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The Strong U.S. Dollar: A Dilemma for
Foreign Monetary Authorities
DALLAS S. BATTEN and JAMES E. KAMPHOEFNER

J S o L S T E R E D by higher short-term market in
terest rates and a lower rate of inflation than those
abroad, the U.S. dollar has been quite strong in foreign
exchange markets since the middle of 1980. Its tradeweighted value has risen 35 percent from July 1980 to
April 1982.1 The general strength of the dollar has
elicited sharp criticism from foreign monetary author
ities who argue that a stronger dollar forces them to
choose between two unpleasant alternatives: follow
domestic policies that result in historically high in
terest rates or accept depreciation of their currencies.
Within the standard conceptual framework of ex
change rate determination, movements of exchange
rates, in the short run, are caused primarily by changes
in interest-rate differentials.2 Specifically, an increase
in U.S. interest rates relative to those abroad should
result in an increase in the foreign currency value of
the dollar, other things equal. As the above criticisms
demonstrate, however, exchange rate movements also
may play an important role in influencing monetary

'The trade-weighted exchange rate is an average of the value of the
dollar against 10 other currencies weighted by each country’s trade
share. The countries included are Belgium, Canada, France, Ger
many, Italy, Japan, the Netherlands, Sweden, Switzerland and the
United Kingdom. For a more detailed explanation, see “Index of
the Weighted-Average Exchange Value of the U.S. Dollar: Revi
sion,” Federal Reserve Bulletin (August 1978), p. 700. The tradeweighted foreign interest rate presented below is a weighted
average of short-term market interest rates for the same countries
using the same weights.
2To be technically correct, short-run exchange rate movements are
motivated by differences in real interest rates, i.e ., market interest
rates adjusted for expected inflation. For a more thorough discus
sion, see Dallas S. Batten, “Foreign Exchange Markets: The Dol
lar in 1980,” this Review (April 1981), pp. 22-30. Consequently,
changes in market interest-rate differentials and movements of
exchange rates should be positively related only i f the changes in
market interest-rate differentials reflect changes in real interestrate differentials.

policy actions in some countries, which will be
reflected in turn by changes in their short-term domes
tic interest rates. That is, a foreign monetary author
ity’s response to changes in the exchange value of its
currency may be to pursue a policy that affects the
levels of its domestic interest rates. Consequently,
when observing movements of both the exchange rate
and the interest-rate differential, it is not immediately
clear whether a change in the differential causes the
exchange rate to change or whether the interest rate
change is a monetary policy response to the exchange
rate movement.
This element of uncertainty has been especially
prevalent for the first three quarters of 1981. Chart 1
presents the trade-weighted foreign currency value of
the dollar and the difference between the U.S. threemonth CD rate and the trade-weighted foreign in
terest rate. While these two series exhibit the expected
positive relationship before the first quarter of 1981
and after the third quarter of 1981, they display no
statistically significant relationship during the first
three quarters of 1981.3
On the other hand, chart 2 contains the tradeweighted foreign currency value of the dollar and the
trade-weighted foreign interest rate. The relationship
between these two series shows a much different pat
tern than that between the dollar and the interest-rate
differential. While demonstrating only a weak positive
relationship before 1981, the trade-weighted value of
the dollar and the trade-weighted foreign interest rate
'The calculated correlation coefficients between the trade-weighted
dollar exchange rate and the interest-rate differential reported
weekly for the approximate periods, I/1980-IV/1980, 1/1981-111/
1981 and IV/1981-II/1982, are .795, .158 and .828, respectively.
The corresponding critical values at the 5 percent level are .266,
.320 and .339, respectively.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C h art 1

Foreign Exchange V alu e of the Dollar and U.S.-Foreign
Interest Rate Differential

1980

1981

1982
S o u r c e : B o a rd o f G o v e r n o r s o f th e F e d e r a l R e s e rv e S y ste m

follow extremely similar paths during the first three
quarters of 1981. Beginning in the last quarter of 1981,
however, their paths diverge radically, with the tradeweighted foreign interest rate in April 1982 falling to its
July 1980 level, while the dollar continues to rise in
general.4 Foreign monetary authorities apparently
have been relatively more responsive to exchange rate
movements (especially of the dollar) during most of
1981 than previously. Moreover, it also appears that
foreign monetary authorities recently have changed
their response to an increasingly strong dollar.
The purpose of this article is to examine this recent
experience using an analytical framework that de
scribes and evaluates the policy alternatives available
to a foreign monetary authority whose currency is de
preciating. O f particular importance are the rela
tionship between external and internal policy objec

4The calculated correlation coefficients between the trade-weighted
dollar exchange rate and the trade-weighted foreign interest rate
for the periods listed in footnote 3 are .379, .899 and —.789,
respectively. The critical values are the same as those in footnote 3.

tives, the role played by exchange rate movements in
the formation of domestic monetary policy and the
consequences of the policy choice.

POLICY ALTERNATIVES
Since the difference between U .S. and foreign
short-term interest rates is a primary determinant of
short-run exchange rate movements, a monetary au
thority has essentially three policy choices when
domestic interest rates (adjusted for relative inflation
rates) are below those of another country. First, it can
do nothing and allow its exchange rate to depreciate
sufficiently to compensate for the interest differential.
In this case the economy will incur increased do
mestic unemployment in the short run as domestic
resources are reallocated from the production of non
tradable goods to the production of tradable goods in
response to changing relative prices. If the exchange
rate movement is expected to be only temporary,
however, this reallocation may be undesirable since
relative prices are expected to return to previous
levels. Furthermore, it is possible that domestic prices

AUGUST/SEPTEMBER

FEDERAL RESERVE BANK OF ST. LOUIS

1982

C h art 2

Foreign Exchange V alu e of the Dollar and the Foreign Interest Rate

Exchange rate
|S C A IE

Foreign interest rate

StALE|

S o u rc e : B o a rd o f G o v e r n o r s o f the F e d e r a l R e s e rv e System

may rise with the prices of imports as domestic demand
shifts to import-competing products.0
Second, it can adopt a tighter monetary policy to
raise short-term domestic interest rates, thereby re
ducing the interest-rate differential and mitigating the
downward pressure on its exchange rate.6 If this tight
er stance conflicts with the country’s domestic objec
tives, the short-run costs of this choice are increased
dom estic unem ploym ent and lower real output
growth.
Third, a monetary authority can intervene in foreign
currency markets by purchasing its own currency with
its reserves of foreign currency. This would increase
the demand for domestic currency relative to foreign
currency and produce, at least temporarily, a reduc
5See R. I. McKinnon, “Optimum Currency Areas,” American Eco
nomic Review (September 1963), pp. 717-24.
fThe monetary authorities of most of the industrial countries other
than the United States employ interest rate targeting as a means of
controlling their money supplies. Consequently, a desire to lower
the rate of money growth will lead to an increase in market interest
rates (at least in the short run). Casual observation of the rela
tionship between short-term market interest rates and the rate of
money growth in these countries supports this conclusion.

tion in the downward pressure on its exchange rate. It
is not immediately clear whether the intervention will
affect the exchange rate permanently. Consequently,
an investigation of the conditions under which in
tervention will permanently affect the long-run path of
exchange rate movements is crucial in determining
whether intervention can be effective in counteracting
the impact of unfavorable interest-rate differentials on
the exchange rate.'
In analyzing the permanent nature of the impact of
central bank intervention on the exchange rate, one
must distinguish sales or purchases of foreign curren
cies that affect the size of the domestic money supply

Intervention policy may not be necessarily aimed at permanently
affecting the exchange rate. Instead, its focus may be simply to
smooth short-run exchange rate fluctuations without having any
impact on the long-run path of exchange rate movements. In this
latter case, intervention that only temporarily affects exchange
rates is sufficient to accomplish this objective. See, for example,
Michael Mussa, “The Role of Official Intervention, Occasional
Paper No. 6 (Group of Thirty, 1981). The purpose of this article,
however, is to analyze policy alternatives designed to counteract
the impact of unfavorable interest rate differentials. Consequent
ly, the presumed goal of smoothing short-run exchange rate
fluctuations is ignored here.

FEDERAL RESERVE BANK OF ST. LOUIS

from those that do not.8 Specifically, intervention is
said to be “sterilized” if its impact on the domestic
money supply is offset by the sale or purchase of
domestic assets by the central bank. Intervention is
said to be “unsterilized” if its effect on the level of
commercial bank reserves and, consequently, the
domestic money supply is not offset (see box).

Unsterilized Intervention and
Exchange Rate Movements
Suppose, for example, that the Fed attempts to pre
vent the dollar from depreciating by purchasing dollars
with Deutsche marks (DM). If this intervention is
unsterilized, it can affect the exchange rate in at least
three ways. First, because the Fed’s purchase of dol
lars temporarily increases the flow demand for dollars
relative to the supply of dollars, the immediate effect
should be an appreciation of the dollar (or a deprecia
tion of the Deutsche mark).9 This result, however, will
be only transitory unless the Fed continues to pur
chase dollars day after day, thereby maintaining the
higher flow demand for dollars. 10
Second, since this transaction is unsterilized, it
causes the U.S. money supply to fall and the German
money supply to rise. All other things equal, there will
be an excess demand for U.S. money in the United
States and an excess supply of German money in West
Germany — a stock disequilibrium that can be rec
tified only if aggregate spending falls in the United
States and rises in Germany. This decline in U.S.
spending and rise in German spending will cause the
general price level in the U.S. to fall and that in Ger

bFor convenience, it is assumed that all intervention operations are
performed by the central bank. See A. B. Balbach, “The Mechan
ics of Intervention in Exchange Markets,” this Review (February
1978), pp. 2-7, for a discussion of various other types of interven
tion operations.
9If the purpose of the intervention activity is to “lean against the
wind,” its impact may be insufficient to offset completely the effect
of changes in fundamental determinants of the movement of the
exchange rate. Consequently, intervention activity may not com
pletely reverse the direction of exchange rate movements, but only
slow the rate of change.
10All other things equal, if the increased flow demand is not main
tained, demand and supply conditions in foreign currency mar
kets will return to what they were prior to the Fed’s intervention
activity. H ence, this impact would only be temporary. See
Michael Mussa, “Empirical Regularities in the Behavior of Ex
change Rates and Theories of the Foreign Exchange Market,” in
Karl Brunner and Allan H. Meltzer, eds., Policies fo r Employ
ment, Prices, and Exchange Rates, Carnegie-Rochester Confer
ence Series on Public Policy, supplement to the Journal o f Mone
tary Economics, Volume 11 (1979), pp. 9-57, especially pp. 27-38.

AUGUST/SEPTEMBER

1982

many to rise and, at the same time, motivate a perm a
nent appreciation of the dollar. 11
Finally, market participants may interpret the de
crease in the U.S. money stock as an indication of
further tightening of monetary policy by the Fed in the
future. Since an exchange rate is the relative price of
two specific financial assets (the two domestic monies
involved), it is crucially influenced by expectations
about the course of future events. Consequently, ex
pectations of a tighter U.S. monetary policy in the
future should place additional upward pressure on the
current D M/dollar exchange rate as market partici
pants anticipate the lower U.S. and higher German
price levels described above.12

Sterilized Intervention and
Exchange Rate Movements
The immediate impact of sterilized intervention is
the same as that for unsterilized intervention; that is, it
creates a transitory increase in the flow demand for
dollars, causing a temporary appreciation of the DM/
dollar exchange rate. The net effect of sterilized in
tervention, however, is simply a purchase of domestic
securities with foreign securities. Consequently,
neither country’s money supply will be affected; in
stead, private portfolios will contain fewer dollardenominated and more DM-denominated securities.
Inasmuch as sterilized intervention affects neither
the monetary factors that influence the long-run be
havior of prices nor the real factors that determine the
relative competitiveness of the economies, it is unclear
initially what lasting impact it has on the DM/dollar
exchange rate. It can have a permanent impact on the
exchange rate if the public views domestic and foreign
securities as being im perfect substitutes for each
other. 13 Because these securities are denominated in
different currencies, it is argued, the impact of exchange-rate movements and the possibility of exu See, for example, Batten, “Foreign Exchange Markets.”
I2See lacob A. Frenkel, “Flexible Exchange Rates, Prices, and the
Role of News’: Lessons from the 1970s,” Journal o f Political
Economy (August 1981), pp. 665-705.
1!See Dale W. Henderson, “Modeling the Interdependence of
National Money and Capital Markets,” American Economic Re
view (February 1977), pp. 190-99; Lance Cirton and Dale Hen
derson, “Central Banks Operations in Foreign and Domestic
Assets Under Fixed and Flexible Exchange Rates,” in Peter B.
Clark, Dennis E . Logue, and Richard J. Sweeney, eds., The
Effects o f Exchange Rate Adjustments (Government Printing
Office, 1976), pp. 151-79; Peter Isard, Exchange-Rate Determina
tion: A Survey o f Popular Views and Recent Models, Princeton
Studies in International Finance No. 42 (Princeton University
Press, 1978).

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

The Mechanics of Foreign Exchange Market Intervention
Suppose that the Federal Reserve purchases dollars
(in other words, sells foreign currency — most often
Deutsche marks) in foreign exchange markets in an
atte m p t to p re v e n t (or slow) th e d ollar from
depreciating. 1 To do this, the Fed must have some
Deutsche marks, which it typically acquires either by
selling some of its non-negotiable DM-denominated
securities to the Bundesbank or by borrowing DM
from the B u nd esban k in exchange for a D M denominated account. Since both of these transactions
are between central banks only, they have no impact
on the size of either country’s money stock.
The Fed then buys dollar-denominated demand de
posits of foreign commercial banks held at U.S. com
mercial banks and pays for them from its DM deposits
at the Bundesbank. This produces an increase in for
eign com m ercial banks’ reserve accounts at the
Bundesbank and a decrease in their demand deposits
held at U.S. commercial banks. On the other hand, for
U.S. commercial banks, both their reserve accounts at
the Fed and their demand deposit liabilities to foreign
commercial banks have declined. Since U.S. commer
cial banks’ reserves have fallen while German commer
cial banks’ reserves have risen, the U.S. money stock
will decrease and West Germany’s money supply will
increase as a result of this foreign exchange market
operation.
As this example of unsterilized intervention shows,
'Although the Federal Reserve is portrayed here as the initiator of
exchange market intervention, the analysis would not differ signif
icantly in the case of intervention by foreign authorities.

change or capital controls adds an element of risk to the
holding of foreign assets that cannot be totally elimi
nated with a diversified portfolio.14
If dollar-denominated and DM-denominated secur
ities were perfect substitutes, no change in the ex
change rate or in interest rates would be required to
motivate investors to hold the new portfolio that con
tains few er dollar-denom inated and more DM denominated securities. If, however, these securities
are not perfect substitutes, investors will be unwilling
to hold the new portfolio and, at the original exchange
rate and interest rates, an excess demand for dollar1'See Girton and Henderson, “Central Bank Operations,” pp. 15253.

the U.S. money supply has not been insulated from the
foreign exchange market transaction. If, however, cen
tral banks do not want their foreign exchange interven
tion to affect their domestic money supply, they may
sterilize its impact with an offsetting sale or purchase of
domestic assets. Continuing the previous example, if
the Fed does not want U.S. commercial banks to lose
reserves as a result of its foreign exchange intervention
to support the dollar, it can purchase U.S. government
securities equal to the amount of the reserves that
banks lose, thereby maintaining the level of reserve
accounts of the U.S. commercial banks. In this man
ner, the negative impact of intervention on the re
serves of U.S. commercial banks is exactly offset with
no subsequent change in the U.S. money stock.
In a similar fashion, the Bundesbank could neutral
ize the impact of the U.S. intervention on the German
money supply by draining the newly created reserves
from the West German commercial banking system.2
If completely sterilized, the foreign exchange opera
tion affects neither country’s money supply. Private
portfolios contain fewer dollar-denominated securities
and more DM -denominated securities, while the
F ed ’s portfolio contains more dollar-denominated
and fewer DM-denominated securities.

2The institutional arrangements for accomplishing this may differ
across the countries; the exact means used are not important here.
Moreover, if the Fed acquired DM (used to purchase dollars) by
selling DM-denominated securities in private capital markets, the
German money supply would not be affected by the intervention
activity, and the Bundesbank would not have to sterilize the opera
tion.

denominated securities (and an excess supply of DMdenominated securities) will exist. Consequently, in
vestors will attempt to acquire additional dollardenominated securities and sell DM-denominated
securities in order to return their portfolios to the
desired proportion of dollar-denominated to DMdenominated securities, placing upward pressure on
the DM value of the dollar. 10 In other words, even
though the two domestic money supplies have been
unaffected by the intervention activity, the resulting
portfolio disequilibrium (caused by foreign and domes
tic securities being imperfect substitutes) has a perma
nent impact on the exchange rate.
15The realignment of portfolios will, at the same time, place upward
pressure on German interest rates and downward pressure on
U.S. interest rates.

FEDERAL RESERVE BANK OF ST. LOUIS

Since the efficacy of sterilized intervention hinges
on the imperfect substitutability of foreign and domes
tic securities, the degree of substitutability that actual
ly exists is crucial. Empirical tests of the existence of
this risk have yielded mixed results. 16 Thus, whether
sterilized intervention has a significant lasting impact
on exchange rates remains uncertain.

Intervention and Monetary Policy
It seems that if the monetary authority wants to
influence permanently the path of its exchange rate,
and not merely dampen short-run fluctuations, it must
engage in unsterilized intervention. It is clear, howev
er, that unsterilized intervention is tantamount to con
ducting monetary policy through foreign exchange
market operations. Hence, in this case, intervention is
not really an alternative to monetary policy but merely
a variant of it. Only sterilized intervention is a distinct
policy alternative.
Since there can be only a single monetary policy
stance, the role of unsterilized intervention depends
critically on the importance that policymakers place on
the exchange rate in relation to other economic vari
ables, as a factor influencing the conduct of monetary
policy. In particular, the use of unsterilized interven
tion (with the concomitant impact on the domestic
money supply) implies that the monetary authority
places relatively more importance on reducing the
risks and the real economic disturbances associated
with exchange rate movements than on influencing
domestic prices, output and employment.
Since the exchange rate is the relative price of two
domestic monies, it is affected, among other things, by
changes in the demand for foreign money, actual and
expected policy changes of foreign monetary author
ities, and whatever changes emanate from within the

16Jeffrey A. Frankel, “A Test of the Existence of the Risk Premium
in the Foreign Exchange Market vs. the Hypothesis of Perfect
Substitutability,” International Finance Discussion Paper No.
149 (Board of Governors of the Federal Reserve System, August
1979) finds no support at all for the existence of a risk premium.
Alternatively, Richard Meese and Kenneth J. Singleton, “Ration
al Expectations, Risk Premia, and the Market for Spot and For
ward Exchange,” International Finance Discussion Paper No.
165 (Board of Governors of the Federal Reserve System, July
1980) concludes that the failure of the forward exchange rate to be
an unbiased predictor of the future spot rate is a consequence of
the existence of a risk premium. Finally, Maurice Obstfeld, “Can
W e Sterilize? Theory and Evidence,” N BER Working Paper No.
833 (January 1982) finds evidence of imperfect asset substitutabil
ity, but questions the ability of central banks to exploit it. That is,
imperfect asset substitutability appears to be a necessary, but may
not be a sufficient, condition for sterilized intervention to have a
significant impact on the exchange rate.

AUGUST/SEPTEMBER

1982

domestic economy itself. Directing domestic mone
tary policy at an exchange rate target, therefore, sub
jects the economy to both domestic and foreign in
fluences. Consequently, the monetary authority loses
its ability to control its own money supply indepen
dently of foreign actions and events.17
The desire to influence the movement of exchange
rates without losing control of the money supply is the
primary rationale for using sterilized intervention. As
discussed above, however, it is not clear that sterilized
intervention has a significant lasting impact on ex
change rates. Sterilized intervention may be an
appropriate policy to reduce unwanted short-run
variability of exchange rates for which there may be no
readily identifiable cause. When monetary authorities
desire to alter the path of exchange rate movements,
however, sterilized intervention may be inadequate.
Consequently, monetary policymakers must choose
between internal and external objectives. 18

RECENT EXPERIEN CE
Monetary authorities seldom choose the first policy
alternative discussed above; they don’t appear to like
to “do nothing” about the problems that they face.
Studies of central banks’ demand for and use of foreign
currencies, as well as reports from central banks them
selves, indicate that large-scale intervention in foreign
currency markets has continued since the movement
to floating exchange rates in 1973.19 If central bankers
desire to influence exchange rates, the policy choice
narrows down to sterilized or unsterilized interven
tion. Although policymakers might prefer sterilized
intervention, since it appears to allow them to separate

17The extreme case is the one in which the monetary authority
desires to maintain a completely fixed exchange rate. In this case,
the monetary authority has no ability at all to influence the size of
its domestic money supply. See Herbert G. Grubel, Internation
al Economies (Richard D. Irwin, Inc., 1977), pp. 375-80.
18For an example of a monetary authority’s recognition of this dilem
ma, see Monthly Report o f the Deutsche Bundesbank (February
1981), p. 7.
19See, for example, Dallas S. Batten, “Central Banks’ Demand for
Foreign Reserves Under Fixed and Floating Exchange Rates,”
this Review (March 1982), pp. 20-30; Jacob Frenkel, “The De
mand for International Reserves Under Pegged and Flexible
Exchange Rate Regimes and Aspects of the Managed Float, ” in
David Bigman and Teizo Taya, eds. The Functioning o f Floating
Exchange Rates (Ballinger, 1980), pp. 161-95; H. Robert Heller
and Mohsin S. Kahn, “The Demand for International Reserves
Under Fixed and Floating Exchange Rates,” IM F Staff Papers
(December 1978), pp. 623-49; and John Williamson, “Exchange
Rate Flexibility and Reserve U se,” Scandinavian Journal o f Eco
nomics (No. 2, 1976), pp. 327-39.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 1
Quarterly Money Growth fo r Selected Countries
(compounded annual rates, seasonally adjusted)
Country

111/80

IV/80

1/81

IV/81

I/82

13.2%

-3 .8 %

-1 6 .0 %

14.8%

France

8.3

10.2

11.3

13.2

18.8

N.A.

Germany

4.5

9.5

- 1 .6

- 4 .8

- 1 .6

0.5

5.6

11.8

16.2

16.8

4.5

3.0

10.1

15.5

-6 .1

- 3 .5

2.6

21.0

3.3

11.0

8.7

6.7

10.2

4.9

- 5 .3

- 4 .9

5.7

13.5

5.5

4.8

-1 0 .4

2.8

-5 .1

14.7

41.5

-2 .0

13.1

15.8

14.5

5.1

1.4

10.1

Italy
Japan
Netherlands
Switzerland
United Kingdom

4.7%

111/81

Canada

16.3%

1.1%

11/81

SOURCE: Federal Reserve Bank of St. Louis, International Economic Conditions.

exchange rate policy from domestic monetary policy,
they have come to realize that sterilized intervention
will not suffice, at least in some situations. The last year
and a half provides a good example of the trade-oft
inherent in the choice of intervention policy.
From the middle to the end of 1980, the foreign
currency value of the dollar rose along with U .S.foreign short-term interest differentials. During this
period (actually, since about November 1978), the
U.S. monetary authority had intervened frequently
and on a consistently large scale in foreign currency
markets; it primarily “leaned against the wind, ” that is,
bought dollars when the dollar was depreciating and
sold dollars when it was appreciating.
With the advent of the Reagan administration, the
Treasury announced that it (along with the Federal
Reserve) would cease daily intervention except for
periods of substantial exchange market volatility. This
removed an extremely large and cooperative partici
pant from foreign currency markets. Consequently,
foreign monetary authorities who desired to remain
active in foreign currency markets were faced with two
policy options if they wished to have the same impact
on exchange rates as before: either increase the
amount of their intervention (if they wished to con
tinue to sterilize it) or sterilize less of their existing
intervention.
The magnitude of foreign central bank intervention
activity has not changed significantly since the change
in U.S. intervention policy. There is evidence, howev
er, of more unsterilized intervention since this change.
Table 1 contains the quarterly rates of M l growth for
several major industrial countries that are important
trading partners of the United States. Except in France
and Japan, M l growth in each country displays a sig

nificant slowing during 1981.20 The abruptness of this
change can be seen more clearly in table 2 , which
reports three-month money growth rates for five of
these countries. Not surprisingly, foreign short-term
market interest rates also began to rise rather dramati
cally in early 1981. In fact, as shown in chart 2, market
interest rates of the major trading partners of the
U nited States generally moved with the tradeweighted exchange rate during the first three quarters
of 1981, apparently because foreign monetary author
ities were tightening th eir m onetary policies in
attempts to mitigate the rise of the U.S. dollar.21

20Even though Canada is the only country considered that explicitly
targets on the M l definition of money, this definition is employed
because it has been found to be an appropriate indicator of mone
tary policy. See Dallas S. Batten, “Money Growth Stability and
Inflation: An International Comparison,” this Review (October
1981), pp. 7-12; and Dallas S. Batten and B. W. Hafer, “ShortRun Money Growth Fluctuations and Real Economic Activity:
Some Implications for Monetary Targeting,” this Review (May
1981), pp. 15-20. For France, however, M l growth may be a poor
indicator of the stance of monetary policy after Mitterand took
office in mid-1981. The new administration imposed severe in
terest rate ceilings on savings and time deposits, which motivated
relatively large flows from accounts not included in M l to
accounts included in M l. The net result was extremely rapid M l
growth.
21The relationship between the trade-weighted value of the U.S.
dollar and the trade-weighted foreign interest rates (shown in
chart 2) is much closer in the first three quarters of 1981 than in
any interval since the beginning of the United States’ pro
intervention stance. Obviously, all monetary policy actions taken
by these countries do not necessarily reflect the desire to achieve
exchange rate objectives. For example, Germany has experi
enced a large current account deficit and Canada and Switzerland
have each encountered accelerating domestic inflation. The mag
nitude of the change in money growth at the beginning of 1981
and the fact that the timing of the response so closely paralleled
the change in U.S. policy, however, certainly provide a casual
verification that exchange rate objectives have played an impor
tant role.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 2
Three-Month Money Growth fo r Selected Countries
(compounded annual rates, seasonally adjusted)
Date
1980 October
November
December
1981 January
February
March
April
May
June
July
August
September
October
November
December
1982 January
February
March

Canada

Germany

18.3%
22.2
8.9

9.6%
16.6
2.5

Italy
10.2%
13.4
24.5

Netherlands
11.9%
8.2
10.4

Switzerland
7.4%
4.7
2.4

1.9
- 4 .3
6.2
11.1
8.2
- 4 .6
6.7
- 7 .0
-1 0 .6
-2 8 .7
-1 9 .8
22.7

7.0
- 3 .8
-7 .1
-1 1 .5
-8 .2
6.0
2.9
3.4
- 6 .6
-4 .1
0.8
5.1

20.7
17.7
11.7
5.7
3.7
6.5
5.2
2.2
0.9
3.8
6.6
21.9

9.9
6.5
- 1 .7
- 2 .8
- 4 .8
- 8 .2
-1 0 .7
- 5 .0
1.4
8.8
9.8
-1 .1

- 6 .3
-7 .7
-1 6 .8
1.6
2.7
4.1
- 2 .9
- 5 .7
- 6 .8
-1 7 .1
-1 4 .0
99.6

32.6
28.9
- 0 .5

9.9
2.2
4.9

24.7
21.4
2.1

8.6
2.9
28.7

88.2
94.0
-1 7 .7

SOURCES: Bank o f Canada Review; Monthly Report of the Deutsche Bundesbank; Board of Gov
ernors of the Federal Reserve System; and International Monetary Fund, International Financial Statis
tics. Germany and Italy seasonally adjusted by this Bank.

These policy decisions to limit the rise in the ex
change value of the dollar, however, were not costfree, as charts 3 and 4 show. Continued economic
stagnation was the price paid for redirecting monetary
policy. Except for Japan, all countries experienced
rising unemployment and little or no real economic
growth during the first three quarters of 1981.
In light of the economic conditions at the time, it is
not too surprising that foreign central banks responded
differently to a rising U.S. dollar at the end of 1981 and
the beginning of 1982 than they did at the beginning of
1981. In particular, the re-emergence of a strong dollar
at the end of 1981 did not elicit a tighter monetary
policy stance and the subsequent higher short-term
interest rates that had occurred at the beginning of the
year.22 Since, in general, these countries have con
tinued to experience economic stagnation, it appears

22The increase in the rates of money growth abroad at the beginning
of the fourth quarter of 1981 most likely contributed to the subse
quent rise in the foreign currency value of the dollar. The point
made, however, is that once a relatively strong dollar re-emerged,
foreign monetary authorities did not appear to respond in the
same manner as they had at the beginning of 1981.

that central banks were unwilling to exacerbate the
situation by subjecting their economies to even tighter
monetary conditions necessary to raise domestic in
terest rates further and moderate the rise of the dollar.
In fact, foreign short-term interest rates fell consider
ably during the last quarter of 1981 and the first quarter
of 1982. Thus, foreign central banks now seem willing
to allow the foreign exchange value of their currencies
to depreciate instead.

SUMMARY AND CONCLUSIONS
This article has attempted to describe, using a sim
ple analytical framework, both the policy alternatives
available to a central bank and their consequences.
During the floating exchange rate period, central
banks consistently have intervened in foreign currency
markets. Because unsterilized intervention diminishes
a central bank’s ability to control its domestic money
stock, it generally has opted to separate external and
internal policy objectives by sterilizing the impact of
intervention on its money stock. Sterilization, howev
er, decreases the efficacy of intervention. Consequent
ly, foreign central banks welcomed the U .S .’ pro-

C hart 3

Growth of Real Output

.--

Percent

S e a son a lly A dju ste d

tP
□IV/78-IV/79
□

IV/79-IV/80

□

IV/8 OHV/8 I

Canada

France

Germ any

_L
Japan

Ita ly

United Kingdom

S o u r c e : F e d e r a l R e s e r v e B a n k o f St. L o u i s , I n t e r n a t i o n a l E c o n o m i c C o n d i t i o n s .
* F o r F r a n c e , t h e d a t a a v a i l a b l e is f o r 111/81.

C h a rt 4

Unem ployment Rate
Percent

Percent

S e a s o n a lly A d ju s te d

□

IV/79

□

IV/80

□

l/82

—

m
_ _

—

—
—

1
Canada

France

Germ any

i
Ita ly

S o u rc e : U.S. D e p a r tm e n t o f C o m m e rc e , In te r n a t io n a l E c o n o m ic In d ic a to r s .

1
Japan

N etherlands

United Kingdom

FEDERAL RESERVE BANK OF ST. LOUIS

intervention stance initiated in late 1978 and were
disappointed with the Reagan administration’s deci
sion to abandon this position in February 1981.
The evidence presented in this article suggests that
the February 1981 policy change has forced foreign
central banks that wish to influence exchange rate
movements to alter their domestic monetary growth
rates. In particular, since the exchange value of the
U.S. dollar generally has been rising during the past

AUGUST/SEPTEMBER

1982

two years, foreign central banks have had to choose
between allowing their currencies to depreciate and
changing their monetary growth rates drastically. They
chose the latter in early 1981. Money growth slowed
dramatically, resulting in continued domestic econom
ic stagnation in many of the countries examined. Since
the end of 1981, they have opted for the former policy
choice and, as a result, the foreign exchange value of
the dollar has increased substantially while money
growth in the various countries has eased.

The Link Between Money and Prices in
an Open Economy: The Canadian
Evidence from 1971 to 1980
MICHAEL D. BORDO and EHSAN U. CHOUDHRI

S I lN C E 1970, Canada ostensibly has followed a flexi
ble exchange rate policy that should have allowed their
monetary authorities to focus directly on controlling
the Canadian inflation rate. Since 1975, the Canadian
monetary authorities have been publicly committed to
reducing inflation by a policy of gradually reducing the
rate of monetary growth. Yet Canada has fared no
better than the United States and other industrialized
economies in controlling inflation during the 1970s. As
table 1 shows, the average rate of Canadian money
growth decreased from about 13 percent in 1971-75 to
8 percent in 1976-80, while the average rate of inflation
remained unchanged at about 8 V2 percent in these two
periods.
In this paper, we use a quantity theory framework to
examine Canadian inflation over the past decade. In
addition to assessing the impact of money growth on
price changes, we test for the influence of other factors
commonly believed to have contributed to Canadian
inflation, for instance, the relative price of energy,
Canadian wage-push and the rate of unemployment.
Finally, we examine the influence of U.S. monetary
growth and inflation on Canadian money growth and
inflation. We find that Canadian inflation is largely
explained by lagged Canadian money growth. Fur
thermore, we determine that Canadian monetary poli
cy has not been independent from that of the United
States: we find evidence of a link between Canadian
and U.S. monetary growth in addition to a direct link
between the U.S. and Canadian inflation rates.

*Michael D. Bordo is a professor o f economics at the University o f
South Carolina, Ehsan U. Choudhri is an associate professor o f
economics at Carleton University. This article was written while
Professor Bordo was a visiting scholar at the Federal Reserve Bank
o f St. Louis.

Table 1
Canadian Money Growth and Inflation
Rate of money growth
(M1)

Rate of inflation
(GNP deflator)

1971

12.6%

1972

14.2

3.2%
5.0

1973

14.6

9.2

1974

9.5

15.3

1975

13.7

10.8

1976

8.1

9.5

1977

8.4

7.0

1978

10.4

6.4

1979

7.2

10.3

1980

6.4

10.6

1971-75

12.9

8.6

1976-80

8.0

8.7

1971-80

10.4

8.7

THE RELATIONSHIP BETW EEN
MONEY AND PRICES: A GENERAL
FRAMEWORK
One way to enhance our understanding of a complex
system is to begin with a simple model of that system.
Thus, it is instructive to consider first an economy in
which market information is transmitted rapidly, and
prices and wages adjust smoothly to maintain equilib
rium continuously in all markets.

FEDERAL RESERVE BANK OF ST. LOUIS

The Money-Price Link in a Frictionless
Economy
In a smoothly operating, frictionless economy, the
rate of change in prices would be determined largely
by the rate of growth in the money stock. This can be
derived from the well-known quantity theory of
money. The quantity theory is usually written as:
(1) MV = PY,

where M is the stock of money, V is the velocity with
which money circulates (the number of times money is
used on average to finance final transactions), P is the
price level and Y is the level of real income or output.
According to the modern version of the quantity
theory, V is a stable function of a few variables such as
long-term income, interest rates and inflationary
expectations. 1 I f V is constant or changing at a steady
rate and Y is growing at a steady rate, changes in P
would be directly related to changes in M.2 Expressed
as rates of change, the quantity theory can be ex
pressed as:

AUGUST/SEPTEMBER

1982

labor unions) or the relative price of energy could play
only a limited role in explaining the rate of inflation.
These factors could temporarily affect u (via their
potential effect on full-employment output and veloc
ity), but as long as there is no monetary accommoda
tion— that is, as long as m is not influenced by these
factors— their effect is likely to be short-lived.
Furthermore, in a frictionless economy, no special
problem is created if the domestic rate of inflation
differs from those in other countries. In such a case, the
exchange rate could adjust continuously to reconcile
differences between domestic and foreign rates of
inflation.4 For instance, if the domestic rate of inflation
is 10 percent and the rate of inflation in the foreign
economy is only 5 percent, the exchange rate— de
noted as the number of units of the foreign currency
that could be purchased by one unit of the domestic
currency— would depreciate by 5 percent in each
period and only this specific depreciation would keep
the relative price of domestic and foreign goods the
same.

(2) p = m + u,

where lowercase letters represent the values in natu
ral logarithms and a dot indicates a first difference.
Thus, p is the rate of change in the price level, m is the
rate of change in the money stock and u is a residual
term that represents the difference betw een the rate of
change in velocity and that in output (u = v — y).
If output and velocity grow at the same long-term
rate, the average value of u would equal zero and the
average rate of inflation per year would equal the rate
of monetary growth. Deviations in velocity or output
growth from their long-term trend values could cause
the value of u to deviate temporarily from zero. To the
extent that such changes are transitory, they only tem
porarily influence the rate of inflation.3 In this sense,
inflation is essentially a monetary phenomenon; that is,
continuous growth in the money supply is necessary to
sustain it.
In the above environment, factors such as increases
in either real wages (brought about, say, by aggressive

'See Milton Friedman, A Theoretical Framework for Monetary
Analysis (National Bureau of Economic Research, 1971).
2Given smooth adjustment in our economy, long-term growth in
real output would depend essentially on factors such as technolog
ical advance and population growth.
3For a discussion of the influence of nonmonetary factors such as a
supply shock on the price level and the rate of price change, see
Denis S. Karnosky, “The Link Between Money and Prices— 19711976,” this Review (June 1976), pp. 17-23.

The Effect o f Frictions on the
Money-Price Link
We do not live in a frictionless world. There are
frictions in the adjustment process, for example, that
arise from lags in the transmission of price information
from one market to another and from inertia in the
movement of wages and prices.0 Given these informa
tion lags and temporary wage-price inflexibilities, the
effect of monetary growth on inflation will not be
reflected fully in one period; rather, it will be distrib
uted over a number of periods.6 Taking these lags into
account, the relationship between money and prices
can be modeled as
(3) p = in + E,

'Ileal factors, such as changes in tastes, technology or the supplies of
factors of production, also can affect the exchange rate.
’Information lags have been emphasized by Robert E . Lucas, “E x
pectations and the Neutrality of Money,” Journal o f Economic
Theory (April 1972), pp. 103-24; “An Equilibrium Model of the
Business Cycle, ” Journal o f Political Economy (December 1975),
pp. 1113-44. A recent explanation of wage-price stickiness is that,
under conditions of uncertainty, transactions in markets with rapid
price adjustments are costly, and therefore wages and prices may
be changed infrequently to save these transaction costs. See
Michael D. Bordo, “The Effects of Monetary Change on Relative
Commodity Prices and the Role of Long-Term Contracts "Journal
o f Political Economy (December 1980), pp. 1088-1109.
&See, for example, the discussion by Keith M. Carlson, “The Lag
from Money to Prices,” this Review (October 1980), pp. 3-10.

AUGUST/SEPTEMBER

FEDERAL RESERVE BANK OF ST. LOUIS

where ni is some weighted average o f past monetary
growth rates — call it the long-term or trend rate of
monetary growth— and e is a residual term.
Several caveats, however, should be added to this
simple representation of the lag between money and
prices. First, theoretical analysis does not specify the
pattern of weights that should be used in calculating
the long-term monetary growth rate— it must be dis
covered empirically. Also, because these weights rep
resent the lags between money and prices embedded
in a particular policy regime and institutional setting,
they will shift with significant changes in policy and
institutions. 7 Second, e represents the influence of all
factors other than monetary growth. The effect of these
factors also operates with lags and cannot be simply
dismissed, at least theoretically, as a temporary devia
tion. Finally, in a nonfrictionless economy, the ex
change rate need not change smoothly to offset exactly
the difference between foreign and domestic inflation
rates.8 Thus, the economy generally will not be im
mune from the influence of inflation in the rest of the
world.

DETERMINANTS OF CANADIAN
INFLATION DURING 1971-80
The Role o f Long-Term Monetary Growth
W e begin by examining the influence of long-term
monetary growth. As discussed above, the specific
long-term monetary growth rate that best explains
inflation must be estimated empirically. We found
that, for the I/1971-IV/1980 period, a simple 12quarter average of past growth rates of Canadian M l
provides an adequate measure of the long-term mone
tary growth rate for Canada.9 The effect of long-term
7For instance, Robert E. Lucas, “Econometric Policy Evaluations,”
in Karl Brunner and Allan H. Meltzer (eds.), The Phillips Curve
and the Labour Market (North Holland, 1976), has argued that the
structure of the economy depends upon the conduct of policy.
8See Jacob Frankel, “The Collapse of Purchasing Power Parities
During the 1970s,” European Economic Review (February 1981),
pp. 145-65.
"We regressed the rate of inflation on the simple average of past
monetary growth rates, using three alternative definitions of
money (M l, M1B and M2) and alternative averaging periods,
differing by two-quarter intervals (2, 4, 6. . .). A 12-quarter aver
age of M l worked best in the sense of giving the lowest standard
error of the regression. This procedure constrains the weights on
past growth rates to be equal. To test this constraint, we estimated
the following regression:
12

Pt = a +

bj riit-j + e.

i— 1

In the above regression, the hypothesis that b! = b2. . b12, could
not be rejected at the conventional 5 percent level. Finally, note

1982

monetary growth, thus measured, on the quarterly
rate of inflation in Canada is shown in regression equa
tion 1 in table 2 and is illustrated in chart 1. The chart
shows: (a) the actual rate of inflation measured by the
quarter-to-quarter change in the GNP deflator over
the period and (b) the rate of inflation predicted by the
long-term monetary growth rate from equation 1 in
table 2.
As chart 1 shows, the predicted rate traces quite well
the sharp rise in the inflation rate up to 1974 and the
gradual decline in the subsequent three years. The
chart also shows that the inflation rate was much higher
than the predicted rate in 1974 and, more recently, in
1979 and 1980.
To facilitate a comparison between the U.S. and
Canadian inflation experience, chart 2 presents the
actual and predicted rates of inflation in the United
States using the same procedure as for the Canadian
data (regression estimates for the United States are
shown in equation 4, table 2).10 As in the Canadian
case, the simple 12-quarter average of M l growth pre
dicts inflation quite well. Note, however, that the pre
dicted rate shown in the chart also includes the effect of
price controls in the United States.

Nonmonetary Influences on Canadian
Inflation
Having accounted for the direct impact of monetary
growth on the Canadian inflation rate, we now consid
er certain nonmonetary factors that are potential
causes of the residual inflation rate (the difference
between the actual inflation rate and the rate predicted
by long-term monetary growth). First, it is possible
that the Canadian wage and price controls adopted at
the end of 1975 and terminated in the third quarter of
1978 had some impact on Canadian inflation. If these
controls were effective, the residual inflation rate

that we have not constrained the coefficient of in (m, =
12

X mt_j/12) to be equal to unity.
i= l
l0A 12-quarter average of M l worked best for the U.S. data. The
U.S. evidence also was consistent with the hypothesis that the
weights on lagged monetary growth rates are all equal. In the U.S.
regression, we also have included price-control and decontrol
dummies as defined in Carlson’s paper.
Note that the coefficient on M > 1 may reflect the impact of higher
energy prices in the United States which are not captured expli
citly in the U.S. equation. See Carlson, “The Lag from Money to
Prices.” This paper also provides estimates of the U.S. moneyprice relationship using Almon lags and including additional vari
ables. Also see John A. Tatom, “Energy Prices and Short-Run
Economic Performance,” this Review Qanuary, 1981), pp. 3-17.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 2
Estimates of the Money-Price Relationship in Canada and the United States:
1/1971 -I V/1980
Equation
Canada

(1)

(2)

(3)

United States

(4)

Constant

.003

.772

( -40)

(2.29)

DUMC

DUMA

-.0 0 7

1.205

-.0 0 5

.009

(-1 .3 5 )

(5.90)

(-2 .1 8 )

(2.33)

- .0 0 8

1.119

-.0 0 5

.009

.190

( -1 .7 1 )

(5.77)

(-2 .0 5 )

(2.65)

(2.50)

-.0 0 6

1.555

-.0 0 4

.008

(-1 .7 5 )

(6.66)

(-3 .3 8 )

(4.09)

2.14*

.375*

102

.725*

1.94

.525

.687

2.33

.597

.641

1.88

.706

.316

12
NOTE: The dependent variable is p where pis the log of GNP deflator, rfi = ( 2 mH)/12, where m is the log of M1. DUMC is the price control
i= 1
dummy (for Canada, equal to one over IV/1975-111/1978, zero elsewhere; for the United States, equal to one over 111/1971 -1/1974,
zero elsewhere). DUMA is the dummy for the after-control period (for Canada, equal to one over IV/1978-111/1979, zero elsewhere;
for the United States, equal to one over 11/1974-IV/1974, zero elsewhere), r represents the log of an index of energy prices divided by
the GNP deflator. R2 is the coefficient of determination corrected for degrees of freedom, SE is the regression standard error and
DW is the Durbin-Watson statistic, (t-values are shown in parentheses.)
•Equation 1 is estimated using Cochrane-Orcutt adjustment with p = .357 .

should be negative during the period of controls and
positive immediately thereafter. 11 This pattern is sug
gested by chart 1 and is confirmed by equation 2 in
table 2, where the price control dummy (DUMC) is
significantly negative and the dummy variable for the
one-year period following the end of controls (DUMA)
is significantly positive.
Second, the relative rise of energy prices, which has
been regarded as a significant factor in explaining U.S.
inflation, could similarly have affected Canadian prices
in the 1970s.12 This hypothesis is supported by equa
tion 3 in table 2, which shows that a four-quarter
average of changes in relative energy prices has a sig
nificant positive effect on the Canadian inflation rate. 13

u For a further discussion of the Canadian experience with controls,
see the articles by Michael Parkin and Jack Carr in Jack Carr et al.,
eds., The Illusion o f Wage and Price Control (Vancouver: The
Fraser Institute, 1976).
Tatom, “Energy Prices and Short-Run Economic Performance.”
13Averages of relative energy prices for two, six and eight quarters
also were considered, but the four-quarter average produced the
strongest effect. The evidence also was consistent with the con
straint (implicit in the simple four-quarter average) that the coef-

A third explanation that invariably arises in inflation
discussions is that the rising prices were caused, at
least in part, by wage-push. 14 In Canada we found that
the rate of monetary growth is not systematically re
lated to (current or past) wage changes and, thus, there
is no direct evidence that the Bank of Canada followed
a policy of validating wage increases by accelerating
the growth in m oney. 1’ Even without monetary
accommodation, wage-push elements may still have
influenced the residual inflation rate, at least in the
short run. This possibility also was rejected by the
Canadian evidence, which shows that the rate of wage
change (in the current and past three quarters) does

ficients of current and three lagged energy-price terms were all
equal.
14See Dallas S. Batten, “Inflation: The Cost-Push Myth,” this Re
view (Iunc/1 u1v 1981). dp. 20-26.
15('urrent and up to four lagged values of the rate of change in the
wage index (hourly wage rate of manufacturing sector) were intro
duced in an autoregression of the rate of monetary growth (Ml)
containing four of its own lagged values. All wage terms were
insignificant in this regression (estimated for the period I/1971-IV/
1980). Also, see the evidence in Robert J. Gordon, “World Infla
tion and Monetary Accommodations in Eight Countries,” Brook
ings Papers on Economic Activity (2:1977), pp. 409-68.

AUGUST/SEPTEMBER

FEDERAL RESERVE BANK OF ST. LOUIS

1982

C hart 1

The Actual Vs. Predicted Rate of Inflation in C a n a d a

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

L I The r a t e p r e d i c t e d b y C a n a d i a n l o n g - t e r m m o n e t a r y g r o w t h .

not exert a significant effect in the money-price
regression. 16
A fourth explanation, suggested by the Phillips
curve theory, is that the residual rate of inflation may
reflect the effect of excess supply or demand (in goods
and/or labor markets) as measured by the unemploy
ment rate.1' This explanation also was tested and re
16W e estimated the following regression equation:
p = ao + ai m + a2DUM C + a3DUMA + A4 r +

3
X

b, wt_ t

i = (>

where w represents the log of the hourly wage rate in Canadian
manufacturing, and other variables are as defined in table 1. In
this regression, b; s were insignificant individually as well as joint
ly. A four-quarter average of w’s was tried, but its effect also was
insignificant.
17In the standard version of the Phillips curve theory, a prieeexpectation term is added to the unemployment rate. See, for
example, Rudiger Dombusch and Stanley Fischer, Macroeco
nomics, 2nd ed. (McGraw-Hill, 1980). The above variant, in fact,

jected: the effect of the unemployment rate (in the
current and past three quarters) is insignificant when
introduced in the regression containing the long-term
monetary growth rate. 18

HOW U.S. MONETARY GROWTH AND
INFLATION CONTRIBUTED TO
CANADIAN INFLATION
Monetary growth and inflation in the United States
could have influenced the Canadian rate indirectly
through their impact on Canadian monetary growth,
represents a monetary-growth-augmented Phillips curve.
18As in the case of wage index, the coefficients of the current and

three lagged values of the unemployment rate were insignificant
both individually and jointly when added to the money-price
regression (including control dummies and r). A four-quarter
average of the unemployment rate also did not produce a signifi
cant effect.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C ha rt 2

The Actual Vs. Predicted Rate of Inflation
in the United States

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

L i T h e r a t e p r e d i c t e d b y U.S . l o n g - t e r m m o n e t a r y g r o w t h .

directly through their impact on the residual inflation
rate in Canada, or both. The possible channels are
presented in the flow-chart in figure 1. Both of these
channels are examined here.

the two countries. 19 For instance, the Bank of Canada
generally acted to move Canadian short-term interest
rates in the same direction that the U.S. rates moved,
in order to avoid large fluctuations in the exchange
rate.20 The positive relationship between Canadian

The Impact o f U.S. Money Growth on
Canadian Money Growth

l9Since 1975 the Bank of Canada began announcing target ranges for
the growth of M l. However, it has continued to use the control of
short-term interest rates as the policy instrument in the short run.
For a further discussion of the Bank of Canada’s approach to
monetary policy, see Thomas J. Courchene, “On Defining and
Controlling Monev,” Canadian Journal o f Economics (November
1979), pp. 604-15.'

During the 1970s, despite the nominal existence of a
flexible exchange rate system, the Bank of Canada
often has attempted to control the movement of the
Canadian-U.S. dollar exchange rate. This exchange
rate intervention may have established a link between
the Canadian and U.S. monetary growth. Because the
Bank engages in interest-rate control to implement
monetary policy, Canadian money growth is likely to
be linked to U.S. money growth via interest rates in

20The relationship between the Canadian-U.S. interest rate dif
ferential and the exchange rate could be either positive or nega
tive depending on whether the interest rate differential repre
sents differences between expected inflation rates or real interest
rates in the two countries. For a further discussion of the rela
tionship between the exchange rate and interest rates, see Dallas
S. Batten, “Foreign Exchange Market: The Dollar in 1980,” this
Review (April 1981), pp. 22-30.

FEDERAL RESERVE BANK OF ST. LOUIS

F ig u re 1

The Transmission of U.S. Money Growth to C a n a d i a n Inflation

and U.S. interest rates arising from this policy also is
likely to imply a positive correlation between rates of
monetary growth in the two countries.21
To explore whether Canadian money growth is
systematically related to U.S. money growth, we re
gressed the monetary growth rate in Canada on cur
rent and lagged values of the U.S. monetary growth
rate. The results show a statistically significant, syn
chronous relationship between the rates of growth in
Canadian M l and U.S. M IA .22 Thus, the Bank of
Canada’s exchange rate policy appears to have estab
lished a link between U.S. and Canadian money
growth. This link opens up a channel through which
U. S. money growth can influence Canadian inflation.23
21The direction of the relationship between monetary growth and
the rate of interest in each country also would depend on whether
interest rate changes reflect changes in expected inflation or real
interest rates. W e assume that the direction of this relationship is
the same in both Canada and the United States.
22The estimated regression equation is:
= .012 + .894 m,us
(1.96) (2.40)
DW = 1.98, R2 = .13, SE = .0164

where m‘ “ and mus represent the logs of Canadian M l and U.S.
MIA. Up to four lagged values of m also were introduced in the
regression but their effect was found to be insignificant at the 5
percent level. Using M l as an alternative measure of the U.S.
money supply, the results of the above tests were similar, but the
effect of U.S. M l on Canadian M l was weaker than U.S. MIA.
(Using U.S. Ml instead of U.S. MIA, the coefficient of m[ s was
equal to .666 in the above regression, with a t-value of 1.74.)
^O f course, the synchronous relationship between Canadian and
U.S. money growth does not, by itself, imply anything about the
direction of causation. W e assume, however, that U.S. monetary
policy actions are independent of Canadian monetary policy.

AUGUST/SEPTEMBER

1982

The effect of operating through this channel is illus
trated in chart 3. In this chart, we show both the actual
rate of long-term Canadian monetary growth and the
rate induced by U.S. monetary growth because of
Canadian exchange-rate intervention.24 The differ
ence between the two rates can be viewed as the result
of Canadian monetary policy actions not related to
exchange market intervention.
Two interesting points emerge from this chart.
First, the portion of Canadian money growth induced
by U.S. money growth has been sizable and relatively
stable throughout the period (it has varied between 4.2
and 6.1 percent per year). Second, the residual growth
rate, as represented by the gap between the actual and
the U. S.-induced rates, rose sharply in the early 1970s
but has been declining gradually since the mid-1970s.
Thus, the Bank of Canada’s anti-inflation policy
adopted in 1975 appears to be effectively reducing the
nonintervention portion of Canadian money growth,
while having little impact on the contribution of for
eign exchange market intervention to money growth.

The Impact o f U.S. Inflation on Canadian
Inflation
The Canadian rate of inflation also may be directly
related to the U.S. inflation rate because of price link
ages between Canadian and U .S. tradable goods.
According to one hypothesis about these price link
ages— called the “law of one price’’— the Canadian
price for goods produced both in the United States and
Canada is the same as the U.S. price adjusted for the
exchange rate. According to this hypothesis, the Cana
dian rate of inflation would depend on the U.S. rate of
inflation adjusted for changes in the exchange rate.25 It
should be pointed out that even if Canadian money
growth were held constant and there were no interven
tion in the exchange market, an increase in the U.S.
24Using the regression equation relating ihc“ to mus in footnote 22
and averaging over 12 quarters, the long-term monetary growth
in Canada equals:
.012 + .894 iTius + u

where u is the 12 quarter average of the residual error in the
regression equation in footnote 22. From the above equation, we
estimate the amount of Canadian long-term monetary growth
induced by U.S. long-term growth to be equal to .894 mus.
25For individual tradable goods, the law implies that the rate of
change in the Canadian price would equal the rate of change in the
U.S. price, plus the rate of appreciation of the U.S. dollar. The
relationship between inflation rates in the two countries, how
ever, would be generally weaker because: (a) some non traded
goods would be included in each country’s aggregate price index
and (b) the weights used in the aggregate index may be different
for the two countries.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C h a rt 3

The Contribution of U.S. Long-Term Monetary Growth
to C an ad ian Long-Term Monetary Growth
Percent

Percent

inflation rate need not be accompanied by an equal
depreciation of the U.S. dollar in the short run. U.S.
inflation, therefore, could temporarily affect the re
sidual rate of inflation in Canada.26
The simple version of the law of one price is based on
the assumptions that the costs of making price changes
and undertaking arbitrage are negligible, the goods
produced in the two countries are identical in all re26In terms of the quantity theory framework, the above effect im
plies that U.S. inflation can temporarily influence the rate of
growth in velocity and/or output in Canada. Such an impact is
possible in open-economy models which allow for capital mobility
and/or distinguish between traded and nontraded goods. For a
discussion of monetary adjustment in open-economy models, see
Rudiger Dornbusch, Open Economy Macroeconomics (Basic
Books, 1980).

spects and perfect competition prevails. If one or more
of these assumptions do not hold, the price rela
tionship implied by the law of one price could be
significantly altered.27 For instance, if prices are costly
to change, domestic prices may not respond to those
changes in foreign prices and the exchange rate that are
perceived to be transitory.28 This modification of the
law of one price suggests that Canadian price changes
27For empirical evidence on the depatures from the law of one
price, see Irving B. Kravis and Robert E . Lipsey, “Price Be
haviour in the Light of Balance of Payments Theories, "Journal o f
International Economics (2:1978), pp. 193-246.
28The costs of making price changes would include not only adminis
trative and labeling costs, but also the costs associated with adver
tising price changes, adverse reaction from customers and uncer
tainty about the response of competitors.

AUGUST/SEPTEMBER

FEDERAL RESERVE BANK OF ST. LOUIS

1982

Table 3
The Influence of U.S. Inflation in the Canadian Money-Price
Relationship
Constant
m08

(1)

(2)

(3)

(4)

- .007 (-1 .4 5 )

-.0 1 2 (-2 .2 8 )

- .0 2 0 (-2 .7 3 )

-.0 2 6 (-3 .8 1 )

.994 (5.29)

.997 (5.43)

1.107 (5.68)

DUMC

.004 (-1 .8 1 )

1.015 (5.31)
-.0 0 3 (-1 .0 7 )

-.0 0 1

(-.5 6 )

DUMA

.010 (2.72)

.007 (2.00)

.005 (1.38)

.214 (2.67)

.085 (.87)

.078 (.81)

pus + e

.062 ( - .9 6 )

pus

.474 (1.78)

-.1 4 0 (-1 .9 2 )

.141 (-1 .9 8 )

pus

.933 (2.35)

pUS-pU3

.272 (.93)

2.39

2.37

2.42

1.33

(4.40)

1.90

.608

.653

.677

.579

SE x 102

.642

.613

.601

.638

NOTE: The dependent variable is pca.e is the log of the exchange rate (Can. $/U.S. $ ).p us = -.0 0 6 +
1.555 rfius, represents the fitted value of pus from equation 4, table 2 (without the control
dummies). Other variables are defined in table 2. (t-values in parentheses.)

are related to long-term movements in U. S. prices and
the exchange rate.
To explore the direct link between the U.S. and
Canadian inflation, we experimented with a number of
tests. First, we added the exchange-rate-adjusted U.S.
inflation (pus + e, where e is the logarithm of the price
of the U.S. dollar in Canadian dollars) to the moneyprice regression including price-control dummies and
the relative energy price. As shown in equation 1, table
3, the effect of this variable is insignificant.29 Next, we
included the U.S. inflation rate (pus) and the exchange
rate change (e) as separate variables in the regression
equation. In this test (see equation 2, table 3), while
the U.S. inflation rate has a positive effect, the effect of
the exchange-rate change is negative (both variables
are significant at the 10 percent level, though not at the
5 percent level).30 We are, thus, unable to find a con
sistent effect of the exchange rate on Canadian infla
tion. One explanation of this is that the exchange rate
exhibited little or no time trend during the flexible
29Up to three lagged values of the exchange-rate-adjusted U.S.
inflation also were added to the regression, but their effects
remained insignificant.
30Again, up to three lagged values of both pus and e were introduced
in the regression, but none of these terms produced a significant
effect. A four-quarter average of e was tried, but this variable also
had an insignificant influence.

exchange rate period.31 Its movements, therefore,
could have been considered transitory and largely dis
regarded in the adjustment of Canadian prices.
Finally, to examine the possibility that transitory
and trend changes in U .S. prices may exert different
effects on Canadian inflation, we divided the U.S.
inflation rate in two parts: (a) the rate predicted by
long-term U.S. money growth (pus) and (b) the re
sidual rate (pus — pUS). Each part was entered in the
regression equation separately. As shown in equation
3, table 3, this test produced the interesting result
that, although the effect of the U.S. monetary-induced
trend rate of inflation is positive and significant, the
effect of the residual rate is insignificant. It is also
interesting to note that the effect of both price-control
dummies as well as that of the relative energy price is
insignificant in this regression.32 In equation 4, table 3,
we present the regression equation that emerges when

31From 11/1970 to IV/1980, the exchange rate changed by only 12
percent. The U.S. aggregate price level changed by 102 percent
over the same period.
32As these variables are correlated with the U.S. inflation rate, it is
difficult to disentangle their separate influences on Canadian
inflation. For example, the correlation coefficient between p us
and r is .655, between Pus and DUMC is —.237 and between pus
and DUMA is .198.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C h a rt 4

The Contribution of Monetary-Induced U.S. Inflation
to C an ad ian Inflation

1971

1972

1973

1974

1975

we exclude the dummy variables, the relative energy
price and the exchange rate. In this equation, the
Canadian inflation rate is explained by only two factors:
(1) the long-term rate of money growth in Canada and
(2) the U.S. monetary-induced or trend inflation rate.
The Canadian rate of inflation predicted by regres
sion equation 4 in table 3 is shown in chart 4. To
illustrate the role of U.S. inflation in the Canadian
price equation, the chart also shows the Canadian infla
tion rate that would have been predicted by Canadian
money growth if the U.S. inflation rate had remained
constant throughout the period.33 The difference bea!The U.S. inflation rate is set constant at its quarterly average for
the 1971-80 period (equal to .017 when expressed as a fraction per
quarter). Under this assumption, the Canadian inflation rate is
predicted by the equation: pca = —.003 + .997 mca.

19 76

1977

1979

19 78

1980

tween the two predicted rates can be interpreted as the
contribution of the (money-growth-related) U.S. infla
tion rate to the rate of inflation in Canada. As the chart
illustrates, while the U .S. influence (as operating
through the U.S. inflation rate) has tended to lower the
predicted rate of inflation in Canada during the early
1970s and in the control period, it has added to the
predicted rate during the 1973-74 period and, more
recently, in the post-control period.34
It was noted earlier that the Canadian rate of infla
tion has stayed well above the rate predicted by the
34It is interesting to note that because of lags between U.S. money
growth and inflation, the effect of monetary-induced U.S. infla
tion on Canadian inflation in 1973-74 and the post-control period
has, in fact, been produced by rapid U.S. money growth prior to
these periods.

FEDERAL RESERVE BANK OF ST. LOUIS

Canadian long-term monetary growth in 1979 and
1980. Chart 4 shows that this difference can be ex
plained for most of the period by taking into account
the effect of the monetary-induced U.S. rate of infla
tion. As can be seen from the chart, although there are
large deviations in the first two quarters of 1978, the
predicted inflation rate (based on both Canadian
money growth and U.S. trend inflation rate) tracks the
actual inflation rate quite well in the remainder of the
1979-80 period.
The above discussion of the impact of U.S. money
growth and inflation on the rate of inflation in Canada
has highlighted two channels through which the effect
of U.S. money growth is transmitted to Canadian infla
tion. As illustrated in figure 1, U.S. money growth
influences inflation in Canada via: (1) Canadian money
growth and (2) U.S. inflation. The first channel oper
ates because of the Bank of Canada’s policy of inter
vening in the exchange market. It is interesting to
point out that this policy also may have strengthened
the second channel. For instance, if the Bank of Cana
da had not attempted to influence the exchange rate
and followed an independent monetary policy, the
exchange rate may have shown a pronounced trend
which may have offset, at least in part, the effect of
monetary-induced U.S. inflation on Canadian infla
tion.

SUMMARY AND CONCLUSIONS
This article has examined the role of a number of
factors in determining the rate of Canadian inflation
over the last decade. The evidence shows that long

AUGUST/SEPTEMBER

1982

term monetary growth— as measured by the average
rate of growth of Canadian M l over the past 12 quar
ters— is a key determ inant of Canadian inflation.
Furthermore, after taking into account the effect of
long-term Canadian monetary growth, factors such as
wage-push and unemployment did not exert a signifi
cant effect on Canada’s inflation rate.
The article also has examined the transmission of
inflation from the United States to Canada. It finds that
long-term U.S. monetary growth— also measured by a
12-quarter average of past money growth rates— con
tributed significantly to Canadian inflation in two dis
tinct ways: (1) U.S.monetary growth directly affected
Canadian monetary growth, and (2) the monetaryinduced portion of U.S. inflation— the part of the infla
tion rate explained by long-term U .S. monetary
growth— directly affected Canadian inflation (holding
constant the effect of Canadian monetary growth). The
link between U.S. and Canadian monetary growth
arises, in our view, from the Bank of Canada’s policy of
not allowing the exchange rate to fluctuate freely. In
deed, it is possible that this policy of exchange rate
management also may have strengthened the direct
link between U.S. and Canadian inflation.
Recently, monetarism has been criticized in Canada
because the Bank of Canada, while apparently success
ful in reducing the rate of growth of Canadian M l, has
been unable to significantly reduce inflation. This arti
cle suggests that Canada’s difficulties in controlling
inflation can be explained, at least in part, by taking
into account the effect of U.S. long-term monetary
growth on Canadian inflation.

Does ‘Tight’ Monetary Policy Hurt U.S.
Exports?
DALLAS S. BATTEN and CLIFTON B. LUTTRELL

HE competitive position of U.S. exports in for
eign commodity markets has deteriorated over the past
year. O f the reasons proffered, the major one has been
the adverse impact of the rising exchange value of the
U.S. dollar in foreign currency markets. It is argued
that a rising dollar makes U.S. exports less competitive
in foreign markets by causing their foreign-currency
prices to rise relative to those of commodities pro
duced in other countries. 1 One sector especially
affected is the farm sector. In fact, farm exports are
expected to decline in fiscal 1982, the first such decline
in 13 years (chart 1).
The ultimate “blame” for the dollar’s strength has
been placed on the Federal Reserve’s current “tight”
monetary policy stance, that is, its desire to reduce the
long-run rate of money growth.2 As one noted agri
cultural economist has remarked:
A tight m o n etary policy, o th e r things equal, leads to a
rise in th e value o f th e dollar and a d eclin e in the
com p etitiven ess o f th e exp ort secto r in international
m arkets. An easy m o n etary policy, on th e o th er hand,
leads to a d eclin e in th e value o f th e dollar and in creased
com p etitiven ess. T o p u t it simply, th e trad e sectors
b ear th e ad justm en t o f chan ges in m o n etary policy', and
trad e is now im p ortan t to ag ricu ltu re.3
11'.S. Department of Agriculture, Agricultural Outlook (March
1982), p. 10, and Agricultural Outlook (August 1981), p. 14. Simi
lar views are found in the press and among academic economists.
See, for example, Art Pine, “Strong Dollar, a Point of Pride to
Reagan Is Said to Hurt Exports and U.S. Economy,” The Wall
Street Journal, May 13, 1982; G. Edward Schuh, “The Foreign
Trade Linkages,” in Modeling Agriculture Fo r Policy Analysis in
the 1980s, A Symposium Sponsored by the Federal Reserve Bank
of Kansas City, September 24-25, 1981, pp 82-87; “The Mighty
Dollar Slams U.S. Trade,” Business Week (April 12, 1982), pp.
30-32.
2See Schuh, “The Foreign Trade Linkages,” p. 84; and Robert G.
Chambers and Richard E. Just, “An Investigation of the Effect of
Monetary Factors on Agriculture, "Journal o f Monetary Econom
ics (March 1982), pp. 235-47. There are obviously factors other
than monetary growth that induce short-run exchange rate move
ments. This article, however, ignores these, focusing solely on the
short- and long-run impact of money growth on exchange rate
movements.
3Schuh, “The Foreign Trade Linkages,” p. 84.

This article assesses the validity of this claim that the
reduced competitiveness of U .S. exports is due pri
marily to the Federal Reserve’s monetary policy
stance. Specifically, this article focuses on the impact
of money growth on inflation and exchange rate move
ments over both short- and long-run periods to investi
gate how U.S. exports are affected.

THE DETERMINATION OF PRICES
AND THE EXCHANGE RATE: A
LONG-RUN VIEW
The domestic price level and the exchange rate are
determined jointly by the supply of money relative to
the amount that individuals desire to hold. The supply
of money essentially is determined by the monetary
authority. The demand for money (i.e ., an individual’s
desire to hold a portion of his wealth in the form of
money) is determined primarily by income, interest
rates, prices and price expectations. The equilibrium
price level, then, is the one (given the level of income,
interest rates and price expectations) that induces indi
viduals to hold the exact quantity of money that mone
tary authorities are supplying.4 Any other price level
motivates individuals to attempt to hold more or less
money than is being supplied by altering their spend
ing until the price level is driven to its equilibrium
level.
Changes in the spending of consumers affect not
only domestically produced goods and services, but
commodities produced abroad as well. Altered de
mands for foreign commodities, in turn, produce
changes in the U.S. demand for foreign currencies
and, as a consequence, changes in the foreign ex
change value of the dollar, all other things equal. In
other words, a monetary disequilibrium, through its
impact on aggregate spending, induces a change in the
4For simplicity, the analysis here is performed within a static
framework. A dynamic analysis would be couched in terms of
growth rates instead of levels of the variables examined.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C h a rt 1

M a r k e t V a l u e of U.S. A g ricu ltu ra l Exports
B i l l i o n s of d o l l a r s

Billions

of d o l l a r s

35
30

25
20

•‘P r o je c te d

domestic price level and, in the long run, an equal and
offsetting change in the exchange rate.
For example, if the supply of money in the United
States is less than the amount that individuals desire to
hold, both an excess demand for money and an excess
supply of goods, services and securities exist at current
prices. In an attempt to increase their money holdings
to the desired level, individuals decrease their spend
ing on all goods and services, placing downward pres
sure on domestic prices.
This excess demand for money is associated with
decreased spending, not only on domestically pro

Source: U.S. D e p a rtm e n t o f A g ric u ltu r e

duced commodities, but also on commodities pro
duced abroad. The decreased demand for foreign com
modities motivates a decrease in the demand for for
eign currencies by U.S. importers. With a given sup
ply of foreign currency, the foreign currency value of
the dollar will rise.
In the long run, the foreign currency value of the
dollar should rise sufficiently to offset the differences
between foreign and U.S. prices resulting from the
initial excess demand for money. For example, if prices
in the United States fall by 10 percent relative to those
in Germany, then the Deutsche mark price of the

FEDERAL RESERVE BANK OF ST. LOUIS

dollar should rise by 10 percent, other things equal.0 If
domestic price level and exchange rate adjustments
occur simultaneously and if export prices move with
the general price level, the initial excess demand for
money will have no long-run effect on either the for
eign currency price of U.S. exports or the competitive
positions of U.S. exporters in foreign markets. The
domestic deflation (or, in dynamic terms, disinflation)
would exactly offset the impact of the exchange rate
appreciation on the foreign-currency price of U.S.
goods.
This relationship can be seen quite clearly in chart 2.
This chart displays (a) the trade-weighted foreign cur
rency value of the dollar and (b) the difference between
the U.S. rate of inflation (measured by the CPI) and the
trade-weighted rate of inflation of the Group of Ten
co u n trie s (ex clu d in g th e U n ited S ta te s) plus
Switzerland.6 It is apparent from the chart that, when
the rate of domestic inflation in the United States falls
relative to that of its major trading partners, the foreign
currency value of the dollar rises and vice versa. 1

DOMESTIC PRICES AND THE
EXCHANGE RATE: A SHORT-RUN
VIEW
In the short run, producers cannot tell immediately
whether a decrease in aggregate demand (spending) is
permanent or just a temporary aberration. Conse
quently, their initial reaction is to decrease production
rather than to lower prices. That is, the excess demand
for money initially induces a slowdown in economic
activity. O f course, as soon as the decline in spending
has been identified as permanent, producers will lower
prices and increase production back to “normal”

This condition is known as purchasing power parity. Even though it
has been violated frequently in the short run during the 1970s,
there is no evidence that its usefulness as a condition of long-run
equilibrium has been mitigated. See Jacob A. Frenkel, "The Col
lapse of Purchasing Power Parities During the 1970s, ” European
Economic Review (May 1981), pp. 145-65.
’The G-10 countries are Belgium, Canada, France, Germany, Italy,
Japan, the Netherlands, Sweden, the United Kingdom and the
United States. See “Index of the Weighted-Average Exchange
Value of the U.S. Dollar: Revision,” Federal Reserve Bulletin
(August 1978), p. 700, for a definition of the weights employed.
The calculated correlation coefficients between (1) the tradeweighted exchange rate and the inflation differential and (2)
changes in the trade-weighted exchange rate and changes in the
inflation differential are —.892 and —.533, respectively. Each is
statistically significant at the 5 percent level.
7Chart 2 is not intended as a proof of purchasing power parity, but
simply a demonstration that the rate of inflation and the exchange
rate are jointly determined by excess money growth; that is, one
does not cause the other.

AUGUST/SEPTEMBER

1982

levels.8 Thus, the impact of the excess demand for
money on output eventually vanishes, leaving only
prices permanently affected; however, these long-run
effects are not realized immediately.
On the other hand, the exchange rate responds to
this excess demand for money much more rapidly than
do the prices of domestic commodities. This occurs
because the exchange rate is the relative price of two
assets (two currencies); unlike commodity prices, it is
determined in highly organized markets that quickly
assimilate new information in the same efficient man
ner as the prices of other financial assets (e.g., stocks
and bonds). Therefore, the exchange rate will appreci
ate before prices of commodities fall sufficiently to
eliminate completely the excess demand for money.9
During this interim period, U.S. exporters will face
a deteriorating competitive position in foreign mar
kets. The foreign currency prices of their products will
have risen temporarily because the dollar appreciates
before commodity prices fully adjust to the monetary
disequilibrium.

INAPPROPRIATE POLICY RESPONSES
The argument that tighter monetary policy during
the past few years has strengthened the dollar and thus
reduced the competitiveness of U .S. goods in foreign
markets has elicited several proposed policy re
sponses. Among these are increased protectionism,
increased subsidization of U.S. exports, a return to an
easier monetary policy stance, and large-scale in
tervention in foreign exchange markets. 10 Since the
impact of a tighter monetary policy on the competitive
position of U .S. exports is only a short-run phe
nomenon, such policy reactions are inappropriate. 11 In
particular, policy responses designed to rectify the
short-run disequilibrium actually will exacerbate the
equilibrating process and, consequently, lengthen the
period of adjustment. Moreover, redirecting domestic

T h e normal level of production and its path over time is deter
mined primarily by the availability and the rate of growth of
productive resources.
9For additional support of this argument, see Frenkel, “The Col
lapse of Purchasing Power Parities. ”
" ’See Pine, “Strong Dollar, a Point of Pride;” “The Mighty Dollar
Slams U.S. Trade;” and Chambers and Just, “An Investigation.”
"Jacob Frenkel, “Flexible Exchange Rates, Prices, and the Role of
News’: Lessons from the 1970s, ” Journal o f Political Economy
(August 1981), pp. 665-705, finds that such policy responses also
may be inappropriate when the short-run deviation from purchas
ing power parity is motivated by changes in determinants of
exchange rates other than money growth.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

C ha rt 2

Exchange Rate and Inflation Differential
M arch 1 9 7 3 = 1 0 0

1976

P e rce n t

1977

1978

1979

1980

S o u rce s: B o a rd o f G o v e r n o r s o f the F e d e ra l R ese rve System , a n d
[]_

\ _

1981

1982

In te rn a tio n a l M o n e te ry

F u n d , In t e r n a t io n a l F in a n c ia l S tatistics
4 -q u a rte r m o v in g a v e ra g e
Y e a r - o v e r - y e a r U.S. CPI g r o w t h m i n u s g r o w t h o f t r a d e - w e i g h t e d CPI.

monetary policy (directly or by intervening in foreign
exchange markets) to external objectives, by defini
tion, subordinates the domestic objectives of monetary
policy. Any acceleration of money growth to alleviate
the short-run effect of past policy actions ultimately
would have no favorable long-run impact on U.S. com
petitiveness in foreign markets. It would result simply
in a higher rate of U. S. inflation and a lower exchange
value of the dollar.

SUMMARY AND CONCLUSIONS
Those who feel that exports have been harmed by a
tight monetary policy have overlooked the fact that the
same monetary policy that causes the dollar to
strengthen in foreign currency markets also causes the
rate of domestic inflation to decline relative to that in

other countries. These two events (i.e., a rising dollar
and falling U.S. inflation) exactly offset each other over
time. Consequently, foreign importers of U.S. prod
ucts can purchase fewer dollars with a given amount of
their currency but can purchase more U.S. goods with
those dollars.
A tighter monetary policy in the United States rela
tive to monetary policies abroad is reflected in the
exchange value of the dollar more quickly than in the
relative prices of export goods, which reduces tempo
rarily the competitiveness of U.S. exports. Such a poli
cy, however, has no impact on our long-run competi
tive position. Consequently, foreign exchange market
intervention, trade restrictions or other policy re
sponses designed to offset this short-run disequilib
rium situation are neither necessary nor justified.

Money and Inflation in Israel: The
Transition of an Economy to High Inflation
ZALMAN F. SHIFFER

I s R A E L is a small, open economy with a population
of about 4 million and a per capita national income in
1981 of about $5,400.1 For a long period, until the
beginning of the 1970s, it had experienced relatively
low inflation and high real economic achievements in
terms of employment, economic growth and consump
tion. During the 1970s, however, Israel s economic
performance deteriorated sharply: real GNP growth
fell from about 9 percent to 3 percent per year, and the
rate of inflation accelerated dramatically to over 100
percent per year (unemployment, however, remained
relatively low for most of the decade). At the same
time, the import surplus — the difference between the
value of imports and exports — rose to levels that were
considered unmaintainable in the long run (see tables 1
and 2).2
The dismal experience of the Israeli economy, like
similar developments in other countries, was related to
the economic adjustment to higher energy prices.
Other countries also were subject to lower real growth
and higher inflation since 1973. However, the accel
eration of inflation was particularly acute in Israel (see
table 3). In addition to the oil price shocks, Israel faced

'The degree of the openness of an economy is measured by the
importance of its economic relations with the rest of the world. In
1981 imports and exports were, respectively, equal to 68 percent
and 48 percent of GNP in Israel (compared with 9 percent and 8
percent in the United States).
2Since the establishment of the state, Israel has always imported
more than it exported, financing the difference by foreign grants
and by the accumulation of foreign debt (which reached $ 18 billion
at the end of 1981). The authorities were concerned about the
possibility of future reduction in the availability of international
finanacing and, to avoid the potential high costs of a rapid adjust
ment to a lower import surplus, aimed at its gradual reduction.
For additional information (in English) on the Israeli economy in
general and on monetary policies and developments in particular,
see Bank of Israel Annual Reports and Economic Review. See in
particular Stanley Fischer, “Monetary Policy in Israel,” Bank of
Israel Economic Review No. 53 (May 1982), pp. 5-30. Foran earlier
period, see Nadav Halevi and Ruth Klinov-Malul, The Economic
Development o f Israel, (Praeger, 1968). See also Nadav Halevi,
“Economic Policy Discussion and Research in Israel, American
Economic Review, Supplement (September 1969).

changing military and political conditions that resulted
in higher levels of defense expenditures and govern
ment deficits. The deterioration of the Israeli econo
mic performance in the 1970s was, therefore, also re
lated to the effect of the external burdens imposed on
Israel. Finally, the rapid transition to high inflation
also reflected the relative low priority assigned by
policymakers to the goal of price stabilization and the
specific mix of policy measures used to achieve the
different policy goals.
The purpose of this article is to discuss the sources
and mechanisms of monetary growth in Israel I in
particular the inflationary process during the past dec
ade. Section 1 discusses the relative importance of the
changes in money demand and money supply in the
Israeli inflationary process. Section 2 surveys the
sources of money supply growth, with special empha
sis on the financing requirements of the public sector.
Section 3 discusses how the exchange rate policy and
the debt management policy have created a highly
adaptive money supply process, and section 4 deals
with the short- and long-run implications of this struc
ture on the inflationary process. Section 5 analyzes the
historical evolution of the inflationary process and,
finally, section 6 offers some concluding remarks.

1. MONEY DEMAND, SUPPLY AND
INFLATION
Inflation can be defined as a sustained increase in the
general price lvel or, equivalently, as a sustained ero
sion of the value of money (i.e., the amount of goods
and services that one unit of local currency — say a
dollar or a Shekel) will buy.3
The equilibrium value of money, like that of any
other commodity, depends on its demand and supply.
People generally are not interested in the number of
monetary units that they possess — their nominal
money holdings; instead they are concerned about the
3In 1980, Israel changed its monetary unit from the pound (IL) to
the shekel (IS) at the ratio of 10 IL per IS.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 1
GNP, Prices and Unemployment
Period

Nominal
GNP growth

Real
GNP growth

Change in
implicit GNP
price deflator

Unemployment rate1

1960-65

18%

9.5%

3.8%

1966-69

7.5

7.1

1970

7.9

3.8

1971

11.0

3.5

1972

12.3

2.8

1973

4.1

2.6

1974

4.6

3.0

1975

3.2

3.1

1976

1.3

3.6

1977

1.3

3.9

1978

4.1

3.6

1979

3.0

2.9

1980

133

2.7

128

4.8

1981

137

4.6

126

5.1

1As a percent of the civilian labor force.
SOURCE: Central Bureau of Statistics, Statistical Abstracts o f Israel (1981).

Table 2
Allocation o f Economic Resources
Period

Private
consumption

Public consumption
Total
Defense

Investment

Import
surplus1

Import
surplus2

(as a percent of GNP)
1966-69

66%

28%

17%

22%

19%

1970

1288

1971

1226

1972

1101

1973

1794

1974

3324

$ 645

1975

4106

1976

3200

1977

2535

1978

3283

1979

3943

1980

3927

1981

4430

'The difference between the value of imports and exports.
2ln millions of U.S. dollars
SOURCE: Central Bureau of Statistics, Statistical Abstract o f Israel (1981).

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 3
International Rates of Inflation (annual average percentage1)
Country

1960-69

1970-73

1974-75

1976-78

12.7%

39.5%

39.2%

1979-80

Israel

5.2%

United States

2.3

4.9

10.1

6.6

12.4

United Kingdom

3.4

8.0

20.0

13.5

15.7

Italy

3.7

6.6

18.1

15.3

17.9

West Germany

2.4

5.3

6.5

3.6

4.8

22.2

40.3

86.6

245.7

128.3

Chile

28.52

89.5

436.1

103.1

34.3

Brazil

44.2

17.9

28.3

41.5

67.1

2.9

5.8

12.2

8.0

10.6

21.1

20.5

4.1

6.8

36.1
14.4

48.8
10.8

51.8
13.5

Argentina

Industrial countries
Western Hemisphere
(excluding U.S. & Canada)
World

103.0%

1Based on rates of change for average yearly price levels.
2Computed for 1964-69 period.
SOURCE: International Monetary Fund, International Financial Statistics Yearbook 1981.

quantity of goods and services that their money bal
ances can purchase — the real value of these holdings.
In other words, the equilibrium value of money, or the
price level, depends on the demand for real money
balances and on the nominal money supply.4
Over time, the rate of change of the price level (i.e.,
the rate of inflation) will reflect the difference between
the rates of growth of the nominal money supply and of
the real money demand. ’ In analyzing an inflationary
process, therefore, it is instructive to consider the
forces governing the changes in real money demand
and nominal money supply.
Chart la shows the rate of change of the narrowly
defined money supply M j (local currency and demand
deposits) and the rate of change of the consumer price
level;6 the difference between these two rates is the
4Formally, in equilibrium, P = Ms/(M/P)d, where P is the general
price level, Ms is the nominal money supply and (M/P)d is the real
money demand.
’At any point in time, the price level may not equate exactly the
demand for and supply of money; however, these deviations are of
secondary importance when a longer period is considered. The
exact relation among the equilibrium rates of change of the price
level, money supply and money demand is P = (Ms - Mc()/(1 +
.VP'), where ' represents a rate of change.
6Casual observation suggests a considerable use of foreign exchange
bills and of checks drawn upon overdraft facilities for transactions
in Israel. It has been suggested, therefore, that a more accurate
definition of the “means of payments” should include foreign ex
change cash holdings and lines of credit for overdraft; unfortunate
ly, the statistical coverage of these variables is highly unsatisfac
tory.

rate of change of the real quantity of money. An index
of the real quantity of money is presented in chart lb.
Chart 1 reveals that, since 1973, the real value of the
money stock has decreased dramatically (by about 70
percent between the end of the 1973 and the end of
Chart 1

M o n e y a n d Prices

FEDERAL RESERVE BANK OF ST. LOUIS

1981). This reduction mainly reflected the reaction of
the real demand for money to the increase in the cost of
holding money — which bears no interest — as the rate
of inflation accelerated and interest rates increased.
The increase in money velocity was facilitated by finan
cial innovation which, to a large extent, was also in
duced by the rise in the cost of holding money.7 Some
“autonomous” financial innovation was also present,
and the demand for money also may have been affected
by changes in real wealth.8
Even if the reduction in the real quantity of money
were fully attributable to shifts in money demand, it
could only explain a small part of the accumulated
increase in prices.9 Since the reduction in the real
money balances was, in fact, primarily a product of
inflation, the main factor explaining the Israeli in
flationary experience is the behavior of the money
supply.

'The cost of holding money is the difference between the nominal
return on other assets — physical assets and interest-bearing finan
cial assets — and the zero nominal return on money. As the rate of
inflation increases, the gap between the return on physical goods
and money widens, and the rates of interest on financial assets
adjust upward (either as a result of the incorporation of inflationary
expectations in nominal rates of interest or the higher return
gained on indexed assets). In recent years, there has also been an
increase in real rates of interest in Israel (i.e., after allowing for the
effect of higher inflation on the rate of interest).
The effect of the cost of holding money on financial innovation takes
time to work out. This may at least partly account for the fact that
real money balances continued to decrease for two or three years
after each of the two major episodes of inflationary acceleration in
Israel.
T h e incom e velocity o f m oney, defined as the ratio betw een nom i
nal GNP and M , (or, alternatively, b etw een real GNP and real
m oney balances) increased from 6 in 1973 to 24 in 1981.

’The real demand for money has been investigated by Leonardo
Leiderman and Arye Marom in “New Estimates of the Demand for
Money in Israel’ (Bank of Israel [B .O .I.] Research Dept., June
1981) and by Rafael Melnick in “Two Issues Concerning the De
mand for Money in Israel” (B.O.I. Research Dept., January 1982).
Both studies point to strong effects of the cost of holding money on
its demand. They found some parameter changes in the post-1977
period, but were unable to reject the hypothesis of the function
stability by a Chow Test. (1977 was chosen as a possible turning
point because of the many changes accompanying the foreign
exchange reform, including the autonomous introduction of a new
class of money substitute — see below.)
These authors did not investigate the impossible effect of a wealth
shock on the demand for money around 1974. Such a shock may
have resulted from the combination of the effect of the oil price
increases and the increase in defense outlays. However, a wealth
shock also should have affected the demand for private consump
tion, and there is no indication of a shift in consumption demand at
the time.
“At the end of 1981, the price level was about 100 times higher than
at the end of 1969 (and about 55 times higher than at the end of
1973).

AUGUST/SEPTEMBER

1982

2. THE SOURCES OF MONEY SUPPLY
CHANGES IN ISRAEL
Changes in the nominal quantity of money can be
apportioned between those originating from changes
in the monetary base and those resulting from changes
in the “money multiplier” (the ratio between the
quantity of money and the monetary base).10 Table 4
shows the extent to which the Israeli money multiplier
has fluctuated from year to year. In some years, it has
been an important determinant of the change in the
money supply; over the long run, however, its changes
have had only a secondary effect on the money supply.
We shall, therefore, focus the analysis on the factors
affecting growth in the monetary base.
Changes in the monetary base are created by the net
flow of payments between the economic authorities
and the private sector. In Israel, changes in the mone
tary base equal:
a)

The domestic deficit of the govern
ment and other parts of the public
sector in its nonfinaneial activities;11

The net flows of loans from the public
sector and the central bank to the pri
vate sector. These loans are granted
on favorable terms to investors, ex
porters and to housing mortgages;

minus c)

The net sale of foreign exchange by
the Bank of Israel (B.O .I.) to the pri
vate sector;12

minus d)

The net sale o f governm ent and
B .O .I. debt to the private sector.

plus

To demonstrate the significance of these flows, table
5 presents the evolution of the changes in the monetary
base and in the flows affecting these changes as a
10In this article, we use the Israeli “Broad Money Base.” This
aggregate excludes bank liquidity deficiencies, which are the
Israeli counterpart of the U.S. borrowing at the discount window.
For the purpose of money supply analysis, this aggregate is similar
to the U.S. nonborrowed monetary base.
"T h e direct transactions of the Israeli government with the rest of
the world have no effect on the monetary base and therefore only
domestic deficits are included. The financial transactions of the
authorities with the (domestic) private sector are included in (b),
(c) and (d).
12Except for a few years, the B.O .I. has been a net seller of foreign
exchange to the private sector and net purchaser of foreign ex
change from the government. The government acquires foreign
exchange through foreign borrowing and unilateral transfers from
abroad, spends a part of the proceeds on its direct imports and
sells another part to the B.O .I. to finance its domestic expendi
tures. As a result, the government has not accumulated a large
debt to the B.O .I.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 4
The Money M ultiplier and Its Contribution to Money Growth

Period

Money multiplier1
(end of period)

Contribution of change
in the money multiplier
to the change in money supply2

Rate of change in
the money multiplier

1961-69

1.23

1970

1.16

- 4 .9

-3 7

1971

1.04

-1 0 .3

-3 7

1972

1.02

- 1 .9

-6

1973

1.07

4.9

1974

1.08

0.9

1975

1.24

14.8

1976

1.13

- 8 .9

-3 3

1977

1.07

- 5 .3

-1 3

1978

1.20

12.2

1979

1.28

6.7

1980

1.35

5.5

1981

1.14

-1 4 .9

-1 8

1970-81

1.14

- 1 .3

0.1%

1The ratio of M, to broad monetary base.
2Change in the money multiplier times monetary base at the beginning of the period divided by the
change in M, during the period (and multiplied by 100).
SOURCE: 1960-69: Moshe Sanbar and Saul Bronfeld, “ Monetary Thought, Policy and Development
1948-72,” Israel Economic Quarterly Review (April 1973) and (September 1973).
1970-81: Bank of Israel Annual Reports.

Table 5
Sources of Change in the Monetary Base (as a percent of GNP)
Period

Domestic deficit
of the public
sector1

Net public credits
Government
B.O.I.

Sales of foreign
exchange by the
B.O.I.

Sales of public
debt to the private
sector

Change in the
monetary base

1960-70

4.4%

—

2.0%

1971-72

5.2

—

-7 .8 %

—

5.5

1973-74

14.6

—

2.4%

4.0

—

3.0

1975-76

14.2

—

1.2

5.6

—

2.1

1977

9.2

3.5%

4.3

5.5

1978

6.1

4.4

5.1

2.3

1979

3.7

4.2

5.1

6.4

5.4

1.2

1980

5.2

4.9

3.6

5.1

6.1

2.4

1981

10.2

4.2

- 0 .5

5.9

5.4

2.5

7.7%
11.0

4.0
2.2

NOTE: Dash indicates data unavailable from accessible sources.
'Excluding financial operations. Based on national account data for 1960-76 and B.O.I. estimates of actual flows for 1977-81. The national
account estimates for the share of domestic deficits in GNP for 1977-81 are respectively 11%, 10%, 8%, 8% and 15%.
SOURCE: Same as table 4.

FEDERAL RESERVE BANK OF ST. LOUIS

percentage of GNP. 13
The share of the domestic deficits of the public sec
tor in GNP, already high by international standards in
the 1960s, rose dramatically to 15 percent in 1973-74
and thereafter decreased, through remaining relative
ly high. These deficits increased primarily because of
the higher level of defense expenditures imposed on
the Israeli economy since the Yom Kippur War.
Domestic defense expenditures rose from an average
of 9 percent of GNP in 1968-72 to 16 percent in 19738 1 .14
While we do not possess adequate quantitative in
formation about the net flows of public loans to the
private sector in the 1960s, we know that their magni
tude (relative to GNP) was much lower than in the
1970s. Most of these loans were granted, until recent
years, at low nominal interest rates that were adjusted
to the increase in the rate of inflation only partially and
belatedly.lo This policy brought about a considerable
increase in the difference between the flow of new
loans, which reflected current prices, and the flow of
old loan repayments, which was determined by the
historically low prices and rates of interest.
Table 5 reveals that the increase in the share of
public deficits and loans in GNP has not been accompa
nied by an increased reliance on monetary base expan
sion as a source of government finance (i.e., in the ratio
of new monetary base creation to GNP). The average
ratio of monetary base change to GNP over the 1973-81
period was equal to its 1960-72 value (2.5 percent). In
other words, the net increase in purchases of public
debt and foreign exchange by the private sector essen
tially offset the increase in the public deficits and
credits.

3. THE ENDOGENOUS NATURE OF
THE MONEY SUPPLY IN ISRAEL

AUGUST/SEPTEMBER

1982

did the Bank of Israel not increase the sale of foreign
exchange and public debt to the private sector and thus
bring about a lower rate of money growth and infla
tion?” The answer to this question is that open market
operations in these two assets were governed by con
siderations other than achieving monetary control.
Sales (and purchases) of foreign exchange by the
B. O. I. to the private sector are used mainly to stabilize
the exchange rate, not to control money (and are
generally not sterilized). The B .O .I. offers to sell (or
buy) whatever quantities of foreign exchange that are
necessary to stabilize the exchange rate at a policydetermined level (with minor fluctuations being toler
ated in recent years). The rate of exchange determina
tion and, consequently, the open market operation in
foreign exchange is perceived as an instrument for
achieving a gradual reduction in the import surplus,
which is considered unmaintainable in the long run. In
recent years, the B .O .I. has aimed at stabilizing the
real rather than the nominal rate of exchange by equat
ing the rate of exchange depreciation to the difference
between the domestic rate of inflation and the rate of
inflation in Israel’s main trading markets. 16
Most public debt was in the form of government
bonds (some of which were held directly by the public
and some of which served as coverage for long-term
saving schemes, pension funds and the like). These
bonds were indexed to the consumer price index and
sold to the public in practically unlimited amounts at
real rates of interest that were changed infrequently
and within a relatively narrow range. Open market
operations in public debt were used, to a large extent,
to stabilize the real rate of return on government bonds
in the secondary market. This policy may have
reflected an evaluation that the demand for direct and
indirect holding of government bonds is very sensitive
to variations in the real rate of return.1'

The previous discussion raises the question: “Why

13Due to the way in which monetary base data were published, it is
difficult to apportion the sources of change in the monetary base
according to our functional classification for the full period consid
ered.
14Due to increased defense imports, the increase in the share of
total defense outlays in GNP was even higher (see table 2). De
fense imports, like other direct government imports, however,
have no effect on the monetary base (see above).
15Most loans to exporters have been indexed to the foreign exchange
rate since 1977. The indexation of investment and mortgage loans,
however, was delayed until 1979-81.
The structure of interest rates on public credits had significant
adverse effects both on the efficiency of the allocation process and
on income and wealth distribution.

"T h e real rate of exchange is defined as EP*/P, where E is the
nominal rate of exchange (domestic price of foreign exchange), P*
is the level of foreign prices and P that of domestic prices. Its rate
of change is E - (P - P*), where ' is a notation for rate of change and
(P - P*) is the difference between the local and foreign rates of
inflation. Note that the implications of a fixed real rate of exchange
are different from those of a fixed nominal rate of exchange. While
both imply an effect of the balance of payments on the monetary
base, a fixed nominal rate of exchange tends to reduce the sensi
tivity of the local price level to expansionary domestic policies, by
shifting the adjustment to the balance-of-payments flows.
I7lf this were the case, the government could have lowered the
average rate of interest that it had to pay on a given amount of debt
by its policy of real interest rate stabilization. This also may have
affected the rates of interest charged on nongovernmental bor
rowers.

FEDERAL RESERVE BANK OF ST. LOUIS

Some public debt was in the form of foreignexehange-indexed deposits, the volume of which was
determined in recent years by the private sector de
mand. The return on these deposits depended on the
change in exchange rates and on international interest
rates and was, therefore, not subject to manipulation
for the purposes of monetary control.
Given the elastic supply conditions of foreign ex
change and public debt, the private sector was able to
determine its net acquisition of these assets and, thus,
the net change in the monetary base. As a result, the
quantity of money was largely endogenous — that is,
determined by the economy rather than by explicit
policy decisions. Thus, a recent econometric study has
shown that the rate of money growth was significantly
affected by past price changes. 18 This does not mean, of
course, that the money supply played no crucial role in
the inflationary process. It merely indicates that under
the institutional arrangements prevailing in Israel the
growth of money accommodated and validated prior
price changes. The endogeneity of the money stock has
an important bearing on the dynamics of the Israeli
inflationary process.

4. INFLATION WITH AN
ENDOGENOUS MONEY SUPPLY
A largely endogenous money supply has important
implications for the behavior of short-run price in
creases, for the determination of the long-run rate of
inflation and for the stability of the inflationary process.
The general price level is often subject to short-run
movements that cannot be traced to previous changes
in money growth or to shifts in the long-run demand for
money. The general price level may react to changes in
international prices, fiscal actions and many other

18Elise Brezis, Leonardo Leiderman and Rafael Melnick, “Inflation
and Monetary Variables: Their Interrelationship in Israel”
(B.O.I. Research Dept., September 1981). Using a Granger ex
ogeneity test, these authors found that information about past
price changes improves the regression of money change on its past
values both when short lags (several months to a year) and longer
lags (up to two years) are considered. On the other hand, they
found that information about past money changes improves the
regression of price change on its past values only in the long run.
The long-run results were derived from annual data over a long
period (1954-80). W e have repeated these exogeneity tests using
quarterly data over the 1965-80 period. These tests yielded a
significant effect of money growth lagged up to three years on
prices (and vice versa). When the 1970-80 period was considered,
the effect of lagged money growth on prices was insignificant.
Whether this result reflects a change of structure in the 1970s or is
due to the small number of the degrees of freedom is unclear.

AUGUST/SEPTEMBER

1982

forces that affect the equilibrium in commodity, factor
and asset markets (e.g., by creating imbalances be
tween the physical and financial components of the
public’s portfolios). If the money supply is endoge
nous, the adjustment of money growth can easily mag
nify and prolong the effect of these disturbances on the
general price level — especially since the public is
aware of the accommodating nature of the money
supply. This could affect the public’s inflationary ex
pectations, resulting in further price increases, even
higher growth of the endogenous money supply and
downward adjustment of the real demand for money.
This mechanism, which has been at work in Israel for
at least part of the period surveyed, explains why accel
erations in the rate of price increases have tended to
precede accelerations in money growth. Two factors
especially have contributed to this mechanism in
Israel: (a) The extensive system of indexation transfers
price increases from one sector to another quickly and
inflates the nominal values of indexed financial assets;
(b) The experience with high and rising inflation has
increased the speed with which prices adjust and
shortened the lag between present price experience
and changes in inflationary expectations. 19
The endogeneity of the money supply also affects the
determination of the long-run rate of inflation. With an
exogenous money supply, the rate of inflation will
converge in the long run to the difference between the
given rate of nominal money growth and the rate of
growth of real money demand, which depends princi
pally on long-run real economic growth and the elastic
ity of the demand for money with respect to real GNP.
When, however, the money supply is endogenous, as
is the case in Israel, there is no predetermined rate of
money growth to which the rate of inflation adjusts
itself. In this case, both the long-run rates of money
growth and inflation are determined simultaneously as
a part of a larger and more complex full-equilibrium
solution.20
A long-run equilibrium interpretation of the accel
eration of inflation in Israel has been suggested by

laThe sensitivity of inflationary expectation formation to the level of
inflation was investigated in Daniel Gottlieb and Sylvia Piterman,
“Inflationary Expectations in Israel 1965-80” (B .O .I., Research
Dept., 1981).
For more evidence on the adjustment of the Israeli economy to
inflation, see Zalman F. Shiffer, “Adjusting to High Inflation —
the Case of Israel,” forthcoming in this Review.
2(>This solution will include the determination of long-run equilib
rium values of the different components of table 6.

FEDERAL RESERVE BANK OF ST. LOUIS

Melnick and Sokoler.21 The essence of their argument
is that the long-run equilibrium rate of inflation in
creased in the 1970s, because (a) the ratio of the re
venue from money creation to GNP (the monetary
base change/GNP ratio) has been kept unchanged, and
(b) in view of the reduction in the rate of real GNP
growth, the maintenance of a given monetary base
change/GNP ratio required a higher rate of inflation.22
The unchanged average level of the share of revenue
from money creation in GNP does not, by itself, prove
that the inflationary experience of the last decade
reflects a transition between long-run equilibrium
rates of inflation. Alternatively, this experience could
be viewed as the result of a sequence of disturbances,
that, given the dynamics of an endogenous money
supply, have not necessarily brought the economy to a
new long-run equilibrium.23 Under this view, the im

21Rafael Melnick and Meir Sokoler, “The Government’s Revenues
from Money Creation and the Inflationary Effects of a Decline in
the Rate of Growth of National Income” (B.O .I. Research Dept.,
1981).
22Monetary expansion affects the public sector finances not only
through the direct revenue that it generates, but also through the
effects of the resulting inflation on taxation, government spend
ing, the sale of indexed public debt and the erosion of the real
value of the unindexed loans given by the public sector to the
private sector. According to B.O .I. Report 1980 (p. 240), the loss
due to loan value erosion is higher than the direct revenue from
monetary expansion.
Given these relationships, there is no reason to assume that the
authorities maintained a policy aimed at stabilizing the ratio be
tween the direct revenue from monetary expansion (the monetary
base change) and GNP. Note, however, that the Melnick-Sokoler
argument does not depend on the existence of such a policy, but
on the claim that there is a causal effect from the direct revenue
from money creation to the rate of inflation. Their argument
would also hold if, for example, this revenue was endogenously
determined by the levels of public deficits and loans and by the
foreign exchange and debt policies. The alternative view dis
cussed below is that the main causal effect is from the rate of
inflation to the revenue from money creation, and not vice versa.
Assuming, for simplicity, that the monetary multiplier is 1, the
ratio of the direct public revenue from money expansion to GNP
is:A M /P Y = M(M/PY), where A represents absolute change,
proportional change and M, P and Y are respectively the nominal
quantity of money, the general price level and real GNP. In the
long-run equilibrium, M = (M/PY) + P + Y = P + Y (1 + -rj),
where T| is the elasticity of the desired money-GNP ratio to real
GNP. The long-run equilibrium revenue from money creation
is (M/PY) [P + Y(1 + t))], where (M/PY) depends on the expected
rate of inflation, which in the long-run equilibrium is equal to the
actual rate P. This expression is a positive function of Y, since
(1 + T,) > 0. When the rate of inflation is increased, (M/PY)
decreases, but the “inflationary tax” (M/PY)P increases, provided
that the elasticity of the demand for money with respect to infla
tion is lower than unity in absolute terms; this is the case in Israel
as well as in most other countries.
2 iThe problem of the convergence of an economy with an endoge
nous money supply to a long-run stable inflationary equilibrium is
discussed in D. Chappell and D. A. Peel, “On the Dynamic

AUGUST/SEPTEMBER

1982

pact of money creation on the public revenue would be
interpreted as a result of the acceleration of inflation,
instead of its cause.

5. THE HISTORICAL RECORD OF
MONEY AND INFLATION IN ISRAEL
Table 6 contains data relating the dynamic evolution
of prices to money growth and other variables over the
last decade. This table presents annualized rates of
change of the price level, money (Mi), two larger
monetary aggregates (M4 and M5), short-term bank
credit and the local price of imports. M4 is the sum of
Mi and a group of relatively liquid money substitutes
— tim e deposits, C D s, some types of foreignexchange-indexed deposits and tradable, CPI-indexed
government bonds.24 M5, the largest monetary aggre
gate on which data are available for the whole period, is
the sum of M4 and some less-liquid savings accounts
and foreign-exchange-indexed deposits. Similarly,
short-term bank credit represents the largest credit
aggregate on which data are available on a long-run
basis. The domestic price of imports depends on the
rate of exchange and on international prices.25
The last four measures are included, because they
help illuminate the nature of the relationship between
money and prices. These variables reflect, at least
partially, the results of policy measures and external
shocks and have affected real demands and costs. In
particular, statistical tests indicate the existence of

Stability of Monetary Models when the Money Supply is Endoge
nous,” Manchester School (December 1979), pp. 349-58. The
authors assume that the government maintains a given real level
o f revenue from m oney creation.

In recent years, it has been argued that the Israeli economy might
have moved into a stage of “bubble inflation” in which the rate of
inflation is indeterminate and can explode as a result of any
disturbance or change in expectations. This extreme view is not
supported by the evidence: as discussed below, the two principal
stages of inflationary acceleration in Israel have been triggered by
nontrivial sequences of events and culminated in periods of rela
tive inflationary stability.
24The liquidity of these assets is enhanced by the above-discussed
policies of foreign exchange and real bond interest rate stabiliza
tion. While none of these assets serves as a direct means of
payment, each is largely held as temporary abode of purchasing
power due to its relatively low real risk. Due to the low level of
transaction cost relative to the rate of return, these assets are
largely purchased for periods of a few weeks. At the end of the
1970s, the velocity of the liquid foreign exchange deposits was
close to the velocity of checking accounts at the beginning of the
decade.
2~’Due to data limitations, the rate of change of this variable is based
on end-of-period quarters (and not months). This implies that a
large import price increase which occurs at the end of a quarter
(like the 1974 devaluation) will also affect the next quarter data.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER

1982

Table 6
Rates of Change of Prices, Monetary Aggregates and Credit
Consumer
price
index

Period

Short-term
bank credit1

Import
prices2

1971

13%

28%

35%

36%

1972

1973

26%

1974

1975

1976

1977

1978

1979

111

100

101

102

1980

133

148

141

110

133

1981

101

100

6/70-9/73

9/73-12/74

—

12/74-9/77

9/77-12/78

12/78-12/81

NOTE: M, =

—

Cash and checkable demand deposits.

M4 =

M, + unindexed time deposits + certificates of deposit + foreign-exchange-indexed
residents deposits (excluding deposits originating from personal restitution payments
from the Federal Republic of Germany) + tradable government bonds.

M5 =

M4 + long-term saving schemes and deposits + foreign-exchange-indexed deposits
originating from personal restitution payments from the Federal Republic of Germany.

11ncludes both credit directed by the B.O.I. and “ free” credit. This series is not fully consistent over time.
2Based on quarterly data. These data currently are undergoing revision at the B.O.I.
SOURCEs: B.O.I. and Statistical Abstracts for Israel data.

short-run effects from both M4 and short-run bank
credit to prices. 26 The interpretation of the rela
tionship between these variables and prices, however,
must be done carefully, since they are themselves
largely endogenous. In particular, the broader mone
tary aggregates and credits include sizable indexed
components, and the rate of exchange also is strongly
affected by prices (especially since 1979).
26See Brezis, Leiderman, Melnick, “Inflation and Monetary Vari
ables.” They found a strong short-run effect from credits to prices,
weaker effects of M4 on prices and strong effects of prices on both
M4 and credit. Credit and the large monetary aggregates have
(not surprisingly) more stable velocities than M[.
In recent years, the B.O .I. has used M4 and short-run bank credit
as principal monetary indicators and policy targets. The short-run
effect of bank credit on prices may be due to their effects on the
short-run business liquidity. In Israel businesses have limited
access to alternative sources of finance in the short run and react to
credit squeezes by reducing inventories — both through changes
in production and through changes in pricing decisions.

The Early Period: From Mid-1970 to
September 1973
The transition of the Israeli economy from low to
high inflation began in mid-1970; until then, Israel had
experienced 16 years of low inflation at about 5 percent
per year.27 The rate of price increase hit the 10 percent
range in 1970, rose marginally in 1971-72 and in the
first nine months of 1973 (before the outbreak of the
Yom Kippur War) accelerated to an annual rate of 21
percent.
The first round of the higher price increases in 1970
was due to increased indirect taxation, not to an earlier

27The country had experienced higher inflation during World War
II and its first years of independence.

FEDERAL RESERVE BANK OF ST. LOUIS

increase in the growth of the money supply M j .28
However, money growth took off in the second half of
1970, reaching an average annual rate of growth of 26
percent between June 1970 and September 1973 (com
pared with a 15 percent average annual increase in
prices — see table 6). This monetary accumulation was
part of a general build-up of financial assets. Both M4
and M5 grew at 34 percent per year over the same
period as a result of high net sales of foreign exchange
by the public to the Bank of Israel.29
It would, however, be inaccurate to attribute the
acceleration of inflation in that period solely to forces
operating on the supply of money. Between June 1970
and September 1973, the domestic price of imports
rose at an annual rate of 19 percent, following the
imposition of import duties in 1970, a 20 percent de
valuation in 1971 and international price increases in
1972-73. Had the quantity of money continued to grow
at a low rate, these import price increases would have
had a much smaller effect on the general price level
(probably joined with lower real activity). However,
the fact that money growth began to accelerate only
after the first round of price increases (in spite of an
earlier increase in the larger monetary aggregates) in
dicates that it was, at least in part, adjusting to the
short-run effects of higher import prices.30
Finally, one should note that in this period, the
increase in the local price of imports was to a certain
extent exogenous to the inflationary process, since it
was caused by higher foreign commodity prices. On
the other hand, lower money growth may have pre
vented the 1971 devaluation or reduced its size.

From the 1973 War to the
Foreign Exchange Reform
The October 1973 war and the ensuing political and
economic international events had strong and lasting
effects on the Israeli economy. The real rate of growth

28The quantity of money rose at an annual rate of 13 percent be
tween the end of 1966 and mid-1970 (compared with an average 9
percent real GNP increase) and increased even more slowly in the
last 18 months of that period.
"T h e increased sales were due to the combination of an improve
ment in the private current account and a capital inflow induced
by relatively high domestic rates of interest and a booming
economy.
30That the quantity of money was adjusting to demand and not just
to supply conditions is evident from the fact that its growth was
considerably lower than that of the large monetary aggregates
both in 1973 and afterward, as higher inflation affected the real
demand for money.

AUGUST/SEPTEMBER

1982

fell, higher defense and oil import bills widened the
current account deficit and the rise in domestic de
fense expenditures increased governmental deficits.
Following the outbreak of the war, the B .O .I. con
ducted a permissive policy, in particular encouraging
rapid credit growth. As time passed, however, econo
mic policy began to reflect the growing concern over
the balance-of-payment situation. Monetary policy be
came more restrictive, indirect taxation was increased
and, in November 1974, the rate of exchange was
devaluated by 43 percent.
The effect of the international oil price increase, the
changes in taxation and the devaluation led to sharp
price increases which were largely accommodated.
The larger monetary aggregates grew rapidly through
out 1974 (although more slowly than before in real
terms). The growth of Mi, on the other hand, was
considerably lower than that of the price level, thus
squeezing the real value of the money balances. This
development reflected mainly a downward adjustment
of real money demand to the higher rate of inflation
(see section 1).
The transition to restrictive policies had visible
effects in the 1975-77 period. Domestic and foreign
deficits shrank, economic activity was low, and all the
monetary aggregates grew more slowly than the price
level. The rate of inflation came down from its 1974
peak; it remained, however, considerably higher than
in the pre-war period.
In June 1975, the government adopted a policy of
small and frequent devaluations of about 2 percent per
month (a “crawling peg system”).31 This policy was
motivated by the continuing concern about the balance
of payment and a desire to avoid the strong destabiliz
ing effects of large, infrequent devaluations.32 As a
result of this policy and the absence of external supply
shocks, the fluctuations in the rate of inflation were
reduced considerably.

From October 1977 to the Present
In October 1977, the government embarked on a
foreign exchange reform intended to contribute to

31The transition to the crawling peg system at that time might have
been interpreted as a signal that the government was more com
mitted to adjusting to inflation than to undertaking strong antiinflationary policies.
32The expectations for the 1974 devaluation had produced large
private capital flows, and the devaluation itself brought about a
sharp increase in the general price level.

FEDERAL RESERVE BANK OF ST. LOUIS

greater economic efficiency. This reform included:
1) further steps in the liberalization of foreign
transactions, in particular of international
capital inflows and direct holding of foreignexchange bills;
2) the creation of a universally accessible class of
foreign-exchange-indexed deposits;33
3) the abolition of direct export subsidies and the
reduction and unification of import duties;
4) a transition from the crawling peg system to a
market-determined, flexible exchange rate.
As the reform was enacted, the exchange rate depre
ciated by 47 percent and the general price level partial
ly adjusted upwards.34 As a result of the automatic
indexation, the value of financial portfolios also in
creased.
Between the reform and the end of 1978, the larger
monetary aggregates rose at exceptionally high rates,
even when the effect of indexation is taken into
account. Thus, M4 and M5 grew respectively at 78
percent and 90 percent annual rates between Septem
ber 1977 and Decem ber 1978 compared with a 56
percent annual increase in the CPI. This increase was
fed, to a large extent, by sizable public loans to export
ers and arge capital inflows, which were made possi
ble by the reform and induced by the difference be
tween the foreign and domestic interest rate.30 This
upsurge in public loans and capital inflows reduced the
level of real interest rates. The new foreign-exchangeindexed deposits, which offered an attractive mix of
liquidity and rate of return, increased rapidly; on the
other hand, the growth of M j was slower than that of
the price level.
The increase of the large monetary aggregates and
the lowering of real interest rates played a major role in
“ Before the reform, foreign exchange deposit holding was limited
to agents engaged in foreign trade, banking institutions, reci
pients of foreign incomes and non-residents. Strictly speaking,
the introduction of the new deposits was not part of a foreign
exchange reform, since they are domestic deposits indexed to the
foreign exchange, not claims on foreign exchange. These deposits
are not checkable.
3JThe high depreciation reflected in part the adjustment of the
formal rate of exchange to the reduction of export subsidies and
import duties. The price level rose by 18 percent in the last
quarter of the year, compared with an average of 6.5 percent in
the three former quarters. Most of the price increase in the last
quarter occurred immediately after the depreciation.
35The domestic cost of foreign borrowing is i* + E e, where i* is the
foreign rate of interest and E e the expected rate of exchange
depreciation. Capital inflows at the end of 1978 also were affected
by the anticipation of the imposition of constraints on their move
ments (see below).

AUGUST/SEPTEMBER

1982

the increase of real domestic demand and economic
activity in 1978 and early 1979.36 As the stock of finan
cial assets rose relative to both physical assets and
income, the private sector increased its demand for
physical assets and other goods and services (especially
as investment and purchases of durable goods had
been low in previous years). The housing market, a
traditional leading sector, experienced a boom, GNP
increased rapidly and wages also rose with the demand
for labor. Unconstrained by the largely adaptive
money supply process, these developments culmi
nated in a dramatic acceleration of the rate of price
increase to about 80 percent in annual terms at the end
of 1978 and the beginning of 1979.3‘
The authorities were alarmed both by this sudden
acceleration of price increases and by the fact that,
since the reform, the rate of exchange rose consider
ably more slowly than the general price level. At the
beginning of 1979, the B .O .I. imposed restrictions on
capital inflows and domestic bank credit growth and
began to stabilize the real rate of exchange through
intervention in the foreign exchange market.38 The
restrictive effect of these measures, which were con
tinued throughout the next years, was reinforced in
1979 by a more restrictive fiscal policy and increased
purchases of foreign exchange by the private sector
from the B .O .I.39
36High public demand and expectations related to the beginning of
the peace-making process with Egypt also contributed to the
heating up of the economy.
37This was twice the annual rate prevailing during the first three
quarters of 1978.
Some observers have argued that the end of 1978 price accelera
tion reflected a delayed reaction to the end of 1977 massive
depreciation and relative increase in the price of tradable goods.
Such a delayed reaction would have been unusual compared with
earlier (and later) adjustments to cost shocks. In addition, the
correction of an “excessive” increase in the relative price of trad
ables would have implied logically only a future lower rate of
increase in the rate of exchange relative to the rate of inflation, not
necessarily an acceleration of inflation.
'^Starting in 1979, the B.O .I. generally imposed periodic ceilings
on bank credit growth. These ceilings were partially accommo
dated to deviations of the rate of price increase from its projected
path to reduce the effects of strong real credit crunch on private
economic activity. The B.O .I. also imposed a levy on foreign
exchange credits (exempting exporters and other favored borrow
ers).
The aim of the intervention in the foreign exchange market was to
equate the average monthly rate of depreciation to the difference
between the local and foreign rates of price increase (thus con
trolling the average real rate of exchange along a “purchasing
power parity” path). The B.O .I. did not intervene to prevent
“tolerable” daily fluctuations of the rate.
39The private sector’s current account deficit increased as a result of
the rise in oil prices and the high demand for imported durables at
the beginning of the year. The demand for the highly taxed
durables also affected the government deficit.

FEDERAL RESERVE BANK OF ST. LOUIS

Due to the effect of indexation and higher inflation,
the large monetary aggregates increased more rapidly
in 1979 than in 1978, but they were squeezed in real
terms. Mi increased at an even slower rate than in the
previous year and its real value decreased by 38 per
cent. This reduction may have been affected by the
supply forces that reduced the real values of financial
portfolios in general, but principally it reflected a reac
tion of the demand for (non-interest-bearing) money to
higher inflationary expectations.
Real rates of interest on private credits increased
dramatically and real demand and economic activity
slowed down in the second half of 1979 and in 1980.40
Still, the rate of the price increase rose to a new annual
peak of 150 percent in the second half of 1979, reflect
ing the short-run effects of energy prices and the re
duction of price subsidies.
The rate of inflation remained stubbornly high in
1980 (133 percent), apparently as the higher rates of
recent price increases were incorporated into inflation
ary expectations and the still remaining nominal con
tracts. The growth of the large monetary aggregates
outpaced that of price increase and M j grew at 90
percent — still falling in real terms.41
The economy resumed a higher real rate of growth in
1981, and, at the same time, the rate of inflation went
down. This decrease was led by the short-run effect of a
reduction in indirect taxation, which brought the rate
of price increase to 94 percent in annual terms in the
first two quarters of the year. Later on, the rate of price
increase rose again.
As a result of the reduction in indirect taxation and
the adjustment of income tax brackets, there was a
sharp increase in the share of the domestic public
sector deficit in GNP in 1981. This effect, however,
was offset to a large extent by a reduction in the net
flow of B .O .I. loans to exporters. The real value of the
Mi balances continued to fall, but the growth of M5
kept up with the rate of inflation.42 In addition, there

“'Reiil demand and certain financial demands also were affected by
the anticipation of additional stricter government measures.
41The increase in the large aggregates was due, in part, to the effects
of lower economic activity and real demands on taxation and the
current account, a reversal of the 1979 developments. In addition,
the real market value of government bonds, which had fallen in
1979, went up again.
42M4 was reduced somewhat in real terms. This was due to the
successful marketing of new saving schemes with shorter redemp
tion periods (saving schemes are included inM 5 but not in M4).
It is interesting to note that, while real M, continued to decrease
in 1981 in spite of the reduction in the rate of inflation, the

AUGUST/SEPTEMBER

1982

was a sharp increase in the real growth of other finan
cial assets.43

6. CONCLUDING REMARKS
The Israeli experience demonstrates the inflationary
hazards of economic policies that subordinate mone
tary management to the achievement of other goals.
The inadequate monetary control was technically
caused by the expropriation of open market operations
in public debt and foreign exchange from the arsenal of
monetary instruments. More basically, it reflected the
low priority of price stability when compared with
other policy goals. This preference was due, to a large
extent, to the ability of different economic groups
to reduce some of the costs of inflation by indexation
and other adjustment mechanisms.
Under the favorable conditions prevailing in the
1950s and 1960s, the Bank of Israel was able to main
tain a reasonable monetary growth despite the con
straints on its policy tools. This situation changed in the
1970s. In that decade, the Israeli economy was taxed
heavily by changes in its defense requirements and the
international economic environment. The control over
monetary growth was lost, and the economy veered
rapidly toward high inflation.
Israel has gone a long way along the path of adjust
ment to inflation, but has been unable to neutralize
fully its long-run disruptive effects. The experience
with the implementation of partial anti-inflationary
measures in 1979-81 reveals also that indexation and
other contrivances have not eliminated the short-run
costs of disinflation.
The return to reasonable price stability requires
effective control over monetary growth.44 To achieve
demand for unindexed money substitutes (mainly CDs) increased
rapidly. As a result, the value of Mj plus the unindexed money
substitutes (known as M2) increased in real terms — for the first
time since 1972.
43In recent years, financial concerns have largely intervened in the
stock exchange market to minimize reductions in the real market
value of their stocks. This behavior has led to the argument that
financial shares may be close in liquidity to government bonds. If
the market value of these shares is added to M4 and M5, the rate of
growth of these “augmented” aggregates would be much higher
than the price level in 1981. Pension funds and other forms of
long-term savings that are not included in M-, have also grown
rapidly in recent years.
44The choice of the specific target aggregate should depend on the
nature of the relationship between different alternative aggre
gates and prices and on the controllability of different aggregates.
While the first of these issues has been only partially investigated
in Israel, it seems that aggregates that are tied to an unindexed
monetary base (like M |) could be more easily controlled than
others (like M4).

this, the management of at least one of the major
sources of monetary base change must be subordinated
to monetary considerations. Given the committment
to real exchange rate stabilization in Israel, it seems
that the best way to achieve monetary control in Israel
is through the use of public debt management as an
instrument of monetary control — a solution adopted
in many other countries. It should be recognized,
however, that if, at the same time, the real value of
public deficits and loans is not reduced, the Bank of
Israel will be confronted continuously with pressures
to adopt accommodating policies.40
45These pressures may arise in reaction to two possible effects of
high levels of public deficits and loans: a) these deficits and credits
may create short-run upward pressures on the rate of inflation —
either through the direct effect of the demand that they finance,
or through the effect of rapid public debt accumulation by the
private sector: b) to the extent that large net sales of public debt
are used to finance public deficits, they exert upward pressure
on real interest rates and crowd out private borrowers.

The optimal pace of disinflation in Israel may be
more rapid than in lower-inflation economies that have
not developed similar price adjustment mechanisms.
Whatever the pace chosen, it is important that disinfla
tion be carried out in a consistent way, since stop-go
policies reduce the credibility of the policymakers and
raise the pains of disinflation; in a democratic society
like Israel, such policies may even altogether frustrate
the disinflationary effort.

While the reduction ofpublic deficits and loans also can contribute
to a more efficient resource allocation, the use of direct costreducing measures in the process of inflationary deceleration is
more problematic (cost-reducing measures include reductions in
indirect taxation, the lowering of the real rate of exchange and
intervention in private price and wage determination). Such mea
sures may increase the public sector deficit, induce destabilizing
speculation and interfere with the efficiency of resource alloca
tion. They should, therefore, be considered only as a short-run
expediency and as a part of a comprehensive policy based on
monetary control and lower public deficits and loans.

Full text of Review (Federal Reserve Bank of St. Louis) : August/September 1982

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