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____________ Review____________
Vol. 67, No. 7




August/September 1985

5 The President’s Proposed Corporate Tctx
Reform s: A Move Toward IcL\
Neutrality
18 Factors Behind the Rise and Fall of
Farmland Prices: A Preliminary
Assessment
25 Weekly M oney Announcem ents: N ew
Information and Its Effects

The Review is published 10 times p er year by the Research and Public In form ation D epartm ent o f
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Federal Reserve Bank of St. Louis
Review
August/September 1985

In This Issue . . .




Significant changes in the existing federal incom e tax laws have been proposed
by the President. In the first article o f this Review, "The President’s Proposed Tax
Reforms: A Move Toward Neutrality," authors Dallas S. Batten and Mack Ott argue
that the suggested reforms would increase production and national welfare.
Beginning with a simple illustration o f h ow taxes can alter the allocation o f
econom ic resources, the authors demonstrate h ow the proposed reforms would
reduce such allocative distortions. Batten and Ott argue that this aspect o f the
proposed tax reform has been overlooked in most critiques o f the proposals, such
critiques concentrating on macroeconom ic impacts or the possible loss o f subsi­
dies to particular interest groups. The authors note also that removing subsidies
and making the tax code relatively more neutral w ould improve the productivity
o f investment, measured by its before-tax rate o f return.
In the second article o f this Review, Michael T. Belongia applies a basic m odel of
asset pricing to farmland in an attempt to determine the major factors explaining
the ups and downs o f land prices. In his "Factors Behind the Rise and Fall of
Farmland Prices: A Preliminaiy Assessment,” Belongia shows that expected
future inflation, expected future net returns to farming and the ex ante real
interest rate explain much o f the variation in the growth o f farmland prices
through their 1981 peak.
To test the m odel’s validity in explaining the more recent behavior o f farmland
prices, an out-of-sample simulation experiment was perform ed for the 1982-85
period. The result o f this exercise indicates that the m odel does poorly in
explaining the recent decline in land prices, raising some doubt about the
m odel’s validity in times o f sharp land price declines. The author argues that this
poor performance in explaining recent land price movements is more likely
related to difficulties in measuring unobservable expectations than to weaknesses
in the econom ic model.
The third article o f this Review examines the theoretical effects and reviews the
empirical findings on the impact o f the weekly m oney announcement on finan­
cial markets. In "Weekly M oney Announcements: N ew Information and Its Ef­
fects,” Richard G. Sheehan presents three alternative hypotheses about w hy
financial markets react to this announcement. T w o o f the hypotheses, the
expected liquidity effect and the inflation premium effect, focus on expected
changes in the m oney supply. The third hypotheses, in contrast, concerns the
expected changes in money demand.
These three hypotheses are generally assumed to be com peting explanations of
w hy m oney announcements have an impact on financial markets. Sheehan
demonstrates that, in fact, the three effects may be substitutes or complements.
Only the expected liquidity effect by itself is consistent with till the empirical
evidence. It is also possible, however, that all three effects have been present.

3




The President’s Proposed
Corporate Tax Reforms:
A Move Toward Tax Neutrality
Dallas S. Batten and Mack Ott

T

J - HE President has proposed a significant change
in the federal incom e tax law, The President's Tajc
Proposals to the Congress f o r Fairness, Growth and
Simplicity, (hereafter PTP). Included in PTP are pro­
posed corporate business tax reforms that, in general,
w ould low er the marginal tax rate on business incom e
w hile broadening the corporate tax base. Because, on
net, these proposals w ould increase the average tax
rate on business income, they have been w idely criti­
cized as having deleterious effects on U.S. investment,
em ployment and econom ic growth.1
By focusing on the negative m acroeconom ic effects,
however, these critics have overlooked some o f the
proposed tax reform ’s positive allocative effects. The
President's proposal w ould make tax rates across in­
dustries and activities m ore uniform and reduce the
distorting influences o f inflation, thereby diminishing
the role o f the tax structure in the allocation o f pro­
ductive resources.

Dallas S. Batten, a research officer at the Federal Reserve Bank of St
Louis, is currently on leave as a senior staff economist at the Council of
Economic Advisers. Views expressed are not necessarily those of the
council. Mack Ott is a senior economist at the Federal Reserve Bank of
St. Louis. James C. Poletd provided research assistance.
'See, for example, Rowen (1985), Stemgold (1985) and Yemma
(1985).




The purpose o f this article is to examine the alloca­
tive effects o f the President's proposal. W e begin by
describing the concepts o f econom ic efficiency and
tax neutrality, tw o important criteria for evaluating the
reform. Then, the basic points contained in the Presi­
dent's proposal are outlined and evaluated against
these criteria.

ECONOMIC EFFICIENCY AND TAX
NEUTRALITY
Fundamentally, econom ic efficiency means using
resources in their highest valued activity. A simple
example using the dem and for and the supply o f
apples demonstrates the concept o f efficiency and
shows h ow competitive markets result in efficient
resource use.2The supply curve in figure 1 represents
the minimum price that producers must receive if
they are to supply a specific quantity o f apples. This
price is determ ined by the "opportunity cost" (the
highest valued alternative use) o f the resources used

'This example is simplified for illustrative purposes. It ignores the
issues of externalities and imperfect competition. For a more com­
plete discussion, see Hirshleifer (1980).

5

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

F ig u r e 1

Efficient Production
Q u a lity aid Price Determined by Market

to produce apples. The dem and curve in figure 1
portrays the highest price consumers are w illing to
pay for any specific quantity o f apples.

The only price that is com m on to both the supply
and dem and curves IP*) is called the "equilibrium ”
price; it is the only price at which the quantity de­
m anded equals the quantity supplied IQ*). This sug­
gests that, at equilibrium, the value that people place
on each apple equals the opportunity cost o f the
resources used to produce it. This is w h y the com peti­
tive market equilibrium represents an econom ically
efficient allocation o f resources.

Producing m ore IQJ o r less IQ,( apples than Q*
w ou ld be inefficient. Either too many or too few re­
sources w ou ld be allocated to apple production given
the value people place on apples com pared with other
products that those resources could produce. The
market will induce producers to provide exactly Q*. If
Q, apples w ere produced, consumers w ould be w ill­
ing to pay only P, per apple, w hich is less than the cost
o f production, P,; producers then w ou ld decrease
output, low ering costs and releasing resources to
other higher-valued uses. If Q, w ere produced, the
adjustment w ould proceed conversely, with output
rising and resources for apple production being bid

6



F ig u re 2

Inefficient Production
Qaaatity aad Price Distorted by Tai Sabsidy

away from other activities w hose products w ere not as
highly valued as apples.

Taxes: The Wedge Effect and Reduced
Efficiency
Taxes and subsidies change the allocation o f re­
sources if they alter the incentives confronting pro­
ducers or consumers. In particular, some taxes or
subsidies drive a w edge between the prices that con­
sumers pay and producers receive. A tax on apple
production — or on the resources used to produce
apples — raises firms’ costs o f production. This situa­
tion is depicted in figure 2 as the upward shift in the
supply curve to STAXfrom its position w ithout taxes or
subsidies, S. As a result o f the tax, the equilibrium
price o f apples rises to P2 and the quantity produced
(and sold) falls to Q,; the econom ically efficient quan­
tity o f apples, Q*, is no longer produced because the
tax alters producer incentives. At Q „ the value that
people place on apples IP,) exceeds the actual value of
the resources used in apple production (P,). The
wedge, the difference between these values (P2- P,), is
the amount o f the tax.
Likewise, subsidizing the production o f apples (per­
haps through use o f tax preferences such as special
deductions, credits or abatements) shifts the supply

FEDERAL RESERVE BANK OF ST. LOUIS

curve to S*,,, in figure 2, resulting in more apples being
produced (QJ than is econom ically efficient. At Q*, the
value o f resources used to produce apples (P2) exceeds
the value that people place on apples (P,). The differ­
ence (P, — P,) is the amount o f the subsidy and a
measure o f the econom ic inefficiency.
T o summarize, taxes and subsidies cause econom ic
inefficiency by affecting the quantity o f the good pro­
duced. A tax on production results in too few re­
sources em ployed in apple production, w hile subsi­
dies motivate too many resources devoted to apple
production.3 In either case, resources are wasted, the
value o f the econom y’s output is reduced and con­
sumers are correspondingly worse off than if there
had been no tax or no subsidy.

Nonneutral Taxes: A Cause o f Econom ic
Inefficiency
As w e have seen, some taxes and subsidies distort
resource use, causing inefficiency and making people
worse off. Thus, a useful benchmark against which to
evaluate both the existing tax system and the potential
benefits o f tax reform is an ideal, nondistorting "neu­
tral” tax system. A neutral tax is one that causes no
change in production, consumption or investment. In
the context o f figure 1, the im position o f a neutral tax
w ould not alter the position o f the supply curve.
Consequently, a neutral tax does not induce inef­
ficient resource use.

O f course, many people feel that government should guide resource
use in order to attain ends not necessarily reflected in market prices.
For example, Sen. Russell Long, former chairman of the Senate
Finance Committee, was characterized in a recent Wall Street
Journal interview as being opposed to “[rjelinquishing tax law to the
raw forces of the free market. .
I do not regard this matter of collecting taxes as simply a matter of
bringing in revenue to finance government," he says, “just as the
appropriations process seeks to do more than pay tor national defense."
To shy away from using the tax code to promote the general welfare, he
says, is to be as callous as those who “don't want to be bothered doing
anything that benefits anyone except their own greedy selves.” (Bimbaum. 1985)

This view is widespread in both houses of Congress and on both
sides of the aisle. For example, Senate Finance Committee Chair­
man Robert Packwood concurs in using the tax code for “legitimate
social purposes.” (McGinley, 1985). Frequently, such social pur­
poses are identified with a particular industry as in Sen. Malcolm
Wallop’s defense of tax preferences for the oil industry: “. . . These
provisions are backed by sound tax policy and protect a higher
public need, namely energy independence." (Wallop, 1985) Con­
versely, Sen. Bill Bradley, a proponent of tax reform, argues,
The best allocator of capital is the free market, not the Senate Finance
Com m ittee. . . as laudable as all these credits and deductions may be,
when you put them in the tax code, rates are higher than they would
otherwise be. (McGinley, 1985)




AUGUST/SEPTEMBER 1985

Obviously, any tax that can be reduced by a change
o f activities is not neutral. For example, an incom e tax
is not a neutral tax because it varies w ith income.
Thus, for individuals, an incom e tax lowers the cost o f
leisure (which is not taxed) and induces people to
substitute more leisure in place o f income-generating
(taxed) activities. The extent o f this substitution is
small, o f course, w hen considering the im pact o f taxes
on corporate incom e. A corporation’s shareholders
are unlikely to place much value on the leisure time o f
corporate assets — or that o f the corporation’s w ork­
ers. Consequently, the tax-free status o f leisure does
not preclude neutral taxation o f business income.
Although business incom e taxation could be set up
in a nearly neutral fashion, in reality, it seldom is. Tax
preferences exist explicitly to encourage specific activ­
ities that w ould not be undertaken otherwise. Capitalintensive industries benefit from certain investment
tax credits and accelerated depreciation that are not
as remunerative to less capital-intensive industries.
Some capital expenditures are treated as a current
expense (for example, intangible drilling costsl, and
depreciation deductions based on historical costs are
subject to distortions from inflation.4 Some business
incom e is not taxed at all (for example, additions to
bank reserves for loan defaults and the incom e o f
limited liability partnerships), w hile other business
incom e is taxed twice (corporate dividends). Finally,
tax rates vaiy according to arbitraiy realization proce­
dures (capital gains vs. income). In each o f these in­
stances, taxes can be altered by changing the firm’s
production activity — its input mix, legal structure,
product m ix or timing o f sales. T o the extent that such
tax-induced changes exist, the tax system is not neu­
tral; the result is a distortion o f resource use and
econom ic inefficiency.

Illustrations o f Nonneutral Tapes
T o illustrate the potential allocative effects o f the
current business tax structure, consider table 1, which
contains effective tax rates fo r a sample o f large corpo­
rations in various industries over the past four years.
This table presents average (not marginal) and actual
(not expected) tax rates. It nonetheless provides an
indication o f just h ow diverse tax rates have been
across industries as w ell as h o w important tax prefer­
ences may have been in allocating resources among

4For a discussion of the distortions in depreciation accounting and
the tax acts of 1981 and 1982, see Ott (1984).

7

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

Table 1
Comparison of Tax Rates on Large Corporations in Various U.S. Industries, 1980-83
Industry1

Aerospace
Beverages
Broadcasting
Chemicals
Computers and office equipment
Construction
Electronics and appliances
Financial institutions
Food processors
Glass and concrete
Instrument companies
Insurance
Investment companies
Metal manufacturing
Metal products
Mining
Motor vehicles
Paper and wood products
Petroleum*
Pharmaceuticals
Retailing
Rubber
Soaps and cosmetics
Telecommunications
Tobacco
Transportation:
Airlines
Railroads
Trucking
Utilities5
Wholesalers

1980

1981

1982

1983

1980-83
average

16.4%
28.0

6.8%
28.8

(0.6)%
20.5
8.9
(17.7)
26.4
15.9
14.3
(3.8)
31.6

9.7%
23.2

21.9
(6.3)
21.3

14.0%
18.7
18.5
(1.0)
26.3
0.7
7.4
6.4
25.9
17.5
32.8
9.9
9.3

2

2

3

13.7
24.9

3

5.0
25.3

3

24.5
5.8
35.6

3

17.1
2.7
26.8

3

37.1

3

26.6

3

3

3

3

15.3

10.2

2

3

3

3

3

2

3

3

2

(1.4)
31.1
39.2
34.1

(14.2)
21.7
35.9
22.3

3

3

3

3

3

3

31.4

31.3

3.0
10.7
37.5
10.9

(7.5)
46.1
10.3

2

3

3

30.2

36.1
18.2
32.7
20.4
39.0
33.3
1.6
36.3
2

4.1
36.9
15.6
36.1

15.1

3

3.6
25.8
3

16.2
3.8
29.5
3

29.5
3
3
2
3

2

3

3.5
(0.5)
21.3
27.2
20.0
19.6
35.6
4.8
33.8

3

2

3.3
34.5
7.1
34.8

(2.9)
23.5
32.9
22.9
3
3
3

33.3
2

2.4
38.2
10.7
3

Source: Joint Committee on Taxation, November 30, 1984, as reported in Daily Report for Executives, December 3,1984 (DER No. 232),
p. J-1.
'An industry is included in this table only if substantially the same companies are included in the sample each year.
2Rate not computed on book loss.
3The 1980 and 1981 rates are not available: the 1980-83 average is not computed.
4Some companies included in the 1982 and 1983 group were classified with crude oil production in 1980 and 1981.
5ln 1980 and 1981, the utilities group included AT&T and GTE. The 1980 and 1981 utilities rate is restated to include only electric and gas
utilities.

industries. For example, in 1983, these rates ranged
from an effective tax rate o f —1.0 percent (that is, a
subsidy) for the chemical industry to a 35.6 percent
rate fo r the soaps and cosmetics industry. Further­
more, providers o f services faced substantially diverse
rates: from financial institutions 16.4 percent) to
Digitized for 8
FRASER


wholesalers (34.8 percent).
In large part, these variations are due to variations in
the tax credits available to the corporations. This is
made clear by an examination o f table 2, w hich dis­
plays the data for 1981, the most recent year available.

Table 2

The Impact of Tax Credits on Tax Rates, 1981 (dollar amounts in millions)
Tax Rates

Income
Subject
to Tax

Industry
ALL
INDUSTRIES

Cor­
porate
Tax

$241,496.0 $102,258.0

Agriculture, Forest,
Fishing
Mining
Construction

Effective Net of
Percent’ Credit2

Tax Credits

Total3

Total
Credit
as a
Percent
of Cor­
porate
Tax

Invest­
ment

Investment
Credit
as a
Percent
of
Corporate
Tax

42.3%

18.1% $58,444.0

57.2% $18,887.0

18.5%

Foreign

$21,829.0

Posses­
Foreign
sions
Credit
Credit
as a
as a
Percent
Percent
of Cor­
of Cor­
U.S.
porate Posses­ porate
Tax
sions
Tax

21.3% $1,946.0

1.9%

1,278.0
9,479.0
6,610.0

557.0
4,245.0
2,360.0

32.2
44.8
35.7

24.0
17.8
28.3

142.0
2,556.0
490.0

25.5
60.2
20.8

128.0
582.0
334.0

23.0
13.7
14.2

3.0
1,958.0
107.0

0.5
46.1
4.5

6.0
0.0
2.0

1.1
0.0
0.1

133,416.0
10,163.0
2,179.0

59,555.0
4,574.0
1,003.0

44.6
45.0
46.0

22.6
27.6
35.7

29,439.0
1,768.0
225.0

49.4
38.7
22.4

9,145.0
850.0
151.0

15.4
18.6
15.1

17,737.0
770.0
56.0

29.8
16.8
5.6

1,867.0
117.0
14.0

3.1
2.6
1.4

1,470.0

653.0

44.4

33.9

155.0

23.7

125.0

19.1

14.0

2.1

2.0

0.3

932.0
3,843.0

403.0
1,618.0

43.2
42.1

38.6
21.8

43.0
782.0

10.7
48.3

30.0
303.0

7.4
18.7

4.0
461.0

1.0
28.5

0.0
1.0

0.0
0.1

4,929.0
15,294.0
2,034.0
755.0
1,729.0
5,065.0
6,698.0
15,219.0

2,120.0
6,895.0
871.0
334.0
765.0
2,122.0
2,869.0
6,897.0

43.0
45.1
42.8
44.2
44.2
41.9
42.8
45.3

33.8
18.2
26.7
38.9
23.7
23.4
33.1
23.8

452.0
4,108.0
327.0
40.0
356.0
938.0
649.0
3,268.0

21.3
59.6
37.5
12.0
46.5
44.2
22.6
47.4

350.0
873.0
112.0
19.0
149.0
649.0
326.0
939.0

16.5
12.7
12.9
5.7
19.5
30.6
11.4
13.6

97.0
2,250.0
190.0
5.0
195.0
304.0
277.0
2,229.0

4.6
32.6
21.8
1.5
25.5
14.3
9.7
32.3

4.0
892.0
8.0
12.0
3.0
4.0
20.0
36.0

0.2
12.9
0.9
3.6
0.4
0.2
0.7
0.5

9,561.0
4,292.0

4,282.0
1,869.0

44.8
43.5

24.1
20.2

1,974.0
1,003.0

46.1
53.7

631.0
739.0

14.7
39.5

770.0
218.0

18.0
11.7

473.0
6.0

11.0
0.3

2,005.0
4,531.0

880.0
2,057.0

43.9
45.4

26.6
34.8

347.0
481.0

39.4
23.4

122.0
293.0

13.9
14.2

205.0
472.0

23.3
22.9

0.0
144.0

0.0
7.0

23,843.0
5,413.0
8,113.0

10,727.0
2,257.0
3,789.0

45.0
41.7
46.7

21.3
28.0
16.9

5,660.0
739.0
2,421.0

52.8
32.7
63.9

5,334.0
671.0
2,283.0

49.7
29.7
60.3

228.0
53.0
67.0

2.1
2.3
1.8

22.0
0.0
22.0

0.2
0.0
0.6

10,317.0

4,681.0

45.4

21.1

2,502.0

53.5

2,380.0

50.8

108.0

2.3

0.0

0.0

WHOLESALE AND
RETAIL
Wholesale

32,360.0
16,966.0

12,516.0
6,700.0

38.7
39.5

31.8
33.4

2,234.0
1,038.0

17.8
15.5

1,593.0
695.0

12.7
10.4

420.0
264.0

3.4
3.9

41.0
38.0

0.3
0.6

FINANCE,
INSURANCE,
REAL ESTATE
Banking

21,903.0
7,664.0

8,159.0
2,803.0

37.3
36.6

27.6
19.6

2,121.0
1,301.0

26.0
46.4

888.0
351.0

10.9
12.5

1,190.0
936.0

14.6
33.4

3.0
0.0

0.0
0.0

12,034.0

4,100.0

34.1

24.5

1,156.0

28.2

878.0

21.4

183.0

4.5

3.0

0.1

987.0

396.0

40.1

32.2

78.0

19.7

61.0

15.4

11.0

2.8

1.0

0.3

ALL
MANUFACTURING
Food
Tobacco
Textile and Mill
Products
Furniture and
Fixtures
Paper Products
Printing and
Publishing
Chemicals
Rubber and Plastic
Leather Products
Stone, Clay, Glass
Primary Metals
Fabricated Metals
Machinery
Electrical,
Electronic
Motor Vehicles
Transportation
Equipment
Instruments
UTILITIES
Transportation
Telecommunications
Electric and
Sanitary

SERVICES
Hotels and other
lodging

Source: U.S. Department of Commerce, Statistics of Income 1981, Corporate Income Tax, Table 2.
'Corporate tax divided by income subject to tax.
Corporate tax less total credits divided by income subject to tax.
3Sum of investment tax credits, foreign tax credits, U.S. possessions tax credits, work incentive tax credits, jobs tax credit, nonconventional
fuels tax credit and research activities tax credit.




FEDERAL RESERVE BANK OF ST. LOUIS

In general, industries with proportionally high tax
credits (table 2) correspond with the large corpora­
tions facing low tax rates (table 1) and vice versa. In
particular, chemicals, banking and utilities each have
high ratios o f credits to tax and low tax rates for 1981.
Conversely, food, instruments and wholesalers have
low ratios o f tax credits and high tax rates.
These tax credit ratios differ within industrial
groups as w ell as across them. Within the utilities
group, for example, compare tax credit ratios for trans­
portation (32.7) and telecommunications (63.9) in table
2 with their corresponding tax rates in table 1, or
compare the overall finance, insurance and real estate
tax credit ratio (26.0) and that for banking (46.4) in table
2 with their corresponding tax rates in table 1.
Profit-seeking investors typically w ill ensure that
their expected after-tax rates o f return are the same
across alternative investments, adjusting for risk dif­
ferences. If tax rates differ across industries, however,
the expected before-tax rates o f return w ill vaiy with
the tax rate. Consequently, some higher-earning in­
vestment opportunities, w hen com pared on a before­
tax basis, w ill be passed over in favor o f investments
that have low er before-tax, but higher expected after­
tax, rates o f return. A neutral tax system w ould result
in the same relative ranking o f investment opportuni­
ties before and after taxes. Tables 1 and 2 suggest that
the present tax structure does not have this character­
istic. A tax reform that produced more uniform tax
rates across industries w ou ld generate m ore efficient
allocation o f resources because investments w ould be
chosen more in line with their socially relevant,
before-tax yields.

A MORE NEUTRAL TAX SYSTEM: THE
PRESIDENT’S PROPOSAL
The President’s proposed business tax reform con­
sists o f four primary adjustments. These adjustments
w ould

AUGUST/SEPTEMBER 1985

While the focus o f our discussion is on the third
general feature, the reduction o f nonneutralities, the
analysis cannot be undertaken without considering
the other three.
The President’s tax proposal was set up to be
"revenue-neutral.”3 Consequently, in order to low er
the corporate tax rate yet shift the tax burden from the
personal to the corporate tax, it was necessary to
increase corporate tax revenues by broadening the tax
base — that is, by removing subsidies, exemptions and
credits. Their removal provides just about enough
additional revenues to offset the impact o f the rate
reductions, corporate and individual. This revenue
enhancement also extends to the reduction o f in­
flation distortions. By indexing depreciation for in­
flation, much o f the rationale for the accelerated d e­
preciation system is removed. Thus, the protection of
the depreciation deduction's real value compensates
for the low er depreciation deductions.
The impact o f these changes on total tax revenues
can be seen at the bottom o f table 3. Corporate tax and
other federal tax revenues over the five years 1986—90
w ould rise by about $120 billion, w hile personal tax
revenues w ould fall by $132 billion. The result is that
overall tax revenues over the five years w ould be ap­
proximately unchanged — less than a one-half per­
cent overall decrease — from what they w ou ld have
been in the absence o f tax reform.
Yet, there is m ore to the reform proposal. The Trea­
sury’s estimates o f tax revenues over the 1986—90 p e­
riod are based on an extrapolation o f current macroeconom ic output and grow th; this ignores the
reallocative or m icroeconom ic effects o f the reforms.
With the repeal o f various tax subsidies reducing
profitability in some business sectors, and the net
reduction in marginal tax rates increasing profitability
in other sectors, there w ould be a reallocation of
resources. A m ajor argument in favor o f this tax reform
is that it results in a m ore efficient allocation o f pro­
ductive resources. That is, the decrease in output in
sectors losing tax subsidies w ill be exceeded by the
increase in output in sectors benefiting from net de­
clines in marginal tax rates.

(1) Lower the corporate tax rate from 46 percent to 33
percent;
12) Shift the income tax burden proportionally— from
personal taxes (down 6 percent) to corporate taxes
(up 24 percent);
(3) Reduce nonneutralities in the tax code by broaden­
ing the tax base and repealing tax subsidies; and
(41 Reduce inflation distortions of resource allocation
bv indexing inventory costs and depreciation de­
ductions to reflect price changes.
Digitized for10
FRASER


5This is clearly stated in the summary of The President’s Tax Pro­
posals to the Congress for Fairness, Growth and Simplicity (p. 7);
Taken together, the President's proposals are “revenue neutral" (plusor-minus 1.5% of total revenues) — using conventional estimating
procedures, without changing macro-economic assumptions. That is,
under these assumptions, the proposals would, when fully effective,
raise virtually the same amount of revenue as current law.

AUGUST/SEPTEMBER 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3

Major Proposed Corporate Business Tax Reforms (dollar amounts in billions)
Anticipated Change in Corporate Tax Revenue3
Reform

Principal Elements1

Reference2

1986

1987

1988

1989

1990

Reduce corporate
tax rates

Corporate tax rate reduced from 46 to
33 percent; revise graduated corporate
rate structure; revise corporate
minimum tax

6.01, 13.04

$ -1 0 .0

$ - 2 6 .9

$ -3 5 .9

$ -3 9 .0

$ -4 1 .8

Neutrality toward
location of income

Use per country limitation for foreign
tax credit; allocation of deductions;
replace possessions tax credit (Puerto
Rico) with wage credit

15.00, 15.02,
12.05

1.3

3.4

4.1

4.6

5.1

Neutrality toward types
of investment

Adjust depreciation schedules and
7.01,7.02,
index for inflation; repeal investment tax 7.04, 7.07
credit; allow inflation indexed FIFO
inventory accounting recapture of rate
differential on accelerated depreciation

21.9

41.9

47.8

46.9

48.7

Neutrality toward
form of business
organization

Dividends paid 10 percent deductible
from taxable income

6.02

0.0

- 3 .4

- 6 .2

- 7 .2

- 8 .0

Neutrality toward
income measurement

Match expense and income from
multiperiod construction; treat pledges
of installment obligations as payments;
repeal structure rehabilitation tax
credits

8.01,8.02,
12.01

3.3

6.9

10.3

13.6

15.0

Neutrality toward
industries: repeal
energy and natural
resource subsidies

Repeal business energy credits; repeal
percentage depletion

9.01,9.02

0.24

0.44

0.54

0.84

1.14

Neutrality toward
industries: repeal
financial institution
subsidies

Repeal depository institutions’ bad debt
reserve deduction; disallow interest
incurred to carry tax-exempts; repeal
tax exemption of large credit unions;
limit life insurance reserve deductions;
repeal special percentage of taxable
income deduction for life insurance
companies; limit property and casualty
insurance reserves

10.01, 10.02,
12.08, 12.09,
12.10

2.1

4.2

4.9

5.7

6.9

$18.9
-1 7 .9
0.2
1.2

$26.1
-2 6 .0
0.3
0.4

$24.3
-3 2 .0
0.4
- 7 .3

$23.9
-2 9 .0
0.4
-4 .6

$25.2
-2 6 .9
0.4
- 1 .2

-1 .2 9 %

-0 .7 4 %

-0 .1 8 %

Total Changes

Change in corporate tax receipts5
Change in personal tax receipts5
Changes in other federal tax receipts6
Overall change in federal tax receipts
Percentage change from baseline revenues7

0.25%

0.08%

Source: PTP
'Not complete listing; reforms listed are those with cumulative revenue implications 1986-90 exceeding $1 billion.
References are to subchapters in PTP.
3Static revenue estimates; for each reform group, the total change is reported including specific reforms not referenced in column 2.
•■Includes change in excise taxes.
5Totals include some reforms not listed; source: PTP, Appendix B, p. 461.
6Estate, gift and excise taxes.
7As estimated by Treasury under current law.




11

FEDERAL RESERVE BANK OF ST. LOUIS

An estimate o f the overall gain (a part o f which
results from increased efficiency) due to the Presi­
dent’s proposed reforms has been com puted by the
Treasury Department:
For reasons suggested above, it is reasonable to expect
improved economic performance as a result of the
President’s tax proposals. The Treasury Department
estimates that the effect of the proposals would be to
cause real GNP to be at least 1.5 percent higher by 1995
than it would be under current law. Because of the
inherent uncertainty in such forecasts, however, this
additional growth has not been added to Administra­
tion forecasts and is not reflected in higher revenue
estimates.6
The estimated 1.5 percent rise in the level o f output
results from resource reallocations that w ould be in­
duced by the proposed tax reforms. In that sense, the
proposed repeal o f many so-called tax expenditures
— that is, tax subsidies, exemptions, credits and the
like — are sources o f a rise in U.S. wealth. Repeal o f
these tax expenditures, w hich are subsidies o f pro­
duction in the beneficiary industries, releases re­
sources to higher-valued uses. Thus, the value o f pro­
duction, in other words, income, and its capitalized
value, wealth, w ill rise as a result o f the reforms. T o see
more tangibly the source o f such tax reform benefits,
consider the follow ing description o f specific tax re­
forms outlined in table 3.

Neutrality Toward Location o f In com e
U.S. corporate incom e is subject to the U.S. income
tax regardless o f w here such incom e is generated.
Corporations, however, receive credits against their
U.S. tax liabilities for taxes paid to foreign govern­
ments. (See table 2 for the impact of foreign tax credits
across industries.) Under current tax law, corpora­
tions may receive larger credits from overseas produc-

6See The President's Tax Proposals to the Congress for Fairness,
Growth and Simplicity, p. 7. Estimates of the gain based on the
predecessor to the President’s proposal, the U.S. Treasury's Tax
Reform For Fairness, Simplicity and Economic Growth (1984), pro­
jected similar gains. Allison, Fullerton and Makin (1985) estimated
that the Treasury's tax reform proposal would increase GNP by
about 1.2 percent over what it would be under 1973 tax law. This
corresponds to a rise in wealth of over $895.1 billion dollars at
current prices. For the current U.S. population, this would amount to
over $3,700 per person at current prices. See Allison, Fullerton, and
Makin (1985), p. 12, table 3. Note that these estimated gains do not
exhaust the potential efficiency gains from even more dramatic tax
reform. Again, using the 1973 tax code as the base, Ballard,
Shoven, and Whalley (1985) have estimated the efficiency gains
from an alternative lump-sum tax system designed to avoid com­
pletely the resource misallocation that plagues the current system to
be between $4.0 and $7.3 trillion in 1/1985 dollars.

Digitized for12
FRASER


AUGUST/SEPTEMBER 1985

tion than from the equivalent domestic production.7
This amounts to a subsidy o f foreign production for
U.S. corporations in high-tax foreign countries. The
Treasury proposal w ould eliminate this subsidy by
changing the foreign tax credit to a bilateral basis. U.S.
corporations w ould be allowed to claim credit for
taxes paid in each foreign country up to a limit o f the
equivalent U.S. tax. Since the U.S. tax rate under the
Treasury proposal w ould be low er than most indus­
trial nations, it is likely that some overseas production
w ould be repatriated.8
In addition, the proposal w ould change some ac­
counting rules that allow firms to reduce tax liabilities
by transshipping goods or changing title to them in
offshore facilities. Also, the so-called possessions tax
credit, which applies predom inantly to Puerto Rico,
w ould be replaced with a wage credit. The result of
this change w ould be to limit U.S. corporate tax credit
to job-creating production in Puerto Rico. As shown in
table 3, such reforms w ould result in an expected $18.5
billion increase in tax revenues during the 1986-90
period. Not shown in the table, but clearly important,
w ould be any U.S. production increases induced by
removal o f the tax subsidy.

Neutrality Toward Capital Investment
Currently, tax deductions for the cost o f deprecia­
tion o f capital equipment and structures are based on
their historical cost. This creates a bias favoring invest­
ment in less durable over more durable equipment
and structures when the expected inflation rate is
moderate or high. The 1981 and 1982 tax acts revised
depreciation methods — the Accelerated Cost Recov-

This is because the current tax credit is computed on an overall or,
equivalently, an average basis. For example, suppose a U.S. corpo­
ration has taxable income of $1,000 each in countries A and B,
country A has a 60 percent tax rate and country B has a 20 percent
tax rate. Under current law, the corporation has a U.S. tax liability of
$920 on its foreign income — 46 percent of $2,000. It receives a
foreign tax credit of $800— 60 percent of $1,000 in country A and 20
percent of $1,000 in country B — so that its net U.S. tax on foreign
income is $120. Under the reform, the tax credit would be computed
with regard to the tax paid in each individual country and limited to
the equivalent U.S. tax. Thus, in this example, the foreign tax credit
would fall to $533 — the maximum of 33 percent under the lower
proposed U.S. corporate tax in country A and the actual 20 percent
in country B. As a result, the profitability of foreign production would
decline relative to domestic production.
8The corporate tax rates in most major industrial countries exceed
the proposed 33 percent U.S. rate: France, 50 percent; Germany,
56 percent; The Netherlands, 43 percent; United Kingdom, 35
percent (as of 1986); Japan, 43.3 percent on retained earnings, 33.3
percent on distributed earnings; Canada, 46 percent. See U.S.
Treasury (1984), vol. 1, p. 260.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

Table 4

Effective Corporate Tax Rates on Income from Equity-Financed
Investments for 46 Percent Taxpayer under ACRS1__________
Asset class
Type of asset

Inflation rate (percent)

(years)

0

5

10

Automobiles, light
trucks

3

-7 5 %

-9 %

18%

Most other producers’
durable equipment

5

-4 7

-4

16

-6

Railroad equipment

10

19

31

Utilities' equipment
and low-income housing

15

8

33

43

Structures

18

27

39

45

Source: PTP, p. 136.
'Assumptions: Real return after tax is 4 percent. The investment tax credit selected is the maximum
allowable tor new equipment (6 percent on three-year equipment and 10 percent on five-, 10- and
15-year equipment). Effective tax rates are the difference between the real before-tax rate of return and
the real after-tax rate of return divided by the real before-tax rate of return.

e iy System (ACRS) — to counteract the effects o f in­
flation by a more rapid w rite-off o f assets, especially
longer-lived assets, such as structures. As table 4 illus­
trates, however, the bias against more durable equip­
ment and structures rem ained a feature o f the tax
code. W hile the bias narrows as the inflation rate rises,
it remains heavily skewed in favor o f short-lived equip­
ment investment.

paper products industry, w hich put 88.2 percent o f its
investment into equipment, received an ITC covering
18.7 percent o f its tax liability and had a net negative
tax rate ( —14.2 percent) in 1981. In contrast, the to­
bacco products industry put 68.8 percent o f its invest­
ment into equipment, resulting in an ITC covering 15.1
percent o f its tax liability and a 31.3 percent effective
tax rate.

This bias against investment in structures does not
im pinge evenly on the earnings o f all industries. Some
industries invest a larger proportion o f their capital in
equipment than others. As table 5 shows, across all
industries, equipment accounts for more than fourfifths o f investment, but the proportion varies widely:
the tobacco products and pharmaceuticals industries
are on the low side, w hile the m otor vehicle and paper
industries are quite high.

To reduce these biases and their nonneutral tax
effects, the President’s tax proposal would revamp the
depreciation accounting deduction and repeal ITC.
ACRS w ould be replaced with the Capital Cost Recov­
ery System (CCRS). CCRS differs from ACRS in three
important respects:

The importance o f such investment patterns is their
impact on tax rates, both from the bias in the deprecia­
tion system (table 4) and the investment tax credit
(ITC). 1TC applies only to equipment; no credit is given
for structures. Thus, industries with high proportional
investment in equipment (table 5) tend to have high
ratios o f ITC to tax liabilities (table 2) and, conse­
quently, low er tax rates (table 1) than firms w ith low er
equipment-to-investment ratios. For example, the



First, CCRS would allow cost recovery of the real or
inflation-adjusted cost of depreciable assets, rather
than only the original, nominal cost. Second, CCRS
would assign property among new recovery classes
based upon economic depreciation rates. Third, CCRS
would prescribe depreciation schedules and recovery
periods which produce systematic investment incen­
tives that are neutral across recovery classes. {PTP,
p. 138)
Along with this revamping o f depreciation accounting,
ITC w ould be repealed. The result is to drastically
reduce the biases against durable equipment and
structures. As can be seen by comparing tables 4 and

13

FEDERAL RESERVE BANK OF ST LOUIS
*

AUGUST/SEPTEMBER 1985

Table 5

Investment Expenditures and the Proportion Invested in
Equipment by Selected Industries (dollar amounts in millions)
Investment in Producers
Durable Equipment Structures
Industry

Total Expenditures

Aerospace
Beverages
Chemicals
Computer and Office Equipment
Electronics
Food processors
Glass and concrete
Instruments
Metal manufacturing
Fabricated metal products
Motor vehicles and equipment
Paper and wood products
Petroleum and coal products
Pharmaceuticals
Rubber
Soap and other detergents
Tobacco products
All industries

$ 672.5
993.9
5,812.7
826.1
2,866.5
4,214.9
1,050.4
938.9
4,496.8
2,606.1
3,636.1
3,887.0
2,261.3
578.5
1,645.3
334.0
181.5
47,459

Percent in Equipment
82.5%
80.2
85.8
79.9
81.9
78.5
83.1
74.9
85.4
81.5
87.5
88.2
72.7
73.2
81.4
80.3
68.7
82.1

Source: U.S. Department of Commerce, Census of Manufacturers, 1977.

6, the effective tax rates on equipment are changed
from subsidies for short-lived equipment to a level tax
rate across all durabilities, and the bias against struc­
tures is reduced to a few percentage points from its
current huge spread. Note also that the indexing for
inflation removes that tax distortion as an influence on
asset choice. Correspondingly, there w ould be a nar­
rowing o f the tax rate differentials across industries.
It is important to em phasize that these reforms are
not intended to be neutral in the sense o f removing
incentives to invest. The new depreciation scheme
(CCRS) retains w rite-off periods for capital recovery
that are shorter than the anticipated econom ic lives of
the assets. Rather, the neutrality sought is between
investments o f varying durations:
The proposed CCRS depreciation system, in conjunc­
tion with repeal of the investment tax credit and other
capital and business taxation proposals, makes possi­
ble a substantial lowering of statutory tax rates for
individuals and corporations. This reduction in statu­

14




tory tax rates is accomplished without sacrificing in­
vestment incentives necessary to stimulate continued
economic growth for the economy as a whole. The
CCRS depreciation rates and recovery periods pro­
duce effective tax rates which would stimulate new
investment in depreciable assets. The indexing of de­
preciation allowances for inflation and the classifica­
tion of assets on the basis of economic depreciation
would ensure that the CCRS system provides neutral
investment incentives. (FTP, p. 148I
Another form o f investment w hose yields are dis­
torted by the current tax code is inventories. The costs
o f maintaining inventories are a relatively more im por­
tant part o f business in the service sector, particularly
wholesale and retail trade, than in manufacturing.
Inflation reduces the real deductible expense in­
curred in inventory replacement. This tends to low er
the profitability o f production in retail and wholesale
trade relative to manufacturing both directly and indi­
rectly (by inducing a smaller inventory level than oth­
erwise w ould be held). The President’s proposal

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

income tax.!l In contrast, incom e from sole proprietor­
ships or partnerships is not taxed at the firm, only as
the ow ner’s personal income.

Table 6

Effective Tax Rates on Equity-Financed
Investments in Equipment and
Structures1_________________________
Asset Type (example)

Paid2

Held3

Equipment:
four-year depreciation (autos)

16%4 18%

five-year depreciation (trucks, computers,
office equipment)

16

18

six-year depreciation (construction,
machinery, aircraft, instruments)

17

18

seven-year depreciation (furniture, industrial
machinery, communications and railroad
equipment)

17

18

10-year depreciation (ships, turbines, plant
and equipment for electric utilities)

17

18

23

25

Structure:
28-year depreciation (industrial and
commercial buildings, rental housing)

Source: PTP, p. 147.
'Assumes 33 percent statutory tax rate and 4 percent required
return after tax and inflation. The effective tax rate at the entity
level may be lower than reported here on leveraged investments,
depending on the degree of debt-finance and the relation
between the interest rate on debt and the rate of return on the
investment. Effective tax rates on different property within a
recovery class may vary somewhat depending on experienced
economic depreciation rates.
2Assumes application of a 10 percent dividend-paid deduction to a
corporation which distributes 100 percent of its earnings derived
from depreciable assets.
3Assumes no distribution of corporate earnings derived from
depreciable assets.
"The differences between the 16 percent effective tax rate for
classes 1 and 2 and the 17 percent effective tax rate for
equipment with six-year through 10-year depreciation write-off
periods are due to rounding and are not significant.

To reduce this distortion, the President's proposal
w ould allow corporations to deduct from taxable in­
com e 10 percent o f their dividend payout. As shown in
table 3, this w ould result in a decline in tax revenues
during 1986-90 o f about $24.8 billion.

Neutrality Toward In com e
Measuremen t
Analogous to the nonneutralities in the existing
depreciation deduction system are distortions in d e­
termining taxable incom e from the production o f as­
sets covering more than one tax year. Examples are the
construction o f large buildings or ships and the design
and production o f aircraft. This raises the issue of how
to treat the costs o f production incurred before the
sale. Economic theory suggests these costs should be
capitalized and deducted w hen the project is com ­
pleted or sold; however, current tax law allows many
such costs to be deducted currently, w hile receipts
are not taxed until received, perhaps years later. Revis­
ing the tax code to require matching o f expenses and
income from multiperiod production w ould raise cor­
porate tax receipts by $39.7 billion over 1986-90.
The President’s proposed tax reform w ou ld repeal
structural rehabilitation tax credits, yielding an in­
crease in corporate taxes o f about $1.5 billion in
1986-90.'" Also, the interest tax exem ption for privatepurpose state and municipal bonds — the so-called
industrial developm ent bonds — w ou ld be repealed.
W hile this repeal w ould not increase corporate tax
revenues, it w ould significantly reduce the number of
tax-exempt bond issues and increase individual tax
revenues — by an estimated $15.9 billion over 1986-90.

Neutrality Toward Industries
w ould alleviate this bias by indexing for inflation the
inventory replacement expense tax deduction.
As shown in table 3, the result o f such changes in
the tax code for investment w ould be an increase in
corporate tax revenues during 1986-90 o f about $207
billion.

Neutrality Toward Form o f Business
Organization
Income generated by corporations is subject to
double taxation. It is subject to the corporate tax; then,
dividends paid out from this after-tax incom e to the
corporation’s shareholders are subject to the personal



R epeal o f Energy and M ining Subsidies — An im ­
portant tax subsidy to the oil- and gas-producing
industry as well as other mining industries is percent­
age depletion. No longer available to large integrated

9Tax procedures that avoid double taxation of dividends are common
among the principal industrial countries. For example, France has a
50 percent dividend tax credit, Germany effectively excludes 100
percent of dividends paid from double taxation and Japan excludes
38 percent. See U.S. Treasury (1984), vol. 1, p. 260.
'“Individual tax revenues, including those from limited partnerships,
which are very common in real estate investment, would rise over
1986-90 by about $5 billion as a result of this repeal. (The Presi­
dent's Tax Proposals to the Congress for Fairness, Growth and
Simplicity, p. 459)

15

FEDERAL RESERVE BANK OF ST. LOUIS

petroleum producers, it primarily benefits small inde­
pendent producers. Percentage depletion allows
these small producers to deduct from taxable incom e
a fixed percentage o f the value o f production to com ­
pensate for the reduction in the total amount remain­
ing." In practice, it results in a total deduction over the
life o f the well or mine that exceeds the capitalized
value o f the deposit. The proposed reform w ould
phase out this subsidy o f oil and mineral production
over the 1986-90 period, except for oil wells with small
amounts o f production.
Also to be repealed are the business energy tax
credits. Originally, these credits w ere introduced to
increase non-petroleum energy production, low er en­
ergy use and enhance petroleum production from
technically difficult or deep deposits.
In total, the repeal o f these energy and mineral
industry deposits w ould yield an increase in corpo­
rate tax revenues over 1986-90 o f about $3 billion.
R epeal o f Financial In s titu tio n Subsidies — As
shown in table 1, the tax rate levied on the U.S. finan­
cial and insurance industries has been substantially
low er than in other industries. Largely, this has been
due to tax subsidies that the reform proposal w ould
eliminate. Primarily, the form o f these subsidies has
been to permit deductions from taxable incom e con­
tributions to reserves for various losses. Under the
proposed reforms, only the actual losses w ould be
deductible.
Overall, the Treasury’s proposed reforms o f finan­
cial and insurance institution tax deductions would
raise corporate tax revenues during 1986-90 by $23.8
billion. In particular, the principal reforms are the
following (estimated tax revenue gains during 1986-90
in parentheses):
• the repeal of the deduction for depository institu­
tions’ contribution to bad debt reserves ($5.1 billion);
• the disallowance of the deduction of interest paid by
financial institutions to finance purchase of taxexempt securities ($2.2 billion); and

"The rationale is that production of the mineral essentially entails the
removal of a quantity from a fixed inventory of mineral, the original
deposit. The producer bought the mineral right, and it is being used
up in the production process. Thus, for the same reason that a retail
department store deducts the cost of goods sold out of inventory
from its gross proceeds to compute taxable income, mineral pro­
ducers should deduct the proportion of the value of current period
production that was capitalized in the mineral lease. The proposal
does not dispute the propriety of an appropriately computed deduc­
tion for depletion. It does, however, dispute the fixed percentage
form which is arbitrary in relation to the value of the deposit.

Digitized for16
FRASER


AUGUST/SEPTEMBER 1985

• a limit on property and casualty insurance company
tax-deductible additions to reserves equal to the
capitalized value of expected claims ($5.6 billion).

Impact o f Reform : Investment Yields
Less Affected by Taxes
The most important measures o f the overall impact
of tax reform, in terms o f making the tax code more
neutral, are the tax rates displayed in table 6. Compar­
ing these rates w ith those under current law in table 4,
one can see two m ajor differences; no impact on
investment due to inflation and nearly level tax rates
on investments o f diverse durations.
While tax rates are considerably less variable across
types o f investments under the n ew tax plan, as levies
against corporate income, they are somewhat higher
on average. The net result may be a low er aggregate
investment rate. A decline in investment, however,
w ould not necessarily im ply a low er level o f output.
The m ore uniform tax rates on investments ensure
that investment w ill be induced by market demands
— the valuations o f consumers — rather than tax
subsidies. A resulting decline in investment w ould
mean that some projects undertaken under the old
tax code w ere inefficient. The release o f resources
from such inefficient investment w ould im ply an im ­
provement in welfare.

SUMMARY AND CONCLUSION
The taxation o f business incom e in the United States
has evolved into a com plex system o f distortions,
subsidies and preferences, that has induced corpora­
tions to em ploy valuable resources inefficiently. Out­
put could be increased and people made better off if
these tax-generated distortions w ere eliminated. If it
becomes legislation, the President’s proposed busi­
ness tax reform w ould be a m ajor step in reducing the
role that taxation plays in allocating our nation’s re­
sources. Those w h o concentrate on the m acroeco­
nomic impacts o f the proposal are overlooking some
substantial efficien cy gains from the prop osed
changes.

REFERENCES
Allison, Michael T., Don Fullerton, and John H. Makin. “Tax Reform:
A Study of Some Major Proposals," AEI Working Paper No. 2
(February 1985).
Ballard, Charles L., John B. Shoven, and John Whalley. “The Total
Welfare Cost of the United States Tax System: A General Equilib­
rium Approach," National Tax Journal (June 1985), pp. 125-40.

AUGUST/SEPTEMBER 1985

FEDERAL RESERVE BANK OF ST. LOUIS
Birnbaum, Jeffrey H. “Sen. Long, An Architect of the Income-Tax
Codes, Is Ready to Protect Handiwork From Reform’,” Wall Street
Journal, May 7,1985.
Hirshleifer, Jack. Price Theory and Applications (Prentice-Hall,
1980), pp. 440-45.

Rowen, Hobart. “New Tax Rules, New Inequities,” Washington
Post, June 6, 1985.
Sterngold, James. “Forecasters and the Tax Plan,” New York
Times, June 8,1985.

McGinley, Laurie. “The Treasury’s Plan To Overhaul Tax Code
Sparks Heated Debate,” Wall Street Journal, April 3,1985.

U.S. Department of the Treasury. Tax Reform for Fairness, Simplic­
ity and Economic Growth, (U.S. Treasury Department, November
1984), vols. I and II.

Ott, Mack. "Depreciation, Inflation and Investment Incentives: The
Effects of the Tax Acts of 1981 and 1982,” this Review (November
1984), pp. 17-30.

Wallop, Malcolm.
7,1985.

The President’s Tax Proposals to the Congress for Fairness, Growth
and Simplicity (U.S. Government Printing Office, May 1985).

Yemma, John. “Business View of Tax Plan,” Christian Science
Monitor, June 10,1985.




“Amplification,” letter to Wall Street Journal, May

17

Factors Behind the Rise and
Fall of Farmland Prices:
A Preliminary Assessment
Michael T. Belongia

T

J L HE current debt problems facing many farmers
can be attributed, in large measure, to the factors that
produced the spectacular rise in farmland prices dur­
ing the 1970s and their precipitous decline since 1981.
After increasing at a 5.6 percent average annual rate
between 1951 and 1971, the growth in the price o f U.S.
farmland accelerated dramatically: farmland prices
rose at a 14.0 percent average annual rate from 1972 to
1981. Because land prices w ere rising faster than the
rate of inflation at that time, the collateral base against
which farmers could borrow increased significantly.
Moreover, the availability o f subsidized credit for farm­
land purchases and certain tax advantages enhanced
farmland ownership as an investment. Finally, re­
peated warnings about im pending w orld food short­
ages suggested that returns to farmland in production
w ould rise, further increasing the demand for it.'
Recently, however, the price o f farmland has been
falling. Since its 1981 peak, the price o f farmland in the
United States has declined at a 5.1 percent average
annual rate, bringing farmland prices near their 1979
values. Of course, as land prices have fallen, the value

Michael T. Belongia is a senior economist with the Federal Reserve
Bank of St. Louis. Jude L. Naes, Jr., provided research assistance. J.
Bruce Bullock, James A. Chalfant, David Ervin, E. C. Pasour, Jr., Daniel
A. Sumner and James Seagraves provided comments on an earlier
draft of this paper. Any remaining errors or omissions are the responsi­
bility of the author.
’For example, as late as 1981, just two years prior to when the PIK
program was implemented to reduce large and growing surplus
grain stocks, the title of USDA's Yearbook of Agriculture was Will
There Be Enough Food?

Digitized for 18
FRASER


o f farm equity has declined, and the ability o f farmers
to secure additional credit has been diminished.
Many studies o f the general movem ent in farmland
prices have been conducted in the past.- Most o f these
studies, however, predate the recent-period decline in
land prices. The purpose o f this article is to examine
the theoretical determinants o f farmland values and to
determine w hether they can account for the rise and
decline o f farmland prices in recent years.

THE UPS AND DOWNS OF
FARMLAND PRICES
The data plotted in chart 1 show the behavior o f
farmland prices in the postwar period.3The first point
to note is that the price o f farmland generally has
increased at a rate higher than the rate o f inflation, as
measured by the GNP deflator. Moreover, the variabil­

2Explanations for rising land prices include the accumulated savings
from farm income and accumulated real estate debt, variations in
farm income, increases in the general price level and increases in
the provisions of commodity price support programs. See Shalit and
Schmitz (1982), Herdt and Cochrane (1966) and Castle and Hoch
(1982). Other studies of farmland prices include Tweeten and Martin
(1966), Phipps (1984) and Reinsel and Reinsel (1979). A recent
paper that provides a descriptive overview of the initial year of the
recent land price decline is by Scott <1983). Doll, Widdows and
Velde (1983) have surveyed the theoretical and empirical literature
on land prices.
3The index is based on an average of farmland prices, per acre, in the
48 contiguous states. Until 1975, the prices were those existing on
March 1. From 1976-81, February 1 prices were used. April 1 is the
basis for 1982-84 prices. See Economic Report of the President
(1985), p. 341.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

C h art 1

Farmland Prices and Inflation

1948

SO

52

54

56

58

60

62

64

66

68

70

72

74

76

78

80

82

1984

N O T E : D a t a a r e d e l t a lo g s.
Q

D a ta a re fro m the 198 5 E c o n o m ic R e p o r t o f the P resident.

[2 D a ta a re c a lc u la t e d u s in g the G N P d e fla to r.

ity in farmland price growth appears to be consider­
ably greater than the variability o f increases in the
general price level.4Although the growth o f land prices
and the rate o f inflation obviously are correlated, the
chart suggests that land prices may be affected by
additional factors. Chart 1, however, merely summa­
rizes what has occurred to land prices and does not
tell us what has produced this result. For inferences
concerning what these causal factors might be, w e
turn to a simple m odel o f land prices.

4The standard deviations ot the growth rate of land prices and the
rate of inflation are, respectively, 6.5 and 2.6. Average values for the
annual growth rate of land prices and the rate of inflation over the
1948-85 (through 1984 for inflation) sample are 6.0 and 4.1 percent,
respectively.




THEORETICAL DETERMINANTS OF
THE PRICE OF FARMLAND
Although the supply o f land for use in farming has
some price elasticity and w ill change in response to
factors that affect its returns in other uses, it is conve­
nient for our purposes to examine primarily those
factors that change the demand for farmland.5There­
fore, w e assume that the total amount of land available
for farming is constant. Because w e have ruled out
changes in the supply o f land, changes in the price o f

5Stigler (1966) notes the common fallacy, which argues that the
supply of land is perfectly inelastic. While this is not even strictly true
for the total supply of land, the important consideration is how easily
land can be shifted from other uses to agricultural production. In this
sense, the supply of land certainly is not perfectly inelastic.

19

FEDERAL RESERVE BANK OF ST. LOUIS

farmland must arise from changes in the dem and for
farmland. The section that follows explains the factors
that, theoretically, should influence the dem and for
farmland.

Farmland as a Capital Asset
The price o f land always w ill be determ ined by two
factors: the net return to land em ployed in its “best”
alternative use and the interest rate or rates that are
used to discount these net returns to the present. For
purposes o f illustration, consider an acre o f land best
suited to corn production that will yield 100 bushels at
a price of $3 per bushel; total receipts, then, are $300. If
variable costs in producing corn each year — the costs
o f fertilizer, seed, the use o f equipment and labor —
were $200, the residual return to the land w ould be
$100 each year. In the absence o f expected inflation,
increased productivity and special knowledge about
future econom ic shocks, $100 w ould be the net return
expected in all future years as well.
This net expected annual return to the ow ner o f an
acre o f farmland used to produce corn w ill be evalu­
ated against the stream o f returns accruing to other
investments. That is, the farmer w ill ask him self what
amount, if invested elsewhere at the current interest
rate, w ould yield an annual return o f $100. A rational
farmer-investor, ceteris paribus, w ill not pay more for
the acre o f farmland than the amount o f this alterna­
tive investment.
This acre o f land w ill sell for its capitalized value,
that is, the present discounted value o f all future
earnings from the land. This relationship can be ex­
pressed as:

AUGUST/SEPTEMBER 1985

receipts from selling corn or the expected variable cost
o f producing corn are altered.
In assessing changes in real returns, w e are inter­
ested in changes in receipts or costs apart from those
changes in nominal values associated with the general
trend in inflation. Expected real receipts w ould rise,
for example, if yields per acre w ere increased and the
demand for corn w ere relatively elastic in the relevant
range, or if government price supports w ere raised.
The expected real cost o f producing corn is affected by
changes in the relative prices o f fuel, fertilizer, crop
insurance, water and a variety o f other factors em ­
ployed as inputs in the production process. In either
case, for a given rate o f interest, changes in expected
real receipts or costs w ill produce changes in the
expected net returns to investment in farmland rela­
tive to the returns available on other investments.
When this occurs, land prices w ill change to bring the
rate o f return for farmland back into line w ith other
alternative rates.
Changes in government farm programs have af­
fected land prices by raising the expected net incom e
associated with farming. Direct incom e transfers
based on target prices have increased the expected
income from crop production by allowing farmers to
sell eligible crops at the market price and then receive
a direct payment equal to the quantity o f a crop sold
m ultiplied by the difference between the market price
and target price. Loan rates, w hich establish a price
floor for crops, also increase expected incom e by elim ­
inating the risk associated w ith market prices falling
below the support level.7 Because these program
benefits increase the expected incom e from farming,
they are capitalized into land values.

(1) land price = net returns -r- interest rate.1’
If the interest rate is currently 5 percent, the value o f
the land w ould be $2,000 ($100
0.05); this is the
maximum price that an investor w ould pay for the
land. If the land price w ere higher, for example, $2,500,
it w ould be irrational and unprofitable to purchase the
land; investing the $2,500 in bonds or stocks yielding 5
percent w ould earn m ore ($125) than the $100 return
to land em ployed in farming.
It is clear from equation 1 that, for a given interest
rate, the price o f farmland w ill change w henever there
are changes in the expected real net returns to farm­
ing. Expected net returns w ill change if the expected

This representation of an asset's capital value can be found in
virtually all economics texts. Implicit assumptions are an infinite
planning horizon and a constant real interest rate.

20FRASER
Digitized for


LAND PRICE DETERMINATION: SOME
STATISTICAL EVIDENCE
The M odel and Data
The relative impacts on land prices from
nomic relationships discussed above can be
in a simple statistical model. Based on the
discussion, the annual percentage change in
of farmland can be estimated as:

the eco­
assessed
previous
the price

(2) %ALP, = a + p, ,_,£(%AP,I + p, ,_,E(%ANR,I
+ 03 %Ar +

e,.“

This result has been demonstrated by Harris (1977), Boehlje and
Griffin (1979), Gardner (1981), Pasour (1980) and Belongia (1983).
8Percentage changes (%A) are calculated as first differences of
logarithms, multiplied by 100.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

are shown in table 1. The m odel explains 49 percent o f
the variation in the growth o f land prices.

Table 1

Assessing the Contribution of
Alternative Factors to the Growth
of Land Prices
%ALP, = 2.981 + 1.398 x E(%APt) + 0.196 x E(%ANR,)
(2.18)
(4.54)
(2.65)
+ 0.001 x %Ar
(0.15)

R2 = 0.49

SER = 3.48

DW = 1.80

NOTE: t-statistics in parentheses.

Equation 2 states that the rate o f change in farmland
prices (%ALP) w ill be determined by the expected
future rate o f inflation [,_,E(% AP,)], expected growth in
real net returns from farming [, ,E(%ANK,)], which in­
cludes cash receipts and government payments m i­
nus variable costs, and the percentage change in the
real rate o f return on an alternative investment (%Ar).
Note that, in contrast to many previous empirical
studies, this equation is based on eji ante expectations
rather than actual ept post data. Although using esti­
mated proxies for unobserved expectations variables
introduces the problem o f measurement error, ex post
data values have little to do with the eji ante decision
to buy or sell farmland.
Expectations for future inflation and real returns are
assumed to be three-year moving averages o f past
actual values. Exact variable definitions and data
sources appear in the appendix to this article. Based
on the earlier discussion o f h ow land prices are deter­
mined, expected inflation and the expected growth in
real net returns to farm production should be posi­
tively related to land values. The expected sign on the
percentage change in the real opportunity cost o f
capital, %Ar, is negative.”

The Results
The results o f estimating equation 2 using annual
data from 1955 through the 1981 peak in land prices

9Changes in expected inflation are linked, in theory, to transitory
changes in the real rate of interest. This possibility introduces the
potential for a collinearity problem in the estimating equation if
E(%AP,) and %Ar are correlated. Their simple correlation coefficient
(0.06), however, is not significantly different from zero.




The results show, as expected, that increases in the
growth of expected real net returns and an increase in
expected future inflation tend to increase the rate at
which farmland prices increase. The sizes o f these
estimated coefficients and actual changes in expected
inflation and returns offer m ore insight. W hile a 1
percentage-point increase in expected inflation has
an effect on the rate o f land price appreciation about
seven times larger than a similar increase in expected
receipts, expected receipts exhibit considerably larger
changes over time than expected inflation. For exam­
ple, expected inflation ranged between 1.4 and 8.1
percent over the 27-year sample, whereas expected
growth in real net returns was as high as 24 percent in
1974 and as lo w as —25 percent in 1977. Considered
together, these coefficients and the raw data suggest
that expected inflation is a determinant o f the longrun trend growth o f nominal land prices and expected
net returns, which are subject to considerable year-toyear variability, are a significant factor in producing
short-run variations in the growth o f land prices.
It also is interesting to note that the coefficient on
expected inflation is not significantly different from
one, im plying that expected inflation was com pletely
reflected in land prices. From an econom ic viewpoint,
this result indicates that farmland was a perfect hedge
against inflation over the estimation period. Finally,
the growth in land prices is not significantly related to
the regression’s other variable, the real rate o f interest.
Examining the in-sample fit o f the m odel can be
used as a guide to the m odel’s likely usefulness in
determining its ability to predict the future behavior o f
land prices. For example, if the m odel’s errors are
randomly distributed through time and are neither
one-sided nor o f larger absolute value in recent peri­
ods, one might infer that it represents a reasonably
accurate description o f the process through which
changes in land prices are determined. Conversely, if
recent errors are significantly larger or one-sided, this
information may im ply that the m odel is misspecified.
As chart 2 indicates, the in-sample errors o f equation 2
over the 1955-81 period appear to be random ly dis­
tributed, despite the volatile behavior o f land prices.
Tw o o f the residuals are m ore than twice the size of
the regression’s standard error (6.96).

Out-of-Sample Simulation Errors
The results in table 1 explain the behavior o f land
prices through their 1981 peak. In view o f the variety o f

21

AUGUST/SEPTEMBER 1985

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 2

Residuals from Equation 2

1955

57

59

61

63

65

67

explanations that have been offered for the sharp drop
in land prices, it is interesting to investigate w hether
the m odel w ill reveal any one variable as a dominant
factor in the recent land price decline.
This experiment is conducted by using the esti­
mated coefficients in table 1 and actual values for the
variables in equation 2 to project values for the per­
centage change in farmland prices for 1982-85. These
projections and the out-of-sample errors are reported
in table 2.
The table clearly shows that the variables in equa­
tion 2 do a poor job o f explaining the sharp decline in
farmland prices since 1981. W hile the m odel projects
slower growth for land prices, it does not explain the
actual reductions in the levels o f land prices that have
occurred in each o f the last four years.
A number o f possible explanations for this poor
simulation performance can be offered. Equation 2
Digitized for22
FRASER


69

71

73

75

77

79

1981

could be m isspecified in a variety o f ways, including
the omission o f variables important to the land price
decline. A more likely explanation is that the variables
included are subject to considerable measurement
error. Since they are intended to reflect expectations,
they are not observable directly and may not follow
the assumed m oving average process. Moreover, ex­
pectations may be asymmetric: that is, expectations
may be based on a long history o f past data while
inflation and government payments are rising, but
take on a short history w hen these variables are de­
clining. This effect may be particularly true since 1981,
when proposals to cut government's support o f agri­
culture significantly began to emerge. The evidence
presented in the bottom half o f table 2 lends some
support to this conjecture by indicating that only
expected returns from farming have moved in a direc­
tion and changed by a magnitude consistent with the
land price decline, w hile expected inflation has ad-

AUGUST/SEPTEMBER 1985

FEDERAL RESERVE BANK OF ST. LOUIS

REFERENCES
Table 2

Belongia, Michael T. “Agricultural Price Supports and Cost of Pro­
duction: Comment,” American Journal of Agricultural Economics
(August 1983), pp. 620-22.

Simulation Results and Actual Data
Values, 1982-85________________

Boehlje, Michael, and Steven Griffin. “Financial Impacts of Govern­
ment Support Price Programs," American Journal of Agricultural
Economics (May 1979), pp. 285-96.

Out-of-Sample Simulations
Year

Actual

Simulated

Error

1982
1983
1984
1985

-0 .6 3
-5 .9 0
-1 .3 6
-1 3 .1 6

14.34
10.05
8.73
8.32

14.97
15.96
10.09
21.48

Actual Values of Explanatory Variables in Equation 2
Year

E(%AP)

1982
1983
1984
1985

8.77
7.95
6.26
4.43

E(%ANR)
-5 .0 2
-2 0 .3 0
-1 5 .4 3
-4 .4 3

E(%Ar)
56.07
- 46.64
15.34
7.52

Castle, Emery N., and Irving Hoch. “Farm Real Estate Price Com­
ponents, 1920-78," American Journal of Agricultural Economics
(February 1982), pp. 8-18.
Doll, John P., Richard Widdows and Paul D. Velde. “A Critique of
the Literature on U.S. Farmland Values," ERS Staff Report No.
AGES830124 (U.S. Department of Agriculture, January 1983).
Economic Report of the President.
Office, February 1985).

(U.S. Government Printing

Gardner, Bruce L. The Governing of Agriculture (The Regents Press
of Kansas, 1981).
Harris, Duane G. “Inflation-Indexed Price Supports and Land Val­
ues,” American Journal of Agricultural Economics (August 1977),
pp. 489-95.
Herdt, Robert W., and Willard W. Cochrane. “Farm Land Prices and
Farm Technological Advance,” Journal of Farm Economics (May
1966), pp. 243-63.
Holland, A. Steven. “Real Interest Rates: What Accounts for Their
Recent Rise?” this Review (December 1984), pp. 18-29.

justed slowly to low er actual inflation. Thus, while the
drop in expected real returns is consistent with the
land price decline, it is largely offset by movements in
the other variables that are smaller or in the wrong
direction.

Pasour, E. C., Jr. “Cost of Production: A Defensible Basis for
Agricultural Price Supports?” American Journal of Agricultural Eco­
nomics (May 1980), pp. 244-48.
Phipps, Tim T. “Land Prices and Farm-Based Returns," American
Journal of Agricultural Economics (November 1984), pp. 422-29.
Reinsel, Robert D., and Edward I. Reinsel. “The Economics of
Asset Values and Current Income in Farming,” American Journal of
Agricultural Economics (December 1979), pp. 1093-97.

SUMMARY

Scott, John T., Jr. “Factors Affecting Land Price Decline,” American
Journal of Agricultural Economics (November 1983), pp. 796-800.

The price of farmland generally has followed the
rollercoaster o f expectations about future inflation
and income from farming. The influences o f these
expectations were assessed in conjunction with other
factors that affect the demand for farmland as an input
to farm production. A simple model of land prices was
constructed based on variables that were expected to
influence the net returns to land used in farming and
the returns and costs of holding land as an investment
relative to the returns on other investments. The
results of estimating a statistical model derived from
these arguments showed that expected inflation and
expected growth in real net returns to farm produc­
tion were significant factors in determining the rate of
increase in land values during the 1970s. Even with the
recent sharp reductions in expected returns, however,
the m odel does not explain the rapid decline in farm­
land values since 1981. A likely reason for this failure,
when contrasted with the m odel’s in-sample perfor­
mance, is error in the measurement o f expectations
concerning the future paths o f inflation, returns and
the real interest rate.

Shalit, Haim, and Andrew Schmitz. “Farmland Accumulation and
Prices,” American Journal of Agricultural Economics (November
1982), pp. 710-19.




Stigler, George J. The Theory of Price, 3rd ed. (The Macmillan
Company, 1966).
Tweeten, Luther G., and James E. Martin. “A Methodology for
Predicting U.S. Farm Real Estate Price Variation,” Journal of Farm
Economics (May 1966), pp. 378-93.
U.S. Department of Agriculture. Will There Be Enough Food? The
1981 Yearbook of Agriculture (GPO, 1981).

APPENDIX
Data Sources and
Variable Descriptions
Land prices w ere measured by an index of farmland
values for the 48 states reported in the E conom ic
Report o f the President (1985), p. 341. Inflationary
expectations were represented by a three-year moving

23

FEDERAL RESERVE BANK OF ST. LOUIS

average o f past actual inflation as measured by growth
in the GNP deflator. Expected real net returns from
farming w ere assumed to be a three-year moving
average o f past grow th in actual returns; this
assumption was based on the notion that, since
random shocks to production are the largest source of
price change but cannot be predicted in advance,
expected returns follow a random walk around some
trend. Net returns w ere defined to be receipts from
farm marketings plus government payments minus

Digitized for24
FRASER


AUGUST/SEPTEMBER 1985

variable costs and w ere obtained from the E conom ic
Report o f the President, p. 338. Real returns are net
returns deflated by the GNP deflator. The e* ante real
rate o f interest was measured as the nominal interest
rate on one-year Treasury securities in the fourth
quarter o f yea r t-1 m inus the one-year-ahead
expectation o f inflation as measured by the December,
year t—1, Livingston survey; see Holland (1984) for
further details. The data used to estimate equation 2
are annual series from 1955—81.

Weekly Money Announcements:
New Information and Its Effects
Richard G. Sheehan

T

-M. HE consensus among economists is that m one­
tary policy has its primary effects over relatively long
time intervals — that is, quarters or years rather than
days or weeks. Financial market participants, how ­
ever, devote considerable attention to the weekly
m oney stock announcement, despite substantial
“noise” in the series.1 Moreover, some economists
recently have “discovered" that an announcement o f
an unexpectedly large m oney stock increase causes
interest rates and U.S. exchange rates to rise and stock
prices to fall.2
At first glance, the weekly impacts on financial mar­
kets may seem to contradict the consensus that
money has its primary effects over longer horizons. In
this paper, w e show w hy m oney stock announce­
ments may have an impact on financial market vari­
ables on a daily or weekly basis even though the
principal effects o f m onetary policy are felt over sub­
stantially longer periods. The explanation for this ap­
parent contradiction is the adjustment o f financial
markets to new information. The focus is on financial
markets since their adjustments to new information
tend to be more rapid than the adjustments o f other
markets.3The paper examines three hypotheses that
relate m oney stock surprises to financial market
prices, the relationships between these hypotheses
and the existing empirical evidence that attempts to
discriminate between the hypotheses.

Richard G. Sheehan is an economist at the Federal Reserve Bank of
St. Louis. Larry J. DiMariano and Michael L. Durbin provided re­
search assistance.
'That is, much of the week-to-week movements in the money stock
are unrelated to any economic phenomenon. See Pierce (1981).
2For a sample of these results, see Cornell (1983b), Hardouvelis
(1984), and Urich and Wachtel (1984).
3The standard assumption is that financial market prices adjust
rapidly to changes in their determinants, within a span of hours or at
most days, while prices in other markets tend, for a variety of
reasons, to adjust more slowly. See Fama (1982).




MONEY ANNOUNCEMENTS AND
MONEY EXPECTATIONS
Before examining the effects o f m oney announce­
ments, one must begin with an obvious observation:
the m oney stock announcement itself does not create
money. It does, however, create new information
about the m oney stock. At the time o f the announce­
ment, the level o f the m oney stock to be announced
has already been determined. Thus, any response
resulting from the announcement is due to new infor­
mation rather than new money. In the following analy­
sis, it w ill be important to distinguish between these
two.
Announcements about the weekly m oney stock typ­
ically are made on Thursday afternoons at 4:30 p.m.
EST; at this time the Federal Reserve Board releases
figures on the stock o f m oney (M l) for the statement
week ending 10 days earlier.4 If changes in the money
stock itself have an immediate impact on financial
markets, that impact w ill begin to be felt almost two
weeks before the announcement when the m oney
stock itself changed.3
The evidence discussed below suggests that the
m oney stock announcements themselves appear to

"Information also is released on the monetary base for the week
ending one day earlier, the components of the money stock and the
monetary base, and the aggregate portfolio of weekly reporting
banks.
5The hypothesized short-run impact on interest rates of changes in
the money stock is termed the “liquidity effect." For example, the
Federal Reserve may buy government securities and in so doing
provide currency and reserves. To convince economic agents to
part with the securities in exchange for money, the Federal Re­
serve’s purchase of securities will bid the price of securities up, thus
bidding the yield down. This liquidity effect occurs as soon as the
stock of money is increased. See Brown and Santoni (1983) for
evidence about the existence, magnitude and duration of the liquid­
ity effect.

25

FEDERAL RESERVE BANK OF ST. LOUIS

influence interest rates independent o f any effect that
the actual m oney growth may have had. To explain
w hy the m oney announcements — which carry only
new information — may influence interest rates, one
must distinguish between expected and unexpected
money announcements.

Theoretical Effects o f Expected and
Unexpected M oney Announcements
The m oney stock figures, w hen announced, are not
reported in a vacuum. Financial market participants
have substantial information on current and previous
interest rates and previous m oney announcements,
allowing them to form expectations about the likely
amount o f the m oney stock to be announced. Current
asset prices are based in part on expected future
econom ic conditions, including future m oney stocks.
Observers generally believe that if financial markets
are efficient, only the unexpected com ponent o f the
money stock announcement should influence finan­
cial variables. The expected com ponent conveys infor­
mation already digested by the markets and incorpo­
rated in the prices and yields o f financial assets.
Consequently, only surprises matter, not because they
provide new money, but because they provide new
information that may be useful in predicting policy­
makers’ actions and the behavior o f both real and
nominal variables. The m oney stock announcement,
to the extent that it is expected, com m only is assumed
to have no impact on econom ic activity.6

THE IMPACTS OF UNANTICIPATED
MONEY ANNOUNCEMENTS
There are a number o f hypotheses about w hy
money surprises influence financial market variables.
The following sections compare three hypotheses and
their underlying assumptions. All three hypotheses
are based on the assumption that financial markets
efficiently use all available information. Thus, current
interest rates, exchange rates and stock prices reflect
the implications o f the expected future m oney stocks.

AUGUST/SEPTEMBER 1985

ment can affect market rates o f interest by altering
perceptions o f the real rate o f interest, expected in­
flation or both.

Expected Liquidity Effect
Under this hypothesis, an unexpected change in the
m oney stock that moves it away from its annual target
w ill be follow ed by changes in the opposite direction
to get m oney growth back on target.7 The expected
liquidity effect, therefore, is based on the belief that
the Federal Reserve has credibility in pursuing its
objectives for the m oney stock. The expected liquidity
effect is based on financial market participants believ­
ing (1) that Federal Reserve policy is, at least in part,
adhering to a long-run m onetary aggregate target; (2)
that it will take the necessary steps to achieve its target
over a relatively short time period; and (3) that such
actions w ill change interest rates.8
The impact o f an unexpectedly large m oney stock
announcement based on the expected liquidity effect
is illustrated in figure 1. The cone form ed by the solid
lines in figure 1 represents the Federal Reserve’s target
range for m oney growth.3At any point in time, market
participants know past announced m oney stock levels
and have form ed expectations about the future path of
the m oney stock, given by the line m ” in figure 1. The
slope o f this line represents financial markets’ expec­
tations o f the m oney growth rate based on available
information, including some estimate o f the Fed’s
desired short-run growth rate.10
Unexpected money deviations here refer exclusively to those as
seen by financial market participants. The money announcement
itself is assumed to reveal no information to the Federal Reserve.
See Urich (1982).
8While there may be professional debate over the impact of monetary
policy on the real interest rate, there is general agreement among
economic textbooks that monetary policy does play a significant
role. For example, see Dornbusch and Fischer (1984).
9Money growth in this and the following sections refers exclusively to
M1 growth since data on the M2 and M3 monetary aggregates are
released only monthly. The Federal Reserve is required by Con­
gress to state target ranges for all three monetary aggregates.

The analysis o f the alternative hypotheses is based
on the Fisher equation, which divides the current
nominal interest rate into the expected real return
over the holding period o f the asset and the relevant
anticipated rate o f inflation. The m oney announce-

10To focus on the expected liquidity effect and the impact of an
unexpected money shock, we temporarily abstract from the noise in
the series. In fact, the actual money stock numbers on a week-toweek basis as initially released form a saw-toothed pattern with an
upward trend. In a more realistic setting, expected money may also
be expected to fluctuate substantially as market participants attempt
to adjust their forecasts due to a host of changing economic and
institutional factors.

6See Cornell (1983b) for an explicit statement of this assumption. It
should be noted, however, that more general models can be devel­
oped in which expected and unexpected announcements are both
important. For example, see Belongia and Sheehan (1985b). These
more general models have not been widely applied.

The most common measure of expected money is the median of a
survey of market expectations of money growth conducted weekly
by Money Market Services, Inc. A time series forecast is infrequently
used instead. Regressions of actual money changes on expected
money changes indicates that about 30 percent of all money
changes are expected. Thus, money changes have a large random
component, but are not entirely unpredictable.

26



FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

Long-term rates w ill rise to the extent that they are an
average o f the current short-term rate and expected
future rates.

F ig u re 1

Expected Liguidity Effect

The strength o f the expected liquidity effect may
vary over time.'2 A deviation o f announced from ex­
pected M l w ill typically have a larger effect on interest
rates when market participants think the Fed is plac­
ing greater emphasis on controlling M l. Thus, the
expected liquidity effect should have been stronger
from October 1979 to September 1982 w hen the Fed­
eral Reserve targeted on nonborrowed reserves as an
intermediate target.

( ii weeks)

To focus on the expected liquidity effect, assume
that the m oney stock for the week announced previ­
ously was Ma. Just before the m oney announcement,
interest rates, exchange rates and stock prices reflect
the assumption that Mb is the m oney stock to be
announced. Further assume that the announcement
o f the m oney stock during week t is then made and
reveals that the m oney stock was, in fact, M,, rather
than M b.
The expected liquidity effect assumes that financial
markets believe the Fed w ill adhere to its previous
policy and w ill take action to return the m oney stock
to its expected path." This temporary tightening may
begin even before the m oney announcement, since
the Fed develops estimates o f the m oney stock before
its announcement. During this period, higher nominal
interest rates w ill be expected. If the long-run growth
rate in the m oney stock is assumed to remain un­
changed, the rate o f expected inflation should also
remain unchanged. Thus, short-term real interest
rates should rise as short-term nominal rates rise.

"The analysis in figure 1 is presented in terms of money growth vis-avis its expected growth rate. Alternately, it is possible that no
reaction (or a smaller reaction) would be expected until the money
stock went outside of the Fed’s stated target range. For example,
see Roley (1983).




It is not w idely recognized that the expected liquid­
ity effect also makes an assumption about the perma­
nence o f the shock underlying the unexpected change
in money, assuming the Fed is not the cause o f the
shock. If the cause is tem poraiy — for example, a
w inter snowstorm delaying check clearance — no Fed
intervention is required. When the disturbance is re­
moved, the stock o f m oney w ill return to its expected
growth path even without Federal Reserve interven­
tion. A movement from Mato M tl during week t w ill still
be expected to yield money stock Mc in week t + k even
without Fed intervention. Thus, a positive shock per­
ceived as temporary w ill not result in expected m one­
tary tightening or higher interest rates. In contrast, if
the shock is perceived to be permanent, then discre­
tionary policy action w ill be required to return to the
expected path as discussed above.
If the change is temporary but the adjustment back
to the expected path is slow, policy action may be
expected. For example, if delays in processing tax
refunds were an important but temporary factor in
lowering m oney growth, the Fed might act to offset
factors that w ould otherwise result in a temporary

'2For example, see Roley and Walsh (1984) and Gavin and Karamouzis (1984). The most important institutional change was the
switch in the Federal Reserve’s operating procedures for conduct­
ing monetary policy. Before October 6, 1979, the Federal Reserve
primarily focused on interest rates in the short run, although there
were explicit monetary aggregate targets since 1975; see Wallich
and Keir (1979). From October 1979 through September 1982, to
improve monetary control, the Federal Reserve adopted a policy of
targeting on nonborrowed reserves in the short run. Since then, the
Federal Reserve has pursued a more flexible policy, paying some­
what more attention to interest rate fluctuations than it had in the
previous period, although not reverting to the pre-October 1979
regime. See Wallich (1984) and Gilbert (1985).
Institutional changes since 1977 also include changes in the
money stock announcement date (switched from Thursday to Friday
and back to Thursday), a change from lagged to contemporaneous
reserve requirements (in February 1984), and the changes associ­
ated with financial deregulation. Any of these, in theory, could alter
the informational content of the money stock announcement.

27

FEDERAL RESERVE BANK OF ST. LOUIS

decline in the money stock. Thus, the expected liquid­
ity effect is also predicated on the assumption that the
cause o f an unexpected m oney change is permanent
(or o f long enough duration to prom pt an expectation
o f Federal Reserve intervention).

AUGUST/SEPTEMBER 1985

F ig u re 2

Inflation Premium Effect

Inflation Prem ium Effect
The inflation premium hypothesis, like the ex­
pected liquidity hypothesis, focuses on market per­
ceptions o f Federal Reserve behavior in response to
money surprises. In sharp contrast to the expected
liquidity effect, this hypothesis assumes that the Fed­
eral Reserve will not react to offset unexpected m oney
fluctuations.
Again assume the Federal Reserve has a target range
for m oney growth given by the cone in figure 2, and the
dashed line represents expected m oney growth. The
last announced value o f the m oney stock was M „ and
Mb is the level expected to be announced in the cur­
rent week. Also assume the actual announced value is
Md, yielding a positive m oney surprise o f M d- M b.
The inflation premium effect assumes that the sur­
prise w ill not be offset but that the m oney surprise will
induce (or is the result of) changes in the Federal
Reserve strategy toward less restrictive m onetary pol­
icy. Thus, the money stock is not expected to return to
its form er target path but is expected to move along a
new path as indicated by m ' in figure 2. The slope o f
this new path generally will be greater than that o f the
previous expected path, w hich indicates higher ex­
pected m oney growth and thus higher expected in­
flation.13The inflation premium effect predicts that the
increase in expected inflation w ill lead to higher nom i­
nal interest rates for as long as this inflationary policy
is expected to last.
A crucial assumption underlying the inflation pre­
mium effect is that an increase in the m oney stock, at
least in part, signals an easier m onetary policy
stance.'4 An unexpected increase in the m oney stock

announcement leads financial market participants to
revise upward their perceptions o f expected future
money growth and expected inflation. What does this
assumption im ply about financial market partici­
pants’ view o f Federal Reserve policy? T o the extent
that the Fed has stated monetary aggregate targets,
market participants must believe that those aggre­
gates may not be the sole target o f policy.
The inflation premium effect, like the expected li­
quidity effect, also assumes that unexpected shocks
are perceived as permanent or only slowly selfcorrecting. If the shock w ere perceived as temporary,
Fed intervention w ould be unnecessary, and money
growth w ould return to its original expected path
without Fed intervention.15

13lf the slope along rh® is less than that along me, the two paths will
ultimately converge, as they are assumed to do in the analysis of the
expected liquidity effect. Alternately, the growth path could have
exactly the same slope, m' = me, before and after an unexpected
increase in the money stock. In this case, money growth before and
after the one-week shock would be expected to be the same. The
long-run money growth rate would increase only by the amount that
the one-week increase had an impact on the average. Since money
growth influences inflation only with a substantial lag and since a
one-shot level change in the money stock is generally small in
relation to, say, the year-to-year change in the money supply, a
simple step up in the level of the money stock would usually have
little effect on the actual or the expected inflation rate.

M oney Dem and Effect

’4Again, this discussion assumes financial markets believe the Fed is
using a single target within the cone.

"This effect has also been titled the real economic activity effect. See
Cornell (1983b).

Digitized for 28
FRASER


A third hypothesis suggested as an explanation of
positive m oney surprises leading to interest rate in­
creases focuses on m oney dem and effects.16 Suppose

15This statement also abstracts from considerations such as interest
rate smoothing. For example, a temporary shock may lead to Fed
intervention to smooth the adjustment to equilibrium. In addition, if
the shock were temporary but led to a permanent shift in Fed policy,
it could also have the effect shown in figure 2.

FEDERAL RESERVE BANK OF ST. LOUIS

AUGUST/SEPTEMBER 1985

tual shift in the dem and curve, subject to the limita­
tions noted above, w ou ld already have had its impact
felt before the announcement.17

F ig u re 3

Money Dem id Effect

hi.™

• '* * '• • • *

Distinguishing Between the
Alternative Effects
Th e three effects described above all predict that an
unexpected m oney stock increase w ill lead to higher
nominal short-term interest rates. In an effort to differ­
entiate the impacts o f the expected liquidity effect, the
inflation prem ium effect and m oney dem and effect,
some studies have exam ined the implications o f the
alternative effects on stock prices and exchange
rates.'*

stack

m oney dem and depends in part on expected future
output, a situation considered by Fama 11982). Since
expectations about future output tire unobservable,
financial market participants cannot determine aggre­
gate m oney demand. The money announcement then
conveys information not only about m oney demand
but also about expected future output. An increase in
m oney dem and due to an increase in expected future
output is expected to persist and cause interest rates
to be bid up. This effect is illustrated in figure 3, which
focuses direcdy on market perceptions o f m oney sup­
ply and demand. W hile an increase in m oney dem and
may lead market participants to also expect an in­
crease in m oney supply, it is assumed in this section
that only the m oney dem and curve has shifted. The
case o f m oney dem and and supply both changing is
discussed below.
Before the m oney stock announcement, the ex­
pected future m oney supply and dem and curves are
given by S and D, respectively. After an unexpectedly
large m oney announcement, the future m oney de­
mand curve is perceived to have shifted (permanently)
from D to D ’. Interest rates in the future are expected
to rise to equilibrate the m oney market, and the expec­
tations o f higher future rates lead current rates to rise
in anticipation. Note that it is the n ew information
about the location o f the present and expected future
dem and curves that influences interest rates. Any ac­



Based on the expected liquidity effect, som e have
argued that, because the m oney surprise leads to
higher expected interest rates, it depresses the
present discounted value o f future dividends, thus
lowering stock prices. In addition, the expected li­
quidity effect predicts that, after taking into account
exchange rate risk, higher expected real returns in the
United States relative to, say, Germany should induce
a capital inflow that w ill be accom panied by a rising
value o f the dollar vis-a-vis other currencies.
The inflation premium effect predicts that an unex­
pected m oney stock increase w ill low er exchange
rates, as U.S. inflation increases relative to inflation in
other countries. Th e inflation premium effect makes
no prediction about the effect o f an unexpected
money stock increase on stock prices.”

"A shift in money demand that is not due to a shift in expected future
output is not necessarily associated with any change in stock prices.
One particular money demand effect that is sometimes consid­
ered separately is the reserve settlement effect This effect existed
only under lagged reserve requirements when the timing of the
money announcement was such that it revealed information about
current reserve demand. Consider a money stock announcement
say, on August 26, 1982. Data on the money stock was released
then for the week ending August 18,1982. But deposits for the week
ending August 26,1982, determined required reserves for the week
ending September 2,1 982 . When the money stock numbers were
released, they may have contained incremental information on the
demand for reserves.
An individual bank may know its own reserve requirements prior
to the money announcement, but it has only limited information on
aggregate reserves and thus on the federal funds rate expected to
prevail for the remainder of the reserve settlement period. An
unexpected money increase generally implies that deposits, as wed
as the demand for required and total reserves, are all greater than
expected. The reserve settlement effect demonstrates how institu­
tional characteristics can influence the relationship, say, between
money announcements and interest rates.
“ For example, see Cornell (1983b).
,9See Cornell (1983b) for a more detailed explanation.

29

FEDERAL RESERVE BANK OF ST. LOUIS

In contrast, the m oney dem and effect im plies that
an unexpectedly large m oney announcement w ill in­
crease stock prices due to the underlying increase in
expected future output. Th e international value o f the
U.S. dollar may increase due to the direct impact o f an
increased m oney dem and as w ell as the indirect effect
o f greater m oney dem and leading to higher real inter­
est rates and resulting capital inflows.3"

COMPARING THE HYPOTHESES:
SUBSTITUTES OR COMPLEMENTS?
Previous studies have advanced the three hypothe­
ses presented above as com peting theories to explain
w h y unanticipated m oney announcem ents alter
financial market variables.21In fact, the three effects do
not necessarily com pete and m ay be either substitutes
or complements. Consider a sim ple exam ple in which
they are complements. As in figures 1 and 2, the
expected m oney stock prior to the announcement at
tim e t was M(l. w hile the announced value was Md. The
expected liquidity effect again predicts a slowing o f
m oney growth from time t to t + k . Assume that this
tightening is expected to be only partially successful.
In terms o f figure 2, the m oney grow th rate w ill be
between m ' and m'. In this scenario, nominal interest
rates w ill be expected to rise due to both the expected
restrictive policy and higher expected inflation. Sim­
ply stated, m onetary policy is expected to be tighter
after the unexpected increase, but not tight enough to
restore the form er growth rate.
Figures 1 to 3 each focus on one m onetary distur­
bance. There is, however, substantial noise in the
w eekly M l series. Tim s, tem porary shifts cannot read­
ily be distinguished from permanent shifts. Further­
more, in light o f this uncertainty w hich all financial
market participants face, the Federal Reserve may be
expected to hedge its response to fluctuations.21Thus,
it is plausible that market participants may expect
monetary policy to be tighter after an unexpected
increase, but not tight enough to restore the form er
growth rate.
Both the expected liquidity and the inflation pre­
“ tt should be noted that the relationship between real interest rates
and capital inflows has only recently been emphasized. See Batten
and OH (1983). Previously the emphasis would have been placed on
relationships like an expected expansion leading to a rise in imports
and a drop in the U.S. exchange rate.
21In fact. Come* (1983b) introduces an additional theory, the risk
premium hypothesis, based on increased monetary variability re­
quiring larger risk premiums. Since neither he nor Belongia and Kolb
(1984) found any evidence of its existence, it is omitted here.
®See Brainard (1967) for a formal model making this point.

30



AUGUST/SEPTEMBER 1985

mium effects are based on the assumption o f a perma­
nent m oney market shock that m ay prom pt Federal
Reserve response. W hile such a shock need not origi­
nate in m oney demand, clearly it could. I f it does, then
the expected liquidity and inflation premium effects
cannot be distinguished from the m oney dem and
effect.
Further com plicating the analysis o f the m oney
dem and effect is that it presumes a shift in m oney
demand, but market participants are unlikely to be­
lieve m oney dem and can shift w ithout some Fed re­
sponse based on its presum ed targets. Thus, the
m oney dem and effect m ay imply, say, an expected
liquidity effect in response. For example, assume
m oney dem and increases and the Federal Reserve is
believed to be focusing exclusively on a m onetary
aggregate target. The increase in m oney demand, ce­
teris paribus, w ill lead to increases in both the m oney
stock and interest rates as figure 3 demonstrates. Fur­
thermore, the announcement o f a m oney stock in­
crease could lead financial market participants to ex­
pect the Fed to reduce the m oney supply in order to
maintain its m onetary aggregate target. This tighten­
ing, however, is the expected liquidity effect.
Alternately, if financial market participants believe
the Federal Reserve is tiyin g to peg nominal interest
rates, the expected Fed response to a m oney dem and
increase w ou ld be very different. An increase in m oney
dem and w ould prom pt the Fed to increase the m oney
supply to prevent interest rates from increasing. In
this scenario, the unexpected m oney announcements
should have no effect on interest rates. Between the
extremes o f focusing exclusively on interest rates and
focusing exclusively on a monetary aggregate, both the
expected liquidity and inflation premium effects may
be present.

EVALUATING THE EMPIRICAL
RESULTS
The findings o f previous em pirical analyses o f the
impact o f anticipated and unanticipated m oney an­
nouncements are summarized in table 1. The results
presented indicate considerable disagreement among
previous studies.

Short-Term Interest Rates
Unexpected Changes

—

Most studies conclude that short-term interest rates
are significantly and positively influenced by unantici­
pated m oney announcements. W hile this is true in
both the pre- and post-October 1979 periods, the ef-

Table 1

Summary of Empirical Results
Pre-October 1979
Unexpected
Money Changes

Post-October 1979

Expected
Money Changes

Expected
Money Changes

Unexpected
Money Changes

NOMINAL INTEREST RATES
Short-Run

+ Grossman (1981)
Urich and Wachtel (1981)
Roley (1982)
Urich (1982)
Cornell (1983a)
Roley (1983)
Roley and Troll (1983)
Loeys (1984)
Urich and Wachtel (1984)
Judd (1984)
Gavin and Karamouzis
(1984)

0 Cornell (1983b)
Roley and Walsh (1984)

0 Grossman (1981)
Urich and Wachtel (1981)
Urich (1982)
Cornell (1983b)
Roley (1983)
Urich and Wachtel (1984)
Roley and Walsh (1984)
Gavin and Karamouzis
(1984)

Long-Run

+ Roley (1982)
Cornell (1982)
Cornell (1983a)
Cornell (1983b)
Shiller, et. al. (1983)
Roley (1983)
Roley and Troll (1983)
Loeys (1984)
Belongia and Kolb (1984)
Urich and Wachtel (1984)
Roley and Walsh (1984)
Hardouvelis (1984)
Judd (1984)
Gavin and Karamouzis
(1984)
Hein (1985)
Belongia and Sheehan
(1985)

-

Belongia and Kolb (1984)
Urich and Wachtel (1984)
Gavin and Karamouzis
(1984)
Hein (1985)
Belongia and Sheehan
(1985)

0 Roley and Troll (1983)

0 Cornell (1983b)
Roley (1983)
Roley and Walsh (1984)

+ Cornell (1983a)

-

Gavin and Karamouzis
(1984)

Cornell (1983b)
Loeys (1984)
Rotey and Walsh (1984)
Gavin and Karamouzis
(1984)
0 Cornell (1983a)
Cornell (1983b)
Loeys (1984)
Roley and Walsh (1984)
Judd (1984)
Gavin and Karamouzis
(1984)
STOCK PRICES

-

0 Cornell (1983b)
Roley and Walsh (1984)
Gavin and Karamouzis
(1984)

Pearce and Roley (1983)
Pearce and Roley (1985)

0 Cornell (1983b)

0 Shiller, et. al. (1983)
Hardouvelis (1984)
Judd (1984)

-

Cornell (1983b)
Pearce and Roley (1983)
Pearce and Roley (1985)

0 Cornell (1983b)
Pearce and Rotey (1983)
Pearce and Roley (1985)

EXCHANGE RATES

0 Cornell (1983b)
Pearce and Roley (1983)
Pearce and Roley (1985)
+ Cornell (1982)
Cornell (1983b)
Engel and Frankel (1984)
Hardouvelis (1984)
Gavin and Karamouzis
(1984)

0 Cornell (1983b)
Gavin and Karamouzis
(1984)
+ indicates a significant positive effect was found.
- indicates a significant negative effect was found.
0 indicates an insignificant effect.




0 Cornell (1983b)
Gavin and Karamouzis
(1984)

0 Cornell (1983b)
Roley and Walsh (1984)

-

Gavin and Karamouzis
(1984)

0 Cornell (1983b)

AUGUST/SEPTEMBER 1985

FEDERAL RESERVE BANK OF ST. LOUIS

fects are substantially larger in the latter period.21For
example, Judd (1984) finds that a 1 percent positive
m oney surprise w ou ld increase the three-month Treasu iy bill rate by only 6 basis points before October
1979, but by 36 basis points after September 1979.14
That this is true is consistent w ith financial markets
believing that after September 1979 the Fed placed
substantially m ore w eight on short-term m oney stock
movements in their efforts to achieve monetary aggre­
gate targets Apparently, the market believed the Fed's
statements that its procedures w ere being changed.
The v e iy small estimated coefficients before October
1979 indicate that financial markets believed the Fed
was less interested in short-term movements in the
m oney stock before then.
That an unexpectedly large m oney announcement
increases short-term nominal interest rates cannot be
used as evidence to distinguish between the expected
liquidity, inflation premium and m oney dem and ef­
fects, however. All three predict a positive relationship
between the two.25 Thus, previous research also has
aThete is also substantially greater interest rate volatility in the latter
period. In addition, studies that have attempted to assess the impact
of money surprises have been faced with the task of sorting out the
influences of other factors such as a change in the day of the mooey
announcement, a discount rate surcharge, credit controls, etc. See
also the institutional changes mentioned in footnote 12. Most stud­
ies have simply chosen a period (or periods) for analysis and
assumed that non-money-announcement effects were unchanging
over that period. Whether this approach is valid is debatable. It
should be noted, however, that most estimated equations can
explain only 30 percent or less of the fluctuation in interest rates
around the time of the money announcement.
**ln general, no attempt is made here to present the magnitude of
estimated coefficients since the studies differ with respect to time
periods, definitions of the dependent variable (e.g., federal funds
rate vs. three-month Treasury bill as the short-term interest rate)
and equation specification. In addition, all the studies except Judd
(1984), Loeys (1984) and Gavin and Karamouzis (1984) make no
systematic study of differential effects occurring after October 1982
when the Federal Reserve deemphasized the M1 monetary aggre­
gate.
“ Cornell (1983b) states:
The dramatic shift in the market response to money supply an­
nouncements after October 6 is difficult to reconcile with the expected
inflation hypothesis. If the money supply announcements are providing
information about future money growth, there is no obvious reason why
the Fed’s stated intention to control monetary aggregates should induce
a positive correlation between announced innovations in money and
changes in interest rates. In fa c t it is more reasonable to conclude that
the correlation would decline because week-to-week variation in the
agcpegates would no longer provide information about long-run policy.

Cornell's argument is that the expected liquidity effect predicts a
greater response to money surprises pre- vs. post-October 1979,
while the inflation premium effect predicts no change in response.
This lack of change with the inflation premium hypothesis, however,
is based on the assumption that the change in operating procedures
dkl not alter market participants’ view of the money supply process.
The inflation premium effect could also be associated with a greater
response to a money surprise after October 1979 if, for example, an
unexpected increase in the money stock after that date is viewed as
having a greater probability of signaling monetary ease than under
the previous operating procedures.

32



focused on financial market variables for w hich the
responses to m oney surprises might differ. These vari­
ables include long-term interest rates, stock prices
and exchange rates.

Long-Term Interest Rates
Studies that have considered the impact o f m oney
announcements on long-term interest rates have been
unanimous in concluding that neither announcement
surprises nor anticipations influenced long-term rates
prior to October 1979. This is again consistent with
financial markets believing that the Federal Reserve
was pegging interest rates before October 1979. After
September 1979, w ith lim ited analysis there is some
evidence that expected announcements have no im­
pact on long-term rates. Expected increases in the
m oney stock m ay lead to higher inflation and higher
long-term interest rates, but d o not necessarily lead to
h i^ ie r inflation and interest rates im m ediately after
the m oney announcement.
The results concerning announcement surprises
are mixed. Studies that have used long-term forward
rates such as Shiller, et. al. (1983), Hardouvelis (1984)
and Judd (19841 generally have found no significant
response.® These findings are not consistent w ith the
inflation premium effect. A m oney surprise is appar­
ently expected to be quickly offset by the Fed and thus
has no effect on long-run inflation expectations. Alter­
nately, financial market participants could sim ply be­
lieve that weekly m oney announcements, from a longrun perspective, convey little o r no information useful
in forecasting long-term interest rates.
Studies such as Cornell (1983a) that have used
changes in actual long-term rates, w hich include the
effects o f short-term rates, have found significant ef­
fects. W hether these effects are the result o f market
participants’ short-run expectations about current or
prospective short-term interest rates or w hether they
truly convey information about inflation expectations
has not been determined.

Stock Prices
Relatively few studies have considered the im plica­
tions o f m oney announcements on stock prices. Stock
prices apparently decreased in response to positive
m oney surprises in the post-September 1979 period.
In the pre-October 1979 period, there is no consensus

^■Gavin and Karamouzis (1984) find the four-year forward rate three
years ahead is significantly influenced by money surprises, while
the 23-year forward rate seven years ahead is not.

FEDERAL RESERVE BANK OF ST. LOUIS

on w hether m oney surprises influenced stock prices
(table 1). Expected changes had no effect on stock
prices in either period.
These results are inconsistent with the m oney de­
mand effect. If the m oney announcement reveals an
increase in m oney dem and due to an increase in
expected output, stock prices should increase.27

Exchange Rates
The exchange rate results presented in table 1 indi­
cate that neither anticipated announcements nor sur­
prises significantly influenced exchange rates before
October 1979. After September 1979, m oney surprises
have resulted in significant appreciation o f the dollar
relative to some currencies, in particular the German
mark and the Swiss franc. Other exchange rates, such
as those relative to the British pound and the Cana­
dian dollar, have not appreciated significantly. To
date, there apparently have been no joint tests o f the
significance o f m oney surprises on all exchange rates.
The evidence that exchange rates generally did not
depreciate is also inconsistent with the inflation pre­
mium effect. The inflation premium effect predicts
that an unexpectedly large m oney announcement,
associated with higher expected inflation, should lead
instead to low er exchange rates.28

Short-Term Interest Rates
Expected Changes

—

Most studies also indicate that expected m oney
announcements had no impact on short-term interest
rates before October 1979. After then, table 1 indicates
a consensus that expected m oney announcements
had significant negative effects on short-term interest
rates. This result is inconsistent with any o f the com ­
peting theories and the efficient markets hypothesis.29
Thus, either the efficient markets hypothesis is incor­
rect, the theories as they are currently formulated or
tested are insufficiently detailed, or other factors are
changing that are correlated with expected money.
27This conclusion implies only that the money demand effect by itself
cannot explain all of the impacts of the money announcements.
28The exchange rate results imply only that the inflation premium
effect by itself is not capable of explaining all the impacts of money
announcements.
^After October 1979, an expected increase in the money supply
would cause movement down the money demand cun/e with a
resulting decrease in interest rates. Market efficiency implies that
this decrease in interest rates would occur immediately upon the
change in expectations. Thus, if the money supply is expected to
increase prior to the money announcement, interest rates would
already have adjusted to this expectation prior to that an­
nouncement.




AUGUST/SEPTEMBER 1985

It is difficult to argue that the efficient markets
hypothesis is incorrect. If it were, it w ou ld im ply that
profitable trading opportunities exist based only on
knowledge o f expected money.30Given that the money
announcement is w id ely forecasted and both the fore­
casted and announced values are w idely dissemi­
nated, it seems unreasonable to expect profitable trad­
ing opportunities to remain for long. It seems more
plausible to attribute the significance o f expected
m oney either to correlation between expected money
and om itted variables or to limitations in the underly­
ing theory.31

CONCLUSIONS
While a number o f theories have been advanced to
explain w hy m oney stock announcements, particu­
larly the com ponent that is unexpected, influence
financial market variables, this paper shows that these
theories are not generally competing. For example, the
expected liquidity and inflation premium effects may
be com plem entaiy depending on financial market
participants’ perceptions o f Federal Reserve goals.
Some empirical results are inconsistent with either
the inflation premium effect or the m oney demand
effect alone. The expected liquidity effect, by itself, can
explain the responses o f interest rates, exchange rates
and stock prices to unexpected m oney announce­
ments. There is no reason, however, to believe that this
effect, or either o f the tw o others, operates in isolation.

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FEDERAL RESERVE BANK OF ST. LOUIS

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