Full text of Review (Federal Reserve Bank of St. Louis) : February 1982

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February 1982
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3 The Three-Year Experience with the
Community Reinvestment Act
11 The Shift in Money Demand:
What Really Happened?

The R eview is publ ished 10 tim es per year by the Research D epartm ent o f the Federal Reserve
Bank o f St. Louis. Single-copy subscriptions are available to the public f r e e o f charge. Mail
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The Three-Year Experience with the
Community Reinvestment Act
NORMAN N. BOWSHER

c

\ ^ < R E D I T is a scarce co m m o d ity . As lenders
allocate available funds on the basis of a variety o f
considerations, in clu din g price (interest rates), abil­
ity to repay, maturity o f the loan and costs o f servic­
ing, it is generally difficult for an outside observer to
determ ine why one loan application is refused w hile
an apparently similar one is accepted.

D uring the 1970s, banks and thrift institutions
w ere charged with “ redlining” in allocating credit.
Many charged that lenders, in essence, drew a line
(presum ably red) around certain areas on a map and
deliberately redu ced the supply o f mortgage and
other credit to residents o f those areas. R edlining
was cre d ite d w ith both un fairly discrim in ating
among those seeking credit and hastening the e c o ­
nom ic declin e o f the affected areas. Lenders, the­
oretically, did this because they w ere shortsighted,
bigoted or insensitive to the needs o f these indi­
viduals and com m unities.1
In response to such charges, Congress passed the
C om m u n ity R ein vestm en t A ct (C R A ), e ffe ctiv e
N ovem ber 6, 1978, to encourage financial institu­
tions to m eet the credit needs o f their local com ­
m u nities. T his a rticle d iscu sse s r e d lin in g and
examines the CRA experien ce during the three years
o f its existence. Since a study by the C ouncil o f State
Planning A gencies has recom m en ded enactment o f
lTake the Money and Run! Redlining in Brooklyn (New York
Public Interest Group, Inc., 1976), pp. 13-16; and Redlined: A
National Survey by National Peoples Action o f Mortgage Lend­
ing Policies in the United States, October 1976 (U.S. Senate
Hearings, November 23, 1976, pp. 154-87).




a law similar to the CRA, but aimed at increasing
credit to small businesses in the bank’ s com m unity,
this is an appropriate tim e to rev iew the C R A
experience.2

M ORTGAGE MARKETS AND
REDLINING
E con om ics o f M ortga ge L en d in g
T he purchase o f a hom e is typically the largest
financial outlay that an individual makes in his life­
time, usually am ounting to tw o or more years o f a
buyer’ s incom e. H om e purchasers generally rely on
substantial credit to facilitate their purchases since
they do not have sufficient savings readily available
to buy the hom e outright.
By m id -1981 total mortgage debt in the country
am ounted to $1.5 trillion, more than 50 percent
greater than the total federal debt. This mortgage
credit was granted by a vast num ber o f diverse
lenders. Savings and loan associations h eld 34 per­
cent o f the debt, com m ercial banks had 18 percent,
life insurance com panies carried 9 percent, and
federal and related agencies held 8 percent. The
remaining 31 percent o f the mortgage debt was dis­
tributed am ong mutual savings banks, mortgage
p ools or trusts, relatives and other individuals,
2Beth K. Vogt, “ Small Business Loan Act Urged,” American
Banker, December 24, 1981.

3

FEDERAL RESERVE BANK OF ST. LOUIS

mortgage com panies, state and local credit agencies,
credit unions and pension funds.
Because of the unique features o f each property,
the lim ited kn ow ledge about borrowers outside the
comm unity, and legal restrictions on som e lenders,
most mortgage loans are granted by lenders located
in the area of the property to be financed. N ever­
theless, there is, in essence, a national mortgage
market, and terms on mortgages vary only slightly
betw een regions.
The broader market reflects the fact that some
lenders, such as insurance com panies, in searching
for the most profitable opportunities, len d in various
sections of the country. Also, mortgage bankers fre­
quently resell mortgages to institutions situated in
other parts o f the country to enable them to make
additional loans locally. FH A insurance and the
secondary markets further im prove the acceptance
of mortgages outside the local com m unity. In addi­
tion, savings tend to flow from areas o f relatively low
interest rates to areas o f relatively higher interest
rates. As a result, there is, in reality, a national mort­
gage market, bringing com petition for mortgages
into virtually every locality.
Since lenders are in business to m axim ize their
wealth, it is natural for them to seek the most profit­
able loans available. It is rational, therefore, in
determ ining w hether to grant a loan, for lenders to
consider such e con om ic factors as the present and
future value o f the collateral, the incom e, wealth and
other measures o f the creditworthiness o f the bor­
rower, and the probable collection costs, in addition
to the interest rate charged. On the other hand, it is
irrational for lenders to refuse to len d for reasons
unrelated to the likely profitability o f the loan.

T h eoretical O b jec tio n s to the
E xisten ce o f “ Irrational ” R edlining
T o forego profitable opportunities by discrim i­
nating against potential borrowers on the basis o f
non-econom ic criteria is generally con sidered irra­
tional behavior on the part o f lenders. Im posing less
favorable terms in one area than another, or refusing
to lend altogether, w hen not justified by differences
in risk or cost, is inconsistent with the self-interest o f
lenders or borrowers. I f private lenders are profit
maximizers, non-profitable redlining w ou ld be o f
lim ited duration.3 Although som e lenders, at times,

3See Jack M. Guttentag and Susan M. Wachter, Redlining and
Pul)lic Policy, Monograph Series In Finance and Economics,
Monograph 1980-1 (New York University), p. 5.

4




FEBRUARY 1982

may derive satisfaction from denying certain loans
for non-econom ic reasons, com petition from other
lenders w ho seek such profitable loans assures that
such actions are neither com m on nor w idespread.
D espite its practical drawbacks, many b eliev e that
such redlining is com m on and that laws are n eeded
to correct this abuse.4 These observers b eliev e that
many financial institutions exercise local m onopoly
pow er; thus the potential com petition to reduce
unprofitable redlining is severely lim ited. H ence,
lenders allegedly have sufficient market pow er to
indulge their lending prejudices for a considerable
time. Although a lender with sufficient m onopoly
pow er can b ecom e lax or biased if he chooses, h ow ­
ever, m ost m o n o p o list len ders have p ecu n ia ry
incentives to make the most profitable loans, in cen ­
tives that are r e in fo rce d w h en m an agem ent is
accountable to stockholders. An exception, w here
prejudicial discrimination may be practiced without
pecuniary cost, is a m on opoly lender already so
profitable that it fears pu blic p olicy actions may be
forthcom ing if it becom es even more profitable.5
This does not appear to be a problem for mortgage
lenders.

Is There E vid en ce that R edlining E xists?
The principal m ethod of demonstrating the exis­
tence o f redlining is to count mortgages made by
certain lenders in an inner-city, low -in com e area and
in a suburban, high-incom e area for about a year and
com pare the tw o figures.6 Such arguments w ere
supported by data supplied by financial institutions
under the H om e Mortgage D isclosure Act. T hese
data, com bin ed with census information on housing,
incom e and population, indicate that low -incom e
areas receive proportionately less credit than other
neighborhoods.
H o w e v e r , th ese stu d ies have seriou s sh ort­
comings. M ost careful analyses have generally been
consistent with the im plications cited above for
4George J. Benston, “ The Persistent Myth of Redlining,” Fortune
(March 13, 1978), pp. 66-69.
5See Armen A. Alchian and Reuben A. Kessel, “ Competition,
Monopoly, and the Pursuit of Money,” Aspects o f Labor Eco­
nomics (National Bureau of Economic Research, 1962), pp. 15783. Also, Alfred Nicols, “ Stock Versus Mutual Savings and Loan
Associations: Some Evidence of Differences in Behavior,”
American Economic Review (May 1967), pp. 337-46.
6See Michael Agelasto II and David Listokin, “ Redlining in
Perspective: An Evaluation of Approaches to the Urban Mort­
gage Dilemma,” in Donald Phares, ed., A Decent Home and
Environment: Housing Urban America (Ballinger Publishing
Company, 1977).

FEDERAL RESERVE BANK OF ST. LOUIS

profit-maximizing lenders. T w o studies — for Sac­
ramento, California and L ou isville, K entucky —
demonstrated that arguments advanced to show red­
lining om itted many important sources o f credit such
as mortgage bankers and private funds.7 In an anal­
ysis o f data provided by T oled o, O hio, savings and
loan associations, the dem and for mortgages was also
found to be an important om itted factor.8 A study o f
FH A insured mortgage foreclosures in six major
cities w hich focu sed on the risks (costs) o f lending on
properties in alleged redlining areas found that dif­
ferences in loan terms w ere based on econ om ic
rather than prejudicial factors.9 Allegations by com ­
munity groups that properties in low -in com e areas
w ere systematically underappraised w ere not sup­
ported in a study o f savings and loan data for Miami,
San Antonio and T o le d o .10 On the other hand, an
examination of denials o f m ortgage applications
based on a survey o f 176 banks by the Com ptroller
and the Federal D ep osit Insurance C orporation
(F D IC ) found slight e v id en ce of n on-econom ic dis­
crim ination.11
An in-depth study o f the Rochester, N ew York,
metropolitan area found insufficient e v id e n ce to
conclude that redlining was a serious prob lem .12 Its
authors noted that previous inquiries claim ing to
find significant amounts of redlining made incom ­
p lete surveys o f len d ers (particularly m ortgage
bankers), ignored the effect o f rent controls, used
time periods too short for meaningful generaliza­
tions, ignored the collateral offered and the credit­
worthiness o f borrow ers, or did not com pare d e­
mands for credit by areas.

7Dennis Dingemans, “ Redlining and Mortgage Lending in Sacra­
mento,” Annals o f the Association o f American Geographers
(June 1979), pp. 225-39; and Theodore Koebel, Housing in
Louisville: The Problems o f Disinvestment (Urban Studies
Center, University ol Louisville, 1978).
8James R. Ostas, J. David Reed, and Peter M. Hutchinson, “ An
Intertemporal Comparison of Urban Mortgage Lending Patterns
in the Toledo, Ohio SMSA: 1977 vs. 1975,” Unpublished paper
(Bowling Green State University, 1979).
9Richard G. Marcis and Everson W. Hull, “ Analysis of the SocioEconomic Determinants of Foreclosures on 2219(d)(2) and 235
Mortgages,” Federal National Association Meeting, 1975.
10A. Thomas King,“An Analysis of Mortgage Lending in Three
SMSA’ s,” Office of Economic Research, Federal Home Loan
Bank Board (preliminary report, 1979).
"H arold Black, Robert L. Schweitzer and Lewis Mandell, “ Dis­
crimination in Mortgage Lending,” American Economic Re­
view (May 1978), pp. 186-91.
12George J. Benston, Dan Horsky, and H. Martin Weingartner, An
Empirical Study o f Mortgage Redlining, Monograph Series In
Finance and Economics, Monograph 1978-5 (New York Uni­
versity).




FEBRUARY 1982

Another extensive em pirical analysis was made of
virtually all hom e mortgage and hom e im provem ent
loans granted in C uyahoga C ounty, the central
county o f the C leveland area, from 1977 through
1979.13 A fter co n tro llin g for in com e and other
dem ographic variables, the study con clu d ed that
n eighborhood racial com position had little impact
on either the total num ber o f deed transfers financed
by mortgage loans or total housing-related financing.
H ow ever, it also appeared that the portion o f con ­
ventional mortgage financing provided by banks and
savings and loans was significantly low er in inte­
grated and all-black neighborhoods than in all-white
neighborhoods. On the other hand, black and racial­
ly m ixed areas w ere significantly more likely to be
served by mortgage bankers offering FH A and VA
financing. Also, banks and savings and loans were
m uch more likely to make hom e im provem ent loans
in these areas.
One can obtain additional evidence that irrational
redlining does not exist by looking at the operating
history o f new banks established primarily to lend in
low -in com e areas. Twenty-six black-ow ned banks,
for exam ple, w ere established to serve this demand
in low -incom e areas in the last 10 years. O f these
new banks, five have failed, and at least a dozen
others w ere near collapse before other organizations
bailed them out.14 Although minority banks came
into existence to deal with specific minority credit
problem s, their lack o f success suggests that most
creditworthy demands w ere already bein g accom ­
modated, although other factors such as management
and capitalization may also have played a role.
Further tests of banks’ lending behavior support
the profit-maximization m odel. One recent study,
using data on 30,000 com m ercial bank consum er
loans, tested whether sex discrimination existed in
credit allocation by banks.15 The study found no
systematic pattern o f sex discrim ination — even
before the Equal Credit Opportunity Act was passed.
Instead, banks typically beh aved as profit maxi­
mizers, making loans on equivalent terms to equally
risky customers, regardless of their sex.

13Robert B. Avery and Thomas M. Buynak, “ Mortgage Redlining:
Some New Evidence,” Economic Review, Federal Reserve
Bank of Cleveland (Summer 1981), pp. 18-32.
14Michael L. King, “ Black-Owned Banks Facing Doubts About
Their Continued Usefulness,” The Wall Street Journal, August
10, 1981.
15Richard L. Peterson, “ An Investigation of Sex Discrimination in
Commercial Bank Direct Consumer Lending,” The Bell Journal
o f Economics (Autumn 1981), pp. 547-61.

5

FEDERAL RESERVE BANK OF ST. LOUIS

THE C O M M U N IT Y REINVESTMENT
ACT
D espite theoretical objections and the lack oi e v i­
d en ce that such redlining actually existed, Congress
passed the CRA. The congressional action generally
reflected the p u b lic’ s sympathy with the anecdotal
arguments o f those living in blighted areas. The suc­
cess of com m unity groups in con vin cin g the press
and pu blic that lenders w ere not serving older urban
areas was primarily the result o f skillful publicity
rather than substantial confirm ing ev id e n ce .16 The
act was intended to elim inate irrational redlining in
detexmining w hether a loan application is accepted;
lenders w ere still perm itted to evaluate applications
on rational econ om ic grounds.
The act specifically requires financial institutions
to
. . demonstrate that their deposit facilities serve
the con ven ien ce and needs o f the com m unities in
w hich they are chartered to do business.” It directs
four regulatory agencies — the Board o f Governors o f
the Federal R eserve System, the Com ptroller o f the
C urrency, the F ederal H om e Loan Bank Board
(FH LBB), and the F D IC — to encourage each insti­
tution under their jurisdiction to help m eet the credit
needs of its entire local community.
Under the act, a financial institution is required to
adopt a CRA statement, maintain pu blic CRA files
and display a CRA notice, w hich includes informa­
tion on the availability o f the institution’s CRA
statem ent. T h e C R A statem ent m ust in c lu d e a
delineation of the area that com prises the institu­
tio n ’ s com m u n ity and a list o f prin cip a l types
of credit that the institution is prepared to extend.
T he pu blic files must contain any signed com m ents
receiv e d from the p u b lic about the institution’s
record of serving the credit needs o f its community.
In a ddition , the C R A requires the regulatory
agencies to assess regularly each institution’ s record
of m eeting the credit needs o f its com m unity, in­
clu din g low -to-m oderate in com e neigh borh oods,
consistent with the safe and sound operation o f the
institution. These assessments are taken into ac­
count in rulings on merger, holding com pany and
other applications by the institution. Also, the CRA
offers anyone the opportu n ity to ch a llen g e any
merger, holding com pany or branching expansion

16See George J. Benston, “ Mortgage Redlining Research: A Re­
view and Critical Analysis Discussion,” The Regulation o f
Financial Institutions, Conference Series No. 21 (Federal Re­
serve Bank of’ Boston and the National Science Foundation,
1979), pp. 114-95.

6




FEBRUARY 1982

plans o f financial institutions that are considered
unresponsive to the credit demands o f their co m ­
munity.

Protests U nder the C R A
T o date, about 100 protests in opposition to the
applications o f banks and savings and loans on CRA
grounds have b een filed with the regulatory agen­
cies. M ost have been lod g ed by com m unity orga­
nizations, a few have com e from the press or indi­
viduals, and approxim ately one-third have b een
lodged by com petitors. M ost protests have b een
against institutions located in or near low -in com e
areas o f major cities.
At first, com m unity groups w ere hesitant about
using the CRA to challenge applications, perhaps
because o f their unfamiliarity with the operations o f
financial institutions and regulatory agencies and
because most creditw orthy dem ands w ere bein g
accom m odated. Over time, these organizations have
gained experience and b ecom e more active. A num ­
ber o f protests have been supported by considerable
inform ation; these have frequently b een instru­
mental in gaining concessions from financial insti­
tutions.17
Although there are several technical requirements
in the CRA, such as displaying a CRA notice in the
lobby, protesters have had little com plaint c o n ­
cerning them. The ch ief issue raised in most protests
is the failure o f the financial institution to serve
adequately the housing-related credit requirements
o f lo w -in c o m e n e ig h b orh ood s, e sp e cia lly those
com posed o f minorities or those with a shifting racial
balance. T hese complaints typically contend that the
lending institution systematically refuses or severe­
ly limits credit to certain neighborhoods becau se o f
location, age of property or general conditions in the
area, with little regard to the creditworthiness o f the
applicant.
Protests also have b e e n re g istered on other
grounds. These include: the institutions’ failure to
advertise the availability o f credit in the low er in­
com e neighborhoods; a low level o f involvem ent
with governm ent programs, particularly the Small
Business Administration and the student loan pro­
grams; excessively restrictive mortgage loan p o l­
icies, such as larger d ow n paym ents than other

l7See Thomas M. Buynak, “ The Community Reinvestment Act:
Early Experience and Problems,” Economic Commentary,
Federal Reserve Bank o f Cleveland, April 20, 1981.

FEDERAL RESERVE BANK OF ST. LOUIS

lenders in the com m unity require; pre-screening o f
potential loan applicants; and inadequate efforts to
ascertain “ com m unity credit n eeds.”

FEBRUARY 1982

Table 1

CRA Examination Ratings of Member
R egula tory R esponse to the C R A
Congress provided little specific guidance in the
act as to what is satisfactory or unsatisfactory per­
form ance in regard to com m unity reinvestment. The
act does not explain h ow a financial institution’ s
com m unity should b e selected, h ow credit needs are
to b e d e te r m in e d , w h at co n s titu te s lo w - and
m oderate-incom e neighborhoods, or to what extent
the act was to be interpreted by considering the
costs, liquidity, safety and profitability o fth e lender.
Since the provisions o fth e act are vague, regulatory
agencies have had to both enforce the act and inter­
pret it as w ell.
T he regulatory agencies invited the pu blic to sug­
gest h ow to interpret and im plem ent the act in a
series o f hearings h eld in cities across the nation.18
T o provide a focus for the hearings, a num ber o f
questions that the statute raised w ere included with
the p u blic notice o f the hearings.19 C onsequently,
the im plem entation o f the act began m odestly and
cautiously and has b een gradually form ulated over
time. T h e agencies, evolvin g their ow n standards on
a case-by-case basis, have exam ined a variety o f
e v id e n c e in evalu a tin g a le n d e r ’ s C R A p e rfo r­
m ance.20
Under the CRA, regulatory agencies have a num­
ber o f responsibilities. T h ey must regularly assess
each lending institution’ s record o f perform ance in
helping to m eet its com m unity credit needs. This
assessment or inspection covers both the technical
com pliance with regulations and a qualitative eval­
uation o f the institution’ s overall perform ance in
serving the credit requirements o f its com m unity.
The regulatory agencies have agreed on a uniform
rating system to provide a consistent application o f
the act. H ow ever, they assigned no explicit weights

18See statement by Philip C. Jackson Jr., Federal Reserve Bulle­
tin (August 1978), pp. 631-33.
19See “ Community Reinvestment Act of 1977 to Be Imple­
mented,” Federal Reserve Bank o f Dallas Voice (March 1978),
p. 12, for questions posed. Also, see “Community Reinvestment
Act Heaiing Held at Fed,” Federal Reserve Bank o f Dallas,
Voice (May 1978), pp. 22-24, for a sampling of the mixed com­
ments received at the public hearings.
20Glenn Canner and Joe M. Cleaver, “The Community Reinvest­
ment Act: A Progress Report,” Federal Reserve Bulletin
(February 1980), pp. 87-96.




Banks During 1980
Rating
1 - Outstanding

Number of
banks
31

Percentage
of banks
3.5%

2 - Good

328

36.7

3 - Satisfactory

507

56.7

4 - Needs im provem ent
5 - Unsatisfactory
TOTAL

26

2.9

2

0.2

894

100.0

to the assessment factors, since they b e lie v e d that
any such w eighting w ou ld constrain an institution’ s
responses to local credit demands.
A significant aspect o f the C RA inspection is an
overall judgm ental evaluation o f a lender’ s perfor­
mance in m eeting the credit demands o f its com ­
munity. C R A inspections o f a given bank occu r
roughly every 12 to 18 months and, b y and large,
have revealed that the banks served the credit needs
o f their com m unities (table l).21 Even in cases o f un­
satisfactory perform ance, most potential borrowers
w ere protected by other com petitive institutions
in the area.
Regulatory agencies take into account both the
CR A assessments and actions taken b y the lender to
bring about future im provem ent w hen they evaluate
an institution’ s application for a charter, branch,
office relocation, deposit insurance, m erger or acqui­
sition. T he agencies w ill deny any application if they
ju d ge that the bank or savings and loan has not com ­
plied with the substantive provisions o f the CRA.
Also, since the pu blic may challenge a financial
institution’ s application on CR A grounds, the agen­
cies must evaluate the merits o f CRA protests and
objections w hen considering an institution’ s appli­
cation. T o aid protestors, the Federal Reserve Sys­
tem issued Regulation BR, w hich lists the criteria
the Board o f Governors considers in evaluating the
CRA record o f a bank (see insert). In addition, each
Reserve Bank has appointed a Com m unity Affairs
O fficer w h ose resp on sib ilities in clu d e advising

21Glenn Canner, “ The Community Reinvestment Act: A Second
Progress Report,” Federal Reserve Bulletin (November 1981),
pp. 813-18.

7

FEDERAL RESERVE BANK OF ST. LOUIS

com m u n ity groups and banks on p roced u res to
follow in C RA disputes.
T o date, only four applications have b een denied
on C R A grounds. T h ree rejection s w ere b y the
F D IC , two involving branch applications and one a
merger. The fourth denial was by the Com ptroller o f
the Currency. T he three F D IC cases follow ed pro­
tests by com m unity groups; in the other cases, there
was no protest. Three o f these cases w ere subse­
quently approved after specific actions by the insti­
tutions — such as hiring a full-tim e com m unity rela­
tions officer, im proving its marketing programs and

FEBRUARY 1982

com m itting specific amounts o f funds for mortgage
and hom e im provem ent loans in low-to-m oderate
incom e neighborhoods — im proved their C R A per­
formance.
T he relatively few denials under the CRA, h ow ­
ever, is not a reliable measure o f the effect o f the act
on bank lending practices. Recause o f the act, a num ­
ber o f institutions have changed certain len din g
practices, and many approvals o f applications have
been based on com m itm ents to im prove C R A per­
formance. O f the 19 protested cases approved b y the

Assessing the Record of Performance
Regulation BB, Section 228.7
In connection with its examination o f a State
m em ber bank, the Roard shall assess the record of
perform ance o f the bank in helping to m eet the
credit needs o f its entire com m unity, including
low - and m oderate-incom e neighborhoods, con ­
sistent with safe and sound operation o f the bank.
T he Board w ill review the bank’s C R A State­
m e n ts) and any signed, written com m ents re­
tained by the State m em ber bank or the Federal
Reserve Rank. In addition, the Board w ill con ­
sider the follow in g factors in assessing a bank’s
record o f perform ance:

(e) T he geographic distribution o f the State
m em ber bank’s credit extensions, credit applica­
tions, and credit denials;
(f) E vid en ce o f prohibited discriminatory or
other illegal credit practices;
(g) T h e State m em ber bank’ s record of open ing
and closin g offices and p rov id in g services at
offices;
(h) The State m em ber bank’s participation, in­
cluding investments, in local com m unity d e v e l­
opm ent and redevelopm ent projects or programs;

(a) Activities con du cted by the State m em ber
bank to ascertain the credit needs o f its com ­
munity, including the extent of the bank’s efforts
to com m unicate with m em bers o f its com m unity
regarding the credit services bein g provided by
the bank;

(i) T h e State m em ber bank’s origination o f
residential mortgage loans, housing rehabilitation
loans, hom e im provem ent loans, and small busi­
ness or small farm loans within its com m unity, or
the purchase o f such loans originated in its com ­
munity;

(b) T h e extent o f the State m em ber bank’s
marketing and special credit-related programs to
make m em bers o f the com m unity aware o f the
credit services offered by the bank;

(j) The State m em ber bank’ s participation in
governm entally-insured, guaranteed, or subsi­
d ized loan programs for housing, small b u si­
nesses, or small farms;

(c) T he extent o f participation b y the State
m em ber bank’ s board o f directors in formulating
the bank’ s policies and review ing its perform ance
with respect to the purposes o f the Community'
Reinvestm ent Act;
(d) Any practices intended to discourage ap­
plications for types o f credit set forth in the State
m em ber bank’s CRA Statement(s);



(k) The State m em ber bank’ s ability to m eet
various com m unity credit n eeds based on its
financial condition and size, and legal im pedi­
ments, local econ om ic conditions, and other fac­
tors; and
(1)
Other factors that, in the Hoard’s judgm ent,
reasonably bear upon the extent to w hich a State
m em ber bank is helping to m eet the credit needs
o f its entire community.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1982

Board o f Governors, com m itm ents have played a
role in seven.22

some reallocation o f credit and increased the costs o f
financial intermediation.

It is the explicit p olicy o f the regulatory agencies
to encourage discussion b etw een applicants and
protestants to help resolve or narrow their differ­
ences. A num ber o f such discussions have been held,
and, in six protested cases d e cid e d by the Board o f
Governors, a privately negotiated agreem ent b e ­
tween the parties was a factor in resolving the prob­
lem. These discussions resulted in commitments by
financial institutions to change lending practices and
other policies. At times, in private agreements b e ­
tw een the parties, lenders have gone much further
than the act requires, for exam ple, by allocating
specific amounts of mortgage credit in certain d e ­
pressed areas at interest rates of V2 percentage point
b elow the prevailing market rate.23

The philosophy incorporated in the CRA o f re­
quiring each financial institution to give preference
in its lending to those in their local com m unity can
b e questioned. Financial institutions, their stock­
holders and their depositors are clearly better o ff if
funds are loaned w here the interest rates are higher,
regardless o f location. Similarly, the prospects for
increased investment and production are enhanced
w hen credit is allocated efficiently. C om petition
am ong len d ers, the b o rro w e rs’ b est p rotection
against prejudiced lenders, is strengthened when
financial institutions seek to make the best loans
possible.

EVALUATION OF THE CRA
The CRA has b een controversial from its in cep­
tion. Prior to its passage, com m unity groups claim ed
that irrational redlining was com m on, w hile finan­
cial institutions asserted that they w ere m eeting
neighborhood credit demands consistent with pru­
dent lending practices. There is little agreement,
how ever, on the extent o f the problem , though most
careful studies have found little discrim ination in
lending. C onsequently, the desirability o f the act
and the role, if any, that it should play in credit
markets is still in doubt after three years. The Am er­
ican Bankers Association has requested Congress to
repeal the C RA.24
Even if som e managers o f financial intermediaries
w ere w illing to forego profits to satisfy their prej­
udices, the sizable num bers o f lenders operating in
most local markets, especially in the major cities
where redlining is alleged to be greatest, makes it
unlikely that many actual cases o f credit unavail­
ability on com petitive terms w ould be observed.
The experience o f the last three years has been con ­
sistent with many econom ists’ view s that the lack of
credit availability to borrowers caused by irrational
redlining is uncom m on. Yet, also as expected, the act
has placed a burden on lenders, w hich has caused
22lbid.
23See the order in the Landmark case, News Release, Federal
Reserve Bank of St. Louis, November 30, 1979.
24“ ABA Calls For Repeal of CRA; High Costs are Cited,” Ameri­
can Banker, December 11, 1981. The ABA contends that costs
far exceed the benefits of CRA, and the act merely requires what
good sense dictates anyway — serving the communities.




Some analysts regarded the passage o f the act as a
major step toward governmental allocation of credit.
Such concern still exists, even though the regulatory
agencies deny that the act and its enforcem ent allo­
cates credit.25 In fact, the Federal Reserve has stated
that it w ill not endorse any agreements to allocate
cred it.26 Yet, w h en financial institutions desire
favorable rulings on applications, and, as part o f this
process, must demonstrate that the credit needs o f
low-to-m oderate incom e areas are being adequately
served, credit w ill be allocated differently, if for no
other reason than to increase the probability o f a
favorable ruling. Thus, some financial institutions
have adjusted their lending policies to grant more
credit in low -to-m oderate in com e areas in their
communities.
Another result o f the act is that financial institu­
tions have undertaken large projects in w hich finan­
cial risks can be shared. One example o f such efforts
was in Springfield, Massachusetts, w here 11 local
com m ercial and savings banks and two insurance
com panies com bin ed developm ent efforts to revi25The Federal Reserve has stated, “Although CRA is directed at
the problem of meeting sound community credit needs, it was
not intended to establish a regulatory influence on the allocation
of credits. In implementing the Act, the Board has acted on the
belief that banks are in the best position to assess the credit
needs of their own local communities . .
Federal Reserve
System, Community Reinvestment Act, Information Statement,
January 3, 1980, p. 1.
26(The Board)
. . is aware that many banks have on their own
initiative adopted special purpose credit programs, or pilot
programs to test new credit offerings. The Board does not wish
to discourage these efforts. However, the Board will closely
scrutinize any agreements to ascertain that they are not incon­
sistent with the safety and soundness of the bank involved, and
do not establish a preference for credit extensions inconsistent
with evenhanded treatment o f borrowers . .
Federal Reserve
System, Community Reinvestment Act, Information Statement,
January 3, 1980, p. 3.

9

FEDERAL RESERVE BANK OF ST. LOUIS

talize the dow ntow n area.27 The longer-run anti­
com petitive im plications of creating what are es­
sentially lending cartels, how ever, may be unfavor­
able for borrowers.
An evaluation o f the net impact on the com m unity
of C R A -ty p e agreem en ts and com m itm en ts by
financial institutions to com m unity groups is diffi­
cult. Perhaps borrowers in low-to-m oderate incom e
areas have received som ewhat more credit than they
w ould have otherw ise received. The costs to dep os­
itors, stockholders and other potential borrowers,
how ever, are largely hidden. T o the extent that con ­
tacts with com m unity groups im prove the banker’s
k now ledge o f loan opportunities and risks, and gen­
erates new sources o f sound loans at current market
rates, such activities im prove the financial system
w hile rem oving som e inequities. T o the extent that
bankers engage in these activities m erely to create
harmonious pu blic relations, they m erely increase
the costs of financial intermediation.
The costs im posed by the CRA on financial inter­
m ediation have run into many m illions o f dollars.
T he expense o f adopting formal p o licy statements,

27See “ Investing in the Future of America’s Cities: The Banker’s
Bole,” Six Case Studies, prepared by the National Council on
Urban Economic Development for the Office of the Comptroller
of the Currency, Community Development Division.

Digitized for10
FRASER


FEBRUARY 1982

appointing com m unity relations officers, familiar­
izing em ployees with the legal requirements, h old ­
ing meetings with com m unity groups, record k eep­
ing and reporting must be financed by each lending
institution. The administrative costs o f the regu­
latory a g e n cie s in p e r io d ic a lly assessin g each
financial institution’ s CRA perform ance and in ap­
plying CRA standards in the review o f each appli­
cation is a burden on taxpayers. A protested CRA
application generates the additional costs o f pre­
paring a defense and often delays for six months or
more the outcom e o f the application.
Som e have e x p re sse d c o n c e r n that the C R A
eventually w ill reduce the supply o f credit in low incom e neighborhoods. A study prepared for the
FHLBB found that the act shifted housing-related
credit into certain central-city areas, but only in the
short run.28 The regulations also raise costs more
sharply for lenders serving these localities, w hich
could eventually result in a reduction in the supply
o f such credit. With less credit available, it becom es
more expensive, adversely affecting the low -incom e
areas. Also, w hen allegation o f C RA violations com e
from com petitive institutions seeking to prevent or
delay a market entrant, the flow o f credit to the local
area is im peded, an outcom e presum ably opposite to
the act’ s intent.
28Guttentag and Wachter, “ Bedlining and Public Policy.”

The Shift in Money Demand:
What Really Happened?
R. W . HAFER AND SCOTT E. HEIN

T
A HE m oney dem and function is a key relation­
ship in conventional m acroeconom ic m odels. W hen
it appeared that during the mid-1970s the con v en ­
tional specification had undergone an unforeseen
shift, analysts devoted considerable ingenuity and
research effort to testing alternative explanatory
variables that w ou ld account for the change.1 Some
specifications have p rod u ced marginally superior
forecasting results. N one, how ever, has been suc­
cessful in explain in g the post-1974 b eh a v ior of
m oney demand.
Discussions o f the temporal stability o f parameters
in econom etric m odels generally differentiate b e ­
tween tw o distinct types o f shift. O ne type of shift
is an intercept, or level, shift, in w hich the estimated
relationship sim ply undergoes a parallel change
that leaves all marginal (slope) coefficients unaf­
fected. T he other type o f shift occurs w hen at least

1See, for example, Michael J. Hamburger, “ Behavior of the
Money Stock: Is There a Puzzle?’’ Journal o f Monetary Eco­
nomics Quly 1977), pp. 265-88; Gillian Garcia and Simon Pak,
“ Some Clues in the Case of the Missing M o n ey," American Eco­
nomic Review (May 1979), pp. 330-34, and “The Ratio of Cur­
rency to Demand Deposits in the United States,” Journal o f
Finance (June 1979), pp. 703-15; Richard D. Porter, Thomas D.
Simpson and Eileen Mauskopf, “ Financial Innovation and the
Monetary Aggregates,” Brookings Papers on Economic Activity
(1:1979), pp. 213-29; H. Robert Heller and Mohsin S. Khan, “The
Demand for Money and the Term Structure of Interest Rates,”
Journal o f Political Economy (February 1979), pp. 109-29; David
J. Bennett, Flint Brayton, Eileen Mauskopf, Edward K. Offenbacher and Richard D. Porter, “ Econometric Properties o f the
Redefined Monetary Aggregates,” Board o f Governors o f the
Federal Reserve System, Division of Research and Statistics
(February 1980), processed; G. S. Laumas and David E. Spencer,
“ The Stability of the Demand for Money: Evidence from the
Post-1973 Period,” Review o f Economics and Statistics (August
1980), pp. 455-59; and Thomas D. Simpson and Richard D.
Porter, “ Some Issues Involving the Definition and Interpreta­
tion of the Monetary Aggregates,” in Controlling the Monetary
Aggregates III, Conference Series No. 23, (Federal Reserve
Bank o f Boston, 1980), pp. 161-234.




one o f the relative slope coefficients changes. Sur­
p risin g ly , p rev iou s exam inations o f the m on ey
dem and p u zzle have not explicitly investigated
this basic distinction. The approach used in most
previous work has b een to presum e that the change
was not necessarily parametric, but due to the exclu­
sion o f an important variable. H ence, most studies
focu sed on searching for the “ correct” scale or
opportunity cost measures to be used in the rela­
tionship.2
G iven the unsuccessful nature o f this approach,
w e consider a different tack. The purpose o f this
article is to study explicitly the nature o f the shift in
m oney demand. The evid en ce suggests that the con ­
ventional m oney dem and specification was subject
to a once-and-for-all level shift during the mid-1970s.
Our results further suggest that the econ om ic rela­
tionship underlying the estimated slope coefficients
of the conventional equation remained remarkably
stable throughout the turbulent 1960-79 period. This
result conflicts directly with much previous research.
The format o f the paper is as follow s: First, the
apparent deterioration in the standard specification
for M l during the I/1960-IV/1979 period is d ocu ­
m ented.3 Then, a procedure to determ ine likely
point(s) o f intercept change(s) in the m oney dem and
function is suggested and im plem ented. Finally, the
im plications o f our findings are presented.
2For a critical analysis of attempts to repair the conventional
specification, see R. W . Hafer and Scott E. Hein, “ Evidence on
the Temporal Stability of the Demand for Money Relationship
in the United States,” this Review (December 1979), pp. 3-14.
3The 1960-79 period is used to focus attention explicitly on the
problems associated with money demand estimations through
the mid-1970s. Estimation of the function through 1980 and 1981
would necessitate allowances for the possible effects o f the
credit control program and the change in Federal Reserve
operating procedures. Such analysis would divert attention from
the previously unresolved issue.

11

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1982

Table 1

Regression Results for Equation 1
Sum mary statistics2

C o efficie nt1
Period

RCPt

RCBt

(M/P)m

R2

SE(x10-3)

h

rho

0.125
(2.69)

-0 .0 1 6
(3.02)

-0 .0 3 2
(2.08)

0.778
(6.02)

0.967

3.96

1.78

0.31

0.057
(2.51)

-0 .0 1 9
(3.45)

-0 .0 3 9
(1.79)

0.962
(13.55)

0.874

5.27

0.87

0.55

Constant

yt

1/1960-1V/1973

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

1/1960- IV/1979

-0 .2 7 5
(2.35)

1All variables enter logarithm ically. The log-level equation is estimated using Hatanaka’s procedure. The num bers in parentheses
are absolute values of t-statistics.
2lR 2is the coe fficien t of determ ination corrected fo r degrees of freedom , SE is the standard error of the estimated equation, h is
the Durbin h-statistic and rho is the Hatanaka estim ate of the autocorrelation coefficient.

TH E SHIFT IN THE M O N EY D E M A N D
FU N CTIO N : A REVIEW OF
THE PROBLEM
The conventional m oney dem and specification is
(1) In ( M /P ) t = « o + j8i In yt +

p-2

In R C P t

+ /3a In R C B t + (3-1 In (M /P )t.i + et,

where M represents the narrow definition of m oney
(new M l),4 P is the im plicit GNP deflator (1972= 100)',
y is real GNP (1972 dollars), RCP is the com m ercial
paper rate and RCB is a w eighted average o f the
com m ercial bank passbook rate. W hile many differ­
ent m oney dem and equations have b een estimated,
equation 1 is generally the standard used for com ­
parison.
Initial estimates o f equation 1 revealed a signifi­
cant degree o f first-order serial correlation in the
error process. Previous estimates o f equation 1 gen4In response to a changing financial environment, the monetary
aggregates were redefined. Thus, checkable deposits can
now take the form of negotiable orders of withdrawal (NOW),
automatic transfer system (ATS) and credit union share draft
accounts. The old M l measure has been augmented by the
introduction of these deposits. To the extent that this empirical
redefinition ofthe “ transactions” measure of money is induced
by the advent o f near-money substitutes, the use of old M l may
reveal unstable relationships. Whether other financial innova­
tions, such as money market mutual funds, repurchase agree­
ments, overnight Eurodollars and the like, impinge upon the
estimation of equation 1 is an empirical matter to be addressed
below. Indeed, this line of reasoning has been used to explain
the poor post-1973 performance of equation 1. See Garcia and
Pak, “ Some Clues in the Case ofthe Missing Money” and “ The
Ratio of Currency to Demand Deposits,” and Porter, Simpson
and Mauskopf, “ Financial Innovation,” for examples of such
arguments.

12



erally have corrected this problem through the use o f
the Cochrane-Orcutt iterative procedure. This ap­
proach, how ever, yields inefficient coefficien t esti­
mates in the presence o f a lagged dependent vari­
a b le .5 T h e r e fo r e , to ob ta in estim ates that are
(asymptotically) efficient and consistent, Hatanaka’ s
residual adjusted Aitken estimation procedure is
used in this study.6
Table 1 presents estimates o f equation 1 for the
I /1 9 6 0 - I V /1 9 7 3 a n d I /1 9 6 0 - I V /1 9 7 9 s a m p le
periods. T he estimates for the earlier sample period
are quite similar to those o f other studies. These
estimates suggest that real m oney balances adjust
toward their equilibrium levels at the rate of about
22 percent per quarter, ceteris paribus. T he esti­
5Roger Betancourt and Harry Kelejian, “ Lagged Endogenous
Variables and the Cochrane-Orcutt Procedure,” Econometrica
(July 1981), pp. 1073-78; and Michio Hatanaka, “ An Efficient
Two-Step Estimator for the Dynamic Adjustment Model with
Autoregressive Errors,” Journal o f Econometrics (September
1974), pp. 199-220. It has been shown also that the CochraneOrcutt procedure may not iterate to a global minimum of the
regression standard error. See R. W . Hafer and Scott E. Hein,
“ The Dynamics and Estimation o f Short-Run Money Demand,”
this Review (March 1980), pp. 26-35.
6Previous money demand studies using the Hatanaka procedure
include Charles Lieberman, “ The Long-Run and Short-Run
Demand for Money, Revisited,” Journal o f Money, Credit and
Banking (February 1980), pp. 43-57; Laumas and Spencer,
“ Stability ofthe Demand for M oney;” and Stuart D. Allen and
R. W . Hafer, “ Money Demand and the Term Structure o f Inter­
est Rates: Some Consistent Estimates,” Journal o f Monetary
Economics (forthcoming).
For an examination o f the Hatanaka procedure vis-a-vis
Cochrane-Orcutt, Hildreth-Lu and maximum-likelihood estima­
tion techniques, see Edward K. Offenbacher, “ A Comparison of
Alternative Estimators of a ‘ Standard’ Money Demand Equa­
tion,” Special Studies Paper No. 157 (Board of Governors ofthe
Federal Reserve System, July 1981).

FEBRUARY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

mated elasticities also are similar to other estimates.
For example, the estimated long-run incom e elastic­
ity is 0.56, a value that roughly coin cides with the
theoretical value given by a sim ple transactions d e ­
mand framework.7 Finally, the summary statistics
indicate that a large amount of the variation in real
m oney balances is captured by the right-hand vari­
ables, and the error process appears w ell-behaved.
The regression results for the 1/1960-1V/1979
period are quite unlike those of the I/1960-IV/1973
period. The estimated short-run incom e elasticity is
halved, w hile the coefficien t on the lagged dep en ­
dent variable increases markedly. T he estimated
speed of adjustment (0.04 percent) from the 1/1960IV/1979 results indicates that the mean adjustment
lag exceeds 26 quarters, considerably different from
that for the pre-1974 period (4.5 quarters). M oreover,
the estimated long-run incom e elasticity for the full
period is now 1.50, three times the estimate o b ­
tained from the earlier sample period.
The I/1960-IV /1979 estimates seem to support
the claim that the m oney dem and relationship has
b een altered. T he regression evid en ce presented in
table 1 suggests that the estimated coefficients have
shifted dramatically. M oreover, a standard F-test for
structural stability allows one to reject the hypothe­
sis o f stable regression coefficients across the com ­
m on ly h y p o th e siz e d IV /1973 break p oin t: T h e
calculated F-statistie of 4.51 exceeds the 5 percent
critical value o f 2.23.8

Table 2

Post-Sample Static Simulation Results:
1/1974-I V/1979
Log-level sp e cifica tio n 1
Year and Q uarter

Forecast e rro r (x10~2)

1974 I
II
III
IV

0.02
-1 .2 8
-1 .2 9
-1 .6 0

1975 I
II
III
IV

-2 .2 8
-0 .6 8
-1 .3 2
-2.51

1976 I
II
III
IV

-1 .3 2
-1 .3 0
-2 .2 2
-1 .7 5

1977 I
II
III
IV

-1 .4 8
-2 .2 5
-1 .8 5
-1 .3 6

1978 I
II
III
IV

-1 .4 9
-2.41
-1 .8 6
-2 .2 6

1979 I
II
III
IV

-2 .6 6
-1.21
-1 .4 9
-2.31
Summary statistics2

Further ev id e n ce of the breakdow n is d em on ­
strated by an analysis o f the equation’ s forecasting
ability. Post-sample static forecasts for the natural
log o f real m oney balances are presented in table 2.9
These forecasts are based on the coefficient esti­
mates from the I/1960-IV /1973 regression . The
results in table 2 indicate a continual overprediction
o f real m oney balances. T he T h eil bias coefficient

7See William J. Baumol, “ The Transactions Demand for Cash: An
Inventory Theoretic Approach,” Quarterly Journal of Eco­
nomics (November 1952), pp. 545-56; and Robert J. Barro, “ In­
tegral Constraints and Aggregation in an Inventory Model ol
Money Demand,” Journal o f Finance (March 1976), pp. 77-78.
8This test is complicated by the presence ol first-order serial
correlation. In the results reported, the serial correlation coeffi­
cient (p) is allowed to vary across subperiods.
9Those familiar with the recent money demand literature may find
it surprising that static rather than dynamic forecasts are em­
ployed. The latter technique yields an exaggerated picture of
the shift in a relationship without proper interpretation. Conse­
quently, the more widely understood static forecasting pro­
cedure is employed in this paper. See Scott E. Hein, “ Dynamic
Forecasting and the Demand for Money,” this Review (June/
July 1980), pp. 13-23.




RMSE
UM
US
UC

1.782 (x10-2)
0.882
0.010
0.109

'T he forecast errors (actual less predicted) are logs of M1
(billions of 1972 dollars). They are obtained from sim ulating
equation 1 and are based on coefficient estimates in table 1.
2RMSE is th e ro o t-m e an -squa red e rro r in term s o f real
money balances (billion s of 1972 dollars) for the log-level
specification. U M is the Theil bias coefficient, Us the variance
coe fficien t and Uc the covariance coefficient. For an expla­
nation of these statistics, see Theil, A pp lied E conom ic Fore­
casting.

(U M) indicates that almost 90 percent o f the forecast
error is attributable to bias, that is, one-sided pred ic­
tion errors.10 M oreover, the root-mean-squared error
(RM SE) o f 0.01782 is more than four times the insample standard error.

l0For a complete description of the derivation and interpretation
of the Theil coefficients, see Henri Theil, Applied Economic
Forecasting (Amsterdam; North Holland Publishing Co., 1966),
pp. 27-32.

13

FEBRUARY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

CH O O SING B E TW E EN INTERCEPT
AND SLOPE SHIFTS
The precedin g evid en ce suggests that the param­
eter estim ates o f eq u a tion 1 from the 1960-79
period no longer represent a viable em pirical m odel
o f short-run m oney demand. O bviously, “ som e sort
o f shift has occu rred.” 11 The question is, “ What type
o f shift has occu rred?” I f the estimated slope coeffi­
cients have changed, this im plies changes in the
underlying econ om ic relationship (i.e., betw een real
m oney balances and real incom e or interest rates).
W hile the estimates o f the slope coefficients show
marked change over the two periods in table 1, the
true s lo p e c o e ffic ie n ts m ay not h ave a ctu a lly
changed. If, instead, an intercept shift occurred
during the m id-1970s, then em pirical estimates o f
equation 1 for the I/1960-IV/1979 sample period
may be seriously biased because of the failure to
account for the level shift in the relationship, which
produces a “ missing variable” problem .12 C on se­
quently, i f the slope coefficien t estimates are biased,
they cou ld lead a researcher to falsely reject the
hypothesis o f slope coefficient stability.
The major difficulty with an analysis o f intercept
shifts is in pinpointing exactly w h en the shift(s)
occu rred . A u seful p ro ce d u re to determ in e the
likely points o f an intercept or slope shift is to reestimate equation 1 in first-difference form .13 Firstdifferencing equation 1 yields
(2) A in (M/P), = I3i A in y, + fi2 A in KCP,
+ /3s Ain RCB, +

A in (\1/P),.i + Aet,

w here A is the first-difference operator.
Equation 2 provides useful diagnostic information
in the event o f an intercept shift in the level equa­
tion. For exam ple, a once-and-for-all intercept shift
in equation 1 w ill appear as a one-tim e increm ent
in the disturbance pattern o f the first-difference
specification.14 M oreover, changes, if any, in the
slope coefficients in equation 1 also w ill appeal' in

equation 2. If, as many have argued, the marginal
relationships em bod ied in equation 1 have changed,
the first-difference specification also w ill exhibit
similar changes in the coefficient estimates. Thus,
the first-difference specification serves a dual pur­
pose: It can locate the most likely points of an inter­
cept shift, and it provides evid en ce on whether the
slope coefficients have changed.
T o locate and test for potential intercept shifts, the
fo llo w in g p ro ce d u re was a d op ted : T h e 1/1960IV/1979 first-difference specification (equation 2)
was estimated using ordinary least squares, the re­
siduals w ere plotted over time and the large residual
“ outliers” w ere selected.15 Based on this procedure,
three points w ere identified and selected as candi­
dates for points o f intercept shift: 11/1974, IW 1975
and 11/1979. T he first two residuals w ere negative,
suggesting downshifts in the log-level m oney d e ­
mand equation. The 11/1979 residual was positive,
suggesting an upshift. Equation 1 was estimated
(again using the Hatanaka procedure) assuming on e­
tim e shifts at those points using (0,1) intercept
dummy variables: D l = l for I/1960-I/1974, 0 other­
w ise; D 2 = l for II/1974-111/1975, 0 otherw ise; and
D 3 = 1 for IV /1975-1V /1979, 0 otherwise.
Preliminary significance tests revealed that only
the 11/1974 intercept shift term was statistically
significant at the 5 percent level. C onsequently,
we report the version o f equation 1 that incorporates

14This increment will be noticeable if the intercept shift is “ suf­
ficiently large” relative to the variance ol the disturbances.
Thus, the residuals of equation 2 are examined to determine
the likely point at which “ large” shifts occurred.
15The focus of this article concerns the possible intercept shift
in the log-level money demand equation. Consequently, the
reader is referred to Hafer and Hein, “ Investigating the Shift in
Money Demand,” for a more detailed analysis of the firstdifference estimation results. To give the reader some idea of
the outcome, the OLS estimates of equation 2 for the 1/1960IV/1979 period are (absolute value of t-statistics in parentheses)

A In (M/P)t = 0.190 A lnyt — 0.017 A In RCPt
(3.51)
-

“ Stephen M. Goldfeld, “ The Case o f the Missing Money,” Brook­
ings Papers on Economic Activity (3:1976), p. 726.
12Excluding a relevant variable, in this case the intercept shift
term, may bias not only the coefficient estimates, but also the
estimate o f the residual variance. On this point, see G. S.
Maddala, Econometrics (McGraw-Hill, 1977), pp. 155-57.
13A more complete discussion o f this derivation appears in R. W.
Hafer and Scott E. Hein, “ Investigating the Shift in Money
Demand: An Econometric Analysis,” in Empirical Studies o f
Money Demand: Proceedings o f a Conference Held at the
Center fo r the Study o f American Business, Working Paper No.
70 (Center for the Study of American Business, Washington
University, August 1981), pp. 1-28.

Digitized for 14
FRASER


1 {2

=

0 .4 4 8

(2.94)

0.038 A In RCB, 4- 0.562 A In (M/P)t-i
(1.68)
(5.70)
SE

=

0 .0 0 5

h

=

0 .4 7

Not only do the coefficient estimates appear reasonably
close to the pre-1974 estimates, but ex post forecasts indicate
a substantial improvement in the pattern. The resultant RMSE
is well within two standard errors of the equation’s in-sample
standard error and the Theil decomposition statistics indicate
that only 7 percent of the forecast error is attributable to bias.
Moreover, an F-test for structural change at IV/1973 yields
an F-value of 0.06.
For a discussion of these results, see Edward K. Offenbach er,
“ Discussion of the Hafer and Hein, Smirlock and Webster
Papers,” in Empirical Studies o f M oney Demand, pp. 88-106.

FEBRUARY 1982

FEDERAL RESERVE BANK OF ST. LOUIS

only the 11/1974 intercept shift variable (D l). The
resulting coefficien t estimates are (absolute value o f
t-statistics in parentheses)16
(3) In (M/P), = -

-

dum m y variables is (absolute value o f t-statistics in
parentheses)17
In (M/P), = -

0.482 - 0.008 D l + 0.099 D l In y,
(2.76)
(0.53)
(2.61)

0.406 + 0.013 D l + 0.076 In yt
(3.95)
(2.88)
(3.83)

+

0.124 D2 In y, - 0.018 D l In RCP,
(3.69)
(3.41)

0.021 In RCPt - 0.020 In RCB,

-

0.013 D2 In RCPt
(1.76)

-

0.019 D l In RCRt
(1.39)

-

0.015 D2 In RCB,
(0.15)

+

0.832 D l In ( M / P ) n
(7.45)

(4.84)

(1.28)

+ 0.917 In (M/P),.i
(16.09)
R2 = 0.960

SE = 0.0048

h = -0 .0 5

j> = 0.24

T hese results support the contention that the mar­
ginal relationships in the short-run m oney demand
equation w ere not altered as much as previous evi­
dence suggests. T he evid en ce, how ever, points to
the existence o f a significant, once-and-for-all d ow n ­
ward level shift in the relationship in 11/1974.
T h e regression results indicate that the constant
term in the log-level specification decreased from
—0.406 for the I/1960-I/1974 period to —0.419 in
11/1974. This change (0.013) is small relative to the
standard error o f the coefficien t estimate. It is, h ow ­
ever, almost three times as large as the standard error
o f the regression (0.0048) for the I/1960-IV/197.3
period. Thus, its exclusion significantly affects the
full-sample, level estimation.

+ 0.560 D2 In (M/P),.i
(2.77)
R2 = 0.969

SE = 0.0044

D W = 1.90

Standard t-tests w ere used to test the hypothesis
that each slope coefficient had rem ained stable once
the dow nw ard level shift in 11/1974 had been taken
into account. The resulting t-statistics indicate that
each coefficient had not changed statistically over
the full-sample period. T he variables and the t-statisties for their coefficients are In y (0.43), In RCP
(0.19), In RCB (0.03) and ln (M /P )t-i (1.35). This
evid en ce supports the view that m oney demand
was subject to a level not a slope shift during the
m id-1970s.18

A superficial com parison o f the shift-adjusted,
log-level estimates with those for the I/1960-IV/
1973 sample period in table 1 suggests that the slope
coefficients may have changed across the period
tested. T he question to be addressed n ow is, once
the dow nw ard displacem ent o f the constant term has
been accounted for, have the slope coefficients
changed statistically ? T o formally test this hypothe­
sis, equation 3 was re-estimated for the full sample
period with the individual slope coefficients allow ed
to take on different values in the two separate sub­
periods. Z ero-on e dum m y variables again w ere used
to delineate the relevant subsamples (1/1960-1/
1974 and II/1974-IV/1979): the dum m y variables
are D l = l in I/1960-I/1974, 0 otherw ise; and
D2 = l in II/1974-IV/1979, 0 otherwise. The esti­
mated equation using both the intercept and slope

T he purpose o f this article has been to investigate
the nature of the shift in the conventional m oney
dem and specification that occurred during the mid1970s b y determ ining whether it was an intercept
or slope shift. The em pirical results presented in this
article indicate that the conventional equation was
subject to a level, and not a slope, shift in early 1974.
Our analysis of the first-difference results and the

16The use of the dummy variable for the I/1960-I/1974 period
and the constant term is interpreted in the following manner:
The true constant term for the I/1960-I/1974 period is obtained
by adding the estimated constant and the estimate on the
dummy variable. The constant for the II/1974-IV/1979 period
is represented by the estimate of the constant term reported
in the text.

18If the preceding evidence were not sufficient to sway the
skeptical reader, more support conies from the shift-adjusted,
log-level equation’s ex post forecasting record: The RMSE for
the shift-adjusted equation for the period II/1974-IV/1979 is
0.67 (xlO'2). This value is well within two standard errors of the
estimating equation’s in-sample standard error, and is less
than half the RMSE reported in table 2 (1.782 xlO*2).




CO NCLUSIO N

17Since the Hatanaka procedure requires estimation o f the resid­
ual error in the last-stage equation, it, too, was constrained in the
above manner. A test revealed that neither the error process nor
p had changed. This procedure, in conjunction with the dummy
variable test, precludes obtaining a direct estimate of p.

15

properly specified log-level equation suggests that
11/1974 is the most likely point o f the significant
downward shift in the m oney dem and function.
An important im plication o f this study is that the
econ om ic relationships inherent in the conventional
m oney dem and function are more stable than previ­
ous investigations have suggested. Changes in m oney
dem and since 11/1974 can be explained by changes
in the exogenous variables without relying on tenu­
ous assertions that the underlying econ om ic rela­
tionships have degen erated. A lthough previou s
analyses have suggested that there has been a con ­
Digitized for 16
FRASER


tinuous, unexplained deterioration o f the m oney
dem and function after 1973, our analysis suggests
that the marginal relationships have remained
stable over the I/1960-IV/1979 period, providing
useful information in estimating the level o f m oney
dem and.19 Thus, claims that the short-run m oney
dem and function is highly unstable and is responsi­
ble for the erratic behavior o f m on ey growth during
this period must b e reconsidered.
19For example, see Stephen H. Axilrod and David E. Lindsey,
“ Federal Reserve System Implementation of Monetary Policy:
Analytical Foundations o f the New Approach,” American Eco­
nomic Review (May 1981) pp. 246-52.