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FEDERAL RESERVE BANK APRIL 1971 OF ST. LOUIS Monetary Aggregates and Recent Economic Trends................................... 2 Controlling Money in an Open Economy: The German C a s e ................................. 10 Summary of U.S. Balance of Payments, 1 9 7 0 ...................................28 Vol. 5 3 , No. 4 Monetary Aggregates and Recent Economic Trends M he level of real econom ic activity continues be low potential, with little change in trend during the past year. The rate of inflation appears to have slowed somewhat since last spring; the rate of increase in consumer prices has slowed more than the rate for wholesale industrial prices. More expansive monetary actions are reflected in the relatively rapid rates of growth in the monetary base and the money supply. Short-term interest rates have declined markedly; in terest rates on long-term corporate bonds rose in M arch but are still below their recent peaks in mid-1970. Recently there has been greater use of monetary aggregates, particularly various combinations of the money stock, time deposits, and savings deposits, in the formulation and measurement of monetary policy. Time and savings deposits have grown more rapidly than demand deposits in the past year, affecting the relative growth rates of these various monetary ag gregates. The growth of time and savings deposits has altered the channels through which credit flows but not necessarily the total volume of credit extended. Income, Employment, and Prices Personal income has been growing moderately for about a year and a half without a discernible change in trend. Since August 1969, personal income has risen at about a 6 per cent annual rate, after rising at a 9 per cent rate in the previous two years. The 9.5 per cent rate of increase in personal income in the past three months partially reflects a recovery from work stoppages in the automobile industry and preparation for other possible strikes later this year. Estim ated retail sales increased 7 per cent in the year ending M arch 1971, com pared with a 3.7 per cent annual rate of increase from July 1969 to March 1970. Considering price trends, it appears that there has been essentially no change in retail sales activity for a long time. Industrial production has declined at about a 3.3 per cen t annual rate since July 1969. A sharper contraction last fall during the strike has since been offset by the increase since November 1970. Total civilian employment has remained essentially unchanged during the past year. Payroll employment declined about one per cent in the past year. Payroll Personal Income R a tio S c a le Trillio n s o f D o lla rs 1.0 ,------------- ----------- 1963 1964 1.0 1965 1966 1967 1968 E m p lo ym e n t Ra tio S c a le T rillio n s o f D o lla r s M o n th ly T o ta ls a t A n n u a l R a te s 1969 1970 R a tio S c a le Sou rc e : U.S. D e p o rtm e n t of l a b o r 1971 So urce: U.S. Deportm ent of C o m m erce P ercentages are a n n u a l rotes of c ha n ge for p erio d s indicated, la te st d a ta plotted: M a r c h p re lim in a ry Page 2 R a tio S c a le Percentages ore annual rotes of c hon ge for period s indicated late st d ato plotted: M arch F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 employment generally falls faster than total civilian employment during periods of contraction, and in creases faster during periods of expansion. The per cent of unemployed persons out of work 27 weeks or longer rose from about 8 per cent in February 1970 to nearly 8.3 per cent in February 1971. sale industrial prices have increased at a 3.4 per cent rate since May 1970, com pared with a 3.9 per cent rate in the nineteen-month period ending M ay 1970. M anufacturing earnings, adjusted for changes in consumer prices, overtime, and the industrial com position of the labor force, have risen at a 2.2 per cent rate during the past year, com pared with no change in the year ending O ctober 1970. W age in creases have been unequally distributed among workers in different industries. Hourly earnings in retail trade increased 5 per cent in the past year. Hourly earnings in contract construction rose 9 per cent in the past twelve months, compared with a 9.5 per cent annual rate of increase in the sevenmonth period ending March 1970.1 M onetary stimulation to the economy has become greater in the last year. The money stock, defined to include private demand deposits and currency in the hands of the public, has increased at an 8.2 per cent annual rate in the past four months, after rising at about a 6 per cent rate in the previous nine months. By comparison, money increased at a 3 per cent rate from January 1969 to February 1970, and at an aver age 4.7 per cent rate from 1963 to 1968. Recent Monetary and Interest Rate Developments Reduction in the rate of inflation has been proceed ing gradually. Consumer prices rose at a 1.5 per cent annual rate from D ecem ber to February and at a 4 per cent rate from June to February, com pared with a 6 per cent rate from June 1969 to June 1970. W hole- M ore expansive m onetary actions have also been reflected in the growth of the monetary base. The base has increased at a 7.6 per cent annual rate since February 1970 and at about an 11 p er cent rate in the past four months. By comparison, the base increased at a 3 .7 per cent trend rate from 1957 to 1969. The largest source component of the base, Federal Re serve credit, has risen at an 8.8 per cent annual rate since February 1970 and at a 14.2 per cent rate over the past four months, com pared with a trend rate of almost 8 per cent from 1957 to 1969. xThe rates of change in hourly earnings in retail trade and contract construction are not adjusted for changes in con sumer prices or overtime. Short-term market interest rates have declined markedly in recent months, reflecting both a weakPage 3 F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 Interest Rates R a t io S c a l e R a t io S c a l e measurement of monetary policy.2 Currently, policy discussions frequently include references to the growth rates of three measures of the money supply: M 1 = demand deposits plus currency held by the public; M 2 = M 1 plus time deposits at com m ercial banks other than large negotiable certificates of deposit;3 M3 = M 2 plus all savings and loan shares and mutual savings bank deposits. The growth rates of these three aggregates have di verged widely in recent years, which means that on the surface they have not provided consistent infor mation regarding the thrust of monetary actions. These divergent growth rates have been largely the result of substantial swings in m arket interest rates, com pared to the maximum rates that banks, savings and loan associations, and mutual savings banks are permitted to pay on deposits.4 J^Rate on single-maturity d e p o sits in am ounts of less than $ 1 00,000 maturing in 30 d a y s to 1 year. P rior to July 2 0 ,1 9 6 6 a separate ceiling (or these deposits did not exist. The Regulation O rote shown is (or other time dep osits" maturing in one yeor or less, la te st d a ta plotted: M a rc h ness in demand for credit accompanying the slack in econom ic activity and the more expansionary mone tary developments. Three-month Treasury bill rates averaged 3.38 per cent in M arch, down from 4.4 per cent in January 1971 and 6.63 per cent in M arch 1970. Responding to the weakness in demand for loans rela tive to supply, banks have lowered the prime interest rate which they charge to their highest-rated business customers ten times since mid-September. The most recent decline (late M arch) was to 5 V* per cent, com pared with 8 per cent last spring and summer. Interest rates on longer-term issues have declined much less than rates on short-term obligations, reflect ing continued great inflationary expectations and a desire by some borrowers to lengthen their debt to improve their liquidity. Yields on long-term Govern ment bonds averaged 5.71 per cent in M arch, down about 20 basis points from January 1971. L ast June interest rates on these bonds averaged about 7 per cent. Yields on seasoned Aaa corporate securities rose in M arch, averaging 7.21 per cent but still down about 130 basis points from June 1970. Alternate Monetary Aggregates In addition to continued use of interest rates and short-term credit-m arket conditions, recently there has been greater use of the money supply and various other measures of liquidity in the formulation and Digitized for Page FRASER 4 2The role of the monetary aggregates is discussed in “Mone tary Aggregates and Money Market Conditions in Open Market Policy,” Federal Reserve Bulletin (February 1 9 7 1 ), pp. 79-104. 3For expositional purposes, total time deposits at commercial banks minus large negotiable certificates of deposit are re ferred to as “net time deposits.” ^Interest rate ceilings on deposits at banks which are mem bers of the Federal Reserve System are established under Federal Reserve Regulation Q. Under the Interest Rate Control Act of 1966, ceilings at Federally-insured non member banks and mutual savings banks are set by the Federal Deposit Insurance Corporation; the Federal Home Loan Bank Board controls the ceiling rates paid at its F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 T a b le 1 M a xim u m Interest Rates P a y a b le on Time a n d S a v in g s D e p o sits at C o m m e rc ia l B an ks (Effective Ju n e 2 4 , 1 9 7 0 ) T yp e o f D e p o sit S a v in g s d ep o sits Per Cent Per A n n u m 4 .5 0 O th e r time d e p o sits: M u ltip le maturity®: 3 0 -8 9 days 9 0 d a y s to 1 y e a r 1 y e a r to 2 y e a rs 2 y e a rs a n d ove r The accom panying chart, which shows the ratio of time deposits to demand deposits, indicates that time deposits declined more rapidly than demand deposits during the period of restrictive monetary policy in 1969 and early 1970. The decline in time deposits in 1969 and early 1970 was caused by market interest rates rising well above the rates at which com m er cial banks were able to compete under Regulation Q ceilings. 4 .5 0 5 .0 0 5 .5 0 5 .7 5 S in g le m aturity: Less than $ 1 0 0 , 0 0 0 : 3 0 d a y s to 1 y e a r 1 y e a r to 2 ye a rs 2 y e a rs a n d over $ 1 0 0 , 0 0 0 a n d over: 3 0 -5 9 days 6 0 -8 9 days 9 0 -1 7 9 days 1 8 0 d a y s to 1 ye a r 1 y e a r o r m ore 5 .0 0 5 .5 0 5 .7 5 b b 6 .7 5 7 .0 0 7 .5 0 aMultiple m aturity tim e deposits include deposits th at are auto matically renewable a t m aturity without action by the depositor and deposits that are payable a fter written notice of withdrawal. bThe rates in effect beginning Jan u ary 21 through Ju n e 23, 1970 were 6.25 per cent on m aturities of 30-59 days and 6.50 per cent on maturities of 60-89 days. Effective Ju n e 24, 1970. maximum interest rates on these m aturities were suspended until further notice. The interest rate ceilings on all other time deposits were established Jan u ary 21, 1970. Source: Federal Reserve Bulletin. The ceiling rates on various types of time and sav ings deposits currently in effect at commercial banks are shown in Table I. As indicated in the table, the ceiling rates on large negotiable C D ’s bearing maturi ties of one month to three months were suspended in June last year. The ceiling rates on other time and savings deposits were last increased in January 1970, with the maximum interest rates allowed on most types of savings and small time deposits being raised by one-half to three-quarters of one per cent. The maximum rates payable on large negotiable C D ’s were raised by increments ranging from three-quarters of one per cent to one and one-quarter per cent, depending on maturity. Time Deposit Growth Total time deposits at commercial banks generally grew very rapidly in the 1960’s, except for 1969. D ur ing the three years ending D ecem ber 1968, both total time deposits and time deposits excluding large C D ’s rose at a rapid 12 per cent average annual rate. member savings and loan associations; and the Federal Reserve Board can prescribe different rate ceilings for time deposits on the basis of the amount of deposit. These three regulatory agencies are required to consult with each other when Considering changes in the ceiling rates. This act is scheduled to expire June 1, 1971. E arly last year, short-term m arket interest rates be gan to decline, and Regulation Q ceiling rates on cer tain time deposits were raised. Due to this combina tion of developments, time deposits began a period of rapid increase which has continued to the present time. The growth of demand deposits also accelerated in 1970 as monetary actions becam e more stimula tive; however, the much more rapid growth of time deposits is reflected in a significant increase in the ratio of time to demand deposits. It is of interest to note the trend of the ratio of time to demand deposits in the year of reintermediation since early 1970, com pared to the trend of this ratio in the six years prior to the inception of disintermedi ation in early 1969. The ratio of total time deposits to demand deposits rose at a 17 per cent annual rate from February 1970 to M arch 1971, much faster than Page 5 F E D E R A L R E S E R V E B A N K OF ST. LO U IS A P R IL 1971 the 8 per cent annual rate of increase in this ratio from 1963 through 1968 when monetary policy was highly stimulative, but Regulation Q interest ceilings were impinging only for brief periods. The series “time deposits at commercial banks” con sists of several distinct types of interest-bearing de posits offered by banks. The various types of time deposits differ substantially with respect to size limi tations, frequency of interest payments, maximum rates payable, and negotiability. It has recently be come common practice to separate large negotiable certificates of deposit ($100,000 minimum denomina tion) from all other time deposits in analyzing the factors influencing time deposit growth. These two major classes of time deposits will be discussed sepa rately below. L a rg e Certificates of D eposit — During the past few years, the outstanding volume of large negotiable C D ’s at large commercial banks has been subject to sharp swings, as market interest rates on substitute instruments fluctuated widely com pared to the maxi mum rates banks were permitted to pay on these de posits. In 1969, m arket interest rates on commercial paper and U.S. Treasury bills were much higher than the ceiling rates on bank deposits. As a result, cor porations, state and local governments, and others who hold large dollar amounts of short-term interest M o n e y M a rk e t Rates 1963 1964 1965 1966 1967 1968 1969 1970 1971 So u rces: B o a rd of G o ve rn o rs of the F ederol Reserve System a n d Sa lo m o n Brothers an d Hutzler Q_Rate o n d e p o sit s in a m o u n ts of $ 1 0 0 ,0 0 0 or m ore m a tu rin g in 9 0 -1 7 9 d a ys. [2 M onthly ove V o ges of w ee kly rates o f se c o n d a ry yie ld s on n egotiab le time certificates of d ep o sit with 9 0 d a y s rem aining to maturity. 'E ffective June 2 4 ,1 9 7 0 maxim um interest rates on large certificates of d ep o sit m aturing in 3 0-89 d a y s were su sp e nd e d until further notice. Latest d o ta plotted: M a rch Page 6 Certificates of D e p o sit a n d Com m ercial P ap e r O u t s t a n d in g V o lu m e R a tio S c a l e B illio n s o f D o ll a r s R a t io S c a l e B illio n s o f D o ll a r s 50 50 40 i Com mercial Pap er Outsta nding -2 / % / 30 /\ V ■* 32.8 30 ✓ 28.1 Volume o Certificates of De josit ll 20 h . // / // 1 / / 7 1963 1964 1 196 5 1966 196 7 1968 1969 1970 1971 lJ_lorge commercial b anks, a v e ra g e s of W e d n e sd a y figures, se ason ally adjusted by Federal Reserve Bonk of St. Louis. 12. A v e ra g e s of end of preceding and end of current month, se asonally adjusted by Federal Reserve Bank of N e w York. Latest d a ta plotted: Comm ercial Paper-February; Volume of C O 's-M o rch bearing assets turned to lending directly through the com mercial paper m arket and to direct ownership of U.S. Treasury bills. As shown in the charts of com m ercial paper and C D volumes and rates, the growth of outstanding commercial paper accelerated sharply in 1969 as the yield on this instrument rose relative to the ceiling on C D ’s. The rise in commercial paper volume closely mirrored the decline in C D volume. F o r several years prior to 1969, both C D ’s and com m ercial paper had grown steadily and rapidly. In the first half of 1969 the rates on com mercial paper moved more than two percentage points above the official ceiling rates which could be paid on large C D ’s. L arge C D ’s at com m er cial banks dropped over $12 billion during 1969, while growth of commercial paper accelerated and the out standing volume rose over $11 billion in 1969. E arly in 1970 the trends were reversed as a result of changes in the relative yields of these instruments. In January the Regulation Q interest rate ceilings on these large time deposits were raised by increments of three-fourths to one and one-fourth percentage points, and in June the ceiling rates were completely suspended on certain maturities of large C D ’s. At the same time, the yield on comm ercial paper declined along with other short-term market interest rates. Also, in O ctober 1970 reserve requirements were im posed on commercial paper issued by bank holding companies, and there was concern in the financial community about the risk associated with commercial A P R IL 1971 F E D E R A L R E S E R V E BA N K OF ST. LO U IS paper issued by some corporations because of their financial difficulties. The volume of C D ’s recovered $17 billion in 1970 and early 1971, while from May 1970 to February 1971 the volume of commercial paper outstanding dropped $6 billion. N et T im e D eposits— The growth of time deposits at commercial banks net of large negotiable certifi cates of deposit has also been affected by the level of market interest rates relative to the ceiling rates, but to a lesser extent than C D ’s. These net time deposits declined somewhat from m id-1969 to early 1970 be fore resuming a rapid upward trend. From February 1970 to March 1971 net time deposits rose at an 18 per cent annual rate, following a 1 per cent rate of change from D ecem ber 1968 to February 1970, and a 13 per cent rate of increase from D ecem ber 1966 to D ecem ber 1968. These broader measures of money plus near-monies, in addition to the narrowly defined money stock, may be considered by policymakers in assessing the influence of monetary actions on eco nomic activity. Thus, it is useful to look at the rela tive growth of net time deposits and deposits at thrift institutions in recent years. Savings Deposits Household and small business savings deposits at commercial banks, savings and loan associations, and mutual savings banks are generally considered to be close substitutes for each other, although their growth rates have diverged substantially on occasion. During the 1950’s savings and loan shares and mutual savings bank deposits rose relative to time deposits at com Time and Sa vin g s Deposits R a tio S c a le B illio n s o f D o lla rs 250 Ratio S c a le B illio n s o f D o lla rs 2501 1963 1964 1965 1966 1967 1968 1969 1970 1971 y_Thrift institution dep osits ore oil deposits ot savings ond loan associations and mutual savings banks Data are end of month figures, seasonally adjusted by this Bank. 12 Net time deposits ore time deposits at commercial banks other than lorge negotiable certificates of deposit. Data ore monthly averages computed and seasonally odjusted by this Bank, lotest d a ta plotted: M arch; Thrift Institution Deposits for January through M arch 1971 estimated .975 j .975 .958 / 925 .875 .825 .77 5 r 1963 1964 / 1965 .775 1966 1967 1968 1969 1970 1971 .725 Q_Net time deposits ore time deposits at commercial banks other than large negotiable certificates of deposit. Data are monthly averages, calculated and seasonally odjusted by this Bank, 12 Thrift institution deposits are all deposits at savings an d loon associations ond mutual savings banks. Data ore end of month figures, seasonally adjusted by this Bank lotest d ata plotted: March; January through March 1971 estimated mercial banks; however, in the decade of the Sixties, net time deposits at commercial banks have risen more rapidly. As shown in a chart of the ratio of net time deposits to the total of deposits at thrift institu tions, from mid-1964 to the end of 1968 the proportion of household and small business savings flowing into commercial banks rose rather steadily relative to such deposits in the thrift institutions, that is, savings and loan associations and mutual savings banks. On balance since the end of 1968, the ratio of net time deposits to deposits in thrift institutions has not risen significantly, although this ratio has recently been following an upward trend. All of such deposits have risen rapidly from early 1970 to the present, following the increase in the ceiling rates on savings deposits and the general decline in market interest rates. In the period February 1970 to M arch 1971, the volume of net time deposits at commercial banks rose 17 per cent annal rate, savings and loan shares increased 13 per cent, and mutual savings bank de posits increased 9 per cent. A factor contributing to the very rapid reinterm e diation of deposits at financial intermediaries in 1970 was establishment of a $10,000 minimum denomina tion on the purchase of U.S. Treasury bills. Effective beginning with the Treasury bill auction of M arch 2, 1970, $10,000 becam e the smallest denomination of Treasury bills offered. The smallest denomination of Treasury notes and bonds, which carry maturities greater than one year, has continued to be $1,000. Net Time Deposits 12 80'------- ---------------------------- Ratios of Net Time Deposits 1 to Thrift Institution Deposits1 The effect of raising the minimum denomination of Treasury bills to $10,000 is that individuals and small businesses with less than $10,000 increments of sav ings to lend can no longer obtain these highly liquid Page 7 A P R I L 1 97 1 F E D E R A L R E S E R V E B A N K OF ST. LO U IS T a b le II Su m m a ry o f Funds R a ise d a n d A d v a n c e d in U.S. C re d it M a rk e ts (B illio n s of D o lla rs) Total Fund s R aised b y N o n fin a n c ia l Sectors U.S. A ll G o ve rn m e n t O th e r N o n fin a n c ia l Sectors 1968 1969 1970 $ 9 6 .9 $ 9 0 .4 $ 9 5 .4 1 3 .4 -3 .6 1 2 .7 8 3 .5 94.1 8 2 .7 B y Instrum ent C o rp o ra te Eq u ity S h a re s State a n d Local G o ve rn m e n t Sector C o rp o ra te a n d F o re ign B o n d s M o rtg a g e s O th e r B a n k Loans C o n su m e r Credit O p e n M a r k e t Pap er O th e r -.7 9 .6 1 4 .0 2 7 .3 1 3 .4 11.1 1.6 7 .3 4.8 8.1 13.1 2 7 .9 1 5 .7 9 .3 3.3 11.8 6 .6 11.8 2 2 .4 2 4 .6 .7 4.3 3.8 8.4 B y Sector Foreign State a n d Local G o ve rn m en ts H o u se h o ld s N o n fin a n c ia l B u sin e ss 3 .0 9 .9 3 1 .8 3 8 .8 3 .7 8.5 3 2 .2 4 9 .7 2.8 1 2.2 2 1 .3 4 6 .3 $ 9 6 .9 $ 9 0 .4 $ 9 5 .4 4 .9 -.2 3 .7 3 9 .5 1 4 .6 1 9 .6 2.5 7 .4 .4 5 .8 2.5 .2 4 .2 12.2 1 0 .4 2 0 .0 1.3 13.8 6.1 1 8 .0 3.3 1.2 5 .0 31.1 1 4 .9 2 2 .4 1 0 .0 1.9 — 2 .7 7 .0 $ 9 6 .9 $ 9 0 .4 $ 9 5 .4 14.8 7.1 5 .5 3 3 .7 -2 .4 5 6 .4 2 0 .8 1 2 .9 — 1 0 .5 8.1 3 9 .8 1 6 .6 1 2 .3 3 9 .5 7 .5 7 .7 13.4 1 5 .0 2 6 .9 -6 .8 1 4 .2 4 .3 9 .6 2.3 1.8 2.5 8.3 1.3 -7 .8 1 0 .0 — 1.1 .4 Total Fu nd s A d v a n c e d U.S. G o ve rn m e n t U.S. G o ve rn m e n t C redit A g e n c ie s Federal Reserve System C om m e rcial B a n ks, net S a v in g s Institutio ns, net O th e r Private N o n b a n k Finance Foreign B u sin e ss State a n d Local G o ve rn m en t H o u se h o ld s Total Sou rces D em and D e p o sits and C urrency Tim e a n d S a v in g s A ccou nts A t C om m e rcial B a n k s A t S a v in g s Institutio ns C re d it M a rk e t Instrum ents, net U.S. G o ve rn m e n t Securities P rivate C re d it M a r k e t Instrum ent F oreign Funds At Banks Direct Change U.S. in U.S. G o ve rn m e n t C a sh G o ve rn m e n t B a la n ce Loans P rivate In su ra n c e a n d Pen sion Reserves O th e r Sou rces Source: 4 .9 2.5 1 8 .5 1 8 .7 9 .5 1 5 .0 Federal Reserve Bulletin, March 1971. securities. Prior to this action by the Treasury, indi viduals and small businesses had acquired significant holdings of Treasury bills, usually with maturities of six months to one year. After M arch 2, 1970 such holdings in less than $10,000 increments could not be renewed as they m atured, so the individuals were forced to accep t repayment from the Treasury for maturing securities. Small savers then sought alterna tive sources to earn interest on short-term funds. Al though it is not possible to identify the amounts in Page 8 volved, com m ercial banks and thrift institutions w ere undoubtedly benefici aries of this Treasury D epartm ent action. Credit Flows and Reintermediation The disintermediation - reinterm edia tion process shows up dramatically in the Flow of Funds Accounts for the past three years. Table II shows sum m ary d ata for these flows in the past three years. According to those a c counts, private holdings of time and savings deposits increased in 1970 by the largest amount ever recorded after declining slightly in 1969. Most of the reversal is accounted for by deposits at commercial banks, specifically corporate holdings of negotiable C D ’s, state and local government holdings of both C D ’s, and other time deposits. Households re sumed acquisition of time deposits at commercial banks and savings and loan associations. The other side of the re intermediation process is represented by a decline in the holding of credit market instruments. Households and state and local governments switched from rapid acquisition of U.S. Govern ment securities to liquidation. Also, nonfinancial corporate business moved from rapid acquisition of open market paper to liquidation. Along with an easier monetary policy in 1970, total funds raised by nonfinan3.3 cial sectors was larger than in 1969, but 2 0 .0 not as much as in 1968. U.S. Govern — 1.9 ment borrowing resumed levels of ear lier periods after supplying net funds in 1969. This increased borrowing by the U.S. Government of $16 billion was offset by an $11 billion decline in household borrowing. 2.4 Lenders altered their participation in the credit markets in 1969. Comm ercial banks recovered from a low level of lending, while businesses and households reduced sharply the amount of funds they advanced to the credit market. Foreign lenders advanced di rectly an unusually large amount of funds during 1970, principally through the acquisition of U.S. Gov- F E D E R A L R E S E R V E B A N K OF ST. LO U IS eminent securities. However, a large part of these funds represents a transfer of foreign holdings out of Eurodollars and other financing assets as well as a reduction in foreign exchange liabilities held in the U.S. Summary Production and employment remain below capacity levels, with little change in trends in the past year after allowance for strike effects. Inflation remains strong and is receding slowly in response to the down ward pressure from excess capacity. Monetary a c tions have become more expansionary in the last fif teen months, with a view to stimulating growth in A P R IL 1971 sales, production, and employment without intensify ing inflationary pressures. There has recently been a greater use of monetary aggregates, composed of the narrowly defined money supply and time and savings deposits, in the formula tion and measurement of monetary policy. Time and savings deposits increased at a rapid rate in the past year, causing a divergence between the growth rates of the money stock and other monetary aggregates. Individuals and firms invested a larger share of their wealth in time and savings deposits as market interest rates fell relative to the interest ceilings of these de posits. Total credit, total funds raised by borrowers over a period of time, has not been affected as much as the channels of credit flows during the period of reintermediation in the past year. Page 9 Controlling Money in an Open Economy: The German Case by M A N FR E D W IL L M S In recent years inflation has b een a world-wide problem . To stem the tide o f rising prices, stabilization authorities have called on all the econom ic tools available to them. During this period, there has been growing reliance on controlling growth o f the money supplies o f nations to prevent inflationary increases in total spending. However, it has been contended frequently that a country with a large foreign trade position could not effectively control its money stock in order to avoid “im ported inflation.” This is particu larly important if a relatively large country, such as the United States, has persistent inflation and balanceof-paym ents deficits. In the follow ing article, Professor M anfred Willms presents a fram ew ork within w hich the various factors influencing growth o f the m oney stock in open econom ies (possessing a relatively large and fluc tuating stock o f foreign reserves) can be analyzed. The ways that actions o f the monetary authorities and the behavior o f com m ercial banks and the nonbank public affect a nations money stock are discussed, and the relative influence of these groups on the growth o f m oney is estimated. T he article shoius how changes in a nation’s trade balance an d /o r net capital flow s influence its stock o f foreign reserves and growth of its monetary base. Next, there is a discussion of the conditions under which monetary authorities w ould b e able to control the m oney stock. Finally, the article presents em pirical evidence w hich indicates that monetary authorities in Germany have maintained effective control in the short run over that nations money stock, even though foreign re serves have fluctuated sharply and groion very rapidly on balance. The article also presents som e special developm ents in Germany, such as an application o f fiscal actions to control the money stock, w hich illus trate the interacting and opposing forces at w ork betw een monetary authorities, com m ercial banks and the public in a country with a large and volatile foreign sector. To help the general reader follow the main points in this article, the m athem atical formulation o f the m oney supply m odel and the statistical evidence supporting the conclusions are presented in footnotes and in appendices. Professor Willms served as visiting scholar at this Bank for one year, and was engaged in research concerning monetary theory and policy in Germany. Professor Willms received his Ph.D. in Econom ics from the University of Ham burg in 1963. H e has taught econom ics at the University o f Hamburg, the Uni versity o f Bonn, and the University o f Illinois, and for the past year has been on leave from his position as Professor o f Econom ics at the University of Bonn. 10 Digitized for Page FRASER A P R IL 1971 F E D E R A L R E S E R V E BA N K OF ST. LO U IS U N D ER T H E P R E S E N T international monetary system of fixed exchange rates and free convertibility among major W estern currencies, countries with a balance of payments deficit lose foreign reserves (gold and foreign currencies) and those with a surplus a c quire foreign reserves. Such flows of foreign reserves may affect the growth of a nation’s money stock. A controversial issue for each open economy (an econ omy with a large foreign sector) is whether its monetary authorities can offset the im pact of an out flow or inflow of foreign reserves on the money stock, or w hether the present system of fixed exchange rates constrains the domestic m onetary policy of these eco nomies. This question is especially relevant in some W estern European countries which have accumulated very large U.S. dollar reserves over the last few years, and are also confronted with substantial swings in their dollar flows. This article analyzes the controllability of the money supply, in Germany, a country whose economy is both highly dependent on foreign trade, and well integrated into international financial markets. The article (1 ) examines two major hypotheses on the controllability of the money supply in an open eco nomy; (2 ) describes the relationship betw een the balance of payments of a country and its foreign re serve position; (3 ) shows the relationship between the foreign reserve position of the central bank and the total amount of base m oney;1 (4 ) develops a model of the money supply process for an open eco nomy; and (5 ) presents some empirical estimates for the money supply process in Germany. By arranging the article in this manner, the inter relationship between the balance of payments and the money supply is developed step by step. First, balance-of-payments influences on the stock of foreign reserves at the central bank are described; then the impact of foreign reserves on the creation of base money is discussed; and finally the influences of changes in base money and the money multiplier on the money stock are analyzed. “For valuable comments on an earlier draft of this paper, I would like to thank Leonall Andersen, Christopher Bach, Karl Brunner, Albert Burger, Otmar Emminger, Michele Fratianni, Donald Hodgman, Harry G. Johnson, Jerry Jordan, Michael Keran, Allan Meltzer, George Morrison, and Case Sprenkle. I also gratefully acknowledge the assistance of Anita Cooper with respect to computer work and language corrections. Any errors in the analysis are, of course, the responsibility of the author. 1“Base money” is defined as the net monetary liabilities of the central bank and the government held by commercial banks and the nonbank public. It is similar to the magnitude which Friedman, Schwartz, and Cagan call “high-powered money.” Two Views Regarding Money Control in an Open Economy There are two alternative hypotheses concerning the controllability of the money supply in an open economy under fixed exchange rates. One hypothesis states that the money supply cannot be controlled in an open economy because any change in the interest rate differential betw een countries will lead to an in flow or outflow of foreign reserves, neutralizing the desired m onetary im pact on the dom estic economy. According to this hypothesis, the interest rate elastic ity of international capital flows is relatively high. The other hypothesis states that the interest rate elasticity of international capital flows is not so high that coun tries lose control over their money supply. Hypothesis I Those who suggest the first hypothesis argue that the monetary authorities, of a country such as Ger many with continuous balance-of-payments surpluses, are unable to control the money supply and hence are unable to escape inflation without an adjustment in the exchange rate.2 Economists of this group are in favor of more flexible exchange rates as a means of permitting greater national autonomy in the deter mination of the money supply and the price level. They blame fixed exchange rates for preventing na tional economies from adjusting to one another and from reconciling internal employment and price level objectives with external balance-of-payments objec tives by using “sound” policy decisions. To illustrate this viewpoint let us assume that world market prices for a country’s major export goods are rising relative to prices in that country. Exports of this country will increase as foreign customers direct their demand to the relatively cheaper goods. The country realizes a trade surplus and receives foreign 2The view that the German Bundesbank is not in a position to conduct an independent monetary policy under the pres ent international monetary system was recently expressed by Milton Friedman in an address at Frankfurt, W est Germany. The impossibility of a successful fight against inflation in countries with a massive balance-of-payments surplus under a fixed exchange rate system is put forth by Friedrich A. Lutz and Egon Sohmen in How Can a Country Escape Im ported Inflation? Appendix to the 1 9 6 4 /6 5 Annual Beport of the German Council of Economic Experts; Stable Money — Steady Growth (Stuttgart: Kohlhammer 1 9 6 5 ), pp. 157-167. See also the ( 1 9 6 7 /6 8 ) Annual Beport of the Cerman Coun cil of Economic Experts; Stability in Economic Growth (Stuttgart; Kohlhammer 1 9 6 7 ), p. 193; George W . McKen zie, “International Monetary Beform and the Crawling Peg,” this Review (February 1 9 6 9 ), pp. 15-23; Harry G. Johnson, “The Case for Flexible Exchange Bates, 1969, ’ this Review (June 1 9 6 9 ), pp. 12-24; Herbert Giersch, “Growth, Cycles, and Exchange Bates — The Experience of W est Germany,” Wicksell Lectures 1970 (Stockholm: Almquist & Wiksell, 1970), p. 26. Page 11 F E D E R A L R E S E R V E BA N K OF ST. LO U IS reserves which, unless offset by central bank actions, increase the stock of base money and hence exert an expansionary influence on the money stock. The out flow of goods and the expansion of the money stock increase the demand pressure in the country and lead to an increase in its price level. If the country intro duces a restrictive m onetary policy in the short run, domestic interest rates will rise relative to interest rates in other countries. This will attract international capital, which will increase the stock of base money and hinder attempts of the m onetary authorities to slow the growth of the money stock and curb inflation. A critical point in the argument of this group of economists is that capital flows betw een the advanced industrialized countries are highly responsive to changes in international interest rate differentials. Any restriction of the growth of a country’s money stock which causes a deviation in its domestic interest rate from the international rate results in an increased in flow or outflow of foreign reserves until the previous interest rate differential is restored. How ever, premiums and discounts in forward ex change markets indicate that interest rate differences do exist betw een countries, and that countries have some freedom to exercise independent monetary pol icy. This fact is not overlooked by the economists who question the feasibility of a fixed exchange rate sys tem. Nevertheless, they consider the degree of inde pendence of national econom ic policy to be rather small. Due to its im pact on interest rates, monetary policy is considered to be of particularly limited ef fectiveness in a system of fixed exchange rates. B e cause the interest rate effect can be softened if fiscal policy is used, restrictive fiscal actions are considered to be more appropriate than monetary actions in re ducing domestic demand in a country with balanceof-payments surpluses.3 To achieve this effect the fiscal actions must m eet two necessary conditions: (1 ) they must restrain do mestic demand; and (2 ) they must relieve any up ward pressure on interest rates. These conditions are m et if a tax increase is used to repay government debt held by the private sector or if government spending is reduced. However, as long as domestic prices are 3For an analytical foundation of this statement see Robert A. Mundell, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” in Canadian Journal of Economics and Political Science (November 1 9 6 3 ), pp. 509517, reprinted in Robert A. Mundell, International Economics, (N ew York: Macmillan, 1 9 6 8 ), pp. 250-262. See also Egon Sohmen, Flexible Exchange Rates, Revised Edition, (Chicago: Chicago University Press, 1 9 6 9 ), p. 2 0 8 and p. 212. Digitized for Page FRASER 12 A P R IL 1971 not adjusted to prices in the world market, a growing volume of dom estic goods is absorbed by other coun tries. Foreign demand merely replaces dom estic de mand without any relief in total demand pressure. According to the above analysis, in a system of fixed exchange rates m onetary and fiscal policies can have only a short-run effect in restricting dom estic demand in countries with a balance-of-payments surplus. Sooner or later the dom estic rate of inflation will re flect the price level trends in the world m arket. Only for a very limited period can an econom y which is highly integrated in the world econom y control its money stock and resist inflationary pressures from abroad. Hypothesis II A second group of economists have suggested the hypothesis that the m onetary authorities can control the money stock in an open economy even under a system of fixed exchange rates.4 Economists of this group assume that the amount of foreign reserves at tracted by a rise in dom estic interest rates caused by m onetary contraction is smaller than the reduction of base money by the m onetary authorities. Thus, there will be a net restrictive effect on the growth of base money and the money stock. According to this view, short-term international capital flows will not re a ct to the observed interest rate differential betw een two countries, but rather to the interest rate differential adjusted for the forward exchange rate. Movements of interest rates and the forward exchange rate have a tendency to offset each other, reducing the incen tive for large movements of short-term international capital. Transaction costs and risks also restrict the mobility of international capital flows. F o r all these reasons, the interest elasticity of short-term interna tional capital movements does not appear so high that a country would not be able to control its money supply. The above discussion indicates that the main differ ence between the two viewpoints is that the first group assumes a rather high interest elasticity of in ternational capital flows, while the second group con siders this elasticity to be small. W hich viewpoint is correct must be decided by empirical evidence. B e fore presenting evidence on this issue, the relationship 4See J. Herbert Furth, “International Monetary Reform and the Crawling Peg — Comment,” this Review (July 1 9 6 9 ), pp. 21-25. The German Bundesbank and the German Govern ment are obviously also very close to this view. See the official “Comments ’ by the German Federal Government on the (1 9 6 4 /6 5 ) Annual Report of the German Council of Economic Experts, p. 197. F E D E R A L R E S E R V E B A N K OF ST. LO U IS between the balance of payments and the money stock of a nation will be explained. The Balance of Payments and the Central Bank’s Foreign Reserve Position The simplest relationship between the balance of payments and the money stock is given by the classi cal gold standard mechanism. W henever a country’s exports of goods and services exceeded its imports, its gold stock tended to increase. Since there was a close relationship betw een the gold stock and the money stock, an increase in gold led to an increase in the country’s money stock. On the other hand, a country which imported more than it exported, lost gold, and its money stock was reduced. Under such a m echa nism, the money stock would be primarily a function of the country’s balance of payments. Under the present international m onetary system, the close relationship betw een a nation’s gold stock and its domestic money stock is broken. A country’s stock of base money can be altered quite independ ently from changes in the stock of foreign reserves at the central bank. Changes in foreign reserves at the central bank are the result of the total balance-of-payments situation. They are the joint reflection of conditions in domestic and foreign markets for goods and financial assets as well as of the domestic economic policy actions of the monetary authorities. To show this interrelationship and the impact of the balance-of-payments situation on the holdings of foreign reserves at the central bank, three broad categories of international transactions are distinguished. The first category consists of the current account items, primarily exports and imports of goods and services. The second category consists of two capital account items: changes in foreign assets and changes in foreign liabilities. Changes in these stocks reflect direct investments in real assets, port folio investments in long-term financial assets, and investments in short-term financial assets. The third category of international transactions consists of mone tary transactions involving changes in foreign curren cies, official gold holdings, gold tranche positions and special drawing rights. These transfers can be con sidered the balancing items because they represent the means by which a surplus or deficit in the current account or the capital account is financed. Changes in the stock of foreign reserves at the central bank occur within the following balance-ofpayments constraint: ( E x —Im ) - A ( F A - F L ) = AFR A P R IL 1971 where: Ex Im FA FL FR A = = = = = = Flow of exports of goods and services Flow of imports of goods and services Stock of real and financial foreign assets Stock of real and financial foreign liabilities Stock of foreign reserves at the central bank Change in stock variables in one period The first term in parentheses represents the current account, and the second term, the capital account. The preceding equation shows that a surplus in the current account does not necessarily lead to an in crease in the stock of foreign reserves at the central bank.5 Changes in foreign reserves also depend on the capital account. Foreign reserves at the central bank can increase with a balance or even a deficit in the current account. These situations require a surplus in the capital account, and in the latter case this surplus has to be greater than the deficit of the current account. Factors Affecting the Different Balance-of-Payments Items The items of the current account are primarily de pendent upon domestic prices relative to prices in the world market and on domestic income as well as income in the rest of the world. F or the purpose of this paper, the current account is treated as an exo genous variable. Therefore, the functional relation ship is not discussed in detail. The stocks of foreign assets and liabilities desired by private econom ic units are a function of domestic and foreign interest rates as well as uncovered and covered international interest rate differentials.6 The desired stock of foreign assets is postulated to be negatively related to dom estic interest rates and posi tively related to interest rates in foreign markets as 5A surplus (deficit) in the current account is a situation where exports ( imports) are greater than imports ( exports). A surplus ( deficit) in the capital account implies that changes in foreign liabilities (foreign assets) are greater than changes in foreign assets (foreign liabilities). 6The uncovered interest rate differential is defined as the foreign interest rate minus the domestic interest rate. The covered interest rate differential is the short-term interna tional interest rate differential adjusted for forward premiums and discounts. For example, the covered interest rate differ ential between the United States and Germany (idifc) is equal to the U.S. money market rate (iu s ) minus the German money market rate (i GE) minus a forward discount or plus a forward premium on the U.S. dollar: id™ = ius - iGE + 5 The forward discount or premium on the dollar (6) is expressed as a per cent per annum of the spot rate of exchange: 6 = 2 !-----P° "° Po = spot rate of exchange pt = forward rate of exchange t = time period expressed as fraction of a year Page 13 F E D E R A L R E S E R V E BA N K OF ST. LO U IS well as to international interest rate differentials. The desired stock of foreign liabilities is dependent on the same variables, however, with the opposite signs. A P R IL 1971 T a b le 1 Fun ctio ns D e te rm in in g D e sire d Sto ck s o f F ore ign A sse ts ( F A * ) a n d F o re ign Liabilities ( FL * In addition, the desired stocks of foreign assets and foreign liabilities are influenced by speculation in connection with expected changes in the pegged for eign exchange rate. An expected revaluation reduces the desired stock of foreign assets and increases the desired stock of foreign liabilities. Besides the independent variables mentioned above, the desired stocks of foreign assets and liabili ties have been influenced by actions of the monetary authorities. Until September 1969, one of the most im portant instruments used by the German central bank for neutralizing the inflow of short-term foreign capital was to vary the forward exchange rate for U.S. dollars and to alter the maturity of its forward con tracts with com m ercial banks.7 The Bundesbank fixed the forward dollar rate according to the spot exchange rate, the interest rate differentials betw een the do mestic and foreign money markets, and the forward exchange rate in the free forward m arket for U.S. dollars. The fixed forward rate was only applied to forward transactions with com m ercial banks. Its main purpose was to increase com m ercial banks’ holdings of short-term foreign assets. W hile the forward exchange policy was undertaken to stimulate short-term capital exports of commercial banks, other measures w ere introduced to discourage capital imports. One of these measures was a higher legal reserve ratio for deposits of nonresidents than for residents. New deposits of nonresidents sometimes have been charged with a required reserve ratio of 100 per cent. Furtherm ore, interest payments on de posits of nonresidents were forbidden during certain periods.8 According to the above discussion, the desired stocks of foreign assets and foreign liabilities are a function of the domestic interest rates, the foreign interest rates, the uncovered interest rate differential, the covered interest rate differential in the free and 7For a detailed discussion of the forward exchange policy of the Bundesbank, see Ekhard Brehmer, “Official Forward E x change Operations: The German Experience,” in Interna tional Monetary F u n d Staff Papers (November 1 9 6 4 ), pp. 389-413. 8Fo r a further discussion of instruments to influence short term capital flows, see Rodney M. Mills, “The Regulation of Short-Term Capital Movements: Western European Tech niques in the 1960’s,” Staff Economic Studies No. 46, Board of Governors of the Federal Reserve System, Washington, 1968. See also Otmar Emminger, “Practical Aspects of the Problems of Balance of Payments Adjustment,” in Journal of Political Economy, Supplement (August 1 9 6 7 ), pp. 512-522. Digitized forPage FRASER 14 D ependent V a ria b le s In d e p e n d e n t V a ria b le s F oreign A sse ts ( F A * ) Fu nctio nal R e la tio n sh ip s dom estic interest rate fo re ig n ) interest rate (i) n e g a tiv e (if) p ositive uncovered interest rate d ifferen tial (id if) p ositive free covered interest rate differential (idifc) p ositive co ntrolled covered interest rate differential free fo rw a rd rate p ositive (idifc) (8 ) positive controlled fo rw a rd rate ( 5 ) sp e cu la tion v a ria b le positive n e ga tiv e (p ) F oreign L iab ilities ( F L * ) d om estic interest rate (i) fo re ig n interest rate p ositive ( if ) n e ga tiv e uncovered interest rate d ifferen tial (id if) ne ga tiv e free covered interest rate d ifferen tial (idifc) ne ga tiv e co ntrolled covered interest rate differential (idifc) free fo rw a rd sp e cu la tio n rate ne ga tiv e (5 ) v a ria b le ne ga tiv e (p ) p ositive req u ire d reserve ra tio on fo re ig n lia b ilitie s (7f) n e g a tiv e C h a n g e s in the stock o f fo re ig n a sse ts a n d fo re ig n lia b ilitie s are a ssu m e d to fo llo w a n a d justm ent process o f the type: FAt—FAt—l = Fit— FLt— 1 = X i ( FAt—FAt—l ) \2 <FLt— FLt— l ) ; 0 < \ i, X2 < 1 controlled forward market, the free and controlled forward rate, and a variable indicating speculative expectations with respect to an upward variation in the exchange rate. The symbols X, and ~k2 in Table I stand for adjust ment coefficients indicating the proportion of the gap between the actual and desired stock which is elimi nated in one period. The closer A is to 1, the faster is the adjustment. The adjustment process implies that for given values of the variables determining the de sired stock, the rate of change of the stock variables decreases as the actual stock approaches the desired stock. The same variables determining the desired stocks of foreign assets and foreign liabilities influence the stock of foreign reserves at the central bank through their im pact on the capital account. In Germany, fluctuations in the stock of foreign reserves at the Bundesbank are dominated by inter national capital movements. This is shown in the fol lowing chart, where the data for the current account, the capital account, and changes in foreign reserve holdings of the Bundesbank are plotted for the period FEDERAL. R E S E R V E B A N K OF ST. LO U IS A P R IL 1971 from 1958 to 1970. During the periods 1958 through 1962 and 1969 through 1970, changes in the stock of foreign reserves at the central bank followed very closely the movements of the capital account. During the period 1963 through 1968, the im pact of the heavy fluctuations in the current account on the for eign reserve position of the Bundesbank, to a large extent, was neutralized by offsetting movements in the capital account. The movements in the capital account, to some extent, are the result of monetary policy actions. The Bundesbank used forward exchange policy very effectively in periods of increasing balance of pay ments surpluses. In 1960-61, when German interest rates were higher than U.S. rates, the Bundesbank fixed a premium for forward dollars, even though for ward dollars were traded with a small discount in the free forward market. In 1968-69, interest rates in the United States exceeded those in Germany, and the Bundesbank offered the commercial banks a discount on forward U.S. dollars which was lower than the discount in the free forward market. Sources and Uses of Base Money In the preceding section, the im pact of the balance of payments on changes in the stock of foreign re serves was described. Now the relationship between foreign reserves and base money will be examined.9 In Germany, base money consists of the net mone tary liabilities of the Bundesbank and the Federal Government issued to the private sector. Consolidat ing the monetary accounts of the Bundesbank and the Government, a balance sheet can be constructed for deriving the sources and uses of base money. A consolidated balance sheet for base money is illustrated in Table II on the following page. The left side of the balance sheet shows the different sources of base money. The right side shows the uses. Sources of Base M oney The different terms of the source base reflect the impact of the foreign sector, the behavior of the cen tral bank, the behavior of the government, the be havior of the commercial banks or a combination of these influences. As indicated above, the stock of foreign reserves at the central bank is equal to the accum ulated sum of 9Base money is defined in footnote 1. Page 15 F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 on the behavior of the com mercial banks to which open market operations are restricted.10 T a b le II M o n e t a r y B a se in G e r m a n y D e ce m b e r 3 1 , 1 9 7 0 (B illio n s o f m ark s) U se s o f the B ase Sou rces of the B ase Foreign reserves (FR) 5 0 .6 G o ld F o re ig n 1 4 .3 currency 2 8 .4 O th e rs* 3 6 .9 Com m ercial b a n k reserves (R ) 2 9 .8 7 .9 Discou nt b o rro w in g (D B ) G o ve rn m e n t securities C urren cy held b y the n o n b a n k p u b lic (C ) 1 8 .7 (G S Z ) G o ve rn m e n t a d v a n c e s ( G A ) G o ve rn m e n t d e p o sits ( G D ) -6 .7 S p e cia l anticyclical d e p o s it s * * — 5 .4 O th e rs — 1.3 C o in ( C N ) O th e rs (U ) Sou rce b a se (B s ) 1.2 2 .0 3 .0 — 2.1 6 6 .7 B ase Government advances and govern ment deposits can be considered as exogenous variables.11 Both are under the direct control of the Government. Particularly, Government deposits are an im portant instrument to influence the growth of base money. They con sist of three items: regular deposits, special anticyclical deposits of the F e d eral Government and the State Gov ernments, and deposits related to an anticyclical surtax on income. The last two measures w ere made available to the Government by the Stabilization L aw of 1967. 6 6 .7 The most important instrument of monetary policy with respect to its quantitative im pact on the money sup ♦Mainly nonbank foreign assets, plus the reserve position a t the IM F adjusted for special drawing rights. ply has been required reserve policy.12 ♦♦Special anticyclical deposits consist of (1) balances acquired by the Federal Government Changes in required reserves do not and the State Governments (2.9 billion m arks), and (2) accumulated revenues from an anticyclical surtax on income (2.5 billion m a rk s). Both measures were introduced in influence the stock of the source base. 1970 in order to reduce the growth of the money supply. However, they affect the money stock Note: In equation form, the source base is defined as: through the ability of com m ercial banks B8 = F R + DB + GSZ + GA - - GD + CN - U to create money. An increase in the net balance-of-payments surpluses of preceding peri average required reserve ratio increases required re ods. In the short run, foreign reserves are to a large serves and, for a given stock of source base, exerts a extent uncontrolled by the Bundesbank. The Bundes contractionary influence on the money supply. The bank can only change its foreign reserve balances by quantitative im pact of changes in reserve require influencing foreign assets and foreign liabilities of ments is reflected in the m onetary base. The mone commercial banks through variations in the covered tary base is equal to the source base adjusted for interest rate differential or the legal reserve ratio for changes in reserve requirements.13 deposits of nonresidents. Table II shows the sources of the monetary base at the end of 1970, and the following chart illus Comm ercial banks’ borrowings through the discount trates the growth of the monetary base and its domiwindow are controlled by the Bundesbank through changes in the discount rate and the discount quota. 10Fo r a theoretical analysis of the impacts of the two dif ferent types of open-market policy, see Manfred Willms, The discount quota is a limit for discount borrowings. “Bankenverhalten und Offenmarktpolitik” (Commercial It is fixed by the Bundesbank for each commercial Bank Behavior and Open-Market Policy), in Jahrbuecher fu er Nationaloekonomie und Statistik (June 1 9 7 0 ), pp. bank according to its asset and liability structure. This 159-172. limit for discount borrowings has been so high in the n The German Constitution limits government advances to a total of 6 billion marks. past that, with the exception of some short periods, it 12See Juergen Siebke and Manfred Willms, “Das Geldangebot has had very little restrictive effect. Reserve ad justm ent ( B r ) M o n e ta r y b a se (B ) — 1.6 65.1 Reserve ad justm ent M o n e ta r y b a se Open market policy works in a way similar to dis count policy. Instead of determining the quantity of government securities it wants to sell or buy, the Bundesbank establishes the interest rate at which it sells or buys short-term government securities. W ith respect to the quantity, the Bundesbank is dependent 16 Digitized for Page FRASER -1 .6 65.1 in der Bundesrepublik Deutschland. Eine Empirische Anal yse fuer die Periode von 1958 bis 1968” (T h e Money Supply in the Federal Republic of Germany: An Empirical Analysis for the Period 1958 to 1 9 6 8 ), in Zeitschrift fuer die Gesamte Staatswissenschaft (January 1 9 7 0 ), pp. 55-74. 13B = B s + Br B = Monetary base Bs = Source base Br = Adjustment component for changes in required reserves The adjustment component Br is the sum of monthly F E D E R A L R E S E R V E B A N K OF ST. LO U IS A P R IL 1971 G erm any Base M oney and its M ain Sources B illio n s o f B illio n s o f D e u ts c h e M a r k (Quarterly A verag es of End-of-Month Data) D e u ts c h e M a r k 7 0 ------ --------------------- 1------- ---------------------------------------------- 7 0 the Bundesbank. Government deposits exceeded the stock of government se curities held by the central bank, and the Bundesbank becam e a net debtor to the government. Discount borrowings were relatively small until 1964. Since then their con tribution to the m onetary base has be come more important, with a sharp in crease in 1969-70. Over the last five years, borrowings through the discount window typically have moved inversely to foreign reserves. This indicates that the commercial banks reacted to any decline in base money due to a reduc tion in foreign reserves with an increase in discount borrowings. T he net government position con sists of the stock of government securi ties at the Bundesbank plus govern ment advances from the Bundesbank minus government deposits at the Bun desbank. Quantitatively, this variable 1 958 1960 1962 1 964 1 96 6 1968 1970 is relatively unimportant in Germany Source: Monthly Report of the Deutsche Bundesbank com pared with the United States or nant source components for the period 1958 through England. However, in periods like 1961, 1965-66, and 1970. It is obvious that foreign reserves are the largest 1970, it was effectively used to offset at the margin source component of the monetary base, contributing on the average 84 per cent to the monetary base (th e corresponding figure for the U.S. econ The Uses of Base Money omy is 24 per c e n t). Foreign reserves B illio n s o f B illio n s o f were at times greater than the mone D e u ts c h e M a rk p u a rte rly A v e ra g e s of End-of-Month Data) D e u ts c h e M a rk 70 tary base. During these periods, the im 7 0 1----------------p a ct of foreign reserves was offset by an increase in government deposits at G erm any changes in the volume of required reserves due to changes in reserve requirement ratios: Br — 1 t 2 ABr T = to T with to = February 1949 ABr is calculated as: t ABr= — (r t—rt- i ) B V t-i, t where r stands for the average required re serve ratio and BV for the deposits of com mercial banks for which reserves are required. Fo r a detailed analysis see Leonall C. Ander sen and Jerry L . Jordan, “The Monetary Base — Explanation and Analytical Use,” this Re view (August 1 9 68) pp. 7-11. 1 95 8 1 960 962 1 96 4 966 1 968 1 970 S ource: Monthly Report of the Deutsche Bundesbank Page 17 F E D E R A L R E S E R V E BA N K OF ST. LO U IS the im pact of an inflow and outflow of foreign re serves on the monetary base. Uses of Base M oney Base money is used by the public as currency and by the commercial banks as reserves (th a t is, Bs — C -)- R ). The distribution of base money be tween currency and reserves is shown in the p reced ing chart. The amount of notes and coins held by the public follows a relatively stable growth path. The major fluctuations in the source base are related to changes in the reserve position of commercial banks. Both the total amount of base money and its distribu tion between currency and reserves play an impor tant role in the determination of the money supply. T he relationship between these variables is derived in the model presented below. A Model of the Money Supply Process The above analysis indicated how the monetary base is influenced by the balance of payments and the actions of the monetary authorities. The analysis showed that some components of the monetary base, discount borrowings and net short-term foreign bor rowings of commercial banks, are only indirectly con trolled by the Bundesbank.14 Net short-term foreign borrowings of the nonbank public are completely uncontrolled. In order to formulate a hypothesis on the controlla bility of the money supply process in an open econ omy, the monetary base has to be adjusted for these variables.15 This adjusted base series will be referred to as the “net monetary base.” The net monetary base (B n) is defined as: Bn = B - DB + (F A B—F L B ) + (F A P—F L P ) where: B DB FA B FLB = = = = Monetary base Discount borrowings Short-term foreign assets of commercial banks Short-term foreign liabilities of commercial banks FA P = Short-term foreign assets of the nonbank public F L P = Short-term foreign liabilities of the nonbank public 14Within the German institutional framework, the term com mercial banks includes private banks, savings banks and their central institutions the giro banks, state banks, credit cooperatives and mortgage banks. 15In this adjustment it is assumed that all foreign transactions culminate in changes in foreign reserves at the central bank. Page 18 A P R IL 1971 The net monetary base can be considered as the exogenous part of the monetary base. The quantity of money supplied (cu rren cy and demand deposits in the hands of the p u b lic), and the quantity of domes tic earning assets (bank credit) demanded by com mercial banks, can be expressed, respectively, as the product of the net monetary base and a money multi plier, and the product of the net monetary base and a credit multiplier.16 M = mn • Bn kB . B" Net monetary base Money stock Money multiplier related to net monetary base Bank credit Credit multiplier related to net monetary base KB _ B" = M= mn = KB = kB = The determination of these multipliers ( m" and kB) is explained in Appendix II. The multipliers re flect the behavior of the com m ercial banks and the public with respect to the supply of money and bank credit. They are assumed to depend on the market interest rate, the different rates on deposits, the short term foreign rate, the covered interest rate differen tial in the free forward market, the covered interest rate differential in the controlled forward market, the free forward rate, the controlled forward rate, the discount rate, national income, nonhuman wealth, and the expected rate of inflation. The policy variables exercise a direct and an in direct effect on the supply of money and bank credit. The direct effect consists of the im pact of discount policy and forward market policy on the multipliers, and the im pact of required reserve policy on the net monetary base. The indirect effects are on the mul tipliers, related to base-induced changes in the inter est rates. Interest rates affect the money multiplier and the credit multiplier through their im pact on the behavior ratios which determine each multiplier. The desired ratio of discount borrowings to total deposits is as sumed to depend on the m arket interest rate and the discount rate. The desired ratios of short-term foreign assets and short-term foreign liabilities to total de posits are a function of the market interest rate, the short-term foreign rate, the covered interest rate dif16This model of the money supply process is developed within the framework of the Brunner-Meltzer nonlinear money supply hypothesis. Karl Brunner and Allan H. Meltzer, “Some Further Investigations of Demand and Supply Functions for Money,” Journal of Finance (M ay 1 9 6 4 ), pp. 240-283; and “Liquidity Traps for Money, Bank Credit, and Interest Bates,” Journal of Political Economy ( lanuary/February 1 9 6 8 ), pp. 1-37. See also Albert E . Burger, An Explanation of the Money Supply Process, (Belmont, California: Wadsworth Publishing Company, forthcoming 1 9 7 1 ). A P R IL 1971 F E D E R A L R E S E R V E BA N K OF ST. LO U IS ferentials, the forward rates, and the discount rate. The market interest rate and the different rates on demand deposits, time deposits, and savings deposits affect the multipliers through their impact on the currency ratio, the time deposit ratio, the savings de posit ratio, and the reserve ratio. The demand for bank credit by the public is as sumed to be a function of the m arket interest rate, the interest rates in other financial markets, the for eign money m arket rate, the expected rate of infla tion, national income, and nonhuman wealth. Equilibrium in the bank credit market occurs when the quantity of credit supplied by commercial banks is equal to the quantity of credit demanded by the public. The equilibrium in this market determines the market interest rate. Thus, the equilibrium interest rate can be derived by equating the supply function of credit and the demand function for credit. Appro priate substitution of the equilibrium value for the interest rate into the money supply equation leads to the determination of the equilibrium money stock. Thus, according to this approach, for a given net monetary base and other predetermined variables, the money stock is determined in the process of reaching equilibrium in the bank credit market. The interest rate elasticities of the money multi plier, the bank credit multiplier, and the demand for bank credit by the public play an important role in the determination of the money supply elasticities. T a b le III U sin g lo garithm ic form s of the eq u a tio n s, elasticities o f the m o n e y s u p p ly with respect to each of the p red eterm ined v a ria b le s can be derived. S o m e o f the elasticities are sh o w n below . W ith Elasticities o f the M o n e y S u p p ly Respect to S o m e E x o g e n o u s V a ria b le s o f the M o d e l Elasticity of M with respect to the net m o n e ta ry b a se £ (M ,B n) — 1— q Elasticity o f M with respect to the d is count rate £ (M ,i) £ ( m n,i) — q £ ( k B ,i) Elasticity o f M with respect to the fo r The ratio of these elasticities will be referred to as the “q-factor.” Because of their importance, it is n ec essary to analyze these elasticities in more detail. The interest rate elasticity of the bank credit multiplier [e (k B,i ) ] is postulated to be positive, while the in terest rate elasticity of the public’s demand for bank credit [e (k B,i) ] is assumed to be negative. Conse quently, the denominator of the q-factor is positive. Therefore, the sign of the q-factor depends on the elasticity of the money multiplier with respect to the market interest rate [e (m n,i)]. The interest rate elasticity of the money multi plier is the sum of the following elasticities: + + + + s (m n,i) = E(m n,b) ^ ( b . i ) + E(m n,f) •e ( f,i) + £ (m n,a ) '£ ( a , i ) + e (m n,r) - £ (r,i) — 4- — + + £ (m n,t) * £ (t,i) + e(m n,s) * £ (s,i) The signs of the different elasticities are specified above each term. According to this equation, an increase in the market interest rate affects the money multiplier positively through its im pact on the ratio for discount borrowings ( b ) , the short term foreign liability ratio ( f ) , the short-term for eign asset ratio ( a ) , and the total reserve ratio ( r ) . A negative effect on the money multiplier em an ates from the im pact of an increase in the interest rate on the time deposit ratio ( t ) and the savings deposit ratio ( s ) . The interest rate elasticity of the money multiplier is the sum of positive and negative components. Therefore, its sign is theoretically undetermined. However, the first four of the six elasticity terms in the above equation are positive, while only the last two are negative. Em pirical estimates for Germany show that the contribution of the borrowing ratio to the growth rate of the money stock was greater than the joint contribution of the time deposit ratio and the savings deposit ratio to the growth of the money stock.17 Therefore, it can be assumed that the interest elasticity of the money multiplier in Germany is posi tive. In that case, the value of the q-factor is also positive. e ig n m on ey m arket ra le £ ( M , i r ) = E ( m n,it) + q [ E ( k B ,i f) — £ ( k p ,if)] Kl . __ £ ( m n,i) N ote: q = -------------------------- !---- !-£-------------------------£ ( k B ,i) — £ ( k p ,i) For instance, the n otation £ ( Y , X ) is read : “ the elasticity of Y with respect to X . " The elasticity is defined as the ratio of the relative p ercentage c h a n g e in Y to the relative p erce ntage c h a n g e in X. Determining the sign of the q-factor enables us to derive conclusions regarding the controllability of the money supply in an open economy. As long as the 17Siebke and Willms, “Das Geldangebot in der Bundesrepublik Deutschland. Eine Empirische Analyse fuer die Periode von 1958 bis 1968” (T h e Money Supply in the Federal Republic of Germany: An Empirical Analysis for the Period 1958 to 1 9 6 8 ), page 65 and page 69. Page 19 F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 T a b le IV GERM ANY R e g re ssio n Estim ates o f R e d u ce d -form E q u a tio n s for the M a r k e t Interest Rate a n d the M o n e y S u p p ly (Q u a rt e r ly D a ta : 1 / 1 9 6 0 — Regr. N o. D ependent V a ria b le Funct. Form C o n sta n t 1 i lo g — .2 1 9 M lo g — .0 8 4 2 Bn .4 2 7 ( - -4 .6 4 3 ) ( Notes 11/1970) \( -P)/ t - 1 Y jOE .6 0 3 (7 .6 0 6 ) .228 4 .5 0 5 ) .4 6 8 (4 .5 2 8 ) i = Yield on long-term government securities as a proxy fo r the bank credit rate. M = Currency and demand deposits in the hands of the public. Bn = Net monetary base. Y P t-1 .1 3 2 (3 .1 7 6 ) .0 8 7 (4 .1 9 2 ) R2 D -W .61 .321 .0 7 .9 9 .731 .02 S.E. = GNP, computed by Deutsches Institu t fuer W irtschaftsforschung, Berlin. = Sum of real financial assets held by the public a t commercial banks lagged by one quarter. (¥ ), -1 P t~ l = R ate of change of consumer price index lagged by one quarter. iGE = German money m arket rate. R2 — Coefficient o f determination. D-W = Durbin Watson statistics. S.E . = Standard error of estimate. value of the q-factor does not becom e equal to one, the elasticity of the money supply with respect to the net source base is still positive, and the central bank maintains control over the money supply. Only if the q-factor equals one does the response of the money supply to changes in the net monetary base become zero. Those who argue that the monetary authorities are not able to control the money stock in an open econ omy implicitly assume that the q-factor is equal to one, and that such a value of the q-factor only results from the interest rate elasticity of short-term interna tional capital movements. In other words, the interest rate elasticities of the money multiplier and the credit multiplier of commercial banks are dominated by the elasticities of short-term international capital transfers. Others, who assert that the monetary authorities can control the money stock in an open economy, assume a value of the q-factor which is smaller than one. They m ay argue that any increase in the multiplier due to foreign borrowings of com m ercial banks can be neu tralized by a reserve requirement of 100 per cent, and that foreign borrowings of private enterprises cannot be expanded indefinitely. Some Empirical Observations of the Money Supply Process The empirical section begins with some estimates of elasticities which are important for the explanation Page 20 of the money supply process in an open economy. The estimates are derived as reduced-form regression equations determining the market interest rate and the money supply. The estimates are presented in Table IV. To conserve degrees of freedom given the limited number of sample observations, a much smaller num ber of independent variables appear in these reducedform equations than in the theoretical analysis. There fore, in the regressions the market interest rate is a function only of the net monetary base and national income, while the money supply is a function only of the n et m onetary base, real nonhuman wealth, the rate of change in the price level, and the domestic money market rate. In the estimates, the market in terest rate has been approximated by the yield on long-term government securities, and nonhuman wealth by the sum of financial assets held by the public at com mercial banks. To avoid spurious correla tion between the money stock and the proxy variable for wealth, the latter has been lagged by one quarter. A similar lag was introduced for the rate of change in the price level. This variable is assumed to be a proxy for price expectations. The regressions are performed in this manner in order to obtain estimates of the value of the q-factor, that is, the interest elasticity of the money multiplier divided by the interest elasticity of the credit multi plier minus the interest elasticity of the public’s de mand for bank credit. From the regression results the A P R IL 1971 F E D E R A L R E S E R V E BA N K OF ST. LO U IS T a b le V GERM ANY R e g re ssio n Estim ates o f Interest Rate Elasticities o f C o m m e rc ia l B a n k s ' Short-term F o re ign A sse ts, Short-term and F o re ign Liabilities, D isc o u n t B o r ro w in g s (Q u a rt e r ly D a ta : l / l 9 6 0 - l l / l 9 7 0 ) Regr. N o. Dependent V a ria b le Funct. Form. C o n sta n t iG E iE U 3 aB lo g -3 .4 6 3 — .6 7 8 (5 .1 7 8 ) .7 8 5 (6 .3 7 8 ) 4 aB lo g -3 .2 1 0 — .5 1 9 (3 .6 7 7 ) 5 a® log — .8 2 0 6 aB lo g - .5 8 3 7 aB lo g -3 .1 4 5 8 fB lo g -3 .4 3 8 9 fB lo g -3 .2 5 7 10 b lo g — 6 .0 6 8 11 b log -5 .9 0 3 12 b lo g -9 .5 0 1 13 b log — 9 .2 3 6 iU S iE U difc jUS difc R2 D -W S.E. .5 0 .4 1 7 .20 .3 4 .3 0 6 .2 3 — 1 .9 7 3 (5 .5 4 4 ) .52 .691 .1 9 — 1 .9 1 4 (4 .9 0 7 ) .45 .4 8 8 .21 .1 3 .271 .26 .18 .1 8 5 .1 9 .1 0 .2 1 0 .1 9 .75 1 .4 9 5 .2 3 .7 9 1 .6 6 7 .21 2 .4 9 0 (7 .2 8 9 ) .84 1 .3 5 2 .18 2 .4 5 4 (7 .0 4 4 ) .84 1 .2 4 6 .18 i .581 (4 .6 2 8 ) .821 (6 .7 3 5 ) .7 3 2 (5 .7 8 9 ) .8 6 5 (2 .6 4 6 ) -.0 4 7 ( -4 3 9 ) .2 3 8 (1 9 6 7 ) -.3 3 4 (2 .2 5 2 ) .6 7 6 (4 .4 1 0 ) .7 3 8 (5 .1 2 1 ) .7 3 3 (6 .2 6 7 ) .7 0 6 (5 .3 8 1 ) .5 8 7 (5 .0 1 6 ) .561 (4 .9 7 8 ) N otes: aB = R atio of short-term foreign assets of commercial banks to total deposits. fB = R atio of short-term foreign liabilities of commercial banks to total deposits. b = R atio of discount borrowings to total deposits. iGE = German money m arket rate. iEU = Eurodollar rate. iUS — U .S. money m arket rate. i = Yield on long-term government securities as a proxy for the bank loan rate. iEU = Eurodollar rate over German money m arket rate adjusted for forward premiums or discounts on the U .S. dollar, difc iUS = U .S. money m arket rate over German money m arket rate adjusted for forward premiums or discounts on the U .S. dollar, difc value of the q-factor was estimated to be 0.77.18 Al though this value of the q-factor is much greater than the corresponding values for the United States, it is smaller than its critical value of one.19 Thus, it can be 18The elasticities for the determination of the q-factor are calculated in the following way: e(i,B n) = —.427 (according to regression No. 1, Table IV ) e(kB4) — e(kp,i) = ------— --------= — ------ = 2 . 3 4 e (i,B ”) e (M ,Bd) - .4 2 7 = .228 (according to regression No. 2, Table IV ) e(M ,B n) = 1 + £(m ",i) •e(i,B n) £ (i,B n) — 11:77?— = 1.81 -.4 2 7 q = _____ _____________= .77 e (k B, i ) —£ (k r ,i) 19Karl Brunner and Allan H. Meltzer obtained a value of the q-factor for the United States of 0.48. Their regression estimate was 0.94 for the interest elasticity of the money concluded that the Bundesbank had control over the money supply in the period I/1 9 6 0 -II/1 9 7 0 . However, this statem ent is only true for the average of the period in consideration, a period which included two revaluations of the German mark against the U.S. dollar. F o r some sub-periods of speculative inflows of foreign currencies related to an expected revaluation, the possibility cannot be excluded that the marginal value of the q-factor approached its critical value of one. The above estimates indicate the total im pact of the market interest rate on the money multiplier. They do not provide information on the interest elas ticities of the different ratios which determine the multiplier. In order to obtain information about the extent to which the interest elasticity of the money multiplier and 1.96 for the interest elasticity of bank credit. See their “Liquidity Traps for Money, Bank Credit, and Interest Rates,” in Journal of Political Economy (January/ February 1 9 6 8 ), Appendix III. Page 21 F E D E R A L R E S E R V E B A N K OF ST. LO U IS multiplier was influenced by the interest elasticities of international capital transfers and discount borrow ings, some estimates have been made of the interest elasticities of the foreign asset ratio, the foreign bor rowings ratio, and the domestic borrowings ratio for borrowings through the discount window. The results are summarized in Table V. The regressions indicate that commercial banks do in fact respond to changes in domestic and foreign interest rates according to the hypotheses developed in the model of the money supply process. Particu larly, their behavior with respect to short-term foreign assets and discount borrowings can be explained by foreign and domestic interest rates. On the other hand, it is difficult to explain short term foreign borrowings by reference only to interest rates or interest rate differentials. The best estimates of the short-term foreign borrowing ratio of com m er cial banks are reported in Table V. These estimates suggest that other variables are necessary for the ex planations of the foreign borrowing ratio. F o r one thing, the foreign borrowing ratio is to a large extent influenced by expectations regarding the revaluation of the German mark. Due to the forward market op erations of the Bundesbank, the same speculative im p act on the foreign asset ratio was almost completely neutralized. The estimates of Table V show that the interest elasticities of commercial banks with respect to for eign and domestic funds do not deviate substantially in absolute values.-0 This implies that commercial banks are indifferent with respect to foreign and do mestic funds. It also implies that international capital movements, insofar as they are related to commercial banks, disturb the money supply process in the same way, and with a similar impact, as domestic sources of borrowing. The previous analysis has been developed in order to formulate and test a hypothesis of the controllabil ity of the money supply process in Germany. Particular attention was paid to the interest elasticities of en dogenous variables related to the money supply pro cess. A discussion of the technical details of the money supply process has been avoided. However, a few remarks with respect to the control process of the money supply seem to be appropriate. W ithin the framework of the above model, the monetary authorities are assumed to be able to meas 20That is, |£(aB,x)| is approximately equal to |e(b,x)|, where x = i«E, iEU, ius, and i. Page 22 A P R IL 1971 ure and control the net monetary base, while the money multiplier summarizes the endogenous non policy controlled factors influencing the money supply process. If the m onetary authorities, in the context of that model, w ant to control the growth of the money stock, they have to forecast the value of the money multiplier. O nce the multiplier is predicted, the amount of base money which is needed to achieve the desired money stock is determined.21 In order to obtain the desired money stock, it is important to make correct estimates of the money multiplier. As can be seen in the following chart, the money multiplier derived by the use of the above model is relatively unstable and its contribution to the money stock fluctuates considerably. Prediction of this multiplier would be difficult. Therefore, it is worthwhile to consider a slighdy modified formula tion of the multiplier-base concept in which the money multiplier is more predictable. The concept of the monetary base could be an alternative. The monetary base includes the discount borrowings and the net short-term foreign borrowings which the net mone tary base does not include. If the m onetary base concept is used instead of the net monetary base concept, changes in the money multiplier reflect primarily the behavior of the public with respect to the allocation of their funds between currency and demand deposits and the allocation of their deposits betw een demand deposits, time de posits and savings deposits. Since these factors do not flu c tu a te sig n ifican tly w ith in s h o rt p e rio d s o f tim e , th e multiplier relating the monetary base and the money stock would be much more stable and predictable than the multiplier which relates the net monetary base to the money stock. The ch art shows that the re lationship between the monetary base and the money stock is much closer than the relationship between the net monetary base and the money stock. Begression estimates for the period 1 /1 9 5 8 to 1 1/1970 indicate that 80 per cent of the variance of quarterly changes in the money stock resulted from changes in the monetary base, while only 16 per cent of the variance of changes in the money stock w ere explained by changes in the net monetary base. AM = .195 + 1.222AB (1 2 .1 8 9 ) AM = 1.232 + .407AB" (2 .8 4 1 ) R2 D -W .80 2.490 S.E. .99 .16 2.393 2.03 21Fo r a further analysis of a control process of the money supply along these lines, see Lionel Kalish, “A Study of Money Stock Control,” Journal of Finance (September 1 9 7 0 ), pp. 7 6 1 -7 7 6 . FEDERAL. R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 G erm an y Changes in the M oney Stock, Base Money, and the Money Multipliers (Quarterly First Differences) Seasonally Adjusted Billions of Deutsche Mark Money Slock (H) 4 ---------------- Billions of Deutsche M ark 4 2 0 -2 Net Monetary Base (Bn) / Y \v r \ vk v V 4 2 /I K / \ \K/\ 0 -2 T -4 -6 i -8 Of course, the observed close relationship between the monetary base and the money stock does not solve the control problem. In order to control the monetary base the m onetary authorities have to offset move ments in the uncontrolled components of the mone tary base through changes in the controlled com ponents. However, the monetary authorities gain in formation by predicting the multiplier which is re lated to the m onetary base. The probability of a wrong forecast is much smaller for the base multiplier than for the net base multiplier. To analyze whether, and to w hat degree, the Ger man monetary authorities have in the past been neu tralizing undesired influences on the m onetary base, a regression equation was estimated in which it was assumed that discount borrowings and net short-term foreign borrowings are the noncontrolled components of the m onetary base. If the monetary authorities offset all or p art of the movements of the monetary base components which are not subject to their direct control, the regression coefficient in the following equation should be negative and statistically signifi cant. F o r a perfect offset, the regression coefficient should be equal to minus one. -10 Contribution of Multiplier (m") to Changes in Money Stock A (B —D B + F A - F L ) = a 0+ o ciA (D B —F A + F L ) 10 8 6 4 I J\A A/\aW1 l\ 1 2 0 . -2 Monetary Base (B) 4 2 0 -2 Contribution of Multiplier (m) to Changes in Money Stock 4 i----------------------------------------------------------------------------- 1958 1960 1962 1964 1966 1968 1970 Source: M onthly Report of the Deutsche B undesbank (m) = m oney multiplier related to monetary base. (mn)= m oney m ultiplier related to net monetary base. 4 Using central differences of quarterly data for the period 1 /1 9 5 8 -1 1 /1 9 7 0 produced the following results: A (B —D B + F A —F L ) = .824 - .873A (D B —F A + F L ) ( - 1 3 .5 6 6 ) R2 D -W S .E . .82 1.578 .76 The estimates indicate that the monetary authorities responded to changes in the components of the mone tary base which are not under their direct control. According to these results, the monetary authorities neutralized on the average 87 marks for each 100 mark change in discount borrowings and net foreign borrowings in the period under consideration. W ith respect to the question of the- controllability of the m onetary base in an open economy, it is of interest to analyze the offsetting behavior of the monetary authorities with respect to changes in the total amount of foreign reserves. If a change in the stock of foreign reserves is considered to be the vari able to which the monetary authorities adjust the domestic component of the m onetary base, the regres sion coefficient for changes in foreign reserves should be negative and statistically significant. A ( B - F R ) = Pi + (32A FR Page 23 F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 ing that the m onetary authorities re sponded strongly to the inflow or out flow of foreign reserves. G erm any Changes in Foreign Reserves and Domestic Sources of M onetary Base B illio n s o f D e u ts c h e M a r k (Q u arterly First Differences) S e a so n a lly Adjusted 10 B illio n s o f D e u ts c h e M a r k Conclusions In recent years the German economy 10 has experienced a heavy inflow of for eign reserves, primarily U.S. dollars. In real terms the cost of this inflow is a loss in goods and services. In financial 6 terms the primary influence of the flow of foreign reserves in the short-run is on the money supply process. One way 4 to eliminate the continuing inflow of foreign reserves into Germany is to de 2 velop a more flexible exchange rate policy. The other alternative is to main 0 tain the present fixed exchange rate system and have the monetary authori - 2 ties neutralize the impact of changes in foreign reserves on the money supply process. -4 8 i f /\ / / y y Domestic Sources of Monetary Base \ r '\ * \ \ V A s A .A ■/ v 1 1 L a I" / v\ „ A a _a /^ v - y y 'V i T 1 v^ ~ \ / rsA A / \ M / r * i\ Foreign Reserves 1j 1; I In the past the German m onetary authorities have been relatively suc cessful in neutralizing the im pact of -8 the noncontrolled or indirectly con trolled components of the money supply -10 . . .................................................................... ----- -10 process by changing the directiy con trolled components. The most important 1958 1960 1962 1 96 4 1 96 6 1 968 1970 Source: Monthly Report of the Deutsche B undesbank instruments for offsetting the impact of changes in the noncontrolled com ponents of the money supply process have been the Using quarterly central differences of data for the required reserve policy and a change in Government period I/1 9 5 8 -II/1 9 7 0 , the estimates for this equa deposits or special anticyclical deposits at the Bundes tion are: bank. According to the theoretical analysis of this R2 P -W S.E. paper, if the monetary authorities can control the net monetary base, very extrem e conditions must occur A ( B - F R ) = .795 - .863A F R .79 1.693 .70 ( - 1 2 .1 1 4 ) before the money supply cannot be controlled. The empirical estimates of the interest elasticities of the According to the results obtained, the monetary endogenous variables of the money supply process authorities on average offset about 86 marks out of indicate that the observed elasticities are sufficiently each 100 mark change in foreign reserves through low that control of the money supply can be m ain opposite changes in the domestic component of the tained in the short-run. monetary base. In the long-run the use of m onetary and fiscal poli The offsetting behavior of the monetary authorities cies to offset domestic inflationary pressure arising with respect to changes in the stock of foreign re from an inflow of foreign reserves means that Ger serves also becomes obvious in the above chart. Quar many trades investment and consumption goods for terly first differences of seasonally adjusted data of foreign currency. Hence, in real terms a policy of foreign reserves and the domestic part of the mone controlling inflation in a fixed exchange rate system tary base are plotted for the period from 1958 to 1970. results in welfare losses for the German economy. The chart shows that the variations of these variables This article is available as Reprint No. 67. are m ore or less m irror images of each other, indicat Page 24 -6 t FEDERAL. R E S E R V E B A N K OF ST. LO U IS A P R IL 1971 APPENDIX I Alphabetical List of Symbols aB ap B B" Br Bs b C CN c D DB Ex eB FA FL FR f8 fp GA GD GSB GSZ gB Im i i Ratio of short-term foreign assets of commercial banks to total deposits Ratio of short-term foreign assets of the nonbank public to total deposits Monetary base Net monetary base Adjustment of source base for changes in re quired reserves Source base Ratio of discount borrowings to total deposits Currency in the hands of the nonbank public Coin Ratio of currency to demand deposits of the nonbank public Demand deposits Discount borrowings Exports of goods and services Ratio of bank credit to total deposits Short-term foreign assets Short-term foreign liabilities Foreign reserves at the central bank Ratio of short-term foreign liabilities of commer cial banks to total deposits Ratio of short-term foreign liabilities of the non bank public to total deposits Advances of the central bank to the government Government deposits at the central bank Government securities in the hands of commer cial banks Government securities in the hands of the central bank Ratio of government securities in the hands of commercial banks to total deposits Imports of goods and services Market interest rate Discount rate id ig it idifc KB kB kp M m mn p R Rh Rf Re r r rh rf rd rt rs r S s T t Y W 8 7r Interest rate on deposits Rate on government securities Foreign money market rate Covered interest rate differential Supply of bank credit to the public Credit multiplier Demand function for bank credit by the public Money stock Money multiplier related to monetary base Money multiplier related to net monetary base Domestic price level Total reserves of commercial banks Required reserves related to domestic deposits Required reserves related to foreign deposits Excess reserves Ratio of total reserves to domestic and foreign deposits Average required reserve ratio on domestic and foreign deposits Average required reserve ratio for domestic deposits Required reserve ratio on foreign deposits Required reserve ratio on demand deposits Required reserve ratio on time deposits Required reserve ratio on savings deposits Ratio of reserve adjustment component to total deposits Savings deposits Ratio of savings deposits to demand deposits Time deposits Ratio of time deposits to demand deposits National Income Nonhuman wealth Forward rate Expected rate of return on real capital APPENDIX II Behavior Functions and Multipliers Determining the Money Supply Model In the model developed in this article the money sup ply is determined by the joint behavior of the monetary authorities, the commercial banks and the nonbank public. The behavior of the monetary authorities is mainly reflected in the movement of the net monetary base: The commercial banks influence the money supply process through their portfolio behavior, that is, through the adjustment of their assets and liabilities according to changes in policy variables and relative prices of finan cial assets. In the following analysis the consolidated balance sheet of all commercial banks consists of these items: (A l) (A 2 ) Bn= B —D B + ( FA B—F L B ) + ( FA P—F L P ) GSB + KB + FA B + R = D + T + S + DB + F L B Page 25 F E D E R A L R E S E R V E B A N K OF ST. LO U IS A P R IL 1971 T h e assets and th e borrow ings from the cen tral bank and from ab road are related b y coefficients to th e total am ount of deposits. T h e following functions and their d erivatives specify th e hypothesis reg ard in g th e behavior of com m ercial banks: Supply function of com m ercial banks’ funds to the governm ent ( = dem and function of com m ercial banks for G overnm ent secu rities) (A 3 ) R h = rd D + r t T + r s S - n , ( D + T + S ) , R f = r t + F L B, Re= r e ^ D + j + S ) Since R — R h + R f+ R e, and F L B = f3 ( D + T + S ),_ then R = n, ( D + T + S ) + rt [ P ( D + T + S ) ] + r« ( D + T + S ) ; simplifying R = (7h+7rfB+ r « ) ( D + T + S ) . T h e desired total reserve ratio ( r ) is a w eigh ted average of the req u ired reserve ratios on dem and deposits (r a ), GSB = gB( y J g,ir,i— 7 ) [D + T + S ] difc tim e deposits r t ) , savings deposits ( r s) , foreign liabilities with g f > 0 and gf,gf,g|,gf,g| < 0 * E q u ation (A 3 ) indicates th at com m ercial banks will in crease th eir dem and fo r G overnm ent securities if the cen tral bank raises th e rates for these assets. On the other hand, an increase in the m arket interest rate, the dis cou n t rate, the rate in foreign m oney m arkets, the cov ered in terest ra te differential in th e controlled forw ard m arket, or th e av erag e required reserve ratio will induce a red u ction in the dem and for G overnm ent securities by com m ercial banks. of com m ercial banks ( r t ) , and the excess reserve ratio ( r e) : — — R r = r h + r tf s + r ' = D + X _|_s T h e b ehavior of th e public is described by th ree alloca tion param eters and th e dem and function for com m ercial bank cre d its .** E qu ation s (A 9 ) through ( A l l ) relate cu rren cy and tw o different typ es of deposits b y allocation p aram eters to dem and deposits of th e public. D em an d function fo r cu rren cy b y th e public: ( A 9) Supply function of bank cred it to the public ( = de m and function of com m ercial banks for p rivate do m estic earning a s s e ts ): ( A 4) D em an d fu n ction for tim e deposits b y th e public: (A 10) difc (A ll) FA B = aB(i,i,ig,if,i——,r) [ D + T + S ] difc with aB,aB > 0 and aB,aB,aB,a| < 0 D em an d function fo r bank cred it b y th e public: (A 12) D em an d function of com m ercial banks for discount borrow ing: (A 13) with = [ c + ( r + r - b + a B- f B+ a p- f p ) ( l + t + s ) ] D (A 14) ,7) [D + T + S ] ' > 0 and f®,f® < 0 with r2,r3 > 0 and ri < 0 (A 16) T otal reserves ( R ) consist of reserves req u ired against dom estic deposits (R h ), reserves req u ired against foreign deposits (Rt)> and excess reserves ( R e) , w here i gB . i The independent variables with a bar are policy variables. Page 26 “' M - r_____________________ 1 ± £ _____________________ ]B" Lc + ( r + r _ b + a B- f B+ a p- f p ) ( 1 + t + s ) T h e term in th e b rackets is th e m oney m ultiplier w hich is related to th e n et m onetary b ase. T h e m oney m ulti plier related to th e m onetary b ase is described in ( A 1 6 ) . R = r(i|rh!rt) [ D + T + S ] “The symbol gB (j = 1,2,... 6 ) represents the derivative M = C +D = (l+ c)D th e relation b etw een B n an d M is given by D em an d function of com m ercial banks fo r reserves: (A 8) B" = C + R + B r - D B + ( F A B—F L B ) + (F A P—F L P ) and the definition of the m oney stock D em an d function of com m ercial banks for foreign liabilities: difc k p ( i,if i„ ,if , - r , Y , W ) U sing th e follow ing definition of th e n et m onetary base DB = b(i,i,Tg,if,r) [D + T + S ] F L B = fB (i,7,!g,if,i— Kp = with kp kp,kp,kp,kp > 0 and kp kp < 0 with bi,b3,b4,b5 > 0 and 1)2 <C 0 (A 7 ) S = s(i,id,Y ,W )D T h e dem and fo r bank cred it b y th e public is assum ed to b e positively related to th e in terest ra te in another financial m arket, to th e exp ected ra te of retu rn on real capital, as well as to national incom e and nonhum an w ealth, w hile it is n egatively related to th e m arket interest ra te and th e foreign in terest rate. Supply function of com m ercial banks’ funds to foreign m arkets ( = dem an d function of com m ercial banks for foreign earning assets): ( A 6) T = t(i,id,Y ,W )D D em and function fo r savings deposits b y th e public: KB = eB(i,i,Ig,if,i----- ,7) [D + T + S ] with eB > 0 and eB,eB,eB,eB,eB < 0 (A 5 ) C = c (i,id,Y ,W )D 1+c M = [ c + ( r+ 7 ) ( i + t + s ) ]B ° ° Short-term foreign assets and liabilities of the nonbank public in this model are related to total deposits of commercial banks by allocation coefficients similar to those in equations (A 5 ) and (A 7 ). The reasoning is that short-term interna tional capital transactions of commercial banks and the non bank public are considered to be close substitutes for each other. In addition, they are to a large extent dependent on the same arguments with the same signs of the derivatives of the behavior functions. F E D E R A L R E S E R V E BA N K OF ST. LO U IS A P R IL 1971 T h e explicit form ulation of the cred it m ultiplier is de rived from th e b alan ce sheet of th e com m ercial banks. A ccord in g to this b alan ce sheet, bank cred it is defined as: ( A 17) KI! = D + T + S + F L « + F L i '+ D B - R —GSB—FA = (l+ f B + f F + b -r -g B -a ) (l+ t+ s )D T h e relation b etw een bank cred it and th e n et m one tary b ase is given by: / \-\q \ T, P (18) K - - 1 + f B + f P + b —r —gB—a) ( 1 + t + s ) [ c + ( r + T - b - P - f p+ a ) ( 1 + t + s ) ]B T h e term in b rackets is the cred it multiplier. APPENDIX III Calculation of the Elasticities T h e equilibrium condition in th e bank cred it m arket is specified b y equating th e cred it supply and the cred it dem and functions. In logarithm ic form this ca n b e w rit ten as: (A 19) Solving for th e bank cred it ra te gives: <A 2 2> ^ = 6 ( f r j ) - £ ( W - dl° gBn + [£(kP’if) —£ ( kB,it) ] dlogir + [e ( kp,Y ) —£ ( kB,Y ) ] dlogY logB"-flogkB = logkr + [e ( kp,W ) - e ( kB, W )d lo g W + £ ( kp,ir )dlog 7r + £ ( kp,ifi„+£ ( kB,id)dlogi d—£ ( kB,i d) dlogi } T otal differentiation leads to: , AfmN dB° , 1 ,okB j . ! akB akB ,. , akB ( A2 0 ) + dl H-----H------------ :— dit -I-----:— di + ----Bn kB si ai,i an 31 T otal differentiation of th e logarithm ic form of the m oney supply equation leads to: (A 23) = 1 -p = -(— — kp 31 j i j ■ i 3 k1‘ j- i ^kp , , , diH------- :— d ifin H-------— d ir 4 ------------ d?r + . . . . ) 3 i f in a ll 37T E q u ation ( A 2 0 ) can b e w ritten as: dlogB”+ e ( kB,i ) d logi+ e ( kB,id) dlogid+ e ( kB,it) dlogit (A 21) dlogM = dlogBn-f-E(mn,i)d lo g i+ E (m n,id) dlogid + £(m ",if)d lo g if+ E (m n,i)d lo g i+ . . . . Substitution of equation ( A 2 2 ) into ( A 2 3 ) results in: (A 2 4 ) dlogM = ( I —q)dlogBl'+ [ £ ( m n,id)—qE(kB,id)]dlogid + [£(m ",i) — q £(k B,i)] dlogi + + E (k B,i)d lo g i+ . . . . q£(kp,7r)dlog7r + qE(kp,iim)dlogifit = e ( kp, i ) d lo g i+ e ( kp,ifin )dlogitin+ e ( kp, i t ) dlogit + [E(m n,if) + q [£(k p,it) + E ( k p,7 r)d Io g 7r+ . . . — £(k B—if )]d!ogif + ----- 3The ellipses indicate that similar terms for iditc, iditc,8,8,Y, and W have to be added. T h e elasticities in T ab le V in the text are derived from the last equation. Page 27 Summary of U.S. Balance of Payments, 1970 B alance of Paym ents Accounts The Balance of Payments Accounts are a double-entry record of goods, services, and financial transactions be tween United States and foreign residents. Because it is based on double-entry bookkeeping principles, the bal ance of payments always balances in the sense that re ceipts equal payments. The double-entry nature of the balance of payments is illustrated on the lefthand side of the table on the next page. This accounting balance must not be confused, however, with a meaningful eco nomic balance, because the economic behavior underly ing some of these transactions may not be sustainable. For example, the receipt of $2.2 billion in 1970 from the sale of convertible currencies (IV .4.c) can only continue as long as the United States’ stock of convertible cur rencies lasts. There are two officially recognized measures of the economic balance of payments: the Liquidity Balance and the Official Settlements Balance. They represent alternative ways of arranging the balance-of-payments accounts, and are shown on the righthand side of the table. In recent years the appropriateness of both meth ods of measurement has been questioned, because tem porary factors have obscured more basic economic trends. These measurement problems caution one not to rely solely on summary statements about the balance of pay ments of a reserve currency country like the United States. The accounts are divided into four categories: Goods and Services, Private Capital, Government, and Other. These accounts are of course, interrelated; an export of goods can be financed by an import of goods, private capital, a Government loan or grant, or by a private transfer. (I ) Goods and Services — The surplus of receipts over payments in the goods and services account increased to $3.7 billion in 1970 from $2.0 billion in 1969 and $2.5 billion in 1968. A reduced rate of U.S. economic expan sion in late 1969 and 1970 slowed the rate of import growth, while continuing strength in foreign economic activity encouraged export growth. In addition, a faster rate of price increase of internationally traded goods manufactured by foreigners, and a slower rate of price increase of internationally traded goods manufactured by U.S. residents, were also conducive to an improved goods and services balance in 1970. Merchandise exports rose 15 per cent, or $5.5 billion, to $42 billion while mer chandise imports rose 12 per cent, or $4.1 billion, to $39.9 billion in 1970 (I.I). There was little change in the serv ices account surplus from the preceding year (1.2). (II) Private Capital — A larger deficit on capital ac count in 1970 offset the increased surplus on goods and Page 28 services account. The private capital balance was in deficit by $2.6 billion, compared to a deficit of $1.3 billion in 1969 and a surplus of $1.6 billion in 1968. The primary reason was continuing net long-term capital outflows, par ticularly direct investment. Direct investment by U.S. corporations (mainly plant and equipment expenditures for their foreign affiliates) was $4 billion in 1970, $.9 billion higher than in 1969 ( I l.l.a ) . Portfolio investment resulted in a net capital inflow of $1.3 billion in 1970, slightly less than in the previous year (I l.l.b ). (III) Government — The net outflow of government loans, grants, and transfers was slightly lower in 1970 than in 1969. Special liabilities (net sales of $.5 billion of nonconvertible U.S. Treasury securities to foreign official institutions) produced an offsetting inflow of funds (III.2 ) , and thereby lowered the government capital deficit in 1970 from $4.1 billion to $3.6 billion. (IV ) Other — Private transfers (IV .l) represent gifts and similar payments by American residents to foreign residents. The allocation of special drawing rights (IV .2.) represents the receipt of a new international monetary reserve asset that can be used in settling international accounts. Errors and Omissions (IV .3) is the statistical discrepancy between all specifically identifiable receipts and payments. The significance of this item is discussed below. Changes in U.S. Reserve Assets (IV.4 ) represent official transactions of the United States Government with foreign governments and the International Mone tary Fund (IM F ). The $2.5 billion decrease in reserve assets (mainly a decrease in convertible currencies) is recorded with a plus sign because the United States re ceived dollars when foreign governments exchanged their dollar holdings in order to reacquire their national cur rencies. Special drawing rights are analogous to any other reserve asset; a minus sign implies an addition to the stock of reserve assets. Changes in U.S. Liquid Lia bilities (IV .5) represent increased foreign holdings of liquid dollar liabilities of U.S. banks and the Treasury. The major difference between the Liquidity and the Official Settlements Balances is in the different categoriz ing of U.S. Liquid Liabilities. B alance of Paym ents M easures The Net Balance columns show the source and overall size of the deficit or surplus, while the Financing columns show how the deficit is financed or the surplus is disposed. Liquidity Balance — The underlying assumption about economic behavior is that all foreign liquid dollar hold ings (IV .5 ), both private and official, are a potential claim on United States reserve assets. The liquidity bal ance in 1970 was in deficit by $3.8 billion (including the allocation of SDR), compared to a $7.0 billion deficit in A P R IL 1971 F E D E R A L R E S E R V E B A N K OF ST. LO U IS 1969 and a $.1 billion surplus in 1968. Much of the im provement in 1970 represented the absence of factors which enlarged the liquidity deficit in 1969. With the absence of tight money conditions in the U.S., the re moval of some interest rate ceilings on domestic deposits, and a current yield on short-term money market paper well below remaining ceilings, U.S. banks were no longer forced to turn to the Eurodollar market where their branches could bid freely for funds and transfer them to the home office as nondepository advances not subject to the usual cash reserve requirements. Additional re serves and sources of nondeposit funds were available in the United States to help banks meet a reduced loan demand in 1970. As U.S. banks repaid $6.3 billion of liabilities to their foreign branches in 1970, liquid claims on the United States were reduced. Simultaneously, er rors and omissions, which had picked up some of the unrecorded Eurodollar flows which were outside the normal Department of Commerce reporting channels, declined from an outflow of $2.8 billion to an outflow of U. S. BALANCE OF PAYMENTS, 1970* (In Billions of Dollars) Balance of Payments Measures Balance of Payments Accounts Transactions Receipts Payments Balance Goods and Services .... 63.0 59.3 + 3.7 1. M e r c h a n d is e T ra d e ( g o o d s ) ............... 4 2 .0 3 9 .9 21.0 1 9.4 + + 2.2 2 . Se rvice s ,................ 1.5 9 .6 2.3 7.5 4.8 5.1 3 .9 5 .6 a. b. c. d. M ilit a ry Investm ent Incom e Travel O th e r . 3.4 4 .5 + 1.9 3.8 6.4 2.6 1. L o n g term ... 3.1 5.3 2.2 a. Direct Investm ent .................. b. P ortfolio Investm ent ........... . c. B a n k a n d O th e r L oan s (N e t) .9 2.2 .0 4 .0 .9 .4 2. S h o rt term ....................... .7 1.1 1.8 5.4 - 3.6 1.3 3.3 - 2.0 3. G r a n ts a n d T ra n sfe rs + 2.1 - Net Balance + 3.7 — + + 3.1 1.3 -4 Financing of Net Balance 2.6 .4 1. L o a n s ....................... .5 3.7 3.1 1.3 .4 III. Government ....................... L ia b ilitie s ** + Financing of Net Balance 1.6 Private Capital 2. Sp e c ia l Net Balance Official Settlements Balance 1.6 + + Liquidity Balance - .4 - 2.0 - 2.1 .8 3.6 -5 2.1 + -5 + 2.5 + 7 .6 + 9.8 IV. Other 1. Private T ra n sfe rs ............ 2. A llo c a tio n o f S p e c ia l D r a w in g Rights ( S D R ) .... .9 .9 3. Errors a n d O m is s io n s .... 4. C h a n g e s in U.S. Reserve A sse ts ............................ a. G o ld (ou tflo w is receipt) ... b. S p e cia l D ra w in g Rights (S D R ) ____________________ __ c. C o n v e rtib le C urren cie s _____ d. I M F G o ld T ran ch e ........... 5. C h a n g e s in U.S. Liquid L ia b ilit ie s ....................... a. Foreign O fficia l H o ld e rs ____ b. Foreign Private H o ld e rs ____ c. In te rn a tio n a l O r g a n iz a t io n s O th e r than I M F ............ ... Total 3.4 - .9 - .9 + - -9 1.3 + -9 + -9 - 1.3 - 1.3 .9 + 2.5 + -8 .9 2.2 .4 — + 6 .4 + 1-4 6 .4 + — 7 .6 6 .4 + .2 8 0 .6 2.5 + 1-4 .9 .4 .2 + 2.2 + 7 .6 8 0 .6 .9 1.3 .8 7.8 - .0 — + - 3 .8 + 3.8 - 6 .4 -2 9.8 * P re lim in ary * "C e r ta in N o te : n o n -liq u id lia b ilitie s to fo re ig n official age ncies. F igu res m a y not a d d b ecause o f ro u n d in g . Page 29 F E D E R A L R E S E R V E BA N K OF ST. LO U IS $1.3 billion, a figure much closer to historical levels. An increase in special liabilities, which is recorded as a capi tal inflow, improved the liquidity balance of $.5 billion in 1970 compared to a reduction of $.2 billion in 1969, which was recorded as an outflow. The sources of improvement in the liquidity balance in 1970 indicate there has been little fundamental change in the liquidity position in the past two years, even though the recorded liquidity bal ances fluctuated widely. Official Settlements Balance — The underlying assump tion about economic behavior is that only official holdings of dollars represent a meaningful potential claim on U.S. reserve assets. The official settlements balance was in deficit by $9.8 billion (including the allocation of SDR) in 1970 compared to a surplus of $2.7 billion in 1969 and a surplus of $1.6 billion in 1968. In 1968 and 1969 the rapid increase in Eurodollar borrowings by U.S. banks resulted in a drain of dollar holdings from foreign central banks as foreign private holders converted local curren Page 30 A P R IL 1971 cies into dollars at their central bank and deposited them in institutions abroad. Foreign central banks tried to re build their dollar position by selling gold to the United States and drawing dollars from the International Mone tary Fund. In 1970, when monetary conditions at home and abroad induced U.S. banks to repay to their foreign branches many of their Eurodollar borrowings, foreign private holders presented the dollars to their central banks for conversion back into local currencies. Foreign central banks financed the official settlements deficit in 1970 primarily by accumulating $7.6 billion of liquid claims on the United States. Only $2.5 billion of the deficit was financed by drawing on U.S. reserve assets, and $.5 billion by special liabilities. As with the liquidity balance, the shift in the official settlements balance between 1969 and 1970 was the result of the reversal of Eurodollar flows, and reflected little basic change in the underlying strength of the official U.S. external position. ERRATA The gray-screened portion of the following table was incorrect as published on page 18 of the M arch 1971 issue of this R e v i e w . The outlined portion of the table shows the correct figures (w ith the incorrect figures, as originally published, in parentheses). All other figures in the table w ere correct, and are reproduced below. The conclusions of the article, though not altered fundamentally, were modified in the direction of making the difference between the C E A projection and the St. Louis model projection, based on the C E A total spending assumption, slightly less pronounced than indicated in the article. W e thank Frank C. Ripley, Senior Staff Economist, Council of Econom ic Advisers, for pointing out this error. T a b le V II PRO JECTED C H A N G E S IN S P E N D IN G , O U T P U T , P R IC E S A N D U N EM PLO YM ENT — 1970 to 1972 ( Per C e n t * ) 1971 1972 1 II III IV Year 1 II III IV Year 1 3 .0 % 1 1 .5 % 9 .0 % 1 1 .4 % C E A Projection (2 / 2 / 7 1 )" 1 1 .8 % 1 1 .3 % 1 1 .7 % 1 1 .2 % 1 1 .0 % 1 0 .5 % Real Product 9 .4 6.8 7 .7 7.3 4 .6 8.0 7.8 7 .7 7.5 7 .7 Prices 3.2 4 .4 3.8 3 .7 4.2 3 .4 3.1 3.1 2.8 3 .4 U ne m p loym en t Rate 5 .7 5 .5 5 .2 4 .9 5 .3 4 .7 4 .5 4 .2 4 .0 4 .4 1 3 .0 1 1 .5 11.8 1 1 .3 9 .0 1 1 .7 1 1.2 1 1.0 10.5 1 1.4 T otal S p e n d in g St. Louis M o d e l Projections 1) with C E A total sp e n d in g a ssu m p tio n Total S p e n d in g 2) Real Product 9 .3 (8 .5 ) 6 .8 (6 .1 ) 7 .0 (6 .3 ) 6 .5 (5 . 9 ) 4 .4 (3 .9 ) 6 .8 (6 . 2 ) 6 .3 ( 5 . 9 ) 6.1 (5 . 8 ) 5 .7 (5 .5 ) 6 .5 (6 .0 ) Prices 3 .5 (4 .1 ) 4 .5 (5.1 ) 4 .6 (5 .2 ) 4 .6 (5 .2 ) 4 .4 (4 .9 ) 4 .6 (5 .2 ) 4 .7 (5 .1 ) 4 .7 (5 .0 ) 4 .7 (4 .9 ) 4 .6 (5 .2 ) U ne m p loym en t Rate 5 .6 (5 .6 ) 5 .6 (5 .6 ) 5 .4 (5 .5 ) 5 .2 (5 .4 ) 5 .5 ( 5 . 5 ) 5.1 ( 5 . 3 ) 4 .9 (5 .1 ) 4 .7 ( 5 . 0 ) 4 .6 ( 4 . 9 ) 4 .8 (5 .1 ) with 6 per cent m o n e y grow th a n d G o ve rn m e n t s p e n d in g b a se d on fiscal 1 9 7 2 b u d g e t (C E A p o licy a ssu m p tio n s) 11.1 6 .4 9.1 7.2 6 .9 6.9 8.1 7 .3 7 .0 7.5 Real Product 7 .6 2.0 4 .7 3 .0 2.5 2 .9 4 .4 3 .7 3 .7 3 .5 Prices 3 .2 4 .3 4 .2 4.1 4 .3 3 .9 3 .7 3.4 3.2 3.8 U ne m p loym en t Rate 5 .6 5 .8 5 .9 5 .9 5 .8 6 .0 6.1 6.1 6.1 6.1 Total S p e n d in g ♦Per cent changes for total spending, output and prices are a t compounded annual rates ; unemployment rates are levels. ♦♦Quarterly pattern estimated by this Bank based on the 1971 Annual R eport of the Council of Economic Advisers and am plifying statements by the CEA. Page 31 SUBSCRIPTIONS to this bank’s R e v ie w are available to the public without charge, including bulk mailings to banks, business organizations, educational institutions, and others. For information write: Research Department, Federal Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166.