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Expectations and
Monetary Regimes
Gerald P. O'Driscoll, Jr.
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The applicability of the strong policy
implications of rational expectations literature
depends on the monetary regime in place at the
time. The dominant branch of this literature
concludes that intended effects of individual
manipulations of policy variables will be thwarted
by the market's anticipation of policymakers'
actions. Formation of such expectations depends,
however, on the public's ability to perceive
consistent patterns in policymakers' behavior. An
emerging institutional literature indicates that
some regimes facilitate identification of such
patterns while others impede it.
13
The Search for a
Monetary Policy Rule
in an Uncertain World
John H. Wood
The range of views on the appropriate rule to
guide the execution of monetary policy has not
changed significantly since the 17th century .
Rules focusing on interest rates, the price level,
the monetary base, and money remain among the
leading candidates. In practice, which rule is
superior depends on the actual structure of the
economy. The controversy continues because no
durable consensus has developed to establish the
supremacy of one macroeconomic model from
which correct actions could be inferred .
25
What Is the Rule for
Financing Public Debn
W. Michael Cox
Over the 1950-81 period, each $1 of interest paid
on the Federal Government's debt was, on average,
financed with only 41 cents in taxes. The 59-cent
remainder was deficit-financed. Statistical analysis
of federal deficits reveals a shift in this "rule"
in the early 1970s, however. Since then, interest
payments have been totally deficit-financed. The
fact that interest payments on government debt
are not backed entirely by taxes has important
implications for the role this debt plays in
determination of the price level.
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
.. .
Expectations and
Monetary Regimes
By Gerald P. O'Driscoll, Jr. *
There has been an expectations revolution in
economics, a revolution that has both changed
economic theory and altered the way it is applied to
specific issues. The theoretical and econometric innovations constituting this revolution are most
noticeable in macroeconomics, but they have implications for nearly all areas of economics. This article focuses on the developments and implications
for macro and monetary econo,mics.
Conventional macro models accorded comparatively I ittle attention to expectational issues. In
Keynesian models, for instance, transactors' expectations were assumed to be unaffected by changes in
the environment (including changes in monetary or
fiscal policy). Monetarist analysis generally paid
more attention to expectational questions but
assumed that agents made systematic forecast errors
* Gerald P. O'Driscoll, Jr., is a senior economist at
the Federal Reserve Bank of Dallas. The views
expressed are those of the author and do not
necessarily reflect the positions of the Federal
Reserve Bank of Dallas or the Federal Reserve
System.
Economic RevieW/September 1984
in a wide range of circumstances. Keynesian and
monetarist models alike thus violated a core
postulate of economics: that individuals make the
best use of available resources by attempting to
maximize returns from given means. This efficient
use of resources is called "rationality." In conventional macro theory, however, agents did not
behave rationally. They either ignored available information or used it inefficiently. In the new macro
theory, agents are rational in their exploitation of
all available resources, including informationa behavioral assumption termed "rational
expectations."
This article reviews the rational expectations critique of macroeconomics and presents the rational
expectations hypothesis. An emerging literature is
critical of that hypothesis, suggesting that conventional formulations of the hypothesis are inconsistent with the decentralized decision making
characteristic of market economies. While the
article supports that criticism, it also presents a
recent reformulation of the rational expectations
hypothesis. This reformulation links the process of
expectations formation to the monetary regime or
institutional environment in which individuals
operate. The reformulation thereby connects the
literature on expectations to developments in the
theory of institutions.
This article concludes that the reformulated rational expectations hypothesis may obviate the recent criticism. In its reformulated version, however,
the hypothesis can no longer support certain strong
claims associated with it, such as the ineffectiveness
of macroeconomic policy. Nonetheless, the reformulation offers promise for further theoretical
development.
Expectations in a macro model
In modern economics, David Hume demonstrated
the irrelevance of the price level. I n the same
essay,' however, he argued that rising prices
facilitated trade. The idea that a "little bit of inflation" is good for economic activity reappears in
economics with predictable regularity. Knut
Wicksell identified the problem in the Humean
argument:
Those people who prefer a continually upward
moving to a stationary price level forcibly remind
one of those who purposely keep their watches a
I ittle fast so as to be more certain of catching
their trains. But to achieve their purpose they must
not be conscious or remain conscious of the fact
that their watches are fast; otherwise they become
accustomed to take the extra few minutes into account and so after all, in spite of their artfulness,
arrive too late.
The most recent instantiation of the inflationist
argument is the Phillips curve, which represents a
1. "Of Money," in David Hume, Writings on Economics, ed.
Eugene Rotwein (Madison: University of Wisconsin Press, 1970),
33-46; the essay was originally published in 1752.
2. Knut Wicksell, Interest and Prices, trans. R. F. Kahn (1936;
reprint, New York: Augustus M. Kelley, 1965),3-4; the original
was published in German in 1898.
3. Phillips found a relationship between the rate of change of
money wage rates and the unemployment rate (A. W. Phillips,
"The Relation Between Unemployment and the Rate of
Change of Money Wage Rates in the United Kingdom,
1861-1957," Economica 25 [November 1958]: 283-99). Figure 1
is, strictly speaking, an adaptation of his findings substituting
. the rate of change in the price level for that in money wages.
The adaptation is common and easily derived from Phillips'
original relationship. For instance, see Paul Wonnacott,
Macroeconomics, rev. ed. (Homewood, III.: Richard D. Irwin,
1978), 330-33.
2
statistical relationship between inflation and
unemployment 3 The recent controversy over expectations can be elucidated in terms of this familiar
relationship.
In Figure 1, PC plots a series of observations (p, u)
of inflation and unemployment combinations. This
curve was viewed as presenting policymakers with a
choice set yielding an exploitable trade-off between
inflation and unemployment rates. Originally "an
empirical finding in search of a theory,"· the Phillips
curve was rationalized by a variety of theoretical
stories. All related inflation functionally to
unemployment by postulating an inverse relationship between the unemployment and inflation rates.
Milton Friedman provided an early critique and
reformulation of the Phillips curve analysis:
Implicitly, Phillips wrote his article for a world in
which everyone anticipated that nominal prices
would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages. Suppose, by
contrast, that everyone anticipates that prices will
rise at a rate of more than 75 per cent a year- as,
for example, Brazilians did a few years ago. Then
wages must rise at that rate simply to keep real
wages unchanged S
An increase in the inflation rate (that is, a higher
rate of growth of prices) wi II have the pred icted effect on unemployment only if it is unanticipated. In
practice, policymakers can exploit the Phillips curve
(or any other relationship between real and nominal
variables) only with policies that generate accelerating inflation. In terms of monetary policy, money
growth must accelerate. This focus on monetary
acceleration or deceleration provided a name for
the new view-the "accelerationist" theory.
The accelerationist thesis can be illustrated by
considering a hypothetical example. Assume that
4. James Tobin, "Inflation and Unemployment," American
Economic Review 62 (March 1972): 9.
5. "The Role of Monetary Policy," in Milton Friedman, The Optimum Quantity of Money and Other Essays (Chicago: Aldine
Publishing Company, 1969), 102. This paper constituted Friedman's 1967 presidential address to the American Economic
Association. His main argument was elaborated and developed
in an important volume: Edmund 5 Phelps and others,
Microeconomic Foundations of Employment and Inflation
Theory (New York: W. W. Norton & Company, 1970).
Federal Reserve Bank of Dallas
Figure 1
The Inflation- Unemployment Relationship
INflATION RATE, p (PERCENT)
I
I
I
I
I
PC
PC' PC":
I
I
I
I
I
I
I
I
o ~------------~----~~~----------------UNEMPLOYMENT
RATE, u (PERCENT)
the economy is in noninflationary macroeconomic
equilibrium. Unemployment is 6 percent, which
represents equilibrium in labor markets. This
equilibrium rate of unemployment, designated the
"natural rate" in the literature, is determined by
nonmonetary factors like the structure of the labor
market and information costs 6 Assume also,
however, that policymakers believe the unemployment rate is "too high" and that, for example, the
monetary authority acts on this perception by
fostering higher rates of money growth. Aggregate
demand for goods will now grow more rapidly,
bidding up wages.
Will the unemployment rate fall? The answer
depends on expectations. Workers respond to
changes in real, or inflation-adjusted, wages. If, influenced by past price stability, workers believe a
faster rate of increase in money wages represents
more rapid growth in real wages, the unemployment
rate will fall temporarily.7
Demand-management policy might succeed for a
time in reducing the unemployment rate from 6 percent to 4 percent. In doing so, however, it will eventually cause inflation to increase. The beneficial effect on unemployment will persist only so long as
the resulting inflation is unanticipated.
The accelerationist theory denies that inflation
illusion can persist ad infinitum. Though it sets no
6. Friedman, "Role of Monetary Policy," 102-3. In the literature,
"natural" is synonymous with "real" or "nonmonetary." Friedman borrowed the concept of a natural rate of unemployment
from Wicksell's natural rate of interest. The latter is the rate of
interest that would rule without the influence of monetary
disturbances (ibid., 101-2)
7. Among other things, workers will decrease the time spent
searching for better wage offers. This, in turn, decreases
measured unemployment. The search theory of unemployment,
which evolved from the accelerationist theory, is a separate
but important body of analysis to which many of the papers in
the Phelps volume represent early contributions.
Economic Review/September 1984
3
exact quantitative parameters on the process, the
theory postulates a catch-up procedure for expectations. Expansive aggregate demand policy has
moved the system northwest on the Phillips curve
(PC). To accomplish this, policymakers must, in effect, deceive workers. They can do so temporarily if
workers' inflation expectations are adaptive.
Expectations are adaptive if they are some
weighted average of past rates of inflation. The
weights and the number of periods averaged may
vary, but the logic is the same: recent experience
determines individuals' expectations of next period's
inflation rate. In the current example, workers anticipate zero inflation in the future because of the
experience in the recent past.
As inflation accelerates, workers may at first
either not notice it or believe that rising prices are
an anomaly and price stability will be restored. At
some point, however, as the experience of inflation
becomes undeniable, workers will realize that real
wages are not rising. This realization will cause
labor market conditions to return to the situation ex
ante. Only if the authority were to increase the rate
of monetary growth (that is, only if there were an
acceleration in money growth) could an unemployment rate of 4 percent be maintained (remembering
that a 6-percent rate represents "full employment").
In terms of Figure 1, the Phillips curve shifts from
PC to PC as inflation becomes anticipated. Higher
and higher inflation rates are necessary to produce
a given real effect, such as a decline in unemployment. If inflation were to accelerate further, the
Phillips curve would eventually shift from PC to
PC'. Each curve in the family of Phillips curves
represents an unstable, short-run relationship, not a
long-run, exploitable trade-off. The vertical dotted
line is the true long-run relationship.
A similar conclusion is reached for movements on
a curve to the southeast, which represent the shortrun effects of anti-inflationary policy. Unemployment will temporarily increase, falling back to its
equilibrium level as workers adjust their expectations to a lower rate of inflation. The result is symmetric: the unemployment rate is invariant to the
inflation rate. Hume's stricture about the irrelevance
of the price level is extended to the rate of change
of prices.
The rationalization of high inflation and high
unemployment (stagflation) attracted the attention
of many economists to the accelerationist thesis.
4
Yet the thesis has a fatal flaw, which became the
focal point of the rational expectations critique. The
accelerationist theory assumes that economic
agents use an incorrect economic model in forecasting future price changes. If inflation is accelerating, for instance, agents will make systematic
(nonrandom) forecast errors. Systematic errors present unexploited profit opportunities, which alert
entrepreneurs should eliminate. Persistent profit
opportunities are inconsistent with the assumption
of economic equilibrium. To assume that, in the
face of accelerating inflation, agents expect prices
to increase at a constant rate is to repeat the
theoretical error of Keynesian models, which
assumed static expectations.
The rational expectations hypothesis
Rational expectations theorists propose model ing
economic agents as themselves modeling the
economy.8 Not only do agents have a model, but
that model conforms to the actual economic process. "Expectations, since they are informed predictions of future events, are essentially the same as
the predictions of the relevant economic theory.'"
In other words, when economists theorize about
individual behavior, including the formation of expectations, they must take into account the ability
of individuals to theorize about their environment.
Economists must also assume that individuals
utilize the same ("relevant") theory being used by
economists to explain individual behavior. At this
broad level, the rational hypothesis constitutes a
methodological principle. The hypothesis is also
embedded in specific models.
Rational expectations models typically assume
that economic phenomena are generated by an
underlying stochastic process. Forecasts are probabilistic, but an individual's mean or expected outcome should conform to the mathematical expectation of the event being forecast. 1 0
8. The classic article is John F. Muth, "Rational Expectations and
the Theory of Price Movements," Econometrica 29 (July 1961):
315-35; reprinted in Robert E. Lucas, Jr, and Thomas J.
Sargent, eds., Rational Expectations and Econometric Practice
(Minneapolis: University of Minnesota Press, 1981), 3-22. All
subsequent page references are to the Lucas-Sargent volume.
9. Muth, "Rational Expectations and Theory of Price
Movements," 4.
Federal Reserve Bank of Dallas
Rational expecters make unbiased forecasts of
future outcomes. In more narrow, technical terminology, the agent's model is a minimum-meansquared-error generator of forecasts. Forecast errors
will be neither systematic nor correlated with any
information available at the time of the forecast.
Rational expectations theory has three important
elements, which can be summarized as follows:
1. There is an objective probability distribution of
outcomes to which subjective probability distributions will conform.
2. The agents being modeled by economists
are themselves using models in forming their
expectations.
3. Agents' models embody expectations that are
rational in the sense outlined above, utilizing the
relevant economic theory.
It was quickly recognized that, taken strictly, rational expectations would rob authorities of any
ability to exploit observed relationships among
economic variables. At each moment, endogenous
variables incorporate the effects of expected policy
changes. Policy actions may influence observed outcomes but not in any systematic way. Policymakers
will not be able to predict the exact impact of their
actions unless they possess an informational advantage over citizens at large. In many formulations,
citizens also form expectations about the probability of a policy innovation. This assumption deprives
policymakers of the advantage of being better able
to predict their own actions.
Early expositions of rational expectations
incorporated extreme statements of policy
ineffectiveness:
[T]here is no sense in which the authority has the
option to conduct countercyclical policy. To exploit the Phillips Curve, it must somehow trick the
public. But by virtue of the assumption that expectations are rational, there is no feedback rule that
the authority can employ and expect to be able
systematically to fool the public. This means that
the authority cannot expect to exploit the Phillips
Curve even for one period. 11
More recently, rational expectations theorists
have backed off somewhat from consistent pursuit
of this line of reasoning. Models increasingly incorporate a distinction between anticipated and unanticipated policy actions. The former actions have no
systematic effect on outcomes in these models,
since anticipated effects are fully incorporated in
plans. Unanticipated policy changes do have effects
in the models. Even this distinction is not without
problems, however. For one, the reformulated policy
ineffectiveness proposition has failed econometric
tests. Even antiCipated policy changes matter for
economic outcomes. Indeed, unanticipated changes
in monetary and fiscal policy do not have a
significantly greater impact on output and employment than do anticipated movements'"
The econometric battle over policy ineffectiveness (or pol icy neutrality) sti II rages. Important
as it is, however, that empirical literature is not the
primary focus of the discussion here. Rather, this article focuses on crucial issues raised in an emerging
theoretical literature. This literature questions each
of the three elements of rational expectations
theory cited above. Overall, the critique questions
the ability of agents to generate rational forecasts.
It suggests that successful forecasts depend, in part,
on factors that have largely remained outside
models of expectations formation.
Rational expectations: a critical assessment
In this section, one basic issue will be considered.
Critics argue that rational expectations models
presuppose that more information is available to
economic agents than is consistent with standard
assumptions of economic theory. Their basic argument can be divided into three points.
1. Rational expectations models are inconsistent
11
Thomas J Sargent and Neil Wallace, "Rational Expectations
and the Theory of Economic Policy," Journal of Monetary
Economics 2 (April 1976): 177-78: emphasis added.
12. For a discussion of the state of the literature on this topic,
10. "[Elxpectations of firms (or, more generally, the subjective
probability distribution of outcomes) tend to be distributed,
for the same information set, about the prediction of the
theory (or the 'objective' probability distributions of outcomes)" (ibid., 4-5)
Economic ReviewlSeptember 1984
see Frederic S. Mishkin, "A Rational Expectations Approach
to Macroeconometrics," NBER Reporter, Winter 1982/3,6-7.
Also see Frederic S. Mishkin, "Does Anticipated Aggregate
Demand Policy Matter? Further Econometric Results,"
American Economic Review 72 (September 1982): 788-802
That article contains references to empirical work supporting
the policy ineffectiveness proposition.
5
with the assumption that markets operate with an
economy of information.
2. Rational expectations analysis is inconsistent
with economic decentralization.
3. The assumption of rational expectations
ignores the problem of selecting the relevant
economic theory.
Informational economy. The marginalist
(neoclassical) theory of the firm has been attacked
for being "unrealistic" in assuming that businessmen
produce up to the point that marginal revenue is
equated with marginal cost. Businessmen do not
appear to know their marginal costs, much less
use them in decision making. It is now generally
accepted, however, that businessmen follow procedures that amount to maximizing profits. This
practice results in an output level that would have
resulted from equating revenues and costs at the
margin. The marginalist theory is accepted because
economists can identify real-world procedures that
generate predicted outcomes.
In particular, the plausibility of the theory of the
firm was enhanced by demonstrating how little
businessmen (and economic agents generally) need
to know in order to plan. Competitive firms need
only know market data (prices, for example) and be
able to react appropriately to changes in data.
These firms are price takers and frequently operate
in industries for which there are active futures
markets. Firms need not have structural information
or know market demand and supply conditions.
They only react to market signals like price changes.
In short, the system operates with an economy of
information.
Rational expectations theory has effectively
turned the economic argument around 1800. First,
by emphasizing the importance of expectations, it
has pointed to the speculative element in all decision making. Not only professional speculators but
also savers and workers must speculate on, among
other things, future inflation rates. Only by doing so
can they distinguish purely nominal from real
changes in returns. Agents' lives are infinitely complicated by all this, compared with the relatively
simple computational problems facing them in the
theory of competitive price determination.
Further, instead of emphasizing how little agents
must learn, rational expectations theory assures us
of how much they in fact know. Kenneth Arrow has
succinctly posed the problem:
6
The very concept of the market and certainly
many of the arguments in favor of the market
system are based on the idea that it greatly
simplifies the informational problems of economic
agents, that they have limited powers of information acquisition, and that prices are economic
summaries of the information from the rest of the
world. But in the rational expectations hypothesis,
economic agents are required to be superior
statisticians, capable of analyzing the future
general equ il ibria of the economy.1J
The rational expectations literature has thus effected an almost unnoticed but radical escalation in
the information requirements of decentralized (competitive) economies. Decentralized economies have
been thought to operate efficiently because of the
paucity of information needed by each economic
agent. In rational expectations models, it is how
much agents know that ensures rapid adaptation to
policy changes and other shocks.
Neoclassical general equilibrium theory has been
effectively criticized for relying on price signals
alone to allocate resources efficiently. The information available to individuals is insufficient to
generate the allocational outcomes assumed to
characterize competitive markets. 14 Yet rational expectations theory is based on general equilibrium
analysis. The latter provides the theoretical structure for rational expectations models. 1s Consequently, rational expectations models can only
postulate but not demonstrate that agents will
acquire the knowledge assumed to be available to
them in these models. 1 •
13. Kenneth J Arrow, "The Future and the Present in Economic
Life," Economic Inquiry 16 (April 1978) 160.
14 A series of papers by Grossman and Stiglitz constitute the
core of this critique. For an early statement, see Sanford J
Grossman and Joseph E. Stiglitz, "Information and Competitive Price Systems," American Economic Review 66 (May
1976) 246-53.
15. The dependence of the conclusions of rational expectations
models on their general equilibrium underpinnings is emphasized in Kevin D. Hoover, "Two Types of Monetarism,"
Journal of Economic Literature 22 (March 1984): 58-76,
especially 66-68
16. See Gerald P. O'Driscoll, Jr., "Rational Expectations, Politics,
and Stagflation," in Time. Uncertainty, and Disequilibrium,
ed. Mario J Rizzo (Lexington, Mass .. D. C Heath and Company, Lexington Books, 1979). 158-60.
Federal Reserve Bank of Dallas
Rational expectations models are quite reasonable in postulating that individuals will make
the best use of available information. Critics
generally accept this methodological point. These
models frequently assume, however, that individuals
actually possess large stocks of knowledge, including structural knowledge of the economy. It is
true that "information is scarce, and the economic
system generally does not waste it."17 This observation is, however, a two-edged sword. Because information is scarce, theorists cannot assume it is
evenly distributed or available in abundance. It is
not irrational to be poorly endowed with economic knowledge, any more than with capital or
land. What is reasonable for agents to know depends on their environment.
Economic decentralization. I nformation specialization is a counterpart to specialized production.
It is the essence of the decentralized economy
that individuals have different information. Each
individual is specialized in certain activities and
has in general special ized knowledge about those
activities. There is no reason therefore why his
forecasts should be based only on the rather
general kind of information which the econometrician can use."
If market participants have specialized information that the econometrician lacks, they will, a
fortiori, be ignorant of special ized theoretical
knowledge possessed by economists and statisticians. Indeed, if specialization is to be taken
seriously, the knowledge possessed by the two
groups (economic agents and economic analysts)
will differ systematically. Whereas theoretical
knowledge is abstract and general, market information is concrete and specific. Aptly described as
"knowledge of the particular circumstances of time
and place:' 19 market information consists of such
things as knowledge of a temporary discount on an
input or of a profit opportunity resulting from a
transient geographic price difference for a produced
17. Muth, "Rational Expectations and Theory of Price
Movements," 5.
18. Arrow, "Future and Present in Economic Life," 164.
19. "The Use of Knowledge in Society," in Friedrich A. Hayek,
Individualism and Economic Order (Chicago: University of
Chicago Press, 1948), 80.
Economic ReviewlSeptember 1984
good, This is not at all the kind of abstract information yielded by any relevant economic theory,
The more specialized an activity, the more likely
that factors peculiar to that market will be more
important for decisionmakers than are general
economic conditions,'o This fact further diminishes
the likelihood of economic agents' investing in acquiring theoretical economic information, Being
based on different information sets, predictions of
market participants will differ from model-theoretic
forecasts, Transactors surely analyze their environment, but their "model" will differ from that
employed by macro econometricians.
Individual economic agents also possess heterogeneous information, Decentralization implies
strictly that marketwide information is scattered
among economic agents. Heterogeneity of information and inconsistency of forecasts are predictable
features of market economies.'1
To reiterate, decentralization of information is an
essential property of market economies. This feature
is notably lacking in rational expectations models,"
Its absence lends credence to the conclusions of
critics that rational expectations analysis is inapplicable to decentralized economic systems 23 Rational expectations theorists have yet to respond to
this critique, which is more telling when analyzed in
20. Arrow, "Future and Present in Economic Life," 165-66.
21. This point is developed in more detail in Gerald P. O'Driscoll,
J r., "Knowing, Expecting, and Theorizing," C. V. Starr Center
for Applied Economics Research Report no. 81-22 (New York:
New York University, 1981). The existence of informational
differences in equilibrium is argued in Gerald P. O'Driscoll,
Jr., and Mario J, Rizzo, The Economics of Time and Ignorance
(Oxford: Basil Blackwell, forthcoming).
22. One conspicuous exception is Lucas' equilibrium model of
the business cycle, which postulates informational differences
across markets by using Phelps' island paradigm. (See Robert
E. Lucas, Jr., "An Equilibrium Model of the Business Cycle,"
Journal of Political Economy 83 [December 1975]: 1113-44.)
For an analysis, see O'Driscoll, "Rational Expectations,
Politics, and Stagflation," 157-68.
23. Roman Frydman, "Towards an Understanding of Market Processes: Individual Expectations, Learning, and Convergence to
Rational Expectations Equilibrium," American Economic
Review 72 (September 1982): 652-68; and Roman Frydman
and Edmund S. Phelps, Introduction to Individual Forecasting
and Aggregate Outcomes: "Rational Expectations" Examined
(Cambridge: Cambridge University Press, 1983), 1-30.
7
conjunction with the next issue 24
Theory conflict. Macro economists do not agree.
There are an embarrassingly large number of
macroeconomic theories and an indefinitely larger
number of models derivable from these theories.
Granted that individuals purchase economic
forecasts, to which theory will they subscribe? What
constitutes the "relevant" theory is itself a controversial issue among specialists. Informational
disadvantages aside, the public confronts the same
basic problem faced by economists in discriminating
among theories. Every data observation is consistent
with a large number of theories. Even sophisticated
empirical tests are generally subject to alternative
interpretations and analyses.
Rational expectations theory postulates an
underlying objective probability distribution to
which subjective probability distributions ought to
conform. For conformity to occur, however, individuals must discover the parameters of that
distribution. This latter point raises the question of
how individuals learn the required information in a
decentral ized system. I n other words, will there be a
convergence of theories?
One author concluded that there will be no convergence to rational expectations equilibrium if the
economy does not begin in such an equilibrium. 25
To forecast optimally, an individual must know the
average of market forecasts (the "average opinion").
Agents can observe past and current market prices
but cannot infer the average opinion from these
observations. No market data provide this. Surveys
and data collection could only provide ex post information on average opinion, while rational
forecasts need ex ante data. 26 Without this information, no convergence to a unique forecast occurs.
Hence, there is no convergence to a rational expectations equilibrium, nor will forecasts be optimal in
any conventional sense. Individuals will "adopt
some subjective criteria and make what they consider to be their own best guesses of the average
opinion."27
This conclusion seemingly brings us full circle
back to Keynes' position
that human decisions affecting the future, whether
personal or political or economic, cannot depend
on strict mathematical expectation, since the basis
for making such calculations does not exist; and
that it is our innate urge to activity which makes
the wheels go round, our rational selves choosing
between the alternatives as best we are able,
calculating where we can, but often falling back
for our motive on whim or sentiment or chance.28
Rational expectations theorists endeavored to
ground expectations in an objective process, thereby
rendering feasible an expectational equilibrium. The
attempt foundered because, in order to forecast
the economic future, individuals must forecast
each other's forecasts. The apparently objective
process is permeated with seemingly unbounded
subjectivity.
Markets are not generally chaotic, and individuals
can at least sometimes form tolerably accurate expectations of future events. So long as autonomous
economic agents are forming and acting on their individual forecasts, there will be no deterministic
("objective") process underlying economic activity.
If, however, the range of possible or likely outcomes were sufficiently narrowed, an economic
theory of expectations might be possible. In terms
26. If individuals could revise their plans in light of average opin24. David K. H. Begg has asserted that "Rational Expectations
analysis may easily be extended to models in which individuals have access to different information because they
are faced with different costs of acquiring information. Thus
many criticisms refer to the simplicity of the models in which
Rational Expectations has so far been embedded" (The Rational Expectations Revolution in Macroeconomics: Theories
and Evidence [Baltimore: Johns Hopkins University Press,
1982]. 255). The first statement is, of course, precisely the
point of contention. As to the second point, critics can only
respond to actual not hypothetical models.
ion, the survey forecast would no longer reflect the average
of revised forecasts. If the process were to continue (that is,
there were to be a new survey), transactors would face
Keynes' "beauty contest" problem. Individual forecasts would
continually be revised in light of the most recent revision of
average opinion. There is no end to this process and no convergence to an equilibrium. See O'Driscoll and Rizzo,
Economics of Time and Ignorance, chap 5.
27. Frydman, "Towards an Understanding of Market Processes,"
662. He calls this a "subjectively optimal forecast," but it is
not a strictly defined rational expectations equilibrium.
28. John Maynard Keynes, The General Theory of Employment, In25. This section draws from Frydman, "Towards an Understanding
of Market Processes." See especially 652-55.
8
terest and Money (New York: Harcourt, Brace and Company,
1936), 162-63.
Federal Reserve Bank of Dallas
of conventional models, these constraints would
have to be exogenous factors.
Economists are increasingly focusing on institutional constraints and rules as stabilizing forces. An
emerging literature treats the analysis of expectations formation and a theory of institutions as
logically related topics. Indeed, the literature argues
that expectations are heavily influenced by the institutional environment.
Monetary regimes
The ability to form expectations depends crucially
on the existence of some "external" constraints 29
I nstitutions provide constraints on the range of
possible plans and, hence, on expectations. An institution may be an organization, I ike a central bank,
or an established relationship, like that which may
exist between two firms or individuals. As such, institutions represent relatively permanent features in
the economic landscape. They are by no means immutable, but they do change slowly relative to
changes in economic data.
Rules determine the procedures and courses of
action necessary to sustain an institution. The existence of rules implies consistency, though not
necessarily rigidity, in behavior. A central bank may,
for example, have a usual procedure for dealing
with an outflow of international reserves (for example, "raise the discount rate"). This procedure may
or may not involve a rigidly determinate course of
action, such as would be dictated by a mathematical formula. In other words, rules may be discretionary or nondiscretionary, and they may be explicit or implicit.
A set of institutions and rules constitutes a
monetary regime. The existence of a monetary
regime is a publicly known fact. By assumption,
information about a regime's characteristics is
available at relatively low cost. This is precisely the
kind of information, it is reasonable to suppose, that
29. The evolution and operation of institutions ought,
nonetheless, to be explained by economic theory. Richard N.
Langlois surveys the recent literature on this topic in
"Economics as a Process: Notes on the 'New Institutional
Economics,'" C V Starr Center for Applied Economics
Research Report no. 82-21 (New York: New York University,
1982); also see the papers in Richard N. Langlois, ed., The
New Institutional Economics (Cambridge: Cambridge University Press, forthcoming).
Economic ReviewlSeptember 1984
individuals will share and with which they will
forecast.
Instead of acquiring structural knowledge, individuals learn about the operation of basic institutions. Institutions tend to homogenize otherwise
heterogeneous information in a decentral ized
economic system. They do not eliminate information differences but provide a common framework
within which expectations are formed and choices
made.
Consistency in behavior and permanence of
institutions can rationalize an expectational
equilibrium. Indeed, Axel Leijonhufvud has suggested defining a monetary regime as "a system of
expectations that governs the behavior of the public
and that is sustained by the consistent behavior of
the pol icy-making authorities."30
Different monetary institutions will, for instance,
foster different sets of inflationary expectations.
There is negative price change autocorrelation
under a commodity standard. Thus, an increase in
prices (or in the rate of change of prices) today will
be followed by a decrease in prices (or in the rate of
change of prices) in the future. In contrast, there has
been positive price change autocorrelation under
the modern fiduciary standard. Higher prices (or inflation rates) are followed by high or still higher
prices (or inflation rates) in the future 31 If the institutional environment (regime) is well established
and understood, economic agents may be able to
form consistent expectations. A set of consistent expectations establishes an intertemporal equilibrium.
The new institutional view does not hypothesize
the same sort of tight prior equilibrium that is
characteristic of rational expectations models. 32 If
30. Axel Leijonhufvud, "Rational Expectations and Monetary I nstitutions," UCLA Department of Economics Working Paper
no. 302 (Los Angeles: University of California, 1983), 2. He
suggests this as a "loose" rational expectations concept.
31. For an important empirical analysis of the effects on expectations of the movement from the gold standard to today's
fiduciary standard, see Benjamin Klein, "Our New Monetary
Standard: The Measurement and Effects of Price Uncertainty,
1880-1973," Economic Inquiry 13 (December 1975): 461-84.
32. And before them, of the Chicago School. See Melvin W.
Reder, "Chicago Economics: Permanence and Change," Journal of Economic Literature 20 (March 1982): 1-38 passim,
especially 11-13.
9
it did, there would be a distinction without a difference between it and the rational expectations
models generating policy ineffectiveness propositions. Rather, it "assumes that people understand
the systematic components of the authorities'
behavior in a general sort of way but avoids a
linkage so tight as to build, for example, short-run
neutral ity or pol icy ineffectiveness assertions into
the concept itself."33
Two corollaries of the revised equilibrium concept deserve mention. First, some monetary regimes
may engender firmer expectations than others as to
future movements of money prices and quantities.
Information costs differ by regime. Accordingly, the
scope for policymakers to exploit economic relationships, like the Phillips curve, may differ under
alternative policy regimes. Unless a regime is first
specified by the theorist, no definitive conclusion
can be drawn on the effectiveness of such policies.
The second corollary is that changes in regime
raise information costs and make the formation of
appropriate expectations more difficult. This second
point is especially important for understanding 20thcentury monetary history. The pre-World War I era
was characterized by a classic international gold
standard, in which gold coin circulated domestically
and international redeemabil ity effectively fixed exchange rates. After World War I the gold standard
was not completely restored internationally but was
domestically. U.S. monetary policy neutralized gold
flows, however, further modifying the standard 34 In
1934, domestic convertibility was ended though international convertibility was maintained (a "gold
bullion" standard). The Bretton Woods agreement
further modified the international standard. Finally,
in 1971 the gold window was closed in the United
States, and floating exchange rates were introduced.
We have thus had four or five different monetary
regimes in this century- perhaps a historical record
for so short a period of time. Each change in regime
altered the probability distribution of future policy
actions. I n other words, the "relevant" econom ic
theory has probably changed with each change in
regime.
It is by no means clear how to define the
post-1934 regimes, which have consisted of a changing mixture of elements from commodity and
fiduciary standards. They have been described as
"vague and ambiguous."" Unfortunately, "a 'vague
and ambiguous' standard can hardly determine a
well-defined system of rational expectations."36
Modern rational expectations theory may have
developed at a time when it is least applicable to
events.
The literature on monetary regimes suggests that
macroeconomic theories must be less general, certainly less general than is true of rational expectations models. Macroeconomic theories must
recognize the institutional dependence of expectations. In effect, distinct regimes require different
macroeconomic theories J7 If less general, however,
macroeconomics may nonetheless be more applicable to the study of aggregate phenomena.
A resolution
Consideration of the role of institutions in the formation of expectations is by no means foreign to
the rational expectations literature. In a series of
sem inal articles,38 several rational expectations
35. Milton Friedman and Anna Jacobson Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton: Princeton
University Press for National Bureau of Economic Research,
1963),474; quoted in Leijonhufvud, "Rational Expectations
and Monetary Institutions," 27.
36. Leijonhufvud, "Rational Expectations and Monetary
Institutions," 27.
37. Ibid., 2-3.
33. Leijonhufvud, "Rational Expectations and Monetary
Institutions," 2.
34. The United States was not alone in neutralizing gold flows.
Ragnar Nurkse found "a striking fact" that for the interwar
years (1922-38), "central banks' international and domestic
assets, during most of the period under review, moved far
more often in the opposite than in the same direction" as
gold flows (League of Nations, International Currency Experience: Lessons of the Inter-War Period [1944.II.A.4J, 68).
10
38. In various issues of the Federal Reserve Bank of Minneapolis
Quarterly Review since early 1979: Robert E. Lucas, Jr., and
Thomas J Sargent," After Keynesian Macroeconomics,"
Spring 1979,1-16; Thomas J. Sargent, "Rational Expectations
and the Reconstruction of Macroeconomics," Summer 1980,
15-19; Thomas J. Sargent and Neil Wallace, "Some Unpleasant Monetarist Arithmetic," Fall 1981, 1-17; Neil
Wallace, "A Legal Restrictions Theory of the Demand for
'Money' and the Role of Monetary Policy," Winter 1983,1-7;
and Neil Wallace, "Some of the Choices for Monetary
Policy," Winter 1984,15-24.
Federal Reserve Bank of Dallas
theorists have highlighted the variation in
equilibrium expectations under alternative policy
regimes. Consideration of the effects of the institutional environment on expectations formation has
not, however, been a central feature of the rational
expectations literature. Instead, the literature has
been sidetracked by a fascination with questions
like the policy ineffectiveness hypothesis, which is
"uninstitutional."39 Nonetheless, there are indications of a convergence of proponents and critics of
rational expectations regarding the crucial importance of theoretically incorporating institutions into
macroeconomic analysis.
39. Two prominent proponents of rational expectations theory
have observed that the implications of this theory "are
sometimes caricatured, by friendly as well as unfriendly commentators, as the assertion that 'economic policy does not
matter' or 'has no effect'" (Lucas and Sargent, "After Keynesian Macroeconomics," 14-15)
40. See John H. Wood, "The Search for a Monetary Policy Rule
in an Uncertain World," this Economic Review.
41. For an examination of the current fiscal regime, see W.
Michael Cox, "What Is the Rule for Financing Public Debt?"
in this Economic Review.
Economic Review/September 1984
More detailed consideration of the interplay of
regimes and expectations awaits future research 40
This research promises significant gains in our
understanding of the effects of policy on economic
variables. This article has analyzed only some of the
effects of monetary institutions on expectations.
The relationship between institutions or regimes and
expectations is more general than the issues examined here. It encompasses fiscal rules and policymaking generally, as well as the whole range of
econom ic institutions.41
It is not possible to specify the effects of a policy
action without relating the action to the institutional environment in which the policy was adopted
and the action taken. First, depending on the policy
regime, given policy actions may have different effects. Second, the intelligibility and predictability of
a policy action depend on the regime within which
the decisionmaker operates. It is on this point that
the analysis of regimes and the rational expectations
hypothesis have the most in common. Rational expectations theorists have reminded us that the effects of policy are not invariant to the public's expectations. The policymaker proposes but the public
disposes.
11
The Search for a
Monetary Policy Rule
•
In
an Uncertain World
By John H. Wood*
"I don't think they play at all fairly," Alice
began, in rather a complaining tone, "and
they all quarrel so dreadfully one can't hear
oneself speak - and they don't seem to ha ve
any rules in particular: at least, if there are,
nobody attends to them."
-Carroll, Alice's Adventures in Wonderland
The price and output fluctuations of recent years
have stimulated the reconsideration of a wide variety of rules by which Federal Reserve actions might
be guided. Some of the proposed rules would allow
the Federal Reserve System little or no latitude of
choice. One of these nondiscretionary rules would
require the Fed to expand the monetary base or,
even more narrowly, its asset portfolio at some con-
* John H. Wood is a visiting scholar at the
Federal Reserve Bank of Dallas, on leave from
Northwestern University. The views expressed
are those of the author and do not necessarily
reflect the positions of the Federal Reserve
Bank of Dallas or the Federal Reserve System.
Economic Review/September 1984
stant rate. Milton Friedman has argued that the
Fed's control of the money stock is so complete
that a constant-money-growth rule approximates his
ideal of no official discretion. Other rules would
permit a great deal of discretion and might better
be called "general guidelines." For example, some
frequently proposed rules, or guides, call for the
manipulation of interest rates to achieve either
price stability or an acceptable combination of inflation and "real" econom ic activity. A proposal
that has recently gained popularity would require
the Fed to respond directly to prices, specifically to
conduct open market operations with the intention
of moderating or reversing observed price
movements. '
All these rules have been proposed in the past
and several have been tried. And all remain controversial. The purpose of the following discussion is
to give some form to the controversy over rules by
summarizing the theoretical conditions under which
1. References to articles favoring or criticizing some of these
rules may be found in R. W. Hafer, "Monetary Policy and the
Price Rule: The Newest Odd Couple," Review, Federal Reserve
Bank of St. Louis, February 1983, 5-13.
13
each is appropriate and describing some of the apparent consequences of the rules that have actually
been applied. Much of the discussion consists of
historical case studies of rules in Great Britain and
the United States during the 19th and 20th centuries. Perhaps we can learn from experience.
Perhaps not. I n any case, there is no excuse for the
sense of novelty that accompanies "new" policy
proposals or for the repeated attitude of surprise at
their consequences.
No unqualified conclusions will be drawn because
the "right" rule is contingent both upon one's views
of the structure of the economy, especially whether
and how money is believed to affect real economic
activity, and upon the relative intensities of one's
fears of inflation and unemployment. The range of
views of the economic structure has not changed
significantly since the 17th century, by which
time the two opposing camps had already been
formed - those who favor expansionary monetary
and fiscal policies to promote economic activity
and the "hard money" people who believe that the
benefits, if any, of inflation are greatly outweighed
by its costs. Whatever theoretical contributions
might be found in J. M. Keynes' The General Theory
of Employment, Interest and Money/ its policy impi ications are not perceptibly different from those
of William Petty,' who in 1662 urged public works
for the unemployed, even if for no other reason
than "to build a useless Pyramid upon Salisbury
Plain" or to "bring the Stones at Stonehenge to
T ower-H i II," or those of Josiah Chi Id,. who in 1690
called for lower rates of interest to encourage investment. s The frequent and sometimes dramatic
shifts between rules have been due to dissatisfaction with the results of current rules, leading to their
2. New York: Harcourt, Brace and Co., 1936.
3. Treatise of Taxes and Contributions (London: Brooke, 1662).
Reprinted in Charles H. Hull, ed., The Economic Writings of Sir
William Petty, vol. 1 (New York: Augustus Kelley, 1963), 31.
4. Discourse About Trade (London: J. Hodges, 1690).
5. Keynes recognized the similarities between his own arguments
and policy prescriptions and those of Petty, Child, and other
early economists in chapter 23 of The General Theory. In the
preceding article in this Review, Gerald O'Driscoll discusses
some of the history of the debate concerning the so-called
Phillips curve trade-off between inflation and unemployment.
14
replacement by rules that had themselves been rejected earl ier, rather than to the discovery of new
rules derived from new theories. The reactions of
the past half century have been typical. The Great
Depression heightened the fear of unemployment
and increased the ranks of those advocating expansionary monetary and fiscal pol icies- until accelerating inflation led to the adoption of rules
intended to achieve stable prices.
The following discussion considers interest-rate,
price-level, monetary-base, and money rules in both
their discretionary and nondiscretionary forms, principally in the context of policies that are limited to
the goal of price stability. We begin with the operation of the Bank of England under the 19th-century
gold standard because most of the intellectual and
practical basis of central banking was formed by the
conduct of the Bank of England, and conflicting
opinions about that conduct, between the
Napoleonic Wars and World War I. Each of the
rules considered might be applied, at least for a
while, under either a gold standard or the
unrestricted paper standard of the present day.
However, one of these systems implies limits to
policy discretion whereas the other does not. The
main difference between the application of rules
under gold and paper standards is that in the former
system rules resulting in inflation must eventually
be abandoned because of the obligations of central
banks and other banks to redeem their liabilities in
gold.
The development and rejection
of a nondiscretionary rule:
the Bank of England in the 19th century
The Bank of England was formed in 1694 and remained privately owned until 1946. But it was the
chief lender to the government and by the end of
the 18th century had acquired all the influence on
the monetary system that can be possessed by a
central bank within the confines of the gold standard - although the Bank was imperfectly aware of
that influence until later. By a combination of its
monopoly of joint-stock banking in London, its role
as the government's bank, and a conservative lending policy, the Bank of England had achieved a
reputation for safety in an industry plagued by
failures. The Bank's notes and deposits were considered almost "as good as gold" and the country
banks held them as reserves against their own note
Federal Reserve Bank of Dallas
and deposit liabilities. This service as bank reserves
meant that the Bank's liabilities, as much as gold,
were high-powered money in the 18th century in the
same sense that the liabilities of the Bank and the
Federal Reserve are high-powered money today. An
increase in the Bank's lending, and therefore in its
note and deposit liabilities, had a multiplier impact
on aggregate money and credit because other banks
held those liabilities as reserves against expansions
of their own notes and deposits.
But the Bank could not extend credit without
limit. Excessive increases in money caused inflation,
an adverse balance of payments, and an outflow of
gold as foreigners converted their newly acquired
pounds into gold. Rising prices also induced increased transactions demands for cash, including
gold coin. These external and internal drains meant
that the Bank eventually had to restrict its lending
to protect its gold reserve.
This discipline was abandoned in 1797 when wartime inflationary finance led to gold losses and
forced the suspension of convertibil ity. That is,
banks were relieved of the obligation to redeem
their liabilities for gold at the official rate of £3.89
per ounce of gold" Monetary expansion and the
rate of inflation were dictated by the government's
war needs and by 1813 the price of gold had risen
to £5.50. After the defeat of Napoleon, the government decided to return to the gold standard at
the prewar rate. This meant deflation, which was
achieved with a vengeance. The Bank's credit was
reduced from £48 million in 1814 to £17 million in
1822, accompanied by a fall in prices of nearly 40
percent. The price deflation was accompanied by a
depression in trade, high unemployment, and often
violent public protests. David Ricardo argued that
the severity of the deflation had been unnecessary
and was caused by gross mismanagement by the
Bank of England-which, however, "denied that it
was in any way responsible for controlling the national currency, and indeed doubted whether it had
the power even to influence it."?
6. In fact, by the Bank Restriction Act of May 1797 the Bank of
England was forbidden to make payments in gold except in a
few specified circumstances. Shillings and old pence have
been avoided by expressing pounds in decimals.
7. A. E. Feavearyear, The Pound Sterling (Oxford: Clarendon
Press, 1931), 212.
Economic ReviewlSeptember 1984
Throughout this period the Bank sought to escape
blame for the instability of prices by taking refuge
in the real bills doctrine, according to which the discounting of bills for the purchase of goods ("real
bills") was sufficient to cause money and credit to
rise and fall with real transactions so that the price
level would be stable. The Bank's directors testified
in 1810 that their lending merely supplied the needs
of trade. They argued that note issues result solely
"from the applications made for discounts to supply
the necessary want of Bank Notes, by which their
issue in amount is so controlled that it can never
amount to an excess." Given that the Bank discounts only for "solid persons" and "bona fide
transactions," the publ ic "wi II never call for more
than is absolutely necessary for their wants."·
The real bills doctrine is likely to be more conducive to the instability than the stability of prices.
Tying the quantity of money to the money value of
goods renders both indeterminate. I n any case,
whatever their true bel iefs, the Bank's directors
discontinued avowals of the real bills doctrine after
resumption of the gold standard. Gold standard central banks cannot afford the luxury of nonmonetary
theories of inflation. They must look to their
reserves and restrict credit when inflation causes
gold losses. But monetary and price stability were
not much improved after convertibility was resumed
in 1821. The Bank's responses to fluctuations in its
reserve were erratic and continuously a source of
controversy. However, the Bank began to show signs
of feeling its way toward a coherent policy in the
form of the "Palmer rule,'" by which its security
holdings were to be held constant with the purpose
of causing the currency to fluctuate precisely in the
manner of an unregulated metallic currency. The
Bank was to payout or redeem notes only as gold
was brought to or taken from the Bank. If its note
and deposit liabilities were prevented from changing
8. Report from the Select Committee on the High Price of Bullion,
House of Commons, 1810. Reprinted with an introduction by
Edwin Cannan in The Paper Pound of 1797-1821, 2d ed.
(London: P. S. King and Son, 1925), 47.
9. Named for Horsley Palmer, the Governor of the Bank who
described the rule to a parliamentary committee in 1832.
Palmer's testimony may be found in T. E. Gregory, Select
Statutes, Documents and Reports Relating to British Banking,
1832-1928, vol. 1 (London: Oxford University Press, 1929), 3-6.
15
Table 1
THE BANK OF ENGLAND'S BALANCE SHEET ON SEPTEMBER 7, 1844
Issue Department
Government securities
Other securities
Gold coin and bullion
Silver bullion
Total assets
£11,015,100
2,984,900
12,657,208
1,694,087
£28,351,295
£28,351,295
£28,351,295
Notes issued
Total liabilities
Banking Department
Government securities
Other securities
Notes
Gold and silver coin
Total assets
£14,554,834
7,835,616
8,175,025
857,765
£ 3,630,809
8,644,348
1,030,354
18,117,729
£31,423,240
£31,423,240
Government deposits
Other deposits
Seven-day and other bills
Capital
Total liabilities and capital
NOTE: The Bank's position (or "return") was required to be published weekly in the London Gazette. It was
also published in The Economist. The above return was the first under the 1844 act and has been
published in many places, including A. Andreades. History of the Bank of England, 1640 to 1903
(London: P S. King, 1935), 290. The items have been rearranged and some have been renamed
to conform to modern American usage
because of changes in the Bank's lending, the
Bank's liabilities would rise and fall, pound for
pound, with movements of gold into and out of the
Bank.
But the Palmer rule served mainly as a conversation piece, the Bank's erratic behavior continued,
and so did monetary controversy. Of the many proposals for reform, one group of writers, called the
Banking School, argued that no changes in the
Bank's organization or powers were needed and that
no strict rule of policy was desirable. All that was
required was sound banking practice by the Bank of
England and other banks. Specifically, the Bank
should hold a sufficiently large reserve that it would
not have to contract its lending upon every outflow
of gold. They pointed out that the maintenance of
the gold standard did not require the Bank to contract or expand its credit immediately or to the full
extent of every outflow or inflow of gold. In the
event of a temporary external drain due to a bad
harvest, for example, public welfare would be better
served by an increase in bank lending, that is, by
offsetting instead of reinforcing the effects of the
gold loss on money and prices.'o
16
The Currency School, on the other hand, advocated the separation of the Bank into two departments. The Banking Department would be left free
to behave like any other bank but the Issue Department would function strictly, without discretion, in
accordance with the Palmer rule. Parliament
adopted the Currency School's proposals in the
Bank Act of 1844." The first statement of the Bank
under the new act is shown in Table 1. The
monetary rule under which the Issue Department
operated between 1844 and 1914 required the quantity of its notes to be kept equal to the sum of a
10. The Banking School's proposals may be found in Thomas
Tooke, An Inquiry into the Currency Principle, the Connection
of the Currency with Prices and the Expediency of a Separation of Issue from Banking (London: Longman, Brown, Green,
and Longmans, 1844).
11. The Currency School's position was summarized by Samuel
Jones Loyd, Further Reflections on the State of the Currency
and the Action of the Bank of England (London: Pelham
Richardson, 1837). Several interesting documents relating to
the controversy leading up to the Bank Act of 1844 are contained in Gregory's Select Statutes.
Federal Reserve Bank of Dallas
"fiduciary" amount of £14 million and its holdings
of gold and silver coin and bullion. The Bank was
not permitted to issue notes in payment for additional securities but was required to issue notes in
exchange for all the gold offered to it at the fixed
rate of £3.89 per ounce. The Banking Department
was bound by no rule and was free to borrow and
lend as it chose, like other banks, with only its own
safety and profits in view.
But monetary conditions during the 20 years
following the act of 1844 were as volatile as in the
preceding 20 years. A series of monetary expansions
followed by banking crises led to the act's suspension in 1847, 1857, and 1866. On each of these occasions, in the midst of rapid declines of the Banking
Department's note reserve and the Issue Department's gold reserve, the government of the day permitted the Bank to issue notes beyond the legal
limit. The failure of the act during its early years
has been attributed to a variety of causes-most important, the failure of both Parliament and the Bank
to recognize the significance of the Bank's checking
account liabilities, either as part of the money supply or as an increasingly important component of
the monetary base. Fluctuations in the lending of
the Banking Department continued to influence the
money supply fully as much after as before 1844.
Nothing had happened to diminish the significance
of all claims on the Bank of England, deposits as
well as notes, in the reserves of other banks. The
Banking School had emphasized this deficiency of
the Bank Act, and the appropriate identification of
money-whether it should include bank deposits
and perhaps bi lis of exchange and other cred it
market instruments as well as currency and
coin-was a hotly debated issue throughout this
period. The Currency School's error has seemed obvious to most I ater writers - although more because
of their exclusion of the Bank of England's deposits
from the identification of the monetary base than
from the identification of money. But the correct
choice was not and is not clear, and problems of
this kind have always arisen from decisions to
follow ru les based on monetary aggregates.
The Bank eventually adjusted to its role as the
nation's central bank and came to realize that its
discretionary management of the Banking Department was as important to the determination of
money and prices as its nondiscretionary operation
of the Issue Department. But it should be emphaEconomic Review/September 1984
sized that short-run price stability was never the
Bank's overriding objective. Its legal commitment to
the gold standard was thought (correctly, as matters
turned out) to assure long-run price stability. The
Bank's short-run behavior before 1914 was much
like its own stop-go policies and the stop-go policies
of other central banks during the era of more or less
fixed exchange rates of the 1950s and 1960s. I ncreases in the Banking Department's reserve because of gold inflows (which were exchanged for the
I ssue Department's notes) perm itted increases in the
Bank's lending, that is, in the monetary base, which
in turn led to increases in money and prices. The
main difference (perhaps the only important difference) between the Bank's behavior before '1914
and in recent years is that during the earlier period
gold losses eventually forced the ends of inflationary policies.
Interest-rate rules
Wicksell's variable-interest-rate (or price-level)
rule. Although there was often acute dissatisfaction
with the gold standard, its reputation grew with the
prosperity of the late 19th century. But the gold
standard probably derived most of its strength from
lively memories of the even more volatile unrestricted paper-money systems of earl ier periods.
Most economic writers accepted the need for some
kind of nondiscretionary limit on the quantity of
money-and no persuasive alternative to the convertibility of money into gold at a fixed rate was
forthcoming. Nevertheless, many writers still saw
considerable scope for reform within this constraint.
R. G. Hawtrey later argued that an important cause
of price instability before 1914 was the slow
response of the Bank of England to changing
conditions.
Professor Fisher in his Purchasing Power of
Money" held that the fluctuations of the trade cycle were due to the adjustment of the market rate
of interest to the real rate being incomplete. When
prices were rising, the market rate rose, but not
high enough to make the real rate normal; when
prices were falling, it fell, but not low enough.
Professor Fisher, perhaps, laid too much stress
on the tendency to overlook the effect of rising or
12. Irving Fisher, The Purchasing Power of Money (New York:
Macmillan, 1911).
17
falling prices when determining the rate of interest. For Bank rate was settled by a method of
trial and error, which allowed automatically for all
the factors at work. The delay in adjusting it, to
which Professor Fisher quite rightly attributes the
fluctuations, was really due to the practice of using the Bank of England's reserve as a criterion.
The reserve responded very tardily to an expansive
or contractive movement, so that there were long
periods in which the Bank acquiesced in such
movements without attempting to counteract
them. But when it did resort to the rate of interest
as a corrective, the Bank simply went on raising or
lowering the rate till the desired effect followed. If
in raising the rate it stopped short at 7 per cent. or
9 per cent., that was because the market responded. (A Century of Bank Rate, 1938, pp.
Figure 1
The Effects of an Increase
In the Demand for Investment Goods
213-14)
Knut Wicksell had earlier observed the same
tendencies and proposed as a remedy that the central bank should respond directly to the price level
without waiting for the effect of the latter on its
reserve. 13 Wicksell's rule may be explained within
the simplified version of his model depicted in
Figure 1. Let / be real investment, that is, net additions per unit of time to plant, equipment, houses,
and inventories. 5 is real annual saving; it is the portion of national income (output) that is not consumed. Investment and saving are shown as
negative and positive functions, respectively, of the
expected real rate of interest, r e Given the initial investment function, /0' the market for goods and services is in equilibrium at the intersection of /0 with
the saving function, S. Desired saving and investment are equal at the expected real rate of interest,
r~. In equilibrium the nominal rate of interest, R, is
equal to the expected real rate of interest plus the
expected rate of inflation, pe. We assume no inflation initially so that nominal and expected real interest rates are the same.
Now consider an increase in the demand for
investment goods to / n' perhaps because of
technological advances or the opening of new
13. Wicksell's views on this subject are found mainly in Interest
and Prices, published in Sweden in 1898, translated by R. F.
Kahn (London: Royal Economic Society, 1936); and Lectures
on Political Economy, vol. 2, Money, published in Sweden in
1906, translated by E. Classen (London: Routledge and Kegan
Paul, 1934).
18
o
5, I
markets that raise the expected profitabilities of
new or expanded business ventures. Given an unchanged saving function, nominal and expected real
interest rates will be Rn and r~ in the new stableprice equilibrium. But some inflation is bound to
occur in the process of moving from the old to the
new equilibrium. After I has increased from 10 to In
but before R has responded, there is an excess demand for goods, represented by the distance bc.
This distance also represents the real excess demand
for funds required to finance the excess demand for
goods. These excess demands put upward pressure
on prices and interest rates, with the higher prices
being financed by an increase in the velocity of
money. Eventually, R rises to Rn and the new stableprice equilibrium is established at a higher price
level and a higher velocity of money.
We have so far neglected two important aspects
of experience: first, the universally strong positive
association between money and prices, and second,
the almost equally strong tendency of interest rates
to lag behind price movements. The rapid rise in
money and the tardy response of R may be explained in terms of bank demands for reserves. Bank
Federal Reserve Bank of Dallas
allocations of assets between loans and cash
reserves depend partly on loan rates. Suppose that
before the onset of an economic expansion, when
interest rates are low, banks hold large reserves
relative to their deposits. Under these conditions
bank competition for new loans in response to the
rise in investment demand from 10 to In might for a
while inhibit increases in interest rates. Consider the
extreme case in which the nominal rate of interest
remains at Ro and other loan terms are not made
more stringent. Borrowers obtain all the funds they
desire at the interest rate Ro' The funds supplied by
savers (through the capital markets, banks, and
other financial intermediaries) are equivalent, at expected prices, to the quantity of investment goods
indicated by the distance ab in Figure 1. But the excess demand bc is financed by banks' creation of
money.
However, investors will not be able to fulfill all of
their demands ac because only the quantity ab (plus
possible small increments due to increases in production and the crowding out of consumption
demands) is available. As much as we might hope
otherwise, the demand for goods does not create its
own supply, except possibly in deep depression and
then not immediately. Since the excess demand is
not eliminated by a rise in R to Rn as in the previous
example, when the money stock did not change, it
must be eliminated by price increases and delays in
delivery. Would-be investors find that their loans do
not command as many goods as they had expected.
These price increases, and probably expectations of
further increases, will be taken into account in new
loan requests - so' that the same excess demand for
goods (bc) will generate greater and greater increases in money and prices in future periods as
long as R does not rise. But eventually, declining
bank reserves relative to deposits must, in combination with increasing loan demands caused by
accelerating inflation, force interest rates to rise.
Wicksell argued that central banks at times prolonged the inflationary process by resisting increases
in interest rates. The end of the process described
above was hastened by the limited quantity of bank
reserves. But a central bank can supply additional
reserves. It can even for a time ensure that interest
rates will not rise by supplying all the credit the
system desires at existing rates. In terms of Figure 1,
for example, a central bank has the ability to peg
the rate of interest at Ro by standing ready to buy
Economic Review/September 1984
or sell unlimited quantities of securities at that rate.
Of course, this requires ever-increasing purchases of
securities in the presence of the real excess demand
bc as the dollar values of loan demands rise to keep
up with the prices of the goods to be financed. The
gold standard eventually forced a halt to this process. But Wicksell suggested that the inflation
would not have become serious if the central bank
had taken early action to encourage interest rates to
rise to a level consistent with price stability. Conversely, increases in central bank lending should
quickly follow price declines. Wicksell stated his
rule as follows:
So long as prices remain unaltered the banks' rate
of interest is to remain unaltered. /f prices rise, the
rate of interest is to be raised; and if prices fall, the
rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new
level until a further movement of prices calls for a
further change in one direction or the other.
The more promptly these changes are undertaken the smaller is the possibility of considerable
fluctuations of the general level of prices; and the
smaller and less frequent will have to be the
changes in the rates of interest. (interest and
Prices, 1898, p. 189)
A stable-interest-rate rule. Wicksell's objective
was price stability and his rule that interest rates be
allowed to vary without resistance from, and even
with the help of, the central bank was based on the
belief that economic disturbances stem principally
from fluctuations in demand, such as the shift in investment in Figure 1. But the goal of price stabil ity
implies a very different central bank response to
interest-rate movements when those movements are
caused by fluctuations in the demand for money.
For example, an increase in the demand for money
relative to other assets causes interest rates to rise
and, other things equal, depresses commodity
demands and the price level. Prices fall until, given
existing nominal money balances, real money
balances conform to the public's new higher demand at the equilibrium rate of interest determined
by real saving and investment. This price fall could
have been avoided by a central bank determined to
maintain stable interest rates. An increase in the demand for money that puts upward pressure on interest rates could have been met by an increase in
central bank lending. The stock of money would rise
in line with the public's demand for money, which
19
would be satisfied by an increase in nominal money
balances instead of by a fall in prices.
So the goal of price stability may imply either a
variable or a stable interest-rate rule, depending on
the central bank's belief about the source of disturbances." However, the high and long-lived
positive correlations between private investment,
prices, and interest rates, which were observed by
Wicksell and many others in several countries during the 19th century and have been documented for
the United States in the 20th century, strongly support the view that fluctuations in the demand for investment goods dominate those in money.'s
A discretionary monetary-base rule:
the Federal Reserve in the 19205
The successful operation of the gold standard
before 1914 was made possible by the willingness of
the principal actor to play according to the "rules
of the game." The Bank of England allowed gold
movements to affect domestic money and prices
and by its own actions reinforced those effects.
Other central banks were less inclined to play this
game and tended even in the 19th century to neutralize gold flows.'6 But Britain's strength in the international economy, particularly its pull on the
world's gold and its willingness to allow gold to
flow out again, was sufficient to make the gold standard work." All this was ended by the decline of
the British economy and Britain's replacement by
the United States as the dominant force in world
14. It has been demonstrated that stable money growth is preferred to stable interest rates when disturbances stem from
fluctuations in commodity demands but that this preference
is reversed when disturbances .tem from fluctuations in the
demand for money. See William Poole, "Optimal Choice of
Monetary Policy in a Simple Stochastic Macro Model,"
Quarterly Journal of Economics, May 1970,197-216; and John
Karaken, "The Optimum Monetary Instrument Variable,"
Journal of Money, Credit, and Banking, August 1970, 385-90.
15. See Arthur F. Burns and Wesley C. Mitchell, Measuring
Business Cycles (New York: National Bureau of Economic
Research, 1946); and Business Conditions Digest.
16. See Arthur I. Bloomfield, Monetary Policy Under the International Gold Standard, 1880-1914 (New York: Federal Reserve
Bank of New York, 1959).
17. See D. E. Moggridge, British Monetary Policy, 1924-1931: The
Norman Conquest of $4.86 (Cambridge: Cambridge University
Press, 1972), chap. 1.
20
trade.
The necessities of war finance had again forced
the suspension of convertibility by the Bank of
England during World War I. Wartime and postwar
inflation were more severe in Britain than in the
United States, and by November 1920 the pound
had fallen from its prewar par value of $4.86 to
$3.44. (One of the indications of the dominance of
the United States and the world's confidence in the
gold value of the dollar was the new practice of
quoting currencies in terms of the dollar.) But
Britain was as determined after World War I as after
Waterloo to return to gold at the prewar par.
Restrictive monetary and fiscal policies were pursued and by 1925 the pound had been forced to
$4.86, where it was maintained until 1931. The question of whether the pound was overvalued during
this period is still controversial. In any case, the
authorities were prepared to bear the costs of deflation necessary to return to and then to maintain the
gold standard at the prewar parity. But they hoped
that deflation would not be necessary. To a large
extent British policies were based on the expectation that the accumulations of gold in the United
States during and after the war would be allowed to
affect American money and prices. But this hope
was disappointed by the Federal Reserve's goal of
price stability. Benjamin Strong, President of the
Federal Reserve Bank of New York and the most influential official in the Federal Reserve System until
his death in 1928, declared that the Federal Reserve
would not expand its credit in response to inflows
of gold. In 1923 Strong wrote to Montagu Norman,
Governor of the Bank of England, that with
America's "excessive gold stock we must entirely
ignore any statutory or traditional percentage of
reserve and give greater weight to what is taking
place in prices, business activity, employment, and
credit volume and turnover."'8
There was considerable interest in Congress in
legislation that would require the Federal Reserve to
stabilize prices. Strong opposed such legislation
because he felt that unpredictable factors outside
the Fed's control also influenced prices. He testified
before the House Committee on Banking and Currency that" I do not bel ieve, and have never be-
18. Lester V. Chandler, Benjamin Strong, Central Banker
(Washington, D.C.: Brookings Institution, 1958), 188.
Federal Reserve Bank of Dallas
lieved, that any method of fixing the general level
of commodity prices can be devised which would
enable a monetary and credit policy by a bank of
issue to accomplish that object."'9 Nevertheless, he
bel ieved that Federal Reserve actions were the principal determinant of the price level and accepted
price stability as the Fed's primary goal, which he
proposed to achieve by a monetary-base rule: "If I
were Czar of the Federal Reserve System I'd see
that the total of our earning assets did not go much
above or below their last year's average, after
deducting an amount equalling from time to time
our total new gold imports."2o This policy of gold
neutralization was in fact applied. During 12 of the
13 years from 1921 to 1933, Federal Reserve cred it
moved oppositely to changes in the monetary gold
stock 2 ' The United States (and France) continued to
accumulate gold in the late 1920s, and the inflows
accelerated during 1930 and 1931 because of increasingly restrictive tariffs and the greater severity
of the depression in the United States than in Great
Britain and most other countries. Finally, in
September 1931 the Bank of England was forced to
abandon the convertibility of the pound at $4.86.
It should be pointed out that the goal of short-run
price stability, if it is shared by all countries, is not
inconsistent with a permanently successful gold
standard. What was demonstrated by the experience
of 1914-31 was the inability of a gold standard, or
any fixed-rate system, to survive substantially different rates of inflation in different countries.
Friedman's rule
The stability of a free-market economy. The
famous money rules of Milton Friedman and others
at the University of Chicago have been based on the
belief that, whatever the defects of an unregulated
economy, its performance is worsened by government interference. Discretionary and therefore
necessarily unpredictable monetary policies increase
the uncertainties of an already uncertain world. In
his paper on "Rules versus Authorities in Monetary
Pol icy," Henry Simons argued: "An enterprise
system cannot function effectively in the face of extreme uncertainty as to the action of monetary
authorities or, for that matter, as to monetary
legislation. We must avoid a situation where every
business venture becomes largely a speculation on
the future of monetary policy."22 The only means of
achieving this end was to take discretion completely
away from the central bank and to make its actions
fully predictable. None of the earlier rules (Simons
did not regard them as rules) of central bank conduct satisfied these requirements. The Bank of
England's wartime accommodative "real bills" approach placed its lending at the mercy of private
and government credit demands; the gold standard
left much to the Bank's discretion, even under the
act of 1844, and wou Id have done so even if
Wicksell's interest-rate rule had been adopted; and
Benjamin Strong valued the freedom to depart from
his monetary-base rule whenever conditions required. Milton Friedman later argued that the lags
of monetary policy were long and variable, so that
when the central bank followed loose guidelines
such as Wicksell's interest-rate rule, its actions to
combat inflation became effective only after the
problem had become deflation, with the result that
monetary policy tended to accentuate price fluctuations. 23 "The problem with leaning against the wind
is that you have to lean against the right wind, and
then the problem is that you have to lean against
next year's wind, not this year's wind, and unfortunately the people in Washington don't know the
direction of next year's wind any better than we
do."2.
Constant money growth or constant growth of
Federal Reserve credit? As the best means of achieving a monetary environment in which uncertainty
would be minimized, Simons looked to the
"ultimate establishment of a simple mechanical rulE
of monetary pol iCY,"2s preferably "the fixing of the
22. "Rules versus Authorities in Monetary Policy," Journal of
Political Economy, February 1936,1-30. Reprinted in Henry
19. Ibid, 204.
Simons, Economic Policy for a Free Society (Chicago: University of Chicago Press, 1948), 161.
20. I bid., 191.
23. See "The Lag in Effect of Monetary Policy," Journal of
Political Economy, October 1961,447-66.
21. Banking and Monetary Statistics, 1914-1941 (Washington,
D.C.: Board of Governors of the Federal Reserve System,
24. Paraphrased from a speech in New York, November 15,1983.
1943), 369-71.
Economic ReviewlSeptember 1984
25. Simons, "Rules versus Authorities," 170.
21
quantity of circulating media."26 But he did not feel
that the time was ripe for this rule, partly because
of "the abundance of what we may call 'nearmoneys' -with the difficu Ity of defining money in
such a manner as to give practical significance to
the conception of quantity"27 and partly because,
however money might be defined, the Federal
Reserve did not possess complete control of its
quantity. He argued that these problems could be
resolved only by a radical change in the financial
system, including the elimination of all short-term
borrowing (and therefore the elimination of money
substitutes) and the imposition of 1 ~O-percent
reserve requirements on commercial bank deposits,
which following the first change would be limited to
demand deposits (so that fluctuations in bank
reserve behavior and the public's desired currencydeposit ratio would not affect the quantity of
money).28 Under these conditions money would be
clearly identifiable and equal to the monetary base,
which could be controlled by the Fed.
Friedman supported most of Simon's proposals to
make monetary control effective, particularly
1 ~O-percent reserves. But he argued in 1959 that
... even under present circumstances, the links
between Reserve action and the money supply are
sufficiently close, the effects occur sufficiently
rapidly, and the connections are sufficiently well
understood, so that reasonably close control over
the money supply is feasible, given the will. I do
not mean to say that the process would not involve much trial and some error but only that the
errors need not be cumulative and could be corrected fairly promptly. (A Program for Monetary
Stability, p. 89)
The rule by which this control of money should
be exercised was described and supported at length
26. Ibid, 163.
27. Ibid, 171.
28. For example, letting m be the money multiplier, B be the
monetary base, c and t be the nonbank public's currencydemand deposit ratio and time deposit-demand deposit ratio,
respectively, and kd and k t be reserve ratios on demand and
time deposits, respectively, we see that
M
=
mB =
Cd: : ~ tkJB = C: ~)B ~ B
when kd
22
=
1 and t
= o.
in the last chapter of A Program for Monetary
Stability and was later stated succinctly as follows:
My choice at the moment would be a legislated
rule instructing the monetary authority to achieve
a specified rate of growth in the stock of money.
For this purpose, I would define the stock of
money as including currency outside commercial
banks plus all deposits of commercial banks. I
would specify that the Reserve System shall see to
it that the total stock of money so defined rises
month by month, and indeed, so far as possible,
day by day, at an annual rate of X per cent, where
X is some num ber between 3 and 5. The precise
definition of money adopted, or the precise rate of
growth chosen, makes far less difference than the
choice of a particular definition and a particular
rate of growth. (Friedman, Capitalism and Freedom,
1962, p. 54)
But this rule is unsatisfactory by Friedman's own
criteria. In particular, it does not deprive the central
bank of discretion. It is an improvement over the
price-level guides of which Friedman was critical
only in some unknown degree-and then only if we
know what money is. Friedman has written that
A satisfactory policy guide or rule should be connected more directly with the means available to
the monetary authority than is the price level. We
will, I believe, further the ultimate end of achieving a reasonably stable price level better by specifying the role of the monetary authorities in terms
of magnitudes they effectively control and for
whose behavior they can properly be held responsible than by instructing them solely to do the
right thing at the right time when there is no clear
and accepted criterion even after the event
whether they have done so. (A Program for
Monetary Stability, p. 88)
One such magnitude is the stock of Federal
Reserve security holdings. A rule defined in terms of
that stock would eliminate central bank discretion.
It would also, by Friedman's own assumption of
stable private behavior unless shocked by government interference, probably be more consistent with
the stable growth of money (by a variety of definitions) than would the feedback approach to money
control suggested by Friedman and quoted above.
All the arguments about the proper definition of
money and how best to control it, while of
academic interest and crucial to some fine-tuning
approaches to policy, have no relevance for a true
Federal Reserve Bank of Dallas
nondiscretionary ru Ie.
Still looking
In summary, those in favor of discretion might
choose either an interest-rate rule or a moneysupply rule. A money rule is desirable in the
presence of a stable relationship between the quantity of money and the price level (which requires a
stable demand for money) but an unstable relationship between the Federal Reserve's earning assets
and the money supply (that is, an unstable money
multiplier), so that the Fed must be prepared to adjust its actions in response to, or in anticipation of,
variations in the money multiplier.
Now consider an interest-rate rule. But which
one? If disturbances emanate from the demand for
money, rising interest rates imply increases in central bank credit to combat deflation. If rising interest rates are caused by increases in demand, on
the other hand, price stability requires the restriction of credit. These problems suggest that a better
policy might be to respond directly to the price
level, expanding or contracting central bank credit
as price changes are less or greater than desired.
However, this approach increases the chances that
official actions will be too late and perhaps even ex-
Economic Review/September 1984
acerbate cyclical movements in prices and other
variables.
50 for those who desire a discretionary rule but
do not claim complete understanding of the
economy, the unpleasant choice lies between early
actions that may be incorrect and correct actions
that are too late- and the quandary prevails not
only in the present flexible-exchange-rate papermoney regime but also in gold and other fixed-rate
regimes. This is not a pretty picture. But a better
one is not available because of the lack of a
satisfactory macroeconomic model from which correct and timely actions may be inferred. The entire
controversy about monetary policy rules stems from
the absence of such a model. If a good model were
available, complete with calculable uncertainty
known to the policymakers, the controversy would
be silenced and only the arithmetic necessary to the
calculation of the "optimal policy" would remain.
The only rules which do not require degrees of
knowledge that have not been, and perhaps cannot
be, even remotely attained are nondiscretionary
rules of the kind logically implied by the approach
of the Chicago 5chool- such as a constant rate of
change of Federal Reserve credit.
23
What Is the Rule for
Financing Public Oebtl
By W. Michael Cox*
Of the two major types of financial paper issued by
government, money and bonds, traditionally money
alone has been viewed as inflationary. However, the
hypothesis that bonds rolled over forever are like
money, with potentially the same inflationary implications, is not new and has recently been a subject of renewed attention.
One view under which bonds are potentially
inflationary focuses on net financial wealth of the
private sector as the determinant of the price level.'
Under this view, base money issued by the Federal
Reserve is inflationary because it is an asset of the
private sector for which there is no corresponding
liability; it is net financial wealth. U.S. Treasury
securities also are potentially inflationary if (1) individuals do not fully discount the future tax
liabilities associated with public debt issuance or
* W. Michael Cox is a senior economist at the
Federal Reserve Bank of Dallas. The views
expressed are those of the author and do not
necessarily reflect the positions of the Federal
Reserve Bank of Dallas or the Federal Reserve
System.
Economic ReviewlSeptember 1984
(2) public debt is not in fact financed by offsetting
future tax liabilities.
For many years economic theory largely assumed
that there were in fact equivalent offsetting tax
liabilities associated with public debt issuance, and
attention was focused on the question of whether
individuals fully discount these tax liabilities. 2 Emphasis on this aspect is understandable because
over an extended period the federal budget (including interest outlays) was roughly balanced. Over
1. For a clear exposition of the hypothesis that the price level is
related to net financial wealth of the private sector, see Don
Patinkin, Money, Interest, and Prices: An Integration of
Monetary and Value Theory, 2d ed. (New York: Harper & Row,
1965). The term "net financial wealth" refers to fiduciary
assets less liabilities of the private sector. The focus is not on
whether government bonds are net wealth in the sense of augmenting the overall consumption possibility set or utility of
private individuals (they do not under this view) but on
whether the stream of interest receipts from government debt
actually involves an offsetting tax liability.
2. See, for example, Martin J. Bailey, National Income and the
Price Level: A Study in Macroeconomic Theory, 2d ed. (New
York: McGraw-Hili Book Company, 1971); Robert J. Barro, "Are
Government Bonds Net Wealth?" Journal of Political Economy
25
the period 1948-70, for example, the average fiscalyear federal budget deficit was a comparatively
small $3.7 bi II ion. I n contrast, over the period
1971-81 the average budget deficit was $39 billion,
and in more recent years $110 billion to $195
billion. In view of this experience, it has become
questionable whether Congress really intends for
public debt to be entirely tax-financed, and attention has retu rned to the issue of whether government securities unbacked by taxes are like money.
This article provides some evidence on the extent
to which government securities have been backed
by taxes. On average, over the period 1950-81 each
$1 of interest paid by the Treasury bore a tax liability of only 41 cents. The evidence also indicates
that the Treasury's interest-financing behavior
changed during this period. For each $1 received in
the form of interest on government bonds before
January 1971, there was a corresponding expected
tax liability of 62 cents-hence a net receipt of interest of 38 cents by the private sector. Interest
82 (November/December 1974): 1095-1117; Robert J. Barro,
"On the Determination of the Public Debt," Journal of Political
Economy 87 (October 1979, pt 1): 940-71; and Robert J. Barro,
"The Public Debt," chap. 15 in Macroeconomics (New York:
John Wiley & Sons, 1984). For a clear discussion of the issue,
see Gerald P. O'Driscoll, Jr, "The Ricardian Nonequivalence
Theorem," Journal of Political Economy 85 (February 1977):
207-10. For empirical work on the issue of whether individuals
discount the tax liabilities associated with government debt,
see Levis A. Kochin, "Are Future Taxes Anticipated by Consumers?" Journal of Money, Credit, and Banking 6 (August
1974): 385-94; Jess B. Yawitz and Laurence H. Meyer, "An Empirical Investigation of the Extent of Tax Discounting," Journal
of Money, Credit, and Banking 8 (May 1976): 247-54; J. Ernest
Tanner, "An Empirical Investigation of Tax Discounting,"
Journal of Money, Credit, and Banking 11 (May 1979): 214-18;
and John J. Seater, "Are Future Taxes Discounted?" Federal
Reserve Bank of Philadelphia Research Paper no. 50
(Philadelphia, 1980). A discussion and analysis of the issue of
whether bonds are like money may be found in John Bryant
and Neil Wallace, "The Inefficiency of Interest-bearing
National Debt," Journal of Political Economy 87 (April 1979):
365-81; Preston J. Miller, "Deficit Policies, Deficit Fallacies,"
Federal Reserve Bank of Minneapolis Quarterly Review,
Summer 1980, 2-4; Thomas J. Sargent and Neil Wallace,
"Some Unpleasant Monetarist Arithmetic," Federal Reserve
Bank of Minneapolis Quarterly Review, Fall 1981, 1-17;
Bennett T. McCallum, "Are Bond-financed Deficits Inflationary? A Ricardian Analysis," Journal of Political Economy 92
(February 1984): 123-35; and John Bryant and Neil Wallace, "A
Price Discrimination Analysis of Monetary Policy," Review of
Economic Studies 51 (April 1984): 279-88.
26
receipts accruing after that time, however, have
borne no tax liability, and there has been a dollarfor-dollar expected net receipt of interest by the
private sector.
Identifying a financing rule for public debt
This section models the way in which public debt is
financed in the United States. As a necessary
feature of that model, primary attention is paid to
the consolidated budget of the Treasury and the
Federal Reserve and to a mode of behavior- a
"rule" -for financing the interest on public debt.
This rule is viewed as being determined by the
Treasury (in the broad sense of including Congress)J
It is not important that the Treasury has a conscious
debt-financing rule per se. Whatever the behavior of
the Treasury (tax policy, deficit policy, and so forth),
the result is that a certain fraction of the interest on
Treasury debt is deficit-financed. The important
point is that there are a variety of policies under
which the private sector may receive interest on
Treasury debt without a corresponding tax liability.
This article does not attempt to explore those many
forms of pol icy or postulate a motivation for debt
financing on the part of the Treasury. The approach
instead is to accept policy and determine its implications for the financing rule implicitly promised
by Treasury debt.
In setting out the model, it is helpful first to
delineate clearly the decision-making structure. This
study assumes that there are three economic
decision-making units-private individuals, the
Treasury, and the Federal Reserve. The Treasury is
responsible for making decisions regarding the
financing of government spending. This includes
financing of the public debt. Specifically, the
Treasury determines what part of the interest and
principal on public debt it will finance with tax
revenues and what part it will finance with new
bond issuance. For simplicity, it is assumed that
there is only one type of Treasury bond. Each bond
promises to pay $1 per period to its owner, forever.
It is also assumed that the Treasury views the
financing of interest on a per-dollar basis. That is,
3. In using the term "Treasury" in this broad sense, it is recognized that as part of the executive branch of government, the
Treasury is the fiscal agent that carries out the funding decisions of Congress.
Federal Reserve Bank of Dallas
each $1 of interest is financed by T<j: in taxes and
(d<j: = $1 - T<j:) in bond issuance.
The Federal Reserve is responsible for making
asset exchanges, commonly referred to as open
market operations. Specifically, the Federal Reserve
increases or decreases the monetary base through
buying or selling outstanding Treasury securities.
Given that the Treasury views the financing of interest on a per-dollar basis, open market operations
by the Federal Reserve do not alter the tax promise
associated with each unit of Treasury debt. This
assumption allows the Treasury and the Federal
Reserve to be treated as institutionally separate
decision-making units.
Of primary importance is an examination of the
Treasury's budget equation and the consolidated
budget equation of the Treasury and the Federal
Reserve. The Treasury periodically
1. Receives taxes from the private sector
2. Distributes government outlays to the private
sector
3. Pays interest on outstanding Treasury debt
4. Increases or decreases the outstanding stock of
Treasury debt.
The Federal Reserve periodically increases or
decreases the stock of privately held Treasury
securities through open market exchanges for base
money. The Treasury's budget and the consolidated
budget of the Treasury and the Federal Reserve may
be illustrated as follows:
Budget of the Treasury
Expenditures
Receipts
Interest on outstanding
Treasury debt
Tax receipts
form as
B
(1 )
Expenditures
Receipts
I nterest on privately held
Treasury debt
Net tax receipts'
Issuance of new debt
to the private sector
Creation of base money
1. All interest earnings on Treasury securities held by the Federal
Reserve are assumed to be returned to the Treasury and added
to the Treasury's net tax receipts.
+
G = T
+
llM
+
PBllB.
As the consolidated budget equation illustrates,
from the standpoint of the private individual there
is no natural reason to suppose that the interest
payments on government bonds involve a corresponding tax liability. Some portion of the interest
payments may be financed by net tax receipts, and
the remaining portion deficit-financed.
Specifically, suppose that the Treasury follows a
rule of tax-financing T<j: and deficit-financing
(d<j: = $1 - T<j:) of every $1 of interest. That is,
TB = T - G,
(2)
which may be written in alternative form, using the
consolidated budget equation, as
(3)
Consolidated Budget of the
Treasury and the Federal Reserve
Economic Review/September 1984
Adopting the notation
B = the number of privately held Treasury
consols = periodical interest receipts of
the private sector because each security
pays $1 of interest per period
G = nominal noninterest budget outlays
T = nominal Treasury tax receipts
M
the monetary base
PB = the price of Treasury securities
tn = the change in x; x = M, B,
the consolidated budget may be written in equation
Issuance of new debt
All other government spending
All other government spending
For simplicity, government spending will be
viewed as a distribution to the private sector (a
transfer), each $1 of which is valued the same as $1
of private spending. 4 This allows the analysis to
focus on net taxes (taxes net of transfers) and avoids
the question of whether individuals value $1 of
government spending the same as they value the
private spending displaced by $1 in taxes.
dB
=
llM
+
PBllB
=
B
+
G -
T.
Note that (T = 1) describes an interest-financing rule
whereby all interest expenditures are financed out
4. Without this assumption the focus of the analysis must be extended to include the question of whether the public sector
creates net wealth by taxing the private sector and providing
public goods. Public spending is here treated as neutral. Even
if this assumption is violated (say, for example, that $1 of
government spending is valued less than $1 of private spending), it does not follow that government bonds per se are not
net financial wealth but, rather, that public spending creates a
net loss effect.
27
of tax receipts. Such a result would obviously be obtained by a policy of balancing the budget. On the
other hand, (T = 0) describes a rule of deficitfinancing all interest expenditures. For (T < 1) the
Treasury is not merely transferring interest to one
group of private individuals through taxing another
group of private individuals but is paying a part of
the interest by issuing new debt.
Empirical assumptions
In empirically investigating the financing rule for
public debt, one must consider not only the financing rule for interest paid but also the financing rule
for repayment of principal. Over the period of this
study, however, the par value of private holdings of
gross federal debt increased from $212.7 billion
(December 1950) to $723.6 billion (December 1980).'
From December 1950 to December 1960, the par
value of private holdings of gross federal debt increased $23.0 billion. In the 1960s this increase was
$27.6 billion, and over a comparable period from
December 1970 to December 1980, the increase was
$460.3 billion. Over no five-year period was the par
value of private holdings of gross federal debt
reduced. It is, therefore, appropriate to treat the
5. Data used in this calculation are taken from the Federal
Government Finances publication of the U.s. Office of
Management and Budget.
6. Although the discussion of 6 here is for the situation where
(0 < 6 < 1), there is no fundamental reason why 6 must be
limited to these bounds. Clearly, (6 < 0) describes a case where
the government, on average, runs a surplus, and (6 > 1)
describes a case where the deficit, on average, exceeds interest
payments-that is, the budget exclusive of interest is in deficit
Because neither case seems particularly relevant in view of the
experience of the United States over the period of this study,
the analysis is limited to the situation where, on average, the
government runs a deficit but the deficit is less than interest
payments.
7. It is recognized that some of the base has been issued by
acquiring gold and other foreign reserves.
8. Although accurate data are available on these variables since
1948, a decision was made to begin with the decade of the
1950s, during which the Treasury-Federal Reserve accord of
1951 was reached.
9. Signs of significant autocorrelation in the annual observations
of 6 might be interpreted as evidence that the actual budget
period is longer than one year. This question is considered in
the analysis that follows.
28
principal as rolled over and to consider only the
rule for financing interest.
The second important assumption to be supported is that individuals value $1 of government
spending the same as they value the private spending displaced by $1 in taxes. The major support for
this assumption is that since 1950, federal outlays
devoted specifically to non interest transfer-type
spending have ranged from 37 percent to 63 percent
of non interest federal outlays.
Some decision must also be made regarding the
relevant length of the fiscal period. Recall that T
represents the proportion of interest that is taxfinanced and d represents the proportion that is
deficit-financed. Hence, mathematically, d is the
deficit relative to interest outlays. If the federal
budget is consistently in deficit, d is greater than
zero and a portion of outstanding government debt
implicitly bears a claim to future currency or debt
issuance. 6 Obviously, the Congress of the United
States has not, on average, balanced the budget: the
current magnitude of the monetary base plus the
market value of privately held gross federal debt is
over $1 trillion. 7 Clearly, two interesting and important variables are the magnitude of accumulated
interest payments on federal debt and the accumulated federal deficit since the drafting of the first
federal budget.
Unfortunately, accurate statistics on these
variables are not available. However, reliable
statistics on the federal deficit and interest outlays
since 1948 are available from the U.S. Office of
Management and Budget, and it is the 1950-81
period with which this study is concerned. 8 For that
period, accumulated federal deficits total approximately $507 billion and accumulated federal interest outlays total approximately $633 billion.
By implication, the value for d over the 32-year
period is .80. The difficulty with accepting this value
for d is the underlying presumption that the fiscal
period for which the federal budget is drawn up is
32 years; actually, Congress prepares the budget on
an annual basis. In the study here the fiscal period
is assumed to be one year .. Table 1 provides annual
observations on the variable d over the 1950-81
period.
Historical distribution of the
deficit- interest outlay ratio
The first step in determining the financing rule is to
Federal Reserve Bank of Dallas
l
I
I
t
I
I
Table 1
ANNUAL INTEREST OUTLAYS
AND THE FEDERAL DEFICIT
~
Fiscal
year
l
Interest
paid by
Treasury
Federal
budget
deficit (+)
Millions of dollars
d'
1950
1951
1952
1953
1954
$5,692
5,557
5,688
6,250
6,014
$3,112
-6,100
1,517
6,533
1,170
.546
-1.097
.266
1.045
.194
1955
1956
1957
1958
1959
6,032
6,294
6,681
6,946
7,073
3,041
-4,087
-3,249
2,939
12,855
.504
-.649
-.486
.423
1.817
1960
1961
1962
1963
1964
8,300
8,117
8,321
9,216
9,810
-269
3,406
7,137
4,751
5,922
-.032
.419
.857
.515
.603
1965
1966
1967
1968
1969
10,359
11,286
12,533
13,751
15,793
1,596
3,796
8,702
25,161
-3,236
.154
.336
.694
1.829
-.204
1970
1971
1972
1973
1974
18,309
19,602
20,563
22,782
28,032
2,845
23,033
23,373
14,849
4,688
.155
1.175
1.136
.651
.167
1975
1976 2 .
1977
1978
1979
30,911
34,511
45,225
43,966
52,556
45,154
66,413
57,904
48,807
27,694
1.460
1.924
1.280
1.110
.526
1980
1981
64,504
82,590
59,563
57,932
.923
.701
1. The deficit divided by interest outlays.
2. Data for the third quarter of 1976 (the quarter of
the transition from the June fiscal year to the
September fiscal year) are included in 1977.
SOURCE OF PRIMARY DATA:
U.S. Office of Management and Budget.
Economic RevieW/September 1984
examine the distribution of the ratio of the deficit
to interest outlays, d, given in Table 1. Knowledge
of this distribution is important for summarizing key
aspects of the Treasury's interest-financing behavior
and for testing hypotheses regarding that behavior.
Since many of those tests are strictly valid only for
normally distributed random variables, the approach
is to determine whether the observed distribution of
d resembles that which would be expected in a
normal distribution.
From Table 1 the average value of d over the entire 32-year sample is .59 and the standard deviation
of d is .69. Further characteristics regarding the
distribution of the variable are obtained by several
nonparametric procedures.
The first procedure is to compare the interquartile
range of the observed distribution of d to that which
would be expected in a normal distribution. In a
normal distribution the interquartile range is 1.35
times the standard deviation. From the historical
distribution of d given in Table 1, the first and third
quartile boundaries may be calculated as Q1 equals
.18 and Q3 equals 1.08; hence the interquartile
range is .90. Dividing .90 by 1.35 gives the pseudo
standard deviation of .67. Thus, the calculated
historical standard deviation of .69 closely approximates the value .67 that would be expected from a
normal distribution for d.
Further evidence concerning the distribution of d
may be obtained from a stem and leaf plot. Examination of the plot indicates that the distribution
of d exhibits tails approximating those of a normal
distribution.
Stem and Leaf Plot for d
-1.10
-.57
-.07
.43
.93
1.43
to
to
to
to
to
to
-.58
-.08
.42
.92
1.42
1.92
II
II
111111111
1111111111
11111
1111
Another procedure used is to identify outlying
values of d and determine whether any would be
considered extreme in a normal distribution.
Multiplying the interquartile range by 1.5, subtracting this value from Q1' and adding it to Q 3 give a
lower bound of -1.17 and upper bound of 2.43 for
outliers that would be considered mild in a normal
29
distribution. Similarly, the lower bound of - 2.52
and upper bound of 3.83 may be established for
outliers that would be considered extreme in a
normal distribution. Examination of the historical
distribution of d from Table 1 reveals there are no
outliers that would be considered extreme or even
mild in a normal distribution.
Finally, the Kolmogorov-Smirnov goodness-of-fit
test may be applied to examine the hypothesis
that d is normally distributed. Calculation of the
Kolmogorov statistic at all points along the cumulative distribution of d and comparison with its
critical boundaries indicate that the hypothesis that
d is normally distributed cannot be rejected.
The individual's expected tax liability
The central hypothesis is that over the 1950-81
period, each $1 of interest received by the private
sector bore an expected tax liability of 41 cents. A
broad alternative hypothesis, which is considered in
this section, is that the individual's expected tax
liability varied in some way over the period.
The first step in investigating this hypothesis is to
determine whether the sample observations on dare
independently distributed. Evidence regarding the
time independence of the variable is important in
deciding whether the data exhibit any pattern that
may be used in forecasting future tax liabilities on
government debt. Examination of the partial
autocorrelation function for d reveals no significant
partial autocorrelation at any lag. The modified BoxPierce Q statistics at lags of 6, 12, and 24 years are
7.51,16.51, and 32.93, respectively, indicating insignificant accumulated autocorrelation at short,
medium, or long lags for d. Estimation of d as an
autoregressive moving average process related to
immediately prior-period errors (MA1) reveals insignificant coefficients for the MA1 variable. In addition, the diagnostic chi-square statistics for the
residual series from this regression indicate insignificant accumulated autocorrelation at lags of 6,12,
18, and 24 years. Examination of the lag autocorrelation pattern of d from standard Box-Jenkins time
series techniques indicates only marginally significant autocorrelation at lags of 9 and 21 years. The
implication of this evidence is that if d is stationary
with a mean of .59, it is best characterized as an independently, identically distributed normal random
variable.
The hypothesis of nonstationarity will be ex30
amined in two forms. The first is that d is a timedependent variable. The second is that a mean shift
occurred in the distribution of d sometime during
the 1950-81 period. Evidence regarding the stationarity of d may be provided by a standard ordinary least squares regression of d against time.
The results of this regression are
(4)
d =
.38
(.17)
R2
+
=
.03 TIME,
(2.79)
.21; DW
=
2.06; F
=
7.79.
where the numbers in parentheses are t statistics
and the variable TIME takes the values 1 through
32. Note that the t statistic of 2.79 for TIME exceeds
the critical value of 2.04 required for significance at
the 95-percent level. Hence there is evidence that d
might not appropriately be regarded as a stationary
random variable.
Evidence for the hypothesis that a shift occurred
in the distribution of d may be provided by maximum likelihood tests. Breaking the sample of 32
observations into two arbitrary samples of sizes n
and (32 - n) and calculating the standard deviation
of d over the first sample (S1)' over the remaining
sample (s2)' and over the entire data set (s) allow for
a test of the hypothesis that a shift occurred in the
distribution of d. The procedure used is to calculate
the Chow statistic Cn for each subperiod of two
years or longer (n = 2,3, ... , 30).'0 Maximizing Cn by
choice of n gives a value of (C 21 = 8.78) for
(n = 21). A critical value of 3.84 is required for
significance at the 95-percent level. Hence there is
substantial evidence that a shift occurred in the
distribution of d in 1971."
A standard dummy variable regression may be
estimated to gain further evidence on the hypothesis that a shift occurred in the distribution of d in
1971. The resu Its of this regression are
(5)
d
=
.38
(2.72)
R2
=
+
.62 DUMMY,
(2.69)
.19; DW
=
1.95; F = 7.12.
10. Specifically, the Chow statistic used here is
C
n
= -
2 . In (
32 n
- )
5n . 5
1
n
5 32
rv
2
J(
.
11. Why this happened in 1971 is, in itself, an interesting question, one that is beyond the scope of this paper.
Federal Reserve Bank of Dallas
where DUMMY equals zero from 1950 to 1970 and 1
thereafter. Both the estimated constant term and
the estimated coefficient on the dummy variable
are significant at the 95-percent level. The estimated
mean value for d is .38 over the 1950-70 period but
is 1.00 over the 1971-81 period. The implication is
that interest receipts that accrued during the
1950-70 period bore a corresponding average tax
liability of 62 cents whereas there was, on average,
no tax liability over the later period.
To gain further evidence regarding the stationarity
of d, the entire 1950-81 sample is separated into the
suggested subsamples 1950-70 and 1971-81, and the
time dependence regressions are reestimated over
each subsample. The results of these regressions are
as follows:
1950-1970
(6)
d
.08
(.25)
+
.03 TIME.
(1.07)
R2 = .06; OW = 2.19; F
Conclusion
1.16.
1971-1981
(7)
d =
1.47
.02 TIME.
(1.12) (- .04)
R2 = .01; OW = 1.45; F = .13.
The primary result of separating the data into these
two subsamples is that the explanatory power of the
variable TIME is substantially reduced. In each
subperiod the t statistic for the estimated coefficient on TIME falls far below its critical value for
significance. In addition, the estimated coefficient
on TIME changes sign from 1950-70 to 1971-81. The
R2's, measuring the fraction of the variation in d
that is explained, fall substantially and the OurbinWatson statistic worsens for each subperiod when
compared with the time dependence regression
estimated for the entire 1950-81 period. These
results suggest adoption of the hypothesis that a
shift occurred in the distribution of d in 1971 over
the hypothesis that d is time-dependent.
Since there is substantial evidence to support the
hypothesis that a shift occurred in the distribution
of d in 1971, the time series properties of d must be
investigated under the presumption that such a shift
occurred. The observations on d must first be made
stationary by lowering the distribution of d for the
post-1971 sample to the estimated mean for the
Economic Review/September 1984
1950-70 sample (from 1.00 to .38). This series is
referred to as the adjusted series for d (dA ).
Calculation of the Kolmogorov-Smirnov statistic
for the adjusted series indicates that the distribution
of dA does not exhibit significant departures from
normality. Examination of the lag autocorrelation
pattern and partial autocorrelation pattern of dA
reveals marginally significant autocorrelation only
at a lag of 9 years. The modified Box-Pierce
statistics indicate no significant accumulated
autocorrelation at lags of 6, 12, or 24 years. Estimation of dA as an MA1 process yields a highly insignificant value of - .356 for the estimated MA1
coefficient. I n summary, the evidence supports the
hypothesis that d is an independently, identically
distributed normal random variable with a mean
value of .38 from 1950 to 1970 and a mean value of
1.00 thereafter.
Effort directed toward identifying the interestfinancing rule in the United States indicates that on
average over the 1950-81 period, each $1 of interest
paid by the Treasury bore a corresponding tax
liability of 41 cents. There is also substantial
evidence that a change in the interest-financing rule
occurred in this period. Specifically, for each $1
received in the form of interest on government
bonds before January 1971, there was a corresponding expected tax liability of 62 cents-hence a net
receipt of interest of 38 cents by the private sector.
Interest receipts accruing after that time, however,
have borne no expected tax liability, and there is a
dollar-for-dollar expected net receipt of interest by
the private sector.
A familiar proposition in macroeconomics and
monetary theory is that the price level is directly
related to net financial wealth of the private sector.
Treasury securities have traditionally not been
viewed as net financial wealth because their stream
of interest payments was presumably matched by an
equivalent stream of tax liabilities. This paper considers the question of whether in fact the interest
payments on government debt have involved an
equivalent tax liability and finds that they have not.
Evidently, Treasury securities are net wealth, at
least in part. It follows that the ability of the
Federal Reserve to offset the inflationary effects of
deficits through open market exchanges of base
money for Treasury securities is potentially limited.
31
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