :l1ld l<:rmin:ttion of cl11plo) ment for rcasons
of n:org:lnisation or redundancy." Disputes o\,er
otlll'r l11atters hc refelTc'd to the Industrial
Arhitr:ttion Court, whose dccisions arc hinding.
TlwrL' Ius hl:en onL: strike since 197'. im oh-ing
sixty-onc' workers for \\\'0 days. In thl: midst of the
labor disputes of the carly 1960s, the finance minister
complained th:1I ()\'c'r.seas indu.stri:l!ists 11l'.sitatl:d
to open l:ictorie.s in Singa rorl' hecluse of their fear
lahor prohlems (Goh 196.1), This impedimcnt


to foreign investl1lelll h:IS been removed.
SOIl1C <:Ul\10111ists han' rLTol11ml:l1lkLi that
\\age polin' he aimed at the urgc't of emplm'ment
stahilil\ (partly hy maintaining e:\port competiti\'eness) ami that mOI1l'tary policy he dirl:c\ed at
price .sl:I!li!itv 1(' OITicials h:l\ C' not articubted a
polin' ll1odel. al1l1 tlwir contm! o\'er \\ :\ge.s is not
compil'te. hut thc'ir heha\'ior h:ls heen roughly
con.sistl'nt with lhi.s prl:scription
Foreign investment. The quot:ltion hy I'riml:
i\Jinistcr 1', Y. I.l'e at the heginning of the first
sec\ ion u nderst~llc'.s tile g<)\'lTnment's desi r<: for
foreign ilw<:stmenl, which in f:\ct is preferred to ic o\YI1l'rship OITici:t1.s \'iew Sing:\ poreans
as II :Idel sand monc\ lenders. \\ ith preferences for

" For example see Corden (1984) and Lim ( '988 314-19)


·short-term investment in Singapore
and in diversification out of Singapore This
is a rational phenomenon, and deep in the
instincts of the trader The future is uncertain; Singapore's comparative advantages in
the world change quickly; therefore, take
short-term positions and don't put all your
eggs in one basket '"

Hence, private long-term investment in Singapore must be undeltaken by already diversified
multinationals. Finance Minister Goh emphasized
that large foreign firms bring know-how, established
products with world repute, and markets, and Prime
Minister Lee pointed out that "the bigger and more
established a [multinational corporation] is in his
field, the higher his success rate and the bigger his
contribution to jobs and GNP" (Lee 1978). Wholly
owned finns from the United States, Japan, and
Europe had a failure rate of only 6 percent, compared with a 38 percent failure rate for wholly
owned Singaporean enterprises (Goh 1963, 16, and

" George Yeo (minister of state. finance. and fore(gn affairs).
speech reported in The Straits Times, February 9, 1990

Ministry of Trade and Induslry, Republic of Singapore.
Economic Survey of Singapore, various issues


Singapore's consumer prices rose 20 percent in 1973 and
22percentin 1974 Average annual inflation since 1974 has
been 2 7 percent


MAS Annual Report 1981/82, p 4, and Annual Report 1984/
85, P 1 Similar statements have appeared in almost every
Annual Report


For example, the MAS Annual Report 1983/84 staled thaI
"[gjiven the openness 01 the Singapore economy, especially the high integration of domestic and inlernational
financial markets, il is not possible to pursue an independent monetary policy, although there is some flexibility in
influencing domestic conditions in the short run Thus, the
focus of the Authority's poticy is on the exchange rate rather
Ihan on movements of monetary aggregates" (p 4) Similar
statements may be found in every Annual Report since
198/-82 Lee (1987) and Moreno (1988) also have argued
that Singapore operates with an exchange rate target rather
than money or Interest rale targets The MAS's statement
will surprise those who believe that a flexible exchange rate
increases a country's control of its money stock

Lee 1978, 20) In 1984, foreign manufacturing firms
made up 21 percent of establishments, 53 percent
of workers, and 65 percent of value-added (Koh
1987). In recent years, about 80 percent of manufacturing investment commitment., have come from
foreign firms. 1H

Monetary policy
The gamut ofSingapore's experience in
the pastfouryears, ofsevere imported inj7.a/ion, mild recession and prompt recovery in
the con/exl of international economic and
.financial instahiliZY has strengthened the
hases o/domes/ic economic andfinancial
policies The economy avoided the excesses
injiscal, monetary and wage policies, and
their accompaJlying economic costs, evident
in a numher oldeveloped and developing
cO/lnlries loday
-Monetary Authority of Singapore,
Annual Rep0l1 1976/77, p. 2

Singapore's policymakers were slow to
adjust to the new monetary environment following the breakdown of the Bretton Woods system
and failed to insulate the economy from the
monetary expansions undertaken by a large part
of the world in response to the oil-price shock. 19
But the experience redoubled their determination
to find ways to achieve stability at home despite
the instability around them. The MAS has repeatedly
affirmed that "price stability [is] the prime objective,
.. aimed at sustaining confidence in the domestic
economy and mitigating external inflationary
pressures, as well as safeguarding expOit competitiveness. »211 It has been able to pursue this objective with a single-mindedness that must be the
envy of other central bankers because of a pliable
labor force and a conservative fiscal policy and
bolstered by the belief that the authorities' best
contribution to growth is the maintenance of a
stable environment for investment.
In this section, I examine the means by which
Singapore has achieved price stability I first consider exchange rate management because MAS
officials state that since 1981 they have preserved
stable prices by manipulating the value of the
Singapore dollar to offset foreign inflation. 21 However, such a policy would require the continuous
Federal Reserve Bank of Dallas

Table 4

Model of a Small Open Economy
(1) P =

x + p* + s

(2) R = R* + x e +

Purchasing power parity
Interest rate parity


,= ,* + v - s

(4) Y= Yn + (p_pe) +

Equal expected real rates of interest,
where' = R - P and = R* - p*


Aggregate supply


(5) m - p = a + by- oR +


(6) m = f.l + h

Money demand
Money supply

satisfaction of purchasing power parity (1'1'1',
which requires the rate of exch~ll1ge between lhe
cUITencies of counlries i\ ~ll1d B lo vary equ~illy
\\ ith the difference het\\'LTn tllL'ir rales of intbtion), \vhcn in fact SingaporL",s e:\ch~1l1ge rate, like
thnse oj" other countriL's, h~IS deTiated greatlv from
PPP and for long pniods. TIlL' data suggest that
the ;\Ii\S has instead follo\\'ed a constant-monL' gro\\ th rule.""
Exchange rate managenlent under purchasing power parity. In lighl of Singapore's size.
dqX'ndence on foreign trade and investment, and
Irecdom from currency or tr~lde restrictions, thc
simple model of a ,small open economy in Tahle I
ma\ IX' more appropriatL' for Singapore than for
am' other country. It i,s a com entional description
of an open economy under the a,ssumption of
PI' PP1' is an example of the law of one price:
specifically, identical good,s should sell for the
same price in different countries Equation 1
asserts that the rate of change of Singapore's price
len'l (JI) equals the sum of the rates of change of
tilL' Singapore dollar price of foreign exchange (x)
~lml an a\'erage of the price le\ ds of Singapore',s
tr~lding partners (jJ*), and ~l random error term (s):
s and other errors to he introduced have zero
expl'Cled values,"' Equ~llion 2 is the interest r~lte
parity OR!') relation,ship, according to which,
suhject to the random error (d. investors require
thL' nominal rate of intere,st on Singapore inveslments un to equal the foreign rate of interest (/(*)
Economic Review-Second Quarter 1992

plus the expected rale of depreciation of the Singapore dollar ex"). !'PP and IRP imply the expected
equality of Singapore (r) and foreign (r*J real
interest rates, ~IS indicated in equation;) Equation
I is an aggregate supply function such that the
rate of grow,th of Singapore's output (yJ equals
the trend or natural rate of grow,th of output ()'" J
plus a random error (Il) and a constant times the
excess of realized inflation (jJ) over expected
int1ation (pcl. Equation') is the demand for money,
where 177 is the rate of change of the domestic
money stock, DR is the change in the rate of
interest. and II' i,s ~l random error. The suprly of


Several theoretical papers have conSidered optimal monetary policies for open economies; for example, Boyer
(1978), Roper and Turnovsky (1980), and Henderson (1979)
ThiS study IS not concerned with Singapore's optimal combination of poliCies but with those actually pursued


For example, see Marston's model With capital mobility and
flexible wages and exchange rates (1985, 889)

. The following numerical example of PPP between two
countries IS based on data from the period of my empirical
analysis 1981--90 The average annual rates of change of
the Singapore and US consumer price indexes during this
period were 2 percent and 4 percent, respectively In 1981,
US$1 was worth S$2 10 If PPP had worked perfectly that
value would have fallen 2 percent per annum to S$1 73 by
1990 In fact. it fell only 1 2 percent per annum to S$1 89


money is given by equation 6, where J1 and hare
rates of change of the money multiplier and highpowered money The constants a , a, b, and care
Given expectations, the natural rate of growth
of output, the money multiplier, and the variables
determined abroad, the model consists of six equations in seven unknowns- p, x, R, r, y, m, and h
The system is completed by MAS's instrument
choice-x, R, or h. Suppose that, as asserted by the


The weights underlying x andp' were suggested by Deputy
Managing Director of the MAS K P Teh (1988) in a paper
on Singapore's monetary policy Teh used an index of
DECO consumer price inflation as the indicator of p'
Weights for quarterly series were obtained by regressing
his annual 1976-87series for p' on theps of the nine largest
DECO countries and selecting the countries with significant
coefficients (listed in Table 5) These coefficients approximated relative GDPs Regressions of the formofR 1and R 2
were tned using these fixed weights as well as weights
varying with relative GDPs The latter had higher R 2' sand
are reported in Table 5 They also had higher R"s than
regressions based on trade-weighted indexes All regressions had coefficients of p' significantly greater than -1 in
absolute value
Trade-weighted indexes might be most useful in explaining
exchange rates-unless, as it asserts, the MAS manipulates an DECO-weighted index This assertion is the hypothesis under examination in regression R 1, The MAS's
preference for an DECO-weighted index over a tradeweighted index is a result of its concern for the international
competitiveness of Singapore industry The main difference between the two indexes is the exclusion of food,
textile, and handicraft imports from Malaysia, Indonesia,
and Thailand





The Authority, in managing the trade-weighted exchange
rate, was able to playa supporting role in the important
adjustment measures undertaken by the government since
mid-1985 to revive economic activity (MAS Annual Report
Variations of regressions R 1 and R 2, including different or
additional independent variables, as well as alternative lag
structures for the independent variables and alternative
weighting schemes for x and p', had coefficients less than
-1 9 These results also are similar to those generated by
Tehs annual data, for which the estimated coefficient of p'
is -37 (Teh 1988)
See Manzur (1990) for a discussion of investigations of the
empirical validity of PPP

MAS, its instrument is x. If the inflation objective is
po (which is zero if price stability is desired), equation 1 implies x = po - p*, so that realized inflation is
p = po + s and expected inflation is p" = po. The stock
of money is demand-determined in this situation
(largely by p, which also determines y and R) and
follows from the MAS's choice of x. High-powered
money, h (provided mainly by MAS purchases of
t()reign exchange; see Figure 1), is detennined by
equation 6, given m from equation 5.
Regression R.l in Table 5 assumes that the
MAS's policy instrument is the exchange rate and
reports the response of x to P* and three seasonal
dummy variables. x is a weighted average (an
e.lfective exchange rate) of Singapore's exchange
rates with its principal industrial trading partners,
the weights being relative GDPs valued in U.S.
dollars. The same weights were used to compute
p* from consumer price indexes. Several weighting schemes were used, along with various lag
distributions of p*, but regression R.l produced
the best fir. 20 Regression R. 2 adds y and.f, both
lagged one period, as explanatory variables to
determine whether the MAS has tempered its
stable price policy by depreciating the exchange
rate (raising x) in reaction to slowdowns in the
growth of output and foreign exchange reserves. 26
The sample period begins with 1981 because
the MAS indicated a policy shift (from money to
exchange rate management) in that year.
The coefficients of regressions R.l and R.2
are significant (except the seasonals) and have the
expected signs. However, the large deviations of
the estimated coefficients of P* from -1 raise
problems for the hypothesis that the MAS aims at
domestic price stability by exchange rate management in a PPP world. T Statements by the authorities and equation 1 imply dx/dp* = -1, suggesting
that the model is misspecified, the MAS's policy
is different from that announced, or both.
In view of the accumulation of knowledge
of exchange rate movements since the advent of
floating rates in 1973, it would have been surprising
if Singapore had been able to control p by manipulating x according to equation 1. PPP should hold
in a one-good, free trade, frictionless world. But
there is no theoretical justification for its satisfaction
in terms of standard price indexes. 2H Large inflations are usually accompanied by large exchange
rate movements, but changes in the patterns of
Federal Reserve Bank of Dallas

Table 5

Estimates of Exchange Rate, Money, and High-Powered Money Reactions
(Quarterly Data, 1981 :1-1990:1)
Independent Variables
























































- 018

















(1 03)








Definitions and sources
Except when indicated otherwise, the data are from International Monetary Fund, International Financial Statistics,
with price and GOP series made intertemporally consistent by linking data with different (1980 and 1985) bases.


Rates of change of effective exchange rate (quarterly average of S$ per unit of foreign currency) and
foreign consumer price level; weighted averages with weights determined by GOPs in US$ of
Canada, France, Italy, Japan, the United Kingdom, the United States, and West Germany.

p, m,y,
h. h S

Rates of change of Singapore consumer price index, money stock (currency in the hands of the
public and total domestic commercial bank deposits), real GOP (Yearbook of Statistics, Economic
Survey of Singapore, and Liew 1989), high-powered money (currency of the public and bank
reserves), and high-powered money seasonally adjusted by linear regression on seasonal dummies.


Rate of change of Singapore foreign exchange reserves, in US$ end of quarter; mainly monetary
authorities' claims on nonresidents in bank deposits, government securities, European currency units,
"and other claims usable in the event of balance of payments need ... " (International Financial
Statistics, line 1d.d).


Change (in basis points) in the three-month interbank rate (Monetary Authority of Singapore, Monthly
Statistical Bulletin)

(Continued on the next page)

Ecollomic Review -

Second Quarter 1992


Table 5-Continued

Estimates of Exchange Rate, Money, and High-Powered Money Reactions
(Quarterly Data, 1981 :1-1990:1)
Definitions and



Seasonal dummies; unity in the i th quarter, zero otherwise.


Box-Jenkins estimates of i th-order autoregressive and moving-average
Coefficient of determination adjusted for degrees of freedom.


Durbin-Watson statistic; in no case is the null hypothesis of zero first-order autocorrelation of the
errors rejected with 95 percent confidence.


Ljung-Box Q statistic for a test of general autocorrelation, distributed as X2 with eighteen degrees of
freedom. Sig is its significance level. In only one case, R.1, is the joint hypothesis of all zero autocorrelations rejected with more than 42.7 percent confidence. (See Pindyck and Rubinfeld 1981,

Student's t statistics in parentheses; 2 04 and 2.75 indicate coefficients different from zero at thirty degrees of
freedom with 95 percent and 99 percent confidence.

production in different countries imply thaI there
is no unique relationship hetween price indexes.
Furthermore. foreign currencies are assets as WL'II
as means of paYIllL'nt, which means that their
values may change r~lpidly in response to expL'ctations regarding their fUlure values in ways not
explained hy PPP.
IFioreign l'\:change markets exhibit
heha\ ior that is characteristic of other asset
markets E\:l hange 1ales rcau quickh' to


See Dornbusch (1976). McKinnon (1979), Buiter and Miller
(7981), and Cottrell (7986) for theoretical explanations 01
the high volatility of exchange rates relatIVe to differences in
Dornbusch (1982) argued that the PPP exchange rate
policies adopted by some developing countnes have increased the voia/ilily of their pnces and output

llC'\\'S: rates arC' \'obtilc and dilTicult to
rorecast. Both spot and 1'01'\\ :1 I'd r:iles Gin he
modded as anticipatory prices. hut tilL' exact
parameters are unknown (!.('"icll I<)H'»'"

The tendency of floating exchangL' ratL'S (x)
to IlUl'luate more \\ idely than difTL'rences hetween
rate,s of inflation (P -1f) is illustrated for Singapore in Figure 2. If the i\IAS attempted to comhat
a speculati\'e appreciation of the Singapore dollar
hy hu\-ing foreign exchange. it \\"ould lose control
or its money supply and prohahly its price ]cvel.'"
Monetary control. Suppose the MAS seeks stable
prices through control of the money stock. Letting
the instrument be h and eliminating equation 1
from Tahle 4. the resulting system consists of five
equations in five unknov,/ns (N, r, y, p, 111), which
:lre determined by foreign dau (N~ }"'), expectations of the unknc)\\-ns (P'. x"). the coefficients and
random errors of the system (a, a. IJ, c. I', S, If, IC).
the money multiplier (/1). and the instrument (/1),
Exchange rate expectations (as \\'ell :IS the current
exclunge rare) might or might not he closely
Federal Reserve Bank of Dallas

Figure 2

Rates of Change of the Exchange Rate,
Domestic Prices, and Foreign Prices
(Quarterly Percentages)


Foreign Prices (p.)
Domestic Prices (p)
.••••.• Exchange Rate (x)













SOURCE: See Table 5.

related to current and expected p - p*.
The central bank can choose 1.1 each period
subject to its forecasts of these data, or it can
choose a path for h independent of such forecasts Regressions R.3-R.5 in Table '5 are inconsistent with the former policy and consistent with
the latter policy. If the l\tIAS chooses 1.1 based on
reasonably accur~lte forecasts of p, y, and R, then
1.1 and m will be closely related to these variables. 51
Such a relationship is rejected by regressions R.3
and R.4. In fact. seasonally adjusted 1.1, 1.1" has the
characteristics of a \\"hite noise process. It is not
significantly related to prices, output, or interest
rates, and its error terms are not serially correlated,
The Box-Jenkins expression B].l, in which firstand second-order moving-average and autoregressi\'e terms are insignificant. reinforces this
conclusion, Movements in h-' are consistent with
a money-growth rule in which the MAS offsets all
but unpredictable intluences on 1.1'.12

It is dangerous to draw lessons from the
experience of one countly for the conduct of policy
in another because the possibility and success of
Economic Review-Second Quarter 1992

any policy are conditioned by the history, politics,
and institutional framework of the countlY in
which it is employed. However, three aspects of
Singapore's monetary policy are worth consideration by others.
First, Singapore's commitment to price
stability is not limited to the monetary authorities
but is part of a total macroeconomic approach
that avoids budget deficits or the protection and
stimulation of industries (by means of low
interest rates and exchange rate devaluations, as
well as tarifb and quotas) unable to compete in
world markets. Second, Singapore has achieved
stable prices by means of monetary control. This
is a telling blow for the argument that control
of the money stock is impossible in the United
States, where the difficulties of such control are
less than in a smaller and more open economy.
Third, Singapore has adapted to changes in the
world monetary environment, tying its currency
to the predominant full-bodied coins circulating
in the East (Mexican silver) during the nineteenth
century, shifting to a sterling (gold exchange)
standard in 1906 when silver depreciated, linking
the Singapore dollar to the U.S. dollar with the
devaluation of sterling in 1967, and finally, after
the breakdown of fixed exchange rates in the
1970s, turning to the rigorous control of money
that is made possible by a flexible exchange
rate. Clearly, price stability in Singapore has
been the consequence of determined policy
rather than an accidental outcome of auspicious

-" This may be illustrated by a simple case in which the MAS
directly controls m, y is exogenous. and I abstract Irom
R Equation 5 implies EP = m - a bEy = pO, where po is
the goal, so thatthe policy choice is m = m o = pO + a + Eby
Realized p = pO + b(Ey - y) - w

Write h = Eh + z, where z is the unanticipated portion of
h If the MAS makes Eh grow at the constant rate, h O ,

realized h = ho +



Boyer, Russell S. (978), "Optimal Foreign Exchange
Market Intervention," ]oumal ofPolitical
Economy 86 (December): 1045-55.
Buiter, W. H., and M. Miller (981), "Monetary
Policy and International Competitiveness:
The Problems of Adjustment," in The Money
Supply and the Exchange Rate, eds. W. A. Eltis
and P ]. N. Sinclair (Oxford: Clarendon
Central Bank of China (Taiwan), Financial Statistics, monthly, various issues.
Chiang, H. D. (967), "A History of Currency in
Malaysia and Singapore," in The Monetary
System ofSingapore and Malaysia: Implications ofthe Split Currency, ed. ]. Purcal
(Singapore: University of Singapore).

Goh, K. S. (972), The Economics ofModemization
and Other Essays (Singapore: Asia Pacific Press).
- - - (963), Some Problems ofIndustrialisation
(Singapore: Government Printing Office).
Gunaskera, H. A (954), "The Money Supply and
the Balance of Payments in Ceylon," Review
ofthe Banca Nazionale del Lavoro, September, 146.
Henderson, Dale W. (979), "Financial Policies in
Open Economies," American Economic Review
69 (May): 232-39.
International Monetary Fund, Intemational Financial Statistics, monthly, various issues.

- - - , Intemational Financial Statistics Yearbook,
annually, various issues.

Corden, W. M. (984), "Macroeconomic Targets
and Instruments for a Small Open Economy,"
Singapore Economic Review 29 (October):

Keynes, J. M. (913), Indian Currency and Finance
(London: Macmillan).

Cottrell, Allin (986), "Overseas Investment and
Left Policy Proposals," Economy and Society
15 (May): 147-66.

Koh, Ai Tee (987), "Linkages and the International
Environment," in The Singapore Economy
Reconsidered, eds. Lawrence B. Krause, and
others (Singapore: Institute of Southeast Asian

Daniel, Patrick (989), "It's Time to Let Market
Forces Decide Wage Rises," The Straits Times,
November 20, 32.
Dornbusch, Rudiger (982), "PPP Exchange Rate
Rules and Macroeconomic Stability," ]oumal
Q! Political Economy 90 (February): 158-65.
- - - (976), "Expectations and Exchange Rate
Dynamics," ]oumal ofPolitical Economy 84
(December): 1161-76.
Drake, P.]. (969), Financial Development in
Malaya and Singapore (Canberra: Australian
ational University Press).
Emery, Robert F. (991), The Money Markets of
Developing East Asia (Westport, Conn.: Praeger

Lee, K. Y. (978), "Extrapolating from the Singapore
Experience," speech presented to the World
Congress of the International Chamber of
Commerce, Orlando, Florida, October 5 (Singapore: Ministry of Culture).
Lee, T. Y. (987), "Economic Stabilization Policies
in Singapore," in Economic Stabilization
Policies in ASEAN Countries, eds. P. B. Rana
and F. A. Alburo (Singapore: Institute of
Southeast Asian Studies).
Levich, Richard M. (985), "Empirical Studies of
Exchange Rates: Price Behavior, Rate Determination and Market Efficiency," in Handbook of
Intemational Economics, Vol. II, eds. R. W.
Jones and P. B. Kenan (Amsterdam: NorthHolland).
Federal Reserve Bank of Dallas

Lie\\, E L (Il)W>l. .\Iow:)' al/(!!;'cOIIOJlliC Aclil'i/)'
ill ,),illii,aj)ore, Academic E:\ercise. Departmell!
of Economics and Statistics. N:ltional ['ni\'ersit)' of Singapore
Lim. C. Y.. ed. (Il)HHl. Po!icy ()jJfiolls/iJl' the SillgajJore /:'('(JIIoJlll' (Sing:lpore: ~\[c(;r:l\\-I [ill 1
iVlan/.ur, ,\kher ( ll)<)()). "An lnternation:t1 COlllparison of Prices and E:\change Hales: A NL'\\
Test 01 PurLhasing P()\\'L'r P:lrity ... .Iolll'//{/! (!/
IlItel'l/otiolla!,\Iolle)' olld !"iIl(flICe <) (!\;larch):
7':;-<) I

,"-Ioreno, H:llllon (19m-n. "Exchange ]btes and
l\tIonet<lry Policy in Sing:lpore :lI1d Hong
Kong." in ,'vIollefm)' Po!iC)' ill Ptlci/Ic Basil/
eOIl 1/ fries, ed II S Cheng (Boston: KlU\ver
AcadL'mic Puhlishers l.
I'indyck, [{ohert S.. and Danid L. Huhinfdd
( I ()H [l. /;'collol/wfric ..Hodel.,' a lid r;col/om ic
I·()/'(,'casls. 2d L'd. (l\Ie\\' York: McGraw-Hili).
]kpuhlic of Singapore (1<)67). White Paper 01/
eIlITeI/C) ' (Singa pore: Government Printing

i\1:u ston, j{ich:lrd C (1 <)H':;). "Suhil ization PoliciL's
in Open EconomiL'.< in HOlldlJook o/llIfel'l/{/tiolla!I;·coIU)l/lics. Vol II. L'ds. It \Xl Jones
and P B KL'nan (AmstL'rdam: I'\orth-I-Iolbnd)

Roper. Don E.. and Stephen J Turnovsky (l <)HOJ,
"Optimal Exchange Market Intelvention in a
Simple Stochastic Macro Modd," Cal/adian
.Iolll'lltll o//;'collolllics 13 (May): 296-309,

McKinnon. I{onakl l. ( 1<)7<». ,Holle)' ill IlIferJ!tlI iOlltl! f~\'ch{//I,!!,e (1\;;e\\ York: Oxford I inivL'rsity

Tan. C I [ (I <)H<». Financia! ;Harkets and Instituliolls ill Sillgapore. 6th ed. (Singapore: Singapore llniversity Press).

:\Iinistry of Trade and Industry. ]kpuhlic of Singapore. /:'collolllic SIIIH:)' (!/SillgojJore. qU:lrterl y
and annually. \'arious issues,

Teh. K, p, (19HH), "Monetary Policy in an Open
EconolllY: Singapore." paper delivered to the
Seventeenth SEA ZA Central Banking Course,
Reserve Bank of Austrakl. Sydney. ovemher <)

- - - . ) 'earlJ()o!.? o/Slcllislics, annu:t1ly. various

Monetary Authority of Singapore. A II II 1It1! f(ej)()rt.
\'al ious Issues.

World Bank (1990), Wor!d f)el'elopmel/f Repo/1
1f)f)O (New York: Oxford University Press)

- - - . Banking and Financi:t1 Institutions Croup.
,HOllfh/l' Statisfico! /-Jllllefill. \:Irious issues.

Economic Review-Second Quarter 1992


Fiona D. Sigalla
Associate Economist
Federal Reserve Bank of Dallas

Regional Effects of Liberalized
Agricultural Trade
n recent yt:ars. tht: llnitt:d States has workt:d
aggressi\'t:ly. through hoth hilateral and multilateral negotiations, to opt:n trade. Although
negotiations ha\'t: addrt:ssed trade in a myriad of
goods and st:rvict:s, nov" here has liberalization
rroved more intractahlt: than in agriculture. [n the
United States and many othn countries, agriculture is rrotected not only from foreign competition
through tariffs and quotas hut also through heavy
suhsidies These policies have encouraged agricultural production in many rdatively high-cost
areas. increasing tht: o\"l'rall cost of food and
reducing overall gluss national product (GNP),
(See the hox titled Free hade ill Agriculture Has
Been Elusil'e ")
Most economic analysts agree that agricultural suhsidit:s and protectionism distort prict:s
and give rise to high-cost rroducers that would
otherwise ht: forced out of the competitive
market. Whilt: tht: henefits of changing to a fret:
market are wdl-kno\vn. tht: effects of such
changt:s on ditkrt:nt regions are neither wellunderstood nor otkn dehated.
Eliminating \\ orld suhsidies and harrit:rs to
trade \yould 10\\ er the cost of food ancl increast:
gross national product hy encouraging reallocation of rt:sourct:s toward those producers who arc
most efficient, Countries will srecialize in rroducing goods and servin_"s in which they are world
class, One of the henefits of fret:r trade-he it in
agriculture, manufacturing, or services-is that
GNP increlses hecause resources are reallocatt:d
to the most productive firms. Many agricultural
producers, hO\\'l'vt:r. havt: hecome accustomt:d
to protection and rt:alil.e that their production
could become unprofitahle \\ ithout governmel1!
support. Consequt:nll). tht:se rroduct:rs lohby
against frt:er tradt:


Economic Review -

Second Quarter 1992

In the following discussion. I eX;Imine the
impact intern:nional agricultur:d trade liberalization
-such as the reforms possihle under the General
Agrt:ement on Tariffs and Trade (GATI)-would
have on regions of the Unitt:d States. I begin with
a generalized discussion of protectionism and
then analyze the effects of multilateral free trade
on U.S, agriculture, I conclude by examining the
wide range of implications such changes present
for the agricultural sector in t:ach state,
The impact of freer agricultural trade would
V:l1Y among regions in the United States both
hecause the types of agricultural outputs differ by
region and because some agricultural products are
protected much more than others,

The consequences of market interference
Market interference in agriculture is not
unusual. Most governments have chosen to
interfere with free markets hy protecting their
agricultural production from foreign competition.
Different policies around the world either increase
or decrease the price of agricultural products
within countries But all these policies reduce the
dficiency of agricultural production,
us sugar rolicies, for example, use quotas
to protect domestic producers from lower-priced
foreign competition Quotas limit the impoltation

--- - - - - - - - - - - - - - - - - - -

I wish to thank William C Gruben. David M Gould. Lori L
Taylor. and Harvey Rosenblum for helpful comments I also
wish to thank Praveen M D,xil of the US Department of
Agriculture for providing data Any remaining errors are
solely my responsibility

Free Trade in Agriculture Has Been Elusive

Despite a worldwide movement toward
freer trade, agriculture remains protected and
subsidized around the world. For more than
forty years, agriculture was excluded from
multilateral negotiations to reduce trade
barriers. But after being included in the most
recent round of the GATT, agriculture quickly
became the focus of negotiations.
Although a GATT agreement is close in
several areas, a consensus on agriculture
has been elusive. Negotiators have risked
abandoning agreements on textiles, services,
dispute settlement, and intellectual property
in an attempt to encourage an accord to
liberalize agricultural trade. For many

of sugar. h'l'ping dO!llestic sugar prices higher th~ln
\\"()rld prices a III I r~li.sing tlK' prine of sugar to [J.S.
consumer.s 111 199(), tlK' ~1\"l'r~lgl' "'orld price for
sugar was 12 Cl'l1l.S plT pound, \\ hile tIll: ~I\ c:r~lgl'
t" S. price for sug~lr \\ as 25 cents per pound CO\'l'II1ment support for liS sllg;lr producers places ~t1mosl
all the cost of producer support on conSUl11l'l'S LS
taxpayers financl' Ill~II1Y olher crop progr~lms, such
as deficiency payl11l'I1ls and price guarantees
For instance, [I S, la:\pa) c:rs pay for \yhe~lt
policies thal .supp0J"l producer prices and income.
\\'hc:at producer.s \\"ho parlicip~ltc: in acreagereduction progr~IIl1.S arc offered price guarantees
that. in the h~1\ l' Cl"l'a led a donll:stic Iloor pricl'

US price guaranlees IJave been raised Currenlly Iheyeio
not act as a floor price

Harwood and Bm/oy (1990 18)
A/though livestock producers benefit from subsidies t/wl
reduce Ihe pnce of feed grains Ihese producers wou/a
have higher /lJcomes illhere were no agricultural subSidies
and Irade barllers


countries, agricultural liberalization would be
the main benefit of a free trade agreement.
Difficulties have resulted from disagreements between the United States and
the European Community. The United States
has called for the complete elimination of
trade-distorting subsidies and protection,
while the European Community has resisted
large reductions in agricultural support.
Progress has been made toward a
compromise. Recently, GATT watchers have
become hopeful that an agreement can be
reached to reduce trade-distorting barriers in

hl,I()\\ \\ hich the fc:dc:ral gm erllml'nt \\ ould
\\ hl,:1t I \\'heat prodUClT.S also rl'cl'i\ l' u"p:lyerrumk'd dcfic ielKy payml'nlS that gll;lr~lI1\ee income
\\"1K'n 1~1rI11 prices bll hele)\\ ~I prl'sl't l~lrgl't k-Yl'l.
'Llrgel price-deficic:ncy IXIYI111'nt progl;\I11S implicitly
h~I\'e suhsidized exports hecluse 1~lrgl'l prices help
supporl producer incol11e.s :11 high :1 IIII stahle levels.
Thesl' policies also creall' :In il1Cl'nli\'(' for higher
\\ 11L,:1t production that reduces \\ orkl \\ heat prices 2
Although the \\ 1ll::lt suhsid) program 10\\ ers
the prile of \\'heat \\ hilL- tlK' sllg:lr qUOl~1 increases
tlK' price of sugar. hoth policic'.s di.s[ort rl'source
~t1lol':ltion, raising the cus\ of fooll :lI1d 100\'l'l'ing
0\ er~11I l'Conomic output. TllC'se distortion.s occur
hOlh \\ ilhin and outside the ;lgricullllr~t1 sector
\Vithin the agricultur;t1 .Sl'C\Or. protectionism
distort.s production bec:luse proll'c tion i.s not unifonll ~ICross products. SO!lH::' t) pcs oj pruductssuch ~IS \\'he~1l :lnd sug:lr-~Irc ile~I\'ily protccted,
wllile others-such as hcef and pork-:lre not As
~t rc.sull. :I LIrl11er \\!lo producl'.s on!) \\ 1ll'~lt and
sug~lr wi I! Ixenefil greatly fro!ll the l'"i.sting cOll1hin~llion of suhsidics :lml \r:ldc h~ltTilTs, \\ hile
,~( ll11l'OnC \\!m produces on'" Iwcl" ~11ll1 pork \\"ill
!lol henel it ~ll all.'
\\'11\, then, do ;111 I"a rnll'1. , not plOdliCC sugar
Federal Reserve Bank of DaUas

or wheat? Even though subsidies and trade barriers
provide incentives that encourage some less
efficient producers to remain in business, some
regions could not produce these commodities even
with protection. Thus, it may still be more profitable
for some regions to produce only beef and pork,
even though these sectors are not subsidized.
Agricultural protection also distorts production
outside agliculture. Protective policies attract resources
to protected sectors, thereby reducing the resources
available to other sectors. In other words, farm programs artificially increase farm profit and attract to
subsidized farm production resources that would be
otherwise invested in more productive activities.
While society may choose to transfer wealth
to the agricultural sector, protective policies are
not the most efficient means for supporting producers. Society currently supports agriculture with
protection by fixing prices and quantities and by
limiting foreign competition through tariffs and
quotas. These policies distort the prices paid by
both consumers and producers and reduce output
by disturbing market forces. Writing checks to
producers would be a more efficient way to
support producers
Reduced output of some agricultural products
and excessive production of other products
caused by distorted consumer and producer prices
raise the cost of providing agricultural programs
above the benefit to producers. The U.S. Depal1ment of Agriculture (USDA) determined that every
dollar U.S. producers received in 1986 cost consumers and taxpayers $1.38. I

The effect of trade liberalization
Detem1ining the results of eliminating farm
programs is not simple Each country may have
several farm programs that affect the price and output of each crop. Further, farm subsidies and trade
barriers in other countries affect domestic prices
and output
The result of removing domestic farm subsidies has, in most cases, a straightforward effect
on prices and quantities (Tahle 1). Reducing or
removing a subsidy would reduce the price producers receive and decrease production. The price
consumers pay would increase, and the quantity
demanded would fall. Removal of subsidies in
foreign countries, however, can have the opposite
Economic Review -

second Quarter 1992

effect on domestic markets. Domestic producer
prices and output would increase if a foreign
country is a major producer of an imported crop.
Reducing or removing a tariff or import quota
would reduce both domestic producer and consumer
prices. U.S. production would fall in response to
lower prices, but consumer demand would increase
and imports would rise. The magnitude of price and
quantity changes would depend on the size of u.s.
consumption in relation to world market consumption. When U.S. consumption is large enough to
affect world prices, lifting trade protection does not
reduce domestic prices and output as much as when
U.S. consumption is too small to affect world prices.
When U.S. consumption is great enough to affect
world prices, foreign producers bear some of the
tariff burden. As with subsidies, the removal of
tariffs or quotas in foreign countries would have the
opposite effect on producer prices and output when
u.s. consumption has no impact on world prices.
Thus, simultaneously reducing foreign and
domestic subsidies and tariffs could push prices and
output in different directions. Many researchers
have used general-equilibrium models to determine
the net effect of full multilateral liberalization. In a
USDA project, researchers Roningen and Dixit
used an eleven-region, twenty-two-commodity
partial-equilibrium world net trade model to determine the economic implications of full trade liberalization in industrial market economies. (See the box
titled "The USDA Mode!.") Supply, demand, and
trade data for 1986--87 were used to determine an
approximation of the resulting adjustment in production, consumption, trade, and prices of agricultural commodities to be expected after five years of
free trade. The values of all products not covered by
the Roningen and Dixit study, such as fruits, vegetables, and nursery crops, were assumed to remain
constant. (See the box titled "The Effect of Trade
Liberalization on Fruit and Vegetable Producers.")

World effects of full trade liberalization
Full agricultural trade liberalization would
eliminate all trade-distorting agricultural policies,

Table 1

Effects of Trade Liberalization on Domestic Prices and Output
Removal of
Domestic Subsidy

Removal of Domestic
Tariff or Import Quota

Effect on Producer





Effect on Consumer





Removal of
Foreign Subsidy
Effect on Producer
Effect on Consumer


Removal of Foreign
Tariff or Import Quota







NOTES: Although tariffs and import quotas have simliar effects on prices (P) and output (Q), tariffs
have the beneficial effect of generating revenue,The effects of removing subsidies do not
refer to export subsidies for foreign producers Those subsidies would have opposite
effects on domestic prices and output

including suhsidies Each counllY \\ ould tcnd to
specialize in producing those goods-hoth Llrm
and nonfarm-in \\'hich ir has a COlllJxlr~lti\ L'
alh-anrage. Countries ,Yould import commodities
in \\ hich rhey han~ a comJxlrati\'e di,~~llh'~lI1lage.
Resources \\ ould he channeled from uses of Im\
producti\'ir~ ro rhose of high produCli\ il\, pl'rmitting higher l<..~yeis of consumption ~lnd im l·stment.'
\,\;ith full agricultural trade liheraliz:ltion,
\yorlLl prices \\ ould increase for most farm products, at least in the short run. An important distinction exists hetween the price rhe consumer pay,~
and the price the producer recei\'es. Suhsidie,~ ~lre
funded hy taxpayers, E\'en though suhsidic's
misallocate resources and raise the ovcr~t11 cost or
output. in practice suhsidie,s and tradl' h~lrriers hold
dmvn the consumer price of most brm products

The United States could unilaterally etllnmate markotdistorting agricultural policies, removing farm support and
trade protection, while other countries maintain their programs US resources would be utili7ed morc efficlf?ntly
and the economy as a whole would benefll fhe U S farm
sector however woufd experience a greater reducllon m
Income than if all counlfles removed thell p'ogmms because US producers wouid not benefll from the boost III
demand that would occur WltlJ free trade

\Ilhough eliminating m;lrkL't-distorting suhthrouglHlut til\: \\-odd \\oulLl increase prices
in the ,~hort rUIl, in the long run competition '\'(luld
innl'ase, \\ hidl \\ ould raisc etTicienc.y and mitigate
pricl' innl'~lsl'S. 1-\ cn in the shon run, !1(l\YC\ er. the
l'nd oj suhsidies \\ oukl mean a dccline in the
on'l'~lll cosl or ;t11 prt>duets \\'hen gm'crnments sayc
u, doll~lrs lh~ll otll\:r\\'ise \\'t>uld pa\' f()J' suhsidies,
"ril es \\ (>tild likL'ly nor increase as much as tax
clolbrs \\ oulLl go dO\\ n, hecause the costly goYernment hl"'l'~lu(l'acie,~ that nO\\' administl'l' marketdi,~torting progr~lms would dis~lppear.
!\!on,:O\'l'!', \\ hill' suh.~idies lo\\'er prices, trade
harril'rs r~li,~e prices hy reducing lhe effects of
forl'ign compel it ion, Thus, price increases resulting I rom till' removal of hoth suhsidies and trade
harril'l',~ \\'ould he ,~ll1aller than price increases
resulting rlOm Ihe removal of subsidies only,
Mullil~11l'r~J! ~lgriculrural trade liheralization
\\oulLl Slil1ll1l~lll' ~l profound change in \\'here
;lgricuilur;J! commodiries ;Ire producecl and \voulcl
cluse tr;ldc ~Imong counrries to incn:ase greaLly
!\Iosl induslri;J!i/,ed market economies, including
the I nilc,d SUtc's, \\ mild curtail agriculrural
pnJdllcti(Jn 11l'l~lUSe (JC reduced proll'elion
I-! 0\\ C'\ l' i!llll'~ISl'd production in de\-eloping
c'Olll1tl il'~ \\ ould (JJl~l>t this production lo,ss Tn
indll.~lri~t1izc'd m:lrkL'\ l'conol11ies, the Ltrgesl
olitPUt dl'( lines \\ oukl 11L' for rice, sug:tr, and

Federal Reserve Bank of Dallas

The USDA Model

In a U.S. Department of Agriculture study,
Roningen and Dixit used an eleven-region,
twenty-two commodity world net trade model
to study the economic implications of agricultural policy reform in industrial market economies. In their model, unlike that presented in
this article, a region is no smaller than a
country and may constitute a group of countries. The Roningen and Dixit model does not
consider states or other subnational regions.
Roningen and Dixit performed their
analysis in the Static World Policy Simulation
Modeling (SWOPSIM) framework established
by Roningen in 1986. A SWOPSIM model is
characterized by three basic features. It is a
nonspatial price equilibrium model, meaning
that prices do not vary within regions. It is an
intermediate-run static model that represents
world agricultural markets for a given year,

\\!ll'at, \\it!l tIll' I' S. ~lccounting fot, 11111111 or till'
dl'clinl' In .~ugar production. Currl'nth, [l.S ..~ug~lt·
producers ha\ l' ~ln dl'c-ctil'l' lohh\ tl1at l1a.~ aUluit'l'd
hl'~l\ \' suh.~idil'.~ ~lIld protl'ctiun. 1'::\p~lI1dC(1 \\ orld
l!l'nunll. on llll' otlll'r hand \\ oulel .~ti!lluLttl' ~1Il
incrl'~l.~l' in li\·l'.~tock production.

and it is a multicommodity, multiregion partialequilibrium model. That is, although the model
is international and considers many commodities, it does not take into consideration
the impacts on economic sectors not directly
related to the agricultural sector.
The model makes three assumptions.
First, world agricultural markets are competitive. That is, countries behave as if they have
no market power and cannot control world
prices by withholding production. Second,
domestic and foreign products are perfect
substitutes in consumption; consumers do
not care where their agricultural products
come from, and importers do not distinguish
commodities by origin. Third, even though a
single geographic region may contain many
countries, the model still treats the region as
just one market place.

Currl'nl ~lgricultural suhsidil's and trade protl',lion gentT~Jih' llo not ~lftccl each statc's inherent
l'lTiciel1l'\' (l1ar~l, ll'ri.~tics'- Rather. t!lese programs
lllL'rL'i\' ~JittT the costs of operation,' In most cases.
cosl.~ haH' IX:L'n rClluced. permitting some margin~tlk lC's.~ produCli\'l' farms to remain in husiness.

State by state effects of' agricultural
trade liberalization
According to the ISI)/\ stud), full Il11Jililateral trade lihl'ralization \\ oulel only .~Iightly
reduce o\'l'r~Jil U.S. ~lgricultural outpu!. hut thl'
composition of production \\ ould Ch~lllge signil'icantly, The st~ll(' hy state l'iTl'cts 01 thi~ change in
production. howc\'cr, could he .~uhslanlial.
Like countries ..~tatl'S are not equally wl'llsuited to produce all agricultur~Ji com!llodilie.~.
The profitahility of agricultural production dl'lx'mb
on natural factors .~uch as soil ami c1i!ll~Ill' ~lI1d
on the proximity to Ltrgc !lletropolitan Cl'nllTS
or transportation,"
Economic Review -

Second Quarter 1992


Other tactors affectlllg production are Individual state taxes
and subSidies. These wltl remalll unchanged by free trade

- Unlike most subSidies, dairy subsidies alter the relative
efficiency of production Elimlilating these subsidies would
change the relative effiCiency of dairy production among
states Measuring the effect of eliminatlllg these types of
farm programs


very difficult and was not undertaken in

tillS analySIS
AgTlcultural programs such as federal crop insurance and
cilsaster assistance reciuce the Tlsks associated with reeurTlng /latural phenomena Trade liberalization is not likely to
offect this government assistance


The Effect of Trade Liberalization on Fruit and Vegetable Producers

Moving to a free-market economy would
not require as much adjustment for the producers of fresh fruits and vegetables as it
would for the producers of other agricultural
commodities. Fruit and vegetable producers
receive relatively little government support.
And because these crops are often perishable, imported fruits and vegetables can only
compete during the winter months.
Liberalizing world trade would increase
demand for fruits and increase off-season
import competition for vegetables. Trade liberalization is not likely to result in significant
expansion of world production of most fresh
fruits and vegetables. However, some shifts
in trade patterns would occur, particularly for
those commodities that can be stored for
relatively long periods, such as apples and
U.S. fresh fruit producers generally would
benefit from the relaxation of trade barriers.
These producers would increase export opportunities, particularly to Japan and other
Pacific Rim countries where consumer demand is increasing. Price and production of
U.S. fruits are not expected to change much
and may actually increase because fruits have

In the case of livestock, \vl1l're trade protection
has suppressed demand. marginally efficient
ranches may have been puslll'd out of operation,
Liheralizing trade ,Yould nol alter the characteristics lhat determine lhe rclali\'l' d'ficiency of
comn1()dily production in e;lch stall'. Liberalization
\youlel increase competition and eliminatl' subsidies th;lt \\,(Jldd. in most clses. raise the cost of
operalion. Profitable businesses may experience a
redUl'lion in income but would remain in oreration. Marginally rrofitable farms may choose not
lo remain In oreration.
To e\·;t!lIale state hy stall' impacts, I multiplied l';lch stare's 198' \';lIue of ;Igricultural produc48

few production incentives and low tariff rates.
Free trade would increase import competition for some vegetable producers. Currently, fresh vegetables are produced in most
states. Most of these producers would not be
affected by trade liberalization because seasonal prices are low enough to discourage
imports. However, states producing vegetables for consumption during the winter
months, such as Florida and California, would
face increasing competition from foreign
Overall, trade liberalization could increase the production of fruits and vegetables
because these producers receive relatively
less support than producers of other commodities. Currently, resources may be attracted away from fruit and vegetable
production and into more heavily subsidized
commodities. With trade liberalization, fruit
and vegetable production may present viable
opportunities for producers seeking to diversify from crops for which they can no longer
compete without government assistance. 1

, Buckley (1990)

lion hy lhe expected ckll1ges in income stemming
from world liheraliz;llion, as derived from lhe
['SDA study hy ]{oningl'n and Dixit The result.;;
simuLlte the income ch;lnges that ,\'(luld h;l\ e
hecn expected if free tr;lde had occurred in I <)H7
The CSDA st udy delermined that \\ orld\\ ide
elimination of market-distorting subsidies and
b;lrriers \\'oulel increa,se consumer prices for most
;Igricultural rrodlll'ls. Price increases would he
grl';llest for lamb ;lI1d corn, with hoth innca,sing
around 1) percent. Prices for sugar and dairy
products ,,'ould decline. Currently, go\'ernmenl
policies hold prices for thl'se bner prodlll t.;;
;trlificialh' high lO help p:.1) producer subsidies
Federal Reserve Bank of Dallas

For most crops, rising consumer prices
would increase farm income from product sales,
but not by enough to compensate farmers fully
for the loss of agricultural support. While gross
income would decline for many producers, farm
policy liberalization would also lower some types
of production costs, thereby slightly mitigating
liberalization's effects on net farm income. As an
example, agricultural policy liberalization is likely
to lower the price of farmland, for reasons discussed later in this article.
According to the USDA study, current subsidies and trade barriers encourage u.s. farmers
to overproduce many grains and to underproduce
pork, beef, lamb, and oilseeds. Multilateral trade
liberalization would reduce income from most
crops and increase income from most livestock.
Because each state specializes in the production
of a different mix of crops and livestock, changes
in income and output would affect each state
Some states already specialize in producing
commodities for which multilateral trade liberalization would increase income, but in most states
overall farm income would decline (Figure 1).
The greatest declines in agricultural income
\vould be in states that produce large quantities
of sugar, rice, or other subsidized crops but not
much livestock.
In general, the farm economies of most
states would realize little or no effect from agricultural trade liberalization if 60 percent or more
of the state's agricultural income comes from the
production of livestock. Livestock production is
important because the greatest increases resulting
from free trade would be in producer prices,
output, and income from the production of
livestock. The reason is because beef producers
are among those least affected by the U.S. market
distortions currently imposed by farm subsidies
and would therefore benefit from the elimination
of trade protection. Beef producers also would
benefit from a multilateral elimination of protection because it could allow them to sell more to
foreign markets.
The most negatively affected states. With free
trade, fourteen states would reduce agricultural
income by 7 percent or more These states produce large volumes of subsidized or protected
crops and low volumes of livestock. Increases in
Economic Review -

Second Quarter 1992

livestock production in these fourteen states
would likely not be sufficient to compensate for
the reduced production of subsidized commodities.
Hawaii, Louisiana, and North Dakota would
have the largest reductions in agricultural income,
with declines greater than 20 percent. Currently,
more than 35 percent of agricultural income in
each of these states comes from the production
of grains, cotton, sugar, and rice. Producers of
these crops receive large subsidies and trade
protection that artificially raise income and producer prices. Elimination of farm support and
protection would reduce producer prices, output,
and income from these crops.
Because sugar production is heavily subsidized and protected, free trade would hurt sugarproducing states, such as Hawaii, Louisiana,
Florida, and Idaho. According to USDA estimates,
income from sugar production would fall more
than 80 percent with free trade, while output
would decline more than 40 percent.
Cotton and rice production are also subsidized heavily, and income from these crops
would fall 43 percent and 63 percent, respectively,
with free trade. Cotton and rice prices would fall
significantly because of the loss of support and
protection. Producer prices for cotton would fall
more than 35 percent, while rice prices would fall
nearly 60 percent. Production of rice and cotton
would fall about 10 percent. Louisiana would lose
income from both of these crops. Reduced cotton
income also would affect Mississippi and Arizona,
while loss of rice income would affect Arkansas.
The states most negatively affected by free
trade also would sustain income losses because of
reduced output and producer prices for wheat,
corn, and other coarse grains. With free trade,
income from wheat production is expected to fall
nearly 50 percent. Although wheat output would
fall only 5 percent, the loss of government subsidy
and protection would reduce producer incentive
prices by 45 percent. Corn output would drop only
slightly with free trade, but a nearly one-third
reduction in producer prices would lower income
from the production of corn 34 percent. Loss of
corn income would be significant in Illinois,
Indiana, and Ohio. Similarly, income from the
production of other coarse grains, such as sorghum,
oats, and barley, would fall more than 40 percent.
Montana and North Dakota would be hurt by the

Figure 1

State by State Effects of Agricultural Trade Liberalization
Change in Gross Agricultural Income


Positive Effect: 0% 10 51%
Linle or No Effect: -0 4% to -1 2%



Moderate Effect: -21% to ~ 1%
Greatest Effect: -7 3% to -29 5%

SOURCES: Federal Reserve Bank of Dallas; U S Department of Agriculture; U S Department of Commerce, Bureau of the Census.

loss of income from wheat and other COJrse grains.
Illinois, Indiana, and Ohio also would
experience a nearly lO-percent loss in soybean
income. A slight increase in the production of
soybean output would not compensate for a 12percent reduction in producer incentive prices.
Although their mixes of crops V~lIY widely,
many states that lose most from free trade have
one common characteristic: they do not ha ve
significant livestock sectors to mitigate the income
losses of their crop sectors. Hawaii and Louisiana,
for example, are not likely to increase livestock
production significantly with free trade because

they currently do not produce much cattle, pork,
or lamb. In 1987, these states received less than
IO percent of agricultural income from livestock
lot all the large losers fit this pattern, however. North Dakota and Montana would both
significantly reduce agricultural income with free
trade, despite reasonably large livestock sectors.
Livestock production contributes 25 percent of
agricultural income in North Dakota and 55
percent of agricultural income in Montana. Free
trade would increase livestock production 11
percent, not enough to compensate for the loss
Federal Reserve Bank of Dallas

of income from heavily suhsidized crops such as
wheat and other coarse grains. More than 30
percent of agricultural income in North Dakota
and 25 percent in Montana comes from the production of wheat. Income losses in Montana would
he less severe than those in North Dakota because
of Montana's relatively larger livestock sector.
Little effect on some states. Free trade would
have little or no effect on agricultural income in
Kansas, Massachusetts, New Jersey, Oklahoma,
Rhode Island, and Virginia. More than 60 percent
of agricultural income in Kansas and Oklahoma
already comes from the production of livestock
products. Increased income from the production
of cattle, hogs, and sheep would compensate for
reduced income from wheat, corn, and other
coarse grains Slightly more than one-fourth of
agricultural income in Virginia comes from the
production of livestock. Although Virginia does
not produce large amounts of corn or cotton,
reductions in dairy and poultry income would
mitigate increases in livestock income. Massachusetts, New Jersey, and Rhode Island produce
very little livestock hut also do not produce
significant amounts of heavily subsidized or
protected crops. Roughly 60 percent of agricultural income in all three states comes from the
production of nursery products, fruits, and
Which states benefit from free trade? Free
trade would increase gross agricultural income in
six states: Colorado, Nevada, New Mexico, Utah,
West Virginia, and Wyoming. Overall, agricultural
producers in these states are currently heing hurt
by world trade protection and subsidies. Nevada,
Utah, and West Virginia produce little or no
heavily subsidized crops such as cotton, sugar,
wheat, or other coarse grains. Colorado, New
Mexico, and Wyoming receive a small amount of
agricultural income from subsidized crops. All
these states already have large livestock sectors
that contribute more than 40 percent of agricultural income. With free trade, these already large
sectors would expand and benefit. Currently,
beef, pork, and lamb production receive virtually
no subsidy, and trade harriers limit U.S. producers'
access to foreign markets. Increased foreign demand
for beef, pork, and lamh would bolster livestock
prices. These increases would more than compensate for rising feed grain prices.
Economic Review - Second Quarter 1992

Income from the production of sheep and
lamb would increase nearly 25 percent with free
trade. Production would increase 9 percent, while
producer prices would increase 14 percent.
Wyoming and Utah, the largest U.S. producers of
mutton and lamh, would henefit. Income from the
production of beef would increase 11 percent,
and income from the production of pork would
rise 8 percent. Both would henefit from moderate
increases in price and output. Iowa, Indiana, and
Illinois would henefit from increased income from
the production of hogs, while Wyoming, Kansas,
Oklahoma, Colorado, New Mexico, Texas, Nevada,
Nebraska and Montana would increase income
from the production of cattle and calves.
Effects on the rest of the nation. Agricultural
income in the remaining twenty-four states wOlJld
decline 2 percent to 6 percent with free trade.
These states derive less than 25 percent of their
agricultural income from crops that would have
large reductions in income with free trade. Most
of these states also do not have large livestock
Nebraska, South Dakota, Texas, Iowa, and
Missouri have livestock sectors that contribute
more than 40 percent of agricultural income. But
as could be expected, these states also produce
large amounts of grains, cotton, and rice, which
would offset income gains in the livestock sector.
Vermont, Wisconsin, New York, and New
Hampshire would moderately reduce income from
the production of dairy products because of a
slight drop in output and a 12-percent drop in
producer prices. Kentucky and the Carolinas
would have a slight reduction in tobacco production hecause the loss of suhsidies would reduce
tobacco prices and income about 5 percent.
Income from the production of poultry
products would decline only slightly because
production does not receive much support or
protection. Delaware, Alabama, Arkansas, Maryland, and Georgia specialize in the production
of poultry

Effects on the price of farmland
Because the price of farmland reflects its
income potential, Figure 1 can also be interpreted
as a guide to changes in farmland values. Presently, the price of farmland is artificially high in

most states. Because farm support programs
increase agricultural income, they raise returns to
agricultural land, and therefore its price. The
expected changes in various agricultural sectors
would have parallel effects in the value of farmland. Reductions in crop income would push
down the price of cropland, while increases in
livestock income would increase the value of
Also, farm programs have removed a great
deal of agricultural land from production, boosting land prices by reducing the supply of useable
farm acreage. The elimination of output restriction
programs would return currently unused agricultural land to production. As a result, the total
supply of agricultural land would increase,
lowering farmland prices.
Despite a slight decline in overall output,
rising market prices would increase the net value
added by agriculture and improve the US.
balance of trade. According to USDA estimates,
full multilateral agricultural trade liberalization
would increase US. nominal agricultural gross
domestic product between 15 percent and 20
percent. Further, world farm trade liberalization
would improve the US. agricultural balance of
trade by $3 billion, or nearly 25 percent. Most of
this improvement would result from decreases in
beef import costs and increased revenues from
grain exports made possible by rising world
prices. The United States would reduce its exports
of grains but increase its exports of meats. Sugar
imports would increase.
Although agricultural trade liberalization
would reduce agricultural income in most states,
the agricultural sector generally is very small.
Consequently, sectoral income losses would not
cripple state economies. South Dakota, Nebraska,
Idaho, and North Dakota have the largest agricultural sectors CTable 2). But even in these states,
other sectors would benefit from increased
resources, which would mitigate losses. States
such as Louisiana and Hawaii that would suffer
large agricultural income losses from free trade
could benefit overall from increased output in

the rest of the economy. Both states' agricultural
sectors are small contributors to the overall
output of their state.
Winners and losers in the nonagricultural
sectors of the economy
Free trade in agriculture would benefit most
nonagricultural sectors of the U.S. economy
because resources that had been attracted to agriculture through subsidies and protection could be
invested in other sectors. But the nonagricultural
sectors currently benefiting from agricultural
subsidies would be hurt by the elimination of
protection and subsidies.
More than 35 percent of the beneficial
distortionary effects of farm subsidies accrue to
nonagricultural sectors of the economy through
the lower cost of subsidized commodities. 9 For
example, agricultural subsidies hold down input
costs to the food processing and apparel industries. The transportation, warehousing, insurance,
and retailing sectors also benefit from subsidized
commodity prices and the artificially high production they motivate. Free trade would increase
input costs for some industries and reduce
demand for other industries, Income would
decline for all these industries.
For example, a manufacturing firm whose
inputs include agricultural commodities would
face higher input prices for some commodities
under free trade. These increased costs would
lead to slight declines in income and output
for many food processing, canning, apparel,
and textile firms. Reduced agricultural output
would reduce demand for services, wholesale
and retail trade, as well as demands for banking
and insurance firms that focus on agricultural
Producers using livestock byproducts would
experience an increased supply and fall in price,
which would boost income and output. Transportation of livestock would increase, although
transportation of crops would decline,



Kilkenny and Robinson (1990, 548)

Free trade in agriculture would remove
government farm subsidies and protection,
reducing income for most US. crop producers
Federal Reserve Bank of Dallas

Table 2
Agriculture's Share of Gross State Product
for the 50 States, 1989
South Dakota
North Dakota
North Carolina
New Mexico





United States



South Carolina
West Virginia
New Hampshire
New York
Rhode Island
New Jersey
District of Columbia












SOURCE: Bureau of Economic Analysis, U S Department of Commerce.

and innea~ing incoml' for l l.S. li\'l..~lock producers. In this arlicle. I ~l11~t1yzed the regional cffE'cl.~
of mullil~lll'1'al trade lihl'l'alization, l-:fledS \\ oulll
be ~ignil'icanth' different witll unil;lllTtI or
hilater:t1 liheralization, Cl'neraJl). \\orld pricc
incr<'::I~e~ \\ ould he Ic~s \\'jth uni\;llcral liheralization. Consequently. ~Igricultural incolllc losses
would he greatcr. \\:orlcl prices would increase
as more countric.~ lihcr~t1ize TIlus. agricultural
incollle lo.~ses arE' miligatl'd tbc Illo~t under
mullilatl'1'al lihcraliz~lli()n.
With lllultilatl'1':t1 lihcralization. agricultural
incolllc \\ (lulll increa~e in a fe",' ~utt'~. although
Economic Review -

Second Quarter 1992

farm incomc would declinc in most stale~. While
adjustlllcni for individual f~trlners could Ix.' significant. r'or Illo~t ~tatcs income I()~~es in thc agricultural
sector \\'oukl likely be mitigated or cOlllpen~ated
Iw increa~cd incomc in thc nonagricultural sector.
Overall. l i.S output and income would inne:Jse
despite the loss of farm income and increases in
many cOlllmoditv prices. Thc Unitcd SlalCS would
benefit bccausc resources would bc rcallocated to
their l11o~l
icienr u~e~.



Buckley, Katharine C. (990), The World Market in
Fresh Frnit and Vegetables, Wine, and Tropical
Beverages--Government Intervention and
Multilateral Policy Reform, Staff Report no.
AGES 9057, U.S. Department of Agriculture,
Economic Research Service, Commodity
Economics Division (September).
Harwood, Joy 1., and Kenneth W. Bailey (990),
The World Wheat Market-Government Intervention and Multilateral Policy Reform, Staff
Report no. AGES 9007, U.S. Department of
Agriculture, Economic Research Service,
Commodity Economics Division (January).
Kilkenny, Maureen, and Sherman Robinson
(990), "Computable General Equilibrium
Analysis of Agricultural Liberalization: Factor
Mobility and Macro Closure," Journal ofPolicy
Modeling 12 (Fall): 527-56.
Magiera, Stephen 1., and Michael T Herlihy
(988), "Comparing World Price Changes from
Trade Liberalization Models" (Background
paper for the International Agricultural Trade
Research Consortium Symposium, Bringing
Agriculture into the GATT, Annapolis, Md.,
August 19-20).
Meyers, William H., S. Devadoss, and Michael D.
Helmar (987), "Agricultural Trade Liberalization: Cross-Commodity and Cross-Country


Impact Products," Journal ofPolicy Modeling
9 (Fall): 455-82.
Organization for Economic Cooperation and
Development (987), National Policies and
Agricultural Trade (Paris: OECD).
Parikh, Kirit S., Gunther Fischer, Klaus Frohberg,
Odd Gulbrandsen (988), Towards Free Trade
in Agriculture (Dordrecht, The Netherlands:
Martinus Nijhoff Publishers for International
Institute for Applied Systems Analysis).
Roningen, Vernon 0., and Praveen M. Dixit
(989), Economic Implications ofAgricultural
Policy Reforms in Industrial Market Economies,
Staff Report no. AGES 89-36, U.S. Department
of Agriculture, Economic Research Service,
Agriculture and Trade Analysis Division
Tyers, Rod, and Kym Anderson (988), "LiberaliZing
OECD Agricultural Policies in the Uruguay
Round: Effects on Trade and Welfare," Journal
ofAgricultural Economics 30 (May): 197-215.
U.S. Department of Commerce, International
Trade Administration (988), United States
Sugar Policy: An Analysis, prepared by Ralph
Ives and John Hurley (Washington, D.C.:
Government Printing Office, April).

Federal Reserve Bank of Dallas