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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
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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.

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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

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