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FEDERAL RESERVE BAN K OF ST. LOUIS JANUARY 1970 ST LOUIS Monetary Actions, Total Spending and Prices .......................................... 2 EIG H TH D The New, New Economics and Monetary P o licy................................... 5 LIT T LE R O C K Some Issues in Monetary Economics ..........................................10 Vol. 52, No. 1 Monetary Actions, Total Spending and Prices ] V t ONETARY actions of the Federal Reserve System, which became less expansive last January and decidedly restrictive in June, continued in that restrictive stance through the end of 1969. Changes in the rate of advance of total spending usually lag changes in monetary actions by two to three quarters, and the general level of prices tends to respond to changes in total spending with an additional lag of three or four quarters. According to this view of the channels and timing of the effect of stabilization actions, there has not been sufficient time for prices to respond significantly to the monetary actions that have been taken thus far. The only price effect has taken the form of a halt in the acceleration of prices. The influence of monetary actions on the course of total spending may best be indicated by changes in the money stock, defined as demand deposits plus currency in the hands of the public, or by changes in the demand deposit component alone. Growth of the money stock has been restrained in 1969 by restrict ing the growth of Federal Reserve credit and member M o n e ta ry Base a n d Federal Reserve Credit Monetary Actions The Federal Reserve System has restricted the growth of monetary aggregates in an attempt to slow the growth of total spending. The monetary base, a primary determinant of the money stock, increased at a 2.6 per cent rate from January to December after rising at a 6.4 per cent rate in the previous two years. Growth in the monetary base is determined largely by growth of Federal Reserve credit, which includes holdings of Treasury securities, loans, float, and other assets. Federal Reserve credit increased at a 4.7 per cent rate from January to December, after increasing at a 10 per cent rate in the previous two years. Member bank reserves avail able for private demand deposits declined at a 3.2 per cent annual rate from May to December, after remaining about unchanged earlier in the year and growing at a 5 per cent rate in 1967 and 1968. Page 2 [l_Uses of the m onetary b a s e a re m e m b e r b a n k rese rves a n d currency h eld b y the p u b lic a n d n o n m e m b e r b an ks. Adjustm ents are m a d e fo r re se rve requ ire m e n t c h a n g e s and shifts in d e p o sits a m o n g c la s s e s o f b a n k s. D a ta a re com puted by this b an k. [2 Total F e d e ra l R e se rve credit o u tsta n d in g inclu d e s h o ld in g s o f securities, loan s, float, a n d " o t h e r " a ssets. Adjustm ents a re m a d e for rese rve requirem ent c h a n g e s a n d shifts in d e p o sits a m o n g c la s se s of b a n ks. D a ta a re c om puted b y this bank. Percentages are a nn ual rates of c h a n g e betw een p e rio d s indicated. They are presented to a id in c o m p a rin g m ost recent developm ents with p a s t "t re n d s ." Latest d a t a p lotted: D ec em b er pre lim in ary F E D E R A L R E S E R V E B A N K OF ST. LO U IS J A N U A R Y 1970 bank reserves. The money stock was about unchanged from June to December, after rising at a 4 per cent rate in the period from January to June and at a very rapid 7 per cent rate in 1967 and 1968. M o n e y Stock Ratio Scale Billions of Dollars 210 M onthly A v e ra g e s of D a ily Figures Se a so n a lly Adjusted Ratio Scale Billions of Dollars 210 205 +4 OVc K )m 205 Spending, Production and Employment Restrictive monetary actions in 1969 have begun to show their effects on the rate of advance of total spending. Estimates for the fourth quarter indicate that total spending (GNP) increased at a 5 per cent rate, compared with a 7.6 per cent advance in the previous year. Final sales, that is, spending other than for inventory accumulation, increased more than 8 per cent from mid-1968 to mid-1969, rose at a 6.3 per cent rate from the second to third quarter, and slowed further in the fourth quarter. Retail sales have been unchanged since last spring, compared with about a 5 per cent increase in the previous year. In the typical response of spending and prices to changes in monetary actions, real product and employment growth are first affected, and prices only later. Since prices do not respond immediately, any slowing in total spending in response to restrictive monetary actions is reflected initially in a slowing of real product growth. 1966 1967 1968 1969 Percentages are a n n u al rates of c h an ge between periods indicated. They are presented to a id in com paring most recent developm ents with p a st "trends." Latest d ata plotted: D ecem ber p re lim in a ry The money supply defined to also include commer cial bank time deposits has shown an even slower growth trend in recent months. This broader concept of money declined at a 2.6 per cent annual rate from May to December, and was about unchanged in the first part of the year, after increasing at a 10 per cent rate in the previous two years. Real product growth is estimated to have been about unchanged from the third to the fourth quarter, after increasing 2.5 per cent in the previous year. Industrial production declined at a 6 per cent annual rate from July to November, after increasing 5.2 per cent in the previous year. Associated with the decline in output growth, the rate of employment growth has been slowing. Payroll This more marked change in trend of the broader money supply reflects primarily the erratic movements of time deposits to banks. Commercial banks are restricted by Federal Reserve Regulation Q as to the maximum rates they can pay on various classes of time deposits. Since market yields on competitive assets, such as Treasury bills and commercial paper, have risen well above the ceiling rates on time deposits, banks have had difficulty attracting and retaining savings and other time deposits. Time deposit losses have been most pronounced with respect to large certificates of deposit. The amount of large CD’s outstanding declined from $23.7 billion in December 1968 to $11.1 billion in December 1969. A moderate increase of other time deposits in the first half of the year was offset by losses in the last half. Total time deposits declined throughout the year, with the decrease totaling 5 per cent. Page 3 F E D E R A L R E S E R V E BA N K OF ST. LO U IS J A N U A R Y 1970 Em ploym ent Ratio Scale Ratio Scale have continued to rise at about the 4 per cent rate of the past year, compared with a 2.2 per cent rate in the preceding two years and a 0.4 per cent rate in the 1958-65 period. Consumer prices have continued to increase at about the 5.5 per cent annual rate which has prevailed since the spring of 1968. Prices So u rc e : U.S. D e p a rt m e n t o f L a b o r Percentages are annual rates of chan ge between periods indicated. They are presented to aid in co m p a rin g most recent developments with past "tren d s." D a ta for p a yro ll employm ent revised from Ja n u a ry 1967. Latest d a ta plotted: De ce m b e r prelim inary employment rose at about a 1 per cent annual rate in the last half of 1969, compared with about a 3.5 per cent increase in the preceding twelve months. The slowing in the rate of growth of employment was not insignificant, but it probably understates the extent of the economic slowdown which has occurred. Many employers have retained workers in the face of declining growth of sales because of a belief that the overall slowdown in economic activity might be temporary and that the costs of training new personnel at a later date would be excessive. Prices Prices have not yet decelerated. The absence of price response at this point is not to be viewed as an indication of the failure of restrictive monetary actions. Total spending has just begun to slow significantly and, according to historical experience, prices should not be expected to decelerate significantly for an other three or four quarters. In fact, there have been occasions in recent economic history when price in creases accelerated temporarily in the face of a slowdown in real output. Current indications are that prices have stopped accelerating, but this may not be permanent. It is possible that some further acceleration may occur before prices decelerate in late 1970 or early 1971. Wholesale prices of industrial commodities, which ex clude the erratic movements of agricultural prices, Page 4 5 July'67 95 ----- ------ ------ ------- 1----------- --- 1-1961 1962 1963 1964 1965 1966 1967 1968 1969 Source: U.S. Departm ent of Labor P ercentages are an nu al rates of change between periods indicated. They are presented to a id in com paring m ost recent developm ents with p ost "trends." Latest data plotted: C onsum er-Novem ber; Wholesale-Decem ber Conclusion Monetary restraint has already acted to slow growth in spending, output and employment. Average prices, however, have continued to rise rapidly. The curtail ment of total spending is expected to eventually slow price increases. The monetary authorities are con fronted with the necessity of overcoming strong infla tionary pressures without contributing immoderately to declines in real output. Restraint of monetary growth is providing a substantial dampening effect on total dollar spending and on real output, but upward price movements can be expected to moderate only gradually. Continued severe monetary restraint might be expected to reduce inflation more quickly but would also tend to cause immoderate slowing in output and employment growth, and restraint might consequently be reversed prematurely, as in 1967. The New, New Economies And Monetary Policy A speech given by DARRYL R. FRANCIS, President, Federal Reserve Rank of St. Louis, to the Argus Economic Conference, Phoenix, Arizona November 22, 1969 I t IS GOOD to have this opportunity to keynote these seminars you will be attending for the next few days. Before proceeding to what I have to say about “The New, New Economics and Monetary Policy,” let me place the two uses of the term “New” in their proper perspective. of the “New Economics.” The “New Economics” is a combination of depression-oriented theories and ex pansionist objectives. Such a combination contains an inherent inflationary bias which should be carefully considered when it is applied to national economic policy. The expression “New Economics” has been ap plied to the body of economic theory popularly called “Keynesian Economics.” This theory was set forth by John Maynard Keynes in 1936 and has been in vogue among economists since the 1940’s. Eco nomic policymakers in the 1960’s have made great use of the “New Economics” as guidance for their actions. Let us now examine the other use of the word “New.” The body of economic theory which we will study in these seminars is not something new tacked on to the basic analytical framework of the New Economics. Instead, it is an up-dated version of the economic theory which was dominant for many dec ades prior to what has been labeled the “Keynesian Revolution.” The older economics held that our eco nomic system is inherently stable; hence, there was little need for vigorous stabilization actions on the part of Government. In fact, Government was viewed as a source of economic instability. The expression “New, New Economics” refers to a revival and elab oration of this pre-Keynesian body of economic theory. This development has been accelerating dur ing the past few years because of the failures of stabilization policy based on the major premises of the New Economics. The early followers of Keynes stressed the view that chronic unemployment is a characteristic of our economy. This view was consistent with the mass unemployment of the 1930’s. The business fluctuations which continued in the late 1940’s and 1950’s led many followers of the New Economics to conclude that our economy is basically unstable —subject to shifts between periods of recession and inflation. These two conclusions —that unemployment is a chronic problem and that our economy is basically unstable —resulted in the proposition that vigorous Government actions are necessary'to promote high level employment, economic growth, and relatively stable prices. This proposition is embodied in the spirit of the Employment Act of 1946. This view was accepted by the President’s Council of Economic Advisers from 1960 to 1968. The tax cut of 1964 and the tax increase of 1968 are the hallmark I now turn to my main topic, “The New, New Economics and Monetary Policy.” My remarks will be built around three points: First, the two competing views of monetary and fiscal actions in economic stabilization are outlined, and evidence is presented which, I believe, has led most of the economists who will deliver presentations at these seminars to assign great importance to monetary actions. Next, Page 5 F E D E R A L R E S E R V E B A N K OF ST. LO U IS there is an examination of the slow response of inflation to recent monetary restraint. Finally, the problem of reducing the rate of inflation without a great reduction in output of goods and services and a marked increase in unemployment is considered. Two Views of Monetary and Fiscal Actions I will now contrast the two views of monetary and fiscal actions. The basic premise of the “New, New Economics” is that the Federal Reserve System, through its control of the money stock, exercises a pervasive influence on the course of total spending, that is, gross national product, and thereby on prices. On the other hand, Federal Government spending and taxing actions, alone, are held to exert little net influence on movements in GNP and prices. For example, an increase in the rate of Government spending at a time when the money stock remains unchanged requires either of two methods of financ ing —taxing or borrowing from the public. In either case, spending by the private sector is reduced by an amount approximately equal to the rise in Federal Government expenditures, resulting in little, if any, change in the rate of overall spending in the economy. However, if the Federal Reserve System makes it possible for the banking system to acquire sufficient Government debt to permit financing a rise in Gov ernment expenditures without taxing or borrowing from the public, total spending will increase. In this case, the money stock increases and is more properly considered the cause of increased spending. These observations regarding fiscal policy have been recognized by both Keynesians and proponents of the “New, New View,” except that Keynesians have not assigned an important role to money. Unfortu nately, however, this point regarding fiscal actions has received little recognition in the formulation of stabilization policies or in recently constructed econo metric models of our economy from which many policymakers obtain information. Instead, Govern ment spending and taxing have been considered extremely powerful tools of economic stabilization, regardless of the source of funds to finance a deficit or of the disposition of a budget surplus. As a result, fiscal policy in my opinion has been given too great an emphasis and has had a misguiding influence in monetary policy formulation. I now come to monetary actions — the point at which the New, New Economics differs greatly from the school of economic thought prevailing since the Page 6 J A N U A R Y 1970 mid-1930’s. Early Keynesians held that changes in the money stock, unless accompanied by appropriate changes in Government spending, have little influence on GNP. Monetary policy was assigned only a passive, supporting role to fiscal policy. This view —that there is little independent influence of monetary actions on total spending —was widely accepted up to the mid1960’s and has played a dominant role in the formu lation of economic stabilization policies, even up to now. The New, New Economics directly challenges the validity of this proposition. Historical evidence strong ly supports this challenge! Whenever growth of the money stock indicates one direction of movement for GNP and the Government’s budget another, the sub sequent course of GNP in virtually every case follows that indicated by money. There are two important pieces of recent evidence supporting this monetary view. One is the mini-recession experience following the monetary restraint of 1966 —when money re mained unchanged and the budget moved into greater deficits. The other one is the failure of fiscal restraint which began in mid-1968 —a time when money con tinued to increase at an excessive rate. Another piece of evidence is provided by the Great Depression of the 1930’s, when economic activity followed more closely the course indicated by movements in the money stock than the one indicated by the Govern ment’s budget. This evidence, along with that provided by many detailed studies, in my opinion demonstrates that monetary actions measured by changes in the money stock should receive the main emphasis in economic stabilization. To ignore the influence of monetary actions is to insure disruption of our normal, orderly economic processes. History demonstrates that most of our recessions and periods of inflation can be attributed to perverse movements in the money stock. For example, the Great Depression was marked by an 8 per cent annual rate of decrease in money during the four years after mid-1929. Slow Response to Recent Monetary Restraint I now turn to my second main point, the apparently slow response of inflation to recent monetary restraint. We have had an avowed policy of monetary restraint for nearly a year, but there is only scattered evidence at present that the overall pace of inflation has begun to recede. Some have started to question whether monetary restraint will prove to be as ineffective in curbing the current inflation as did fiscal restraint in F E D E R A L R E S E R V E B A N K OF ST. LO U IS the past year and a half. Two things can account for the slow response of inflation to the restrictive mone tary policy adopted last December. First, only in the past six months has there been what may be characterized as substantial monetary restraint. The rate of monetary expansion was reduced in two stages from the excessive 7 per cent annual rate of 1967 and 1968. The rate of growth in the money stock was reduced to about 5 per cent for the first five months of this year, and since then money has not increased. This latter development is one which I would call substantial monetary restraint. Second, there is a considerable lag in the response of the economy to a change in the rate of monetary expansion. At the St. Louis Federal Reserve Bank our staff has conducted an extensive investigation to un cover the nature of this lag, using the New, New Economics’ frame of reference. Although this research is not quite fininshed, I would like to share with you our findings up to now.1 This research indicates that, following a marked decrease in the rate of growth in money, at least two quarters are required for a noticeable reduction in GNP growth. When total spending does finally slow, growth of output of goods and services slows simul taneously, but at least an additional three quarters are generally required for a marked reduction in the rate of inflation to appear. We estimate that the entire process of curbing inflation would normally require about three years. Our research further indicates that the process of fully curbing inflation is delayed still longer when monetary restraint is implemented after a period of prolonged and accelerating price advances. This is the situation which currently confronts efforts to reduce the rate of price increases. We have now had an obvious and accelerating inflation for about five years. As a result, many economic decisions are based on expectations of continued inflation. For example, union leaders seek higher wages in part to protect workers’ earnings from continued inflation, and business firms expect to be able to pay the higher wages by being able to increase their prices. Also, contracts to borrow funds take into consideration expectations of future inflation, thereby adding an inflation premium to market interest rates. Our re search indicates that on the average it may take about five years of decelerating price increases to eliminate most of the expectations of continued inflation. 'This research will be summarized in a forthcoming issue of this Review. JANUARY 1970 Given the normal response of the economy to slower growth in money, the entrenched expectations of continued inflation, and the beginning of really firm monetary restraint only six months ago, I am not disturbed that we have not yet seen a slowdown in the rate of price increases. There is some evidence of the slowing of growth of total spending and real product in recent monthly statistics. Personal income in September and October grew at only half the rate of the previous year. Industrial production in the last three months has declined at a 3 per cent annual rate after increasing at a 5 per cent rate in the previous year. Retail sales have been about un changed since last spring, and in real terms have of course declined. What has been accomplished thus far has been setting of the stage for a reduction in the rate of inflation. Consequently, at least the next three years will be required to eliminate a significant portion of this inflation. In response to recent monetary restraint, assuming it is continued or relaxed only moderately, we believe that gross national product and real output have begun to grow at a slower pace. We believe that there will be further marked slowing in 1970, and that the rate of inflation will have been moderated significantly by late 1971. But even at that point, additional time will be required before we will have reduced inflation below a two per cent rate. With continuation of inflation for some time to come, interest rates, because of the inflation premium men tioned earlier, are not likely to decrease much in the near future. If the results of this research into the nature of the response of output and prices to monetary actions are nearly correct, I have just outlined the extreme problem that lies ahead. A high degree of moral, economic, and political fortitude will be required if we are to overcome the increasingly painful results of the New Economics’ guidance of policy during the last several years. Curbing Inflation Without a Recession I now come to my last main point, the problem of curbing inflation without causing a recession. I believe most economists will agree with the proposi tion I have just advanced —that whenever the rate of growth in total spending decreases for several quarters, real output of goods and services will also grow at a reduced rate, while the rate of price in creases will respond only with a considerable lag. Moreover, there is general agreement that, if total Page 7 JA N U A R Y 1970 F E D E R A L R E S E R V E B A N K OF ST. LO U IS spending slows sufficiently, real output will actually decrease and a recession develop. It is obvious that in developing a strategy for curbing inflation, mone tary authorities face the difficult choice of balancing a desire to avoid inordinate decreases in real output against a desire to curb inflation in as short an interval of time as possible. This choice is made more difficult by the long time required to curb inflation, regardless of whether or not a recession occurs, after such a long period of inflation as we are currently experiencing. The present situation bears careful watching that we not maintain the present degree of monetary restraint too long. If we continue much longer to hold the money stock at about its level of early last summer, I am concerned that the economy will ex perience an unnecessarily severe decrease in output next year accompanied by high unemployment before much progress is achieved in slowing inflation. The recent research at our bank indicates that there is little difference in our ability to reduce the rate of inflation over the next three years if money were to grow at a moderate 3 per cent rate from now than if it were held unchanged for several months longer. With a 3 per cent rate of growth in money beginning soon, we would have a risk of a slight recession, while if money remains unchanged much longer, real output is likely to decrease at about a 3 per cent rate next year. In either case, unemployment will rise, but the extent and duration of higher unemployment will be considerably less if a course of moderate growth in money is now adopted. If a substantial recession were to show signs of developing as a result of an excessive duration of the present level of restraint, I am concerned that there would develop public pressures to expand money once again at such excessive rates as have prevailed during much of the past five years. An examination of the experience of 1967 and 1968 demonstrates the results of such actions. After the money stock re mained unchanged for the last nine months of 1966, the rate of total spending slowed during the first two quarters of 1967, and real output declined slightly in the first quarter of that year. Hoping to avoid overkill, monetary authorities resumed money supply growth at an excessive 7 per cent rate and, thus, stimulated inflation further. It was entirely proper that money growth should have been resumed at that time; if it had remained unchanged much longer, there would have been a Page 8 significant recession in 1967. We estimate that if money growth had been resumed at a moderate 3 per cent rate —the rate which from 1961 to 1964 got the economy out of the previous recession —the rate of inflation would have been about 2 per cent at the present time, instead of the current rate of 5 to 6 per cent. Moreover, achievement of price stability would have been virtually assured for next year. With a slower rate of inflation, long-term interest rates would have been about 2 percentage points lower today. If we once again succumb to pressures for excessive rates of monetary expansion, we will again have lost the battle against inflation, as in 1967 and 1968. Conclusion In conclusion, I am sorry that I cannot present to you a view which maintains that inflation is fairly easy to conquer within a year or so. We should remember that our present inflation was permitted to develop at an accelerating rate over the past five years. It is rather presumptuous to assume that this trend can be reversed in a year or so, or that the cooling-off of inflation can be achieved in a reason able time without a period of very slow growth in output and higher unemployment. Overly optimistic pronouncements of our ability to curb the present inflation in a hurry and with only slight effects on employment are a disservice to our people and a stumbling block to the working of orderly corrective processes. I want to point out that in the 1950’s about 7 years of restraint on spending and output were required to eliminate the inflation which accompanied the Korean War. Three recessions occurred during this period as the result of stop-and-go monetary expansion which alternated between periods of rapid growth and decrease in money. Inflation has now been more in tense than in the 1950’s, making the problem even more difficult. However, if moderate but persistent monetary restraint is applied, avoiding the stop-andgo policies of previous efforts to curb inflation, per haps inflation may be eliminated somewhat sooner this time without subjecting the economy to wide variations in output of goods and services and in employment. This does not mean that monetary actions cannot produce the desired results. Instead, it means that all segments of our society must have patience while these actions are conducted, so as to permit the J A N U A R Y 1970 F E D E R A L R E S E R V E B A N K OF ST. LO U IS economy to achieve non-inflationary growth in out put of goods and services. Such growth, according to the New, New Economics, will be at a rate deter mined by normal growth in the productive capacity of our economy. Once we have achieved this goal, monetary actions must be conducted in such a manner as to assure that they will not be a source of future economic instability. Many individuals have become impatient at the slow progress made in curbing inflation and have been urging the imposition of price and wage controls. Recently, there has been considerable support for selective credit controls. Such measures, even if cloaked with pseudo-respectability by being placed on a voluntary basis for a brief period, are not part of the New, New Economics. Instead, we believe that the best way to cure our nation’s economic ills is to allow stabilization efforts to work their influence through our relatively free, competitive market system. Moreover, experience during World War II and the Korean War has demonstrated that treating only the ’ UBSCRIPTIONS to this hank’s R symptoms of inflation is neither effective nor desirable. Also, reliance on such controls could very well lead to their being substituted for appropriate overall stabilization policy. Such was the experience with the use of price-wage guidelines during the escalation phase of the Vietnam War. Finally, experience reinforces the belief held by many that an inflationary trend should never be per mitted to start because of the great inequities it creates and because of the long and arduous effort which is required to conquer it. Some argue that inflation is a small price to pay for a high level of employment for all segments of our society. This may be a basic tenet of the New Economics; but it is not a tenet of the economic school of thought represented at these seminars. The New, New Economics holds that inflation is not required, and indeed is not a long-run effective means, for our economy to grow at its productive potential or for the achievement of a high level of employment. e v ie w This article is available as Reprint No. 50. are available to the public without charge, including bulk mailings to banks, business organizations, educational institutions, and others. For information write: Research Department, Federal Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166. Page 9 Some Issues in Monetary Economics* By DAVID I. FAND Public policies are continuously sought which will assist in guiding the economy between the perils of inflation and the dangers o f unemployment and under-production. During the last five years the perils of inflation have becom e increasingly apparent, and during the past year stabilization actions have been taken to reduce the rate of advance of the price level. At the present time there is growing concern that these actions may lead the economy into a recession. What are the vehicles and avenues of stabilization policy which can best restore the econ omy to a satisfactory course, that is, a high and rising level of output and employment with a reasonably stable price level? Unfortunately, students of this problem are not in substan tial agreement on an answer. Economists have tended to fall into two conflicting schools of thought regarding economic stabilization —the income-expenditure approach and the modern quantity theory of money approach. Until recently, the dominant school has been the modern version o f the income-expendi ture theory which has evolved from the work o f John Maynard Keynes in the 1930’s. Policy makers in the 1950’s and 1960’s generally adopted the theoretical framework of this school for the formulation of economic stabilization actions. Primary emphasis was given to fiscal actions —Federal government spending and taxing programs —in guiding the economy b e tween inflation and unemployment. During the last two decades, proponents of the modern quantity theory of money have increasingly challenged the basic propositions of the incomeexpenditure school. The modern quantity theory assigns to the money stock the major role in economic stabilization efforts. The folloxving paper by David I. Fand, Professor of Economics, Wayne State University, outlines the nature of some of the major points of disagreement between the income-expendi ture approach to stabilization policy and the modern quantity theory approach. This paper was presented to a seminar of college and university professors o f money and banking sponsored by the Federal Reserve Bank of St. Louis on November 7, 1969. This paper has appeared in B a n c a N a z i o n a l e D e l L a v o r o Q u a r t e r l y R e v i e w , N o . 90, September 1969. In brief summary, Professor Fand analyzes the following four points o f disagreement between proponents o f the income-expenditure school and the modern quantity theory school: (1) The modern quantity theory of money espouses the view that the Federal Reserve System can exercise close control over the nominal money stock. On the other hand, proponents of the income-expenditure school have questioned either the feasibility or desirability o f such control. (2) Economic analysis based on the income-expenditure approach usually assumes a con stant price level, thereby abstracting from the distinction between nominal and real money balances and between market interest rates and real interest rates. Modern quantity theory advocates maintain that this failure to take into consideration the distinction between nominal and real magnitudes has frequently led to erroneous stabilization policies in recent years. (3) The two schools have very different views regarding the causes of inflation. The J modern quantity theory stresses the influence of changes in the money stock on ag gregate demand in explaining movements in the price level, while the incomeexpenditure theory has stressed factors which influence aggregate supply, such as wage movements and other influences on costs of production. (4) Finally, Professor Fand compares the special assumptions o f the income-expenditure school, which led them to conclude that fiscal actions have a great influence on total spending, with those of the modern quantity school, which lead to the opposite con clusion. He points out that most discussions o f the influence o f fiscal actions on total spending implicitly assume that interest rates are held constant by accommo dative changes in the money stock. On the other hand, in discussing the influence o f fiscal actions, proponents o f the modern quantity theory of money assume that the money stock is held constant, which results in an offsetting change in interest rates. The first assumption leads to the conclusion that fiscal influence on total spending is great, while the second assumption leads to the conclusion that induced changes in private spending offset a large part of the fiscal influence. The exposition in the paper is o f necessity somewhat technical, and it may be o f par ticular interest to those familiar with the current debate. Extensive footnotes to the paper provide references to some of the most useful presentations of the various points of view. Page 10 F E D E R A L R E S E R V E BA NK OF ST. LO U IS B a s ic ISSUES in monetary theory are being de bated at the present time, and increasing attention is now being directed to the following rather technical questions: Can the central bank control the (nominal) money stock within fairly close limits, or should we adopt the analytically more complete (and neutral) approach of the large scale econometric models and treat money as an endogenous variable? Can the cen tral bank implement its policy decisions and calibrate its actions by means of an interest rate criterion —ex pressed in money market variables —or would it do better to use one of the monetary aggregates as an indicator and target for monetary policy?1 Can the central bank lower (or raise) market interest rates if •Financial support by the National Science Foundation and Wayne State University is gratefully acknowledged. In pre paring the paper for this Review, the author has benefited from the seminar discussion and comments from the Research staff at the Federal Reserve Rank of St. Louis. ■See W. Dewald, “Money Supply vs. Interest Rates as Proxi mate Objectives of Monetary Policy,” National Banking Re view, June 1966; P. Cagan, “Interest Rates vs. the Quantity Theory: The Policy Issues” and L. Gramley, “The Informa tional Content of Interest Rates as Indicators of Monetary Policy” in Proceedings: 1968 Money and Banking Work shop, Federal Reserve Bank of Minneapolis, May 1968; M. Friedman, “The Role of Monetary Policy,” American Eco nomic Review, March 1968; P. Hendershott, The Neutralized Money Stock —An Unbiased Measure of Federal Reserve Policy Actions (Richard D. Irwin, 1968); the Joint Economic Committee Hearings on Standards for Guiding Monetary Action (Washington, 1968); D. Fand, “Comment: The Impact of Monetary Policy in 1966,” Journal of Political Economy, August 1968; the House Committee on Banking and Currency Compendium on Monetary Policy Guidelines and Federal Reserve Structure (Washington, 1968); T. Mayer, Monetary Policy in the United States (Random House, 1968). See also A. Meigs, “Financial Stability and Inflation,” Bankers Magazine ( London: February 1969); A. Meigs, “The Case for Simple Rules,” and L. Gramley, “Guidelines for Monetary Policy —The Case Against Simple Rules,” presented at the Financial Conference sponsored by the National Industrial Conference Board, February 21, 1969; A. Meltzer, “Controlling Money” in the May 1969 issue of this Review; L. C. Andersen, “Money and Economic Forecasting,” and E. M. Gramlich, “Complicated and Simple Approaches to Estimating the Role of Money in Economic Activity,” Business Economics, September 1969; K. Brunner (ed), Targets and Indicators of Monetary Policy, (Chandler Pub lishing Co., 1969); and L. C. Andersen “The Influence of Economic Activity on the Money Stock: Some Additional Evidence,” in the August 1969 issue of this Review. For an interpretation of the Federal Reserve’s money market strategy —the strategy encompassing instrument vari ables (e.g., open market operations), money market variables (e.g., free reserves) and monetary variables (e.g., the mone tary aggregates) —and an interpretation of the proviso clause as a device for correcting errors in the projected relation between money market variables and the monetary variables, see the recent paper by Governor Sherman Maisel, “Con trolling Monetary Aggregates” in Federal Reserve Bank of Boston, Controlling Monetary Aggregates (September 1969). (See also J. M. Guttentag, “The Strategy of Open Market Operations, ’ Quarterly Journal o f Economics (February 1966). 2The hearings in March and April of the U.S. Senate Com mittee on Banking and Currency on High Interest Rates (Washington, 1969) were directed at the causes of high and rising market interest rates and the extent to which they could be influenced by the central bank. J A N U A R Y 1970 such a change is thought to be desirable?2 Can the authorities better the stabilization performance of recent years by giving more emphasis to the behavior of monetary aggregates?3 These technical questions suggest a number of more fundamental questions concerning recent stabi lization policies. Has the post-1965 inflation been a monetary phenomenon resulting from the extraordi nary expansion in the monetary aggregates, or has it primarily been due to an excessively lax, and inap propriate, fiscal policy?4 Does the theory of fiscal policy (and its calculated multipliers) often assume an elastic, permissive, or accommodating monetary policy, and does it therefore fail to distinguish be tween a pure fiscal deficit excluding any money stock effects, and an increase in the monetary aggregates accompanied by a fiscal deficit?5 Is the transmission mechanism as conceived in the income-expenditure models a valid one, or may changes in the nominal money stock directly affect private expenditures, ag gregate demand, and price levels?6 Should stabiliza tion policy continue to stress temporary changes 3For an articulate and influential statement of the fiscal policy approach to stabilization emphasizing discretionary changes in the full-employment surplus, see W. Heller, New Dimen sions of Political Economy (Norton, 1966). The key stabiliza tion role assigned to changes in the full-employment surplus is critically reviewed by G. Terborgh in his The New E co nomics (Washington, 1968). For a discussion of the stabiliza tion roles to be assigned to monetary and fiscal policy see the Friedman-Heller dialogue, Monetary vs. Fiscal Policy (Norton, 1969). 4See D. Fand, “The Chain Reaction-Original Sin (CROS) Theory of Inflation,” Financial Analysts Journal (July 1969), and his “A Monetary Interpretation of the Post-1965 Infla tion in the United States, Banca Nazionale Del Lavoro, No. 89, (June 1969), especially, Section I, “Has Monetary Policy Been Tight Since 1965?,” pp. 103-106; and the testimony by Chairman Martin ( Board of Governors) and Chairman McCracken (Council of Economic Advisers) in High Interest Rates, op. cit., pp. 6-41. BSee L. Andersen and J. Jordan, “Monetary and Fiscal Ac tions: A Test of Their Relative Importance in Economic Stabilization,” in the November 1968 issue of this Review; the Comment by F. DeLeeuw and J. Kalchbrenner, and Reply by Andersen and Jordan in the April 1969 issue of this Review; M. Levy, “Monetary Pilot Policy, Growth and Inflation” and W. Lewis, “ ‘Money is Everything’ Economics —A Tempest in a Teapot” in the Conference Board Record for January and April 1969; R. Davis, “How Much Does Money Matter? A Look at Some Recent Evidence,” in the June 1969 Monthly Review, Federal Reserve Bank of New York: and L. C. Andersen, “The Influence of Economic Activity on the Money Stock: Some Additional Evidence,” op. cit. 6The transmission mechanism in aggregative models views interest rates as an indicator of monetary policy, as a measure of the cost of capital, and as a key element in the transmis sion mechanism. For a criticism, see D. Fand, “Comment: The Impact of Monetary Policy in 1966,” op. cit., especially Section II, “The Role of Interest Rates,” pp. 825-830; “A Monetary Interpretation of the Post-1965 Inflation in the United States,” op. cit., especially Section II, pp. 106-113, and Section IV, “Market Interest Rates ( Conventional Yields) or Prices (Implicit Yields),” pp. 116-119; and “Keynesian Page 11 F E D E R A L R E S E R V E BA N K OF ST. LO U IS (discretionary or automatic) in the full-employment surplus, as if it were the ultimate weapon, in light of our recent experience?7 In this paper we take up four specific issues. We first consider whether the central bank can actually control the money stock. We then consider whether changes in the (nominal) money stock are identifiable with changes in real cash balances, and whether movements in market interest rates adequately reflect movements in real rates. The third question that we take up con cerns the analytical structure and policy implications of the non-monetary theories of the price level. The fourth and final question is: How do we define, and measure, the monetary and fiscal effects that follow a particular policy? Can the Central Bank Control the Nominal Money Stock? The money stock at any moment in time is the result of portfolio decisions by the central bank, by the commercial banks, and by the public (including the nonbank intermediaries):8 the central bank de termines the amount of high-powered money or mone tary base, that is, currency plus bank reserves, that it will supply;9 the commercial banks determine the Monetary Theories, Stabilization Policy, and the Recent In flation,” Journal of Money, Credit and Banking, August 1969, especially Section IV on “Keynesian Theories of Money and Interest Rates.” See also G. Kaufman, “Current Issues in Monetary Economics and Policy: A Review,” Bulletin No. 57, New York University Institute of Finance, May 1969. 7The symposium volume Fiscal Policy and Business Capital Formation (Washington, 1967) contains an informed discus sion of this subject. See especially the papers by P. Mc Cracken, C. Harriss, S. Fabricant, and R. Musgrave, and the comments by G. Haberler and N. Ture. See also H. Stein, “Unemployment, Inflation and Economic Stability” in K. Gordon (ed), Agenda for the Nation (Brookings, 1968). 8For a discussion of the determinants of the money stock see M. Friedman and A. Schwartz, A Monetary History of the U.S. 1867-1960 (Princeton, 1963), Appendix B on “Proximate Determinants of the Nominal Stock of Money”; P. Cagan, Determinants and Effects of Changes in the Stock of Money 1875-1960 (Columbia, 1965), Chapter I on “The Money Stock and Its Three Determinants”; K. Brunner, “A Schema for the Supply Theory of Money,” International Economic Review, January 1961; D. Fand, “Some Implica tions of Money Supply Analysis,” American Economic Review, May 1967. 8The high-powered money concept used by M. Friedman, A. Schwartz and P. Cagan is essentially the monetary base concept used by K. Brunner, A. Meltzer, and others. The monetary base may be defined either in terms of the sources (Federal Reserve credit, gold stock, Treasury items, etc.) or uses (member bank reserves and currency). To compare movements in the monetary base over time, we need to make a correction for changes in reserve requirements. As used here, the monetary base includes a reserve adjustment; that is, it is equal to the source base plus the reserve adjustment. For a very clear exposition see L. Andersen and J. Jordan, “The Monetary Base —Explanations and Analytical Use ’ in the August 1968 issue of this Review. Page 12 J A N U A R Y 1970 volume of loans and other assets that they will ac quire and the quantity of reserves they will hold as excess (and free) reserves; and the public determines how to allocate their holdings of monetary wealth among currency, demand, time and savings deposits, CD’s, intermediary claims, and other financial assets. The money stock that emerges reflects all these decisions. It is a natural question to consider whether the central bank, by controlling the monetary base, can actually achieve fairly precise control over the money stock. This depends on whether the link between the monetary base and bank reserves, and between bank reserves and the money stock ( the monetary base — bank reserves —money stock linkage) is fairly tight and therefore predictable. If there is a tight linkage the monetary authorities can formulate their policies and achieve any particular target for the money stock; on the other hand, if there is significant and unpredictable slippage, and the central bank control over the money stock is not sufficiently precise to achieve a given target, it will necessarily have to for mulate its policies in terms of other variables that it can control. The variable used to express (or define) the central bank’s objective, or to implement its policy decisions, must therefore be one that it can control within reasonable limits.10 The recently recurring idea that the money stock is perhaps best viewed as an endogenous variable, although not a new idea (it would have been ac ceptable to “real bill” theorists), has received new and powerful support from those who follow the “New View” approach in monetary economics.11 New View theorists have questioned the validity of much of classical monetary theory concerning the importance of money relative to other liquid assets, the unique10It is presumably for this reason that some models treat unborrowed reserves as the policy variable (the practice followed in the FRB-MIT model and other econometric models). These model builders believe that some com ponents of the monetary base, and perhaps the entire base, behave as endogenous variables —as the variables that re spond to income changes, and are not directly (or com pletely) under the control of the central bank. They do believe that the Federal Reserve can control the volume of unborrowed reserves. u For the development of the New View see J. Gurley and E. Shaw, Money in a Theory of Finance (Brookings, 1959); D. Fand, “Intermediary Claims and the Adequacy of Our Monetary Controls” and J. Tobin, “Commercial Banks as Creators of ‘Money,’ ” in D. Carson (ed), Banking and Monetary Studies (Irwin, 1963); H. Johnson, Essays in Monetary Economics (Allen and Unwin, 1967), Chapters 1 and 2; W. Brainard, “Financial Intermediaries and a Theory of Monetary Control,” in D. Hester and J. Tobin (eds), Financial Markets and Economic Activity (Wiley, 1967); and K. Brunner, “The Role of Money and Monetary Policy,” in the July 1968 issue of this Review. F E D E R A L R E S E R V E B A N K OF ST. LO U IS ness of commercial banks relative to other inter mediaries, and the extent to which the central bank can control the nominal money stock.12 They argue that the central bank can control its instruments (open market operations, reserve requirements, dis count rate) and some money market variables (free reserves, Treasury bill rate); that the commercial banks supply deposits at a fixed rate; and that the stock of money and liquid assets which emerge —at least in the short run —largely reflect the public’s preference for demand and time deposits, interme diary claims, and other financial assets.13 Two schools of monetary economics differ on the use of the money stock as an indicator or target vari able, and on the extent to which it is an endogenous variable and therefore not available to the monetary authorities as a stabilization instrument. The non monetarists believe that the central bank should for mulate its policies in terms of money market variables and implement them through operations on the instru ment variables. They view the money stock as (in part) an endogenous variable, and do not conceive of it as a proper instrument or target variable. The monetarists believe that the central bank can, and should, define its objectives and implement its policies in terms of the money stock. Indeed, these two conceptions of the money stock and its role in monetary policy de cisions summarize some important substantive differ ences that have emerged in monetary economics: (1 ) between the monetarist view that changes in the nominal money stock may be a causal, active, and 12Tobin offers the following description of the New View: “A more recent development in monetary economics tends to blur the sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries; to focus on demands for and sup plies of the whole spectrum of assets rather than on the quantity and velocity of ‘money’; and to regard the struc ture of interest rates, asset yields, and credit availabilities rather than the quantity of money as the linkage between monetary and financial institutions and policies on the one hand and the real economy on the other.” He also suggests that this general equilibrium approach to the financial sector tends to question the presumed unique ness of commercial banks: “Neither individually nor collectively do commercial banks possess a widow’s cruse. Quite apart from legal reserve re quirements, commercial banks are limited in scale by the same kinds of economic processes that determine the ag gregate size of other intermediaries.” J. Tobin, “Commercial Banks as Creators of “Money,’ ” op. cit., pp. 410-412. 13Some monetary theorists have argued that while a skillful central bank can manipulate its controls to keep the nominal money stock (M ) on target, it is preferable nevertheless to think of (M ) as an endogenous variable. They argue that a “theory which takes as data the instruments of control rather than M, will not break down if and when there are changes in the targets or the marksmanship of the authorities.” See J. Tobin, “Money, Capital and Other Stores of Value,” American Economic Review, May 1961. J A N U A R Y 1970 independent factor in influencing aggregate de mand and the price level, and the nonmonetarist views ranging from (a ) the older “real bills” doc trine that the money stock responds primarily to changes in the real economy; (b ) the IncomeExpenditure theories (associated with the 45° dia gram) which view money as an accommodating factor; and (c) the more recent New View doc trine that the money stock is best viewed as one of several endogenous liquidity aggregates; (2 ) between the monetarist view that the money stock — using either the conventional or the broader definition — is a reasonably well-behaved quantity, and the Radcliffe-type view that rejects these measures as narrow and inappropriate, and argues for a broader liquidity aggregate; and (3 ) between the monetarist view that the monetary policy posture should be gauged by the behavior of a monetary aggregate, and the Income-Expenditure theories viewing market interest rates as the proper indicator variable. Many who question the advisability of operating monetary policy in terms of money stock guidelines also question whether the central bank control is pre cise enough to comply with the guideline require ments. The extent of this control is therefore a key question. Is the money stock best viewed as an en dogenous variable —determined by the interaction of the financial and real sectors —and outside the direct control of the central bank? Or is it more nearly cor rect to view it as an exogenous variable —as a policy instrument —that the authorities can control, and whose behavior can be made to conform to the stabili zation guidelines? This issue is essentially an empirical one: Does con trol over the monetary base and other instruments provide the central bank with sufficient powers to fit the behavior of the money stock into a given stabiliza tion program? The monetarists, in assigning an im portant role for the money stock in stabilization policy, assume that the central bank can engineer the desired behavior of the money stock. The sub stantive issue can be reformulated in terms of an empirically refutable hypothesis, as follows: Do changes in commercial bank free reserve behavior, and do portfolio shifts by the public involving cur rency, demand and time deposits, and other financial assets, introduce enough variability and enough “noise” to break the monetary base —bank reserves —money stock linkage, and justify treating the money stock as an endogenous variable —and essentially outside the control of the central bank? The empirical examination of this issue fits in nat urally to a framework of money supply analysis which Page 13 F E D E R A L R E S E R V E B A N K OF ST. LO U IS I have described in an earlier article.14 The analysis developed there defines four money supply functions which incorporate alternative assumptions concerning portfolio adjustments. If we let M = the nominal money stock X = a vector of Federal Reserve (monetary policy) instruments variables (the monetary base, re serve requirements, discount rate, Regula tion Q) rb = a vector of endogenous financial variables (e.g., the Treasury bill rate, the Federal funds rate, the Eurodollar rate, the rate on time de posits and other intermediary claims) T,C = time deposits, currency, shares and other fi nancial assets that are close substitutes for demand deposits Y = a vector of real sector variables (GNP, busi ness investment, durables, etc.) a money supply (M.S.) function may be written as: M = f (X, rb; T,C: Y). The four M.S. functions that follow reflect alternative ceteris paribus conditions changing the portfolio ad justments that we permit for both the banks and the public: (1 ) M .S .(I) is a short-run supply concept. It gives the money supply response to a change in reserves on the assumption that while banks may choose to adjust their free reserves, the public can only carry out a limited adjustment with respect to currency, time deposits and other financial assets. There are several ways to impose certeris paribus conditions on the public’s holdings of currency, time deposits, and other financial assets. Some in vestigators hold levels of these assets constant, others hold ratios constant, and different investi gators impose this ceteris paribus condition in a manner most compatible with their model. M .S .(I) is of the form M=f(X,rt>; T ,C :Y ), where T and C specify our assumptions for currency, time de posits, and other close substitutes. To use it as a short-run concept we assume that all variables in the real sector of the economy, including stocks of real assets and flows such as consumption and investment, are held constant, so that it is pri marily a function of the monetary policy instru ment variables. Accordingly, if M .S .(I) is fairly stable it provides some support for the view that the monetary authorities can achieve fairly pre cise control over the money stock. (2 ) To construct M .S .(II) we remove some of these portfolio restrictions by permitting the public to adjust their holdings of currency and time depos its, and the terms on which banks supply time deposits to reflect the underlying preferences. This function is of the form f(X,rt>:Y), and does not 14See D. Fand, “Some Implications of Money Supply Analysis,” American Economic Review, May 1967. 14 Digitized forPage FRASER J A N U A R Y 1970 contain any arbitrary assumptions about currency, time deposits, or the rate paid on time deposits. It is derived by assuming: (a ) that the banks may adjust their free reserves and the rate paid on time deposits; and (b ) that the public’s hold ings of currency and time deposits will be deter mined by their demand function for these assets. Although M .S .(II) does permit a greater degree of portfolio adjustment, it still is a short-run and restricted function because it assumes that the real sector variables and all other financial assets are held constant. (3 ) To construct M .S .(Ill) we permit portfolio ad justments throughout the entire financial sector and solve all the equations in the financial sector simultaneously. The Treasury bill rate and other rates which are endogenous variables in the finan cial sector will therefore be determined, and no longer enter as independent arguments in the money supply function. M .S .(Ill) is a reduced form equation of the form M = g (X :Y ) where all endogenous financial variables will have values determined by the simultaneous solution of the behavior equations in the financial sector. This function measures the supply response due to a change in the monetary base or some other policy instrument, assuming that all the variables in the financial sector adjust simultaneously. (4 ) Finally, we define M .S .(IV ) in the form of M = g (X ), a reduced-form equation which mea sures the movements in the money stock in re sponse to adjustments in both the real and the financial sector. To derive this money supply we must solve all the structural equations in the finan cial and real sectors simultaneously to obtain the reduced form. The real sector variables are no longer treated as exogenous variables, but are now determined simultaneously with all the endogen ous financial sector variables. This reduced-form M.S. gives the equilibrium stocks of money as a function of the monetary base and other monetary policy instrument variables. This is the natural M.S. function to construct for those who view the money stock as passive and responding to real sector developments, and to those who view the money stock as an accommodating variable, whose changes may be necessary in order to validate changes in the real economy.15 This brief review of the four money supply functions suggests that it is possible to test some of the substan tive points that have come up in the recent “control over the money stock” discussions. For example, M.S. (I ) postulates that we can predict the effect of changes in the monetary base (and other instruments) on the money stock, assuming that the public’s portfolio ad 15The M.S. (IV ) function as written implies that an increase in the monetary base will affect the money supply if it in duces some real sector changes. A “real bills’ proponent might therefore prefer to write it as follows: M = f ( Y ) and X = g(Y ); where M and X are both determined by the real sector variables in Y. F E D E R A L R E S E R V E BA N K OF ST. L O U IS justments are restricted; M.S. (II) postulates that we can predict the effect of a change in the monetary base (and other instruments) on the money stock, even allowing the public to adjust their currency and holdings of demand and time deposits; while M .S.(Ill) postulates that we can predict the money stock re sponse, even allowing the public to adjust their entire portfolios. These three M.S. functions assume that commercial bank free reserve behavior and the pub lic’s behavior with respect to currency, demand and time deposits are stable; and that the substitution of intermediary claims and liquid assets for money con forms to behavior that can be incorporated into a stable M.S. function. Econometric estimates of these three functions provide some evidence for testing the reliability of the monetary base —bank reserve — money stock linkage.16 Those who follow the “real bills” view —that the money stock is determined by the real sector variables — or the view in many income-expenditure models — that the money stock is an accommodating or permissive variable —presumably deny the possibility of con structing such functions. In their view these three M.S. functions do not allow any changes in fiscal policy or in the real sector variables; they permit only restricted changes in the financial sector variables, and they emphasize the monetary base and the central bank’s instrument variables. Accordingly, they should pre dict that the first three M.S. functions highlighting the instrument variables are unstable and lack con tent; indeed, their approach to monetary theory im plies that only M.S.(IV), which incorporates changes in the real sector, contains the relevant independent variables. An analysis of these four money supply functions has implications for the use of the money stock as an inde pendent and major instrument in stabilization. Those who argue that money is, at least in part, an en dogenous variable, and who question the precision with which it can be controlled, assume (implicitly perhaps) that no statistically significant supply func tion can be estimated relating the money stock to the monetary base and other instrument variables. More over, if such a function is estimated it would have to be a reduced-form function, and a variant of the M.S. ( IV ) concept, incorporating feedbacks from the real sector. 16A comparison of the three M.S. functions enables us to evaluate the quantitative effects of these portfolio shifts on the money stock. Consider a given change in the monetary base, or any other instrument variable, and compare the money stock response in these three functions. The calcu lated differences reflect the portfolio adjustments that we introduce as we move from M .S.(I) to M.S.( I I I ) —i.e., shifts among currency, demand and time deposits, and the substitution of intermediary claims for money —and thus provide a measure of these effects on the money stock. J A N U A R Y 1970 In an earlier study, we compared estimates of the M.S. functions calculated from different econometric models. We found that the elasticities and multipliers for the first three M.S. functions based primarily on financial variables appear to be stable enough to justify further effort towards their refinement and improvement. We also found that: “There are at present too few studies available to calculate reliable M.S. (IV) elasticities. But the available evidence, meager though it may be, does not point to any superiority of M.S. (IV) over M.S. (I), and does not appear to favor a real view over a monetary view. Those who take the view that money is passive, responding primarily to the real economy, have to recognize that this is an assumption rather than a proposition derived from empirical evidence.”17 Our findings also suggest that the money stock behavior could be made to conform to a specified stabilization program. For example, by controlling movements in the monetary base, monetary authorities can control quite adequately movements in the money stock. The chart below illustrates a rather close relationship between the monetary base and the money stock. RatioScale Billions of Dollars 1962 M oney Stock and Monetary7 Base 1963 RatioScale Billions of D o llars 1964 1965 1966 1967 1968 1969 1970 *U ses of the m onetary b a se are member bank reserves an d currency held by the p ublic and nonmember banks. Adjustm ents are m ade for reserve requirement chan ge s an d shifts in d ep osits am ou n g classes of banks. D ata are computed b y this bank. Percentages are annual rotes of change between periods indicated.They are presented to aid in comparing most recent developm ents with past "trends." late st d ata plotted: De ce m b e r prelim inary 17See D. Fand, “Some Implications of Money Supply Analysis,” op. cit., p. 392. The calculated elasticities and multipliers suggest that the short run M.S. functions —such as the M.S. (I) and M .S .(II)—are reasonably stable. These are pre liminary findings, derived by using the steady-state solutions to simplify the analysis; they are subject to revision and require the construction of significance tests. Page 15 F E D E R A L R E S E R V E BA N K OF ST. LO U IS While this research is far from conclusive it is consistent with, a number of other findings.18 It is difficult to maintain the view that the money stock is sufficiently endogenous so that it is outside the direct control of the authorities, without getting dangerously close to a “real bills” position. Ac cordingly, the focus of the “control over the money stock” discussion will shift, in my opinion, to the more interesting question —and the more relevant and less ideological question —concerning the length of the period needed to give the Federal Reserve System sufficient control to achieve a given money stock guideline. Assuming that a “reasonable” degree of pre cision has been defined, can the particular guideline requirements be achieved in a week? a month? a quarter? Or must we extend the period in order to overcome false signals, “noise,” forecasting errors and other disturbances.”19 It would appear that the de gree of precision desired is not independent of the time period required for the execution of policy, and it is reassuring to note that recent discussions have been directed increasingly at these points. The Income-Expenditure Theory and the Quantity Theory: Nominal and Real Quantities There is considerable agreement on the proposition in monetary theory that the real value of the money stock is an endogenous variable, determined by the interaction of the financial and real sectors, and there fore outside the control of the monetary authorities. This is in sharp contrast to the theoretical (and prac tical) disagreements concerning the extent to which the central bank can control the behavior of the 18See the references to Andersen, Brunner, Cagan, Dewald, Friedman and Schwartz, Meigs, and Meltzer in footnotes 1, 8, and 11. 19This formulation of the problem has come up in several recent papers. Governor Maisel emphasizes this point as follows: “This growth of money supply in any period is the result of actions taken by the Federal Reserve, the Treasury, the commercial banks and the public. Over a longer period, the Fed may play a paramount role, but this is definitely not the case in the short run. To the best of my knowledge, the Fed has not and probably would have great difficulties controlling within rather wide limits the growth of the nar rowly defined money supply in any week or month.” See Sherman J. Maisel, “Controlling Monetary Aggregates,” op. cit. For some other discussions of this issue, see A. J. Meigs, “The Case for Simple Rules,” op. cit.; L. Gramley, “Guidelines for Monetary Policy —The Case Against Simple Rules,” op. cit.; the Hearings on Standards for Guiding Monetary Action, op. cit.; A. Meltzer, “Controlling Money, ’ op. cit. See also L. Kalish, “A Study of Money Stock Con trol,” Working Paper No. 11, Federal Reserve Bank of St. Louis, for an interesting attempt to develop confidence limits for measuring the money managers’ success in con trolling the money stock. Page 16 JA N U A R Y 1970 Nominal anc Real Money Stock Ratio Scale Billions of Dollars _ oorter y e rage s of .. c. .°!!d Ratio Scale Billions of D ollars 200 -I*-— " ” 99.3 2 00 190 180 180 Nominal Money Stock 170 160 teal Ho ey Stock . r " 150 s 000* 52.8 150 140 1962 1963 1964 1965 1966 1967 1968 1969 1970 (J^ Privote dem and deposits an d currency held by the n o nb an k public. [2 Nom inal money stock d ivid e d by the implicit price deflator, latest data plotted: 4th quarter estimated by this bank (nominal) money stock. In equilibrium, the stock of real cash balances has a value —analogous to, say, the real wage —which the stabilization authorities cannot readily influence, except in those special cases where nominal and real variables move together. The above chart demonstrates that such is not always the case. For instance, the nominal money stock was un changed during the latter half of 1966, while real money balances activity declined. Income-expenditure theorists in their macroeconomic models often use nominal balances when the analysis requires real balances. This substitution of a nominal quantity (which can be easily changed) for a real quan tity (with a determinate equilibrium value) has two consequences: it suggests that an increase in nominal balances will always tend to lower market interest rates; it also implies that changes in market rates correspond to, and reflect, changes in real rates. This procedure is sometimes justified by a special inter pretation of the demand for money, an interpretation that is often attributed to Keynes’ General Theory. It is therefore useful to recall the transformation of the demand for money in Keynes’ General Theory. Instead of defining a demand for a quantity of real balances, the demand for money (or real balances) was transformed into the liquidity preference func tion and a basic determinant of the interest rate: the liquidity preference function together with the (real) quantity of money determines the interest rate; and F E D E R A L R E S E R V E BA N K OF ST. LO U IS since Keynes assumed explicitly that the price level was given, he could move from nominal to real bal ances to determine the market (or nominal) interest rate, the real interest rate (or return on capital), and the equilibrium quantity of real balances.-0 The postKeynesian income models follow the General Theory in treating the demand for money as a liquidity pref erence function, but they do not determine explicitly the equilibrium quantity of real cash balances. The failure to define an equilibrium value for the real money stock opens up the possibility of treating both the real and nominal money stock as policy varia bles,21 and as close substitutes. The substitution of nominal balances for real balances in many post-Keynesian income-expenditure models has extremely important consequences. To assume that nominal and real balances may be interchanged is to assume that the authorities have the power to print real capital and wealth: it exaggerates the control of the authorities over real interest rates (and rates of return); and it necessarily abstracts from any direct effects of money on prices (note that the link be tween the money stock and prices requires that we distinguish between nominal and real values). This tendency to abstract from the price level, to freely substitute nominal and real variables, and to equate market interest rates with real rates (of return) re flects the analytical failure to define equilibrium con ditions for real balances, and is a striking feature of the post-Keynesian income models. In sharp contrast to the income-expenditure theory, we have the following postulates concerning real balances in the modem quantity theory: (1) the money demand function defines the demand for real cash balances; (2) the quantity of real cash balances is an endogenous variable and not under the control of the monetary authorities (except for the very short run); and (3) changes in nominal 20For an elaboration of this theme see D. Fand, “Keynesian Monetary Theories, Stabilization Policy and the Recent In flation,” op. tit., Section II on “The Demand for Money and Liquidity Preference: Real Ralances and Interest Rates,” which discusses the changing role of real cash balances in the Keynesian and quantity theories, the shifting emphasis from the price level to the level of employment, and the transformation of the money demand function into a liquidity preference function. 21For a penetrating analysis emphasizing the originality and generality of the Keynes theory, in contrast to the rigidities, traps, and elasticity pessimism in many of the post-Keyne sian income models, see A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford, 1968). See also D. Fand, “Keynesian Monetary Theories, Stabiliza tion Policy and the Recent Inflation,” op. cit., Section III on “Three Keynesian Liquidity Preference Theories,” and J. Tobin’s seminal article on “Money, Capital, and Other Stores of Value,” op. cit., for his illuminating analysis of an aggregative model with three assets. J A N U A R Y 1970 balances will generally have effects on market interest rates, on income, and on prices.22 For the analysis of transition periods it assumes that an increase in nominal balances will have a compound effect on in terest rates —including a short-run liquidity ( Keynes) effect, an income effect, and a longer-run (Fisher) price expectation effect.28 The modem quantity theory also assumes that the demand for money is quite stable, and that a velocity function (derived from the money demand function) may provide a useful link between (changes in) money and (changes in) money in come; and, in contrast to the earlier quantity theory, postulates a stable velocity function, but allows marginal velocity to differ from average velocity. Taken together, these quantity theory propositions have two important implications. They suggest: (1) that the monetary authorities do not control real in terest rates or the stock of real balances, even if they can always control the stock of nominal money and thereby influence nominal or market interest rates; (2) that money is an important variable for explain ing changes in prices, since the equilibrium quantity of real balances links changes in nominal money with changes in the price level. Accordingly, the modern quantity theory uses the money demand function to predict the level of money income and prices if out put is given, or changes in money income if output varies with changes in the money stock. The modem quantity theory and income-expenditure theory thus differ sharply in their analysis of the money demand function. In the modern quantity theory it serves as a velocity function relating either money and money income, or marginal changes in money and money income (if both output and marginal velocity vary with the money stock); in the income-expenditure theory, it serves as a liquidity preference theory of in 22See L. Mints, Monetary Policy for a Competitive Society (McGraw-Hill, 1950); M. Friedman (ed), Studies in the Quantity Theory of Money (Chicago, 1958), and The Op timum Quantity of Money (Aldine, 1969), especially Chap ters 6-9; H. Johnson, Essays in Monetary Economics (Har vard, 1967), Chapters 1-3; D. Patinkin, Money, Interest and Prices, 2nd ed. (Harper, 1965), Chapter XV; and C. Warburton, Depression, Inflation, and Monetary Policy, (Johns Hopkins Press, 1966). 23For a more explicit statement of the relation between changes in the nominal money stock and interest rates see M. Friedman and A. Schwartz, Trends in Money, Income and Prices (forthcoming); M. Friedman, Dollars and Deficits (Prentice Hall, 1968); P. Cagan and A. Gandolfi, ‘The Channels of Monetary Effects on Interest Rates,” American Economic Review, May 1969; W. Gibson and G. Kaufman, “The Sensitivity of Interest Rates to Changes in Money and Income,” Journal of Political Economy, May 1968; D. Meiselman, “Bond Yields and the Price Level: The Gibson Paradox” in Banking and Monetary Studies, op. cit.; and D. I. Fand, “A Monetarist Model of the Monetary Process,” forthcoming in the Journal of Finance. Page 17 F E D E R A L R E S E R V E BA N K OF ST. LO U IS terest rates, or of changes in interest rates (if the price level is given and determined independently of the monetary sector). Accordingly, the modem quantity theory focuses on discrepancies between actual and desired real balances, distinguishes between (exoge nous) nominal balances and (endogenous) real balances, emphasizes monetary aggregates rather than interest rates, and highlights nominal money as the operational policy variable; the income-expenditure theory focuses on discrepancies between actual and full-employment output, abstracts from price level changes, emphasizes an interest rate transmission mechanism, views the monetary aggregates as endo genous variables, and highlights the full-employment surplus as the operational policy variable.24 Viewed as general theories of income determination, both theories have deficiencies. The modem quantity theory seeks to explain prices, or money income, but often abstracts from the level of employment; the income-expenditure theory seeks to explain the levels of employment, but often abstracts from the price level; this difference in focus mirrors the change in the analyt ical roles of real balances and interest rates in the two theories. The quantity theory emphasis on real balances as an endogenous variable implies that the attempt by the monetary authorities to raise the money stock may cause prices to rise, and also cause nominal and real interest rates to diverge. In contrast, the income-expenditure theory, by de-emphasizing the endo geneity of real balances, implies that real balances and interest rates can be controlled (within limits) by the 24The mnemonic statements that money is or is not important do not bring out the essential monetary differences between the income and quantity theories. In some ways the incomeexpenditure theory attaches greater significance to money than does the quantity theory. Thus, the income-expenditure theory assumes that it is often possible to permanently lower interest rates, or rates of return, by an increase in nominal money, while the quantity theory is more inclined to view nominal money changes as having a permanent effect mainly on money income and prices. Yet because quantity theorists are often analyzing situations where inappropriate monetary policies may have caused severe difficulties (e.g., in the 1930’s), they may foster the impression that errors in mone tary policy are always associated with such drastic consequences. One other paradox may be noted. Many income-expenditure theorists treat the nominal money stock as an endog enous variable because they believe that this approach assumes less and is therefore more accurate. But while this treatment of the money stock is most appropriate in this formal sense, it may apparently also lead to substantive errors. For example, the large scale econometric models treat the nominal money stock as an endogenous variable, but do not restrict the movements in real balances by welldefined equilibrium conditions. The assumption that an increase in nominal balances will increase real balances may have been responsible for some of the forecasting errors and policy mistakes in 1968. This assumption may involve a more serious error, substantively and analytically, than treating the nominal money stock, formally, as an exogenous variable. Page 18 J A N U A R Y 1970 authorities —an impression that is reinforced by their failure to distinguish between nominal and real rates. The analysis of money, interest rates, and prices in the post-Keynesian income theories may explain sev eral of the troublesome features of recent stabilization policy: the use of market interest rates as an indicator of monetary policy; the tendency to minimize the price level consequences of excessive monetary growth; the failure to recognize the impact of infla tionary expectations on market interest rates; the re luctance to distinguish between nominal and real quantities; and the conviction that the rise in market interest rates since 1966 was due to an increased demand for money, and not the result of excessive growth in the money supply.25 The failure of income-expenditure theorists to con sider the impact of accelerated (excessive) monetary growth on rising (or high) market interest rates, and to distinguish between market and real interest rates, is especially relevant for analyzing the post-1965 inflation and the stabilization difficulties since June 1968. The surprising failure of the Revenue and Expenditure Control Act of June 1968 to cool the economy thus far could be explained by noting that the fiscal “re frigeration” effect was offset by the monetary “boiler” effect.26 The authorities, while fighting inflation with the surcharge, also wished to lower interest rates and move toward a tighter fiscal and easier monetary policy during this period, and this led to a very substantial increase in the monetary aggregates. Many who favored monetary expansion after the June tax package based their case on the desirability (and social necessity) of lowering market interest rates. In retrospect, it seems difficult to suppose that an increase in nominal money will raise real balances, lower interest rates, curtail disintermediation, facilitate residential construction, and somehow not raise ag gregate demand or prices. But an increase in the 25For a recent, and very useful, statement of the income theory approach to stabilization, incorporating a commit ment to economic growth and viewing it as a key aspect of government policy, see W. Heller (ed), Perspectives on Economic Growth (Random House, 1968). Because the contributors to this volume are outstanding, it may not be inappropriate to mention that the chapters dealing with stabilization policy and monetary theory provide examples illustrating the several questionable tendencies just sum marized. Obviously these tendencies are not just limited to those whose understanding of the income theory may be questioned. It is for this reason that I do not regard these characteristics as analytical errors, but think of them as “methodological commitments” that may have become burdensome, and perhaps analytically oppressive. 26See the cogent analysis by A. Wojnilower, “Blowing Hot and Cold,” First Boston Corporation (September 1968). F E D E R A L R E S E R V E BA N K OF ST. LO U IS J A N U A R Y 1970 money stock which takes place in the midst of an inflation will not only raise prices but also raise market interest rates. Nevertheless, if true, it suggests that an incredibly optimistic theory —based on a refusal to acknowledge the endogeneity of real cash balances and its implications for diverging nominal and real rates —may have contributed directly to the infla tionary pressures which are still continuing; and it may also have contributed to our 1966 stabilization diffi culties, if the authorities believed that monetary ex pansion would bring about lower interest rates.27 The stabilization difficulties that we have experi enced since 1965 may be related to two questionable propositions about money, which are implicit in many income-expenditure models: (1) that the authorities can affect real balances if they can control the nominal stock of money; and (2) that the authorities can in fluence real rates through central bank operations which change nominal market rates. Although both of these propositions are generally accepted, they have only a limited validity, and may lead to serious policy errors when applied to a high-pressure economy such as the United States in the post-1965 period. In an underemployed economy, nominal quantities and nominal rates may move with real quantities and real rates, and real balances may be sufficiently flexi ble to be treated as a policy variable. But in a highpressure economy with rising prices, nominal and real quantities no longer coincide; the real (value of the) money stock cannot be treated as a policy variable, and an increase in the money stock will not only raise prices but will raise market interest rates as well. A similar question arises regarding the behavior of interest rates. In a slack economy market interest rates and real rates move together; but in a high-employment econ omy with rising prices, market rates and real rates may diverge (see accompanying table). Indeed, in a period of price inflation, constant real rates are necessarily associated with rising market rates, so that movements in the market rates cannot always correspond to real rates. need to investigate empirically when movements in interest rates and in money balances begin to diverge, and whether the divergence between real and nom inal interest rates is related to the divergence between real and nominal balances.28 The endogeneity of the real (value of the) money stock, as indicated by the divergence between nominal and real balances and by the divergence between real and market interest rates, is thus a manifestation of an economy approaching full utilization. And we Many investigators have commented on the mone tary lag, and have suggested that because of this lag we would expect very sharp movements in inter est rates —as the initial response to changes in the money stock. It is not clear how the monetary lag may be affected by the divergence between market and real interest rates and between nominal and real balances. Knowledge of the conditions when real and nominal balances diverge, of the process that causes interest rates to diverge, and of the mechanism through which the monetary lag operates, should be useful in improving stabilization policy. It would also help rec 27The fear of overkill articulated by influential sources in the summer of 1968 may have served to reconcile the views of those who favored the tax increase primarily as a stabiliza tion measure to cool the inflation with the views of those who favored the tax increase to shift the policy mix to achieve lower interest rates and stimulate socially desirable capital expenditures. 28Somewhere between the slack economy and the inflationary high-pressure economy there is a change in the relation be tween nominal and real balances and between nominal and real rates. Responsible policy officials must therefore identify and take account of the divergence between nominal and real rates, especially if they follow an interest rate criterion and use money market rates in the implementation of mone tary policy decisions. Page 19 F E D E R A L R E S E R V E BA N K OF ST. LO U IS oncile the income-expenditure and modem quantity theories and thus help complete the work initiated by Keynes by providing us with a truly general theory of employment, interest and money. The Non-Monetary Theories of Price Level and Inflation It is hardly an exaggeration to say that we do not have a satisfactory theory of the price level or of in flation. The post-Keynesian income and modem quan tity theories provide different income determination models: the income-expenditure theory emphasizes the consumption function and other income-expenditure relationships; while the modem quantity theory em phasizes the demand for money and portfolio adjust ments.29 As theories of national income both theories have limitations, as we have just noted, and neither theory provides us with an articulated theory of the price level and a basis for allocating a given change in national income into the fraction due to real output and the fraction due to price level changes. The modern quantity theory, in the absence of an explicit theory of the price level, nevertheless assumes a link between money and prices, and views move ments in the absolute price levels and inflationary (or deflationary) pressures as reflecting current and past changes in the money stock. The income-expenditure theory de-emphasizes any direct link between mone tary assets and prices, and highlights non-monetary factors in explaining upward movements in the price level and inflation. This is particularly evident in the recent large scale econometric models (Brookings, Michigan, Wharton, FRB-MIT), which do not in corporate monetary (or fiscal) variables directly to explain the price level; they base the prediction equa tions for the absolute price level on concepts and empirical regularities that may be appropriate for micro-analysis and for the determination of relative price movements.30 29The capital-theoretic orientation of the post-Keynesian quan tity theory, emphasizing portfolio choice and the substituta bility of money for other assets, has been heavily influenced by the Keynesian Liquidity Preference theory. Unlike the older quantity theory based either on the payments rela tions of the transactions approach or the store of value re lations of the Cambridge approach, it follows the Keynesian theory in treating the demand for money as a problem in capital theory, focussing on the composition of the balance sheet and the selection of assets. See J. Tobin, “A Dynamic Aggregative Model,” Journal of Political Economy, April 1955, and “Liquidity Preference as Behavior Toward Risk,” Review of Economic Studies, February 1958; and M. Fried man (ed), Studies in the Quantity Theory of Money, op. cit. 30In their progress report on the Federal Reserve-MIT model, F. DeLeeuw and E. Gramlich summarize the findings of the econometric models as follows: “The evidence from several of the large econometric modPage 20 J A N U A R Y 1970 As an illustration, consider the recent ( preliminary) FRB-MIT model of the price-wage-labor sector which follows the other large scale models in basing prices on unit labor costs, other markup factors, and intro duces additional variables to pick up the influence of demand shifts or oligopoly pricing.31 This is essen tially a non-monetary theory of the price level. It seems to suggest that a general excise or uniform sales tax (10 per cent on all commodities) would raise prices; yet an income tax, designed to yield the same dollar amount, would presumably lower prices and certainly not cause them to rise. But a conclusion that a uniform excise tax raises the price level, while an income tax which produces equivalent revenue would lower prices seems paradoxical. Moreover, since there are no explicit specifications given for the money stock we have the following strange results: (1) an excise tax may be inflationary even when the revenue is impounded and the stock of money is reduced; and (2) an income tax is deflationary when the stock of money is maintained, or even when allowed to grow at an accelerated rate. This paradox illus trates the difficulties of explaining absolu te price level movements with concepts that are appropri ate for relative price analysis, and of using an els —the Wharton School Model, the Commerce Depart ment Model, the Michigan Model, and to a lesser extent the Brookings Model —is that monetary forces are rather unimportant in influencing total demand.” See F. DeLeeuw and E. Gramlich, “The Channels of Monetary Policy,” Federal Reserve Bulletin, June 1969. The Brookings model is presented in J. Duesenberry, et al., The Brookings Quarterly Econometric Model of the United States (Chicago, 1965); The Michigan model is pre sented each year at a conference and later published in a volume. The Economic Outlook for 1969 gives the 1969 model presented at the November 1968 conference. The FRB-MIT model is described in F. DeLeeuw and E. Gram lich, “The Federal Reserve-MIT Econometric Model,” Fed eral Reserve Bulletin, January 1968, and in “The Channels of Monetary Policy,” Federal Reserve Bulletin, June 1969. The Wharton model is presented in M. Evans and L. Klein, The Wharton Econometric Forecasting Model (University of Pennsylvania, 1967). :!1F. DeLeeuw and E. Gramlich in “The Channels of Mone tary Policy”, op. cit., describe it as follows: “Prices are assumed to be a variable markup over wages, with excise taxes completely shifted onto consumers. The variables determining the markup are the productivity trend which allows producers to maintain profit shares even though wages rise faster than prices, farm and import prices which measure other costs, and the ratio of unfilled orders to shipments, which indicates demand shifts.” For a criticism of the price level equations in the Brook ings model see Z. Griliches, “The Brookings Model Volume: A Review Article,” Review of Economics and Statistics, May 1968, especially his discussions of prices and wages, pp. 221-223, and the rejoinder by G. Fromm and L. Klein, especially pp. 237 and 238. For a more recent attempt to develop price equations without bringing in monetary fac tors explicitly see O. Eckstein and G. Fromm, “The Price Equation,” American Economic Review, December 1968. F E D E R A L R E S E R V E BA N K OF ST. LO U IS aggregative theory that does not incorporate any d irect influence of money on prices.32 The drift towards non-monetary theories of the absolute price level is not a new development in the 1960’s; it has been going on steadily since the end of World War II. And though these theories may have descriptive (or analytical) relevance in suggesting either the initiating factors, or the process in particu lar price level movements, they are not easily inte grated into a coherent set of anti-inflationary policies. Moreover, if the absolute price level is indeed a func tion of unit labor costs, markup factors, new or un filled orders, and other non-monetary factors, then it does sharply limit the scope of the traditional stabili zation measures which are geared to a demand infla tion. In addition, the focus given to the non-monetary aspects by the theorists of the “new inflation” may have also diverted attention from the “classical infla tion” due to expansive monetary-fiscal policies. The conjuncture of all these factors may help explain our inability to identify and deal effectively with the post1965 inflation in the United States. The following six-stage sketch of inflation theory, which summarizes its evolution since World War II, illustrates the shift in emphasis away from the effects of aggregate demand on prices, toward an emphasis of the effects of costs and aggregate supply. The purging of monetary variables from inflation (and price level) theory is also pointed out. One inference emerging from this sketch is that more attention needs to be given to the monetary aggregates and their effect on aggregate demand, if we wish to im prove our ability to forecast price level developments and deal more effectively with inflation.33 (1 ) The “inflationary gap” analysis developed by Keynes during World War II focused on an econ omy where prices were rising because of an excess of aggregate demand over supply. Unlike the 32For a discussion of this issue see H. Brown, “The Incidence of a General Output or a General Sales Tax” in AEA Readings in the Economics of Taxation (Irwin, 1959); E. Rolph, Theory of Fiscal Economics ( University of California, 1954); R. Musgrave, The Theory of Public Finance (Mc Graw-Hill, 1959); and A. Morag, On Taxes and Inflation (Random House, 1965). 33Professor G. Haberler is an outstanding exception to this tendency. His Inflation: Its Causes and Consequences (Wash ington, 1966), first published in 1961, emphasized the need for coordinated monetary and fiscal policy in fighting a demand inflation. For a survey of inflation theory see M. Bronfenbrenner and F. Holzman, “Survey of Inflation Theory,” American Economic Review, September 1962; H. Johnson, Essays in Monetary Economics (London, 1967), especially Chapter 3; and S. Rousseas (ed), Inflation: Its Causes, Consequences and Control (New York University, 1968). J A N U A R Y 1970 classical quantity theory formulation, it did not assume any particular link from money to ag gregate demand, but was intended as an improved theory of an excess-demand inflation. This ap proach fell into disfavor when the postwar em ployment forecasts for 1946 and 1947, based on inflationary gap analysis, turned out very badly, and it was widely recognized that the incomeexpenditure relations were not properly specified in monetary terms. Not surprisingly, this analysis went out of style at the end of the 1940’s. (2 ) Since the early 1950’s, the post-Keynesian income models have typically emphasized the role of ag gregate demand in employment while de-emphasizing its impact on price level movements. One of the earliest cost inflation theories — the wagepush model — was accepted by many neo-Keynesians as an explanation of the creeping inflation of the 1950’s; and it seemed to be a consistent application of the Keynesian doctrine that a cut in the money wage will cause prices to fall (by the same amount) and will not, therefore, stim ulate employment in the depressions. The Key nesian view that the real wage is determined independently, and not influenced by changes in the money wage, would also seem to suggest that rising prices are due to rising wages. Later ver sions of cost inflation models stressed markup pricing, sectoral shifts, and administered (nonmarket clearing) prices. And since creeping infla tion was generally associated with a reduction in aggregate supply due either to rising factor costs or to shifts in demand, it seemed to follow quite naturally that a reduction in aggregate demand was not an appropriate policy for fighting inflation. The wide acceptance of the thesis that the creeping inflation of the 1950’s (viewed as the typical inflation of advanced industrial countries) was basically an aggregate supply phenomenon had two important consequences: it rationalized the view that monetary policy should play only a very minor role in fighting inflation; and it also lent support to the view that the stabilization authori ties should focus directly on the behavior of wages and prices and explore new stabilization tech niques such as incomes policies, wage-price guideposts, and possibly including indicative planning and other techniques of supply management.34 (3 ) Reinforcing the idea that creeping inflation was an aggregate supply phenomenon, and requiring therefore a national wage-guidepost (or incomes) policy, was the growing skepticism about whether monetary policy could play any constructive role in stabilization. First, there was a general concern that a restrictive monetary policy would reduce output but not succeed in lowering prices; second, it was suggested that the monetary authorities may not always be able to control the stock of 34See the Joint Economic Committee volume on The Relation of Prices to the Economic Stability and Growth (Washing ton, 1958) for a fairly comprehensive compendium of non monetary inflation theories that were developed to explain the creeping inflation of the 1950’s. Page 21 F E D E R A L R E S E R V E BA N K OF ST. LO U IS privately held liquid assets through their control of the money stock; and finally, that aggregate demand was functionally related to the total vol ume of liquid assets and not to one component of this total — such as the narrow money stock.35 (4 ) The cost inflation models assume that creeping inflation (unlike galloping inflation) is an aggregate supply phenomenon and not due to an increase in aggregate demand. They differ only in the specific mechanism that they single out: some focus on unions and wage-push; others on markup pricing, on market power and bargaining strength, and on administered prices. But they all assume an autonomous rise in factor costs, a reduction in aggregate supply, and a rise in prices, even though aggregate demand is stable. Similarly, although the demand-shift inflation model does not initiate the process with an autonomous rise in factor costs, it follows the cost models in ex plaining the price rise without introducing any notion of excess demand. (5 ) At the close of the 1950’s, Samuelson, Solow, and others developed the “trade-off” analysis of creep ing inflation. They start with a Phillips Curve — a function relating unemployment and percentage changes in money wage rates — and derive from this a trade-off function — which relates unem ployment and the rate of price change. They sug gest that the unemployment rate at a stable price level may be unbearably high and socially unac ceptable, and that we may have to accept a given degree of inflation (a specified rise in the price level) if we wish to lower the unemployment rate. If this trade-off function, incorporating a dynamic money-illusion effect, applies to the steady-state and is not just a temporary phenomenon, it implies that the degree of inflation is related to the level of unemployment that society will tolerate. It also suggest that we may have inflationary recessions — even substantial unem ployment does not necessarily guarantee us a sta ble price level. From an analytical point of view this theory is a radical departure from traditional analysis in assuming that real variables (the level of employment and of output) are not independ ent of nominal variables (the price level), even in the long run.38 35For a good example of the growing skepticism about the role of monetary policy in stabilization and the acceptance of the “New Inflation” theory see The Joint Economic Com mittee Staff Report on Employment, Growth and Price Levels (Washington, 1959). See the review by H. P. Minsky, “Employment, Growth and Price Levels: A Review Article,” The Review of Eco nomics and Statistics, February 1961, and the analysis of the inflation theory in the “Staff Report,” in G. Haberler, op. cit. See also G. G. Kaufman, “Current Issues in Monetary Economics and Policy: A Review,” op. cit., for a discussion of the monetary issues. 36Although the trade-off function between unemployment and inflation is widely accepted, its interpretation does pose several questions for inflation theory: Are the trade-off estimates, interpreted as long-run steady-state relations, Page 22 J A N U A R Y 1970 (6 ) Finally, some economists have recendy attempted to analyze inflation in terms of a disequilibrium model — thus generalizing the earlier Keynesian wage-push theory to cover sellers’ inflation and administered (non-equilibrium) prices. In their model actual prices, and especially wage rates, are very often somewhere between the demand and supply price, and do not, therefore, satisfy either the demand function or the supply func tion; market prices and wages are determined in their view by market power and relative bargain ing strength. In this model it is possible to have both buyers’ and sellers’ inflation.37 This review of inflation theory illustrates the pro liferation of non-monetary price level and cost infla tion theories since the end of World War II, stressing (a) autonomous increases in factor costs, (b) shifts in demand, (c) administered prices and market power, (d) the trade-off function between unem ployment and price level changes, and (e) mar kets in disequilibrium. These “new inflation” theories reflect a growing consensus among income-expenditure theorists throughout this period that monetary variables are not the causal, independent, or active factors affecting output, employment, or prices. The wide spread acceptance of these new inflation theories, both in the academic world and in business circles, seemed to vindicate the monetary views of the in consistent with our accumulated experience with inflation? Are the trade-off estimates, which assume a long learning period, consistent with our theories of anticipated inflations and expectational behavior? Does the trade-off analysis suggest any role for monetary policy in avoiding or in combating inflation by shifting the trade-off function? And is such a role consistent with the growing volume of empirical studies of the monetary sector? The Samuelson and Solow article developing the trade off analysis by utilizing the Phillips Curve is given in P. Samuelson and R. Solow, “Analytical Aspects of AntiInflation Policy,” American Economic Review, May 1960; and empirical estimates of the Phillips Curve and the trade-off function are presented in George L. Perry, Unemployment, Money Wage Rates, and Inflation (Cambridge: The M.I.T. Press, 1966); Ronald G. Bodkin, The Wage-Price-Productivity Nexus (Philadelphia: University of Pennsylvania Press, 1966); and Roger W. Spencer, “The Relation Be tween Prices and Employment: Two Views,” in the March 1969 issue of this Review. See the discussion of Phillips Curves and trade-off functions in A. Bums and P. Samuel son, Full Employment, Guideposts and Economic Stability (Washington, 1967); and Solow’s paper, “Recent Contro versy on the Theory of Inflation: An Eclectic View,” in S. W. Rousseas, op. cit.; see G. Haberler, “Stability Growth and Inflation,” a chapter in a forthcoming volume dealing with these issues, and D. Fand, “On Phillips Curves ana Trade-off Functions,” a paper presented to the Canadian Economics Association meetings, Toronto, Canada, June 5, 1969 for a discussion of the Phillips (U,W ) function, and its relation to the Samuelson-Solow (U ,I) trade-off function. 37For a statement of this disequilibrium model see A. P. Lemer, “On Generalizing the General Theory,” American Economic Review, March 1960. For a different interpreta tion, see A. Leijonhufvud, op. cit. F E D E R A L R E S E R V E B A N K OF ST. LO U IS come-expenditure theorists, and helped explain the experiments —in the United States and in Western Europe —with new inflation weapons such as incomes policies, wage-price guideposts, indicative planning and other elements of supply management. Nevertheless, the failure to introduce monetary variables in the analysis of the price level and in inflation theory does seem strange. Whatever rele vance or validity these non-monetary theories may have had in explaining, or in providing, effective policies for coping with the creeping inflation of the 1950’s, they are clearly inappropriate for the inflation of the 1960’s. A credible explanation of our recent inflation surely must take account of excess demand and the high rates of monetary expansion since 1965. Whether or not this rate of monetary expansion was inevitable, given the Vietnam War, it surely played a major and substantial role in our recent inflation. The tendency to exclude any direct influence of money on prices and to stress real (non-monetary) factors in explaining the absolute price level has gen erated an intellectual climate in which it is easy to neglect the behavior of the monetary aggregates. And when income-expenditure theorists highlight the effect of monetary policy on interest rates, they necessarily minimize the effect on prices, for this is implicit in al lowing real balances to behave as if they were a policy variable. In consequence, when they were faced with the need to explain the creeping inflation and price level movements of the 1950’s, they sought to locate the cause among the aggregate supply variables such as wage-push, markups, sellers’ inflation, or in demand shifts. Admittedly, this inflation theory was not de signed to serve as the analytical model for analyzing a demand inflation such as that we have experienced since the Vietnam escalation in 1965. Nevertheless, the stressing of real factors in the theory of the price level has made it difficult for many income-expenditure theorists to see the relevance of the substantial growth in the money stock in the recent inflation, even while freely conceding that it is a classical demand inflation. Our experience since 1965 suggests that we direct our attention to the money stock and its effect on aggregate demand and prices. It also suggests that the emphasis given to real factors in explaining the post-1965 infla tion and to discretionary fiscal policy for coping with it, and the relative neglect of the monetary aggre gates, is an inheritance from the past that needs to be re-examined.38 38See D. Fand, “The^ Chain Reaction-Original Sin (CROS) Theory of Inflation,” op. cit.; “A Monetary Interpretation of the Post-1965 Inflation in the United States,” op. cit.; and “Keynesian Monetary Theories, Stabilization Policy, and the Recent Inflation,” op. cit. J A N U A R Y 1970 Fiscal Policy Assumptions and Related Multipliers The theory of fiscal policy highlights the direct income-generating effects of government deficits and surpluses and the stabilization aspects of the cumula tive multiplier expansion process; but the theory often ignores the interest rate or capital market effects, and invariably abstracts from any associated money stock effects. The simplest presentation may be summarized as follows: an increase in government spending is viewed as a direct demand for goods and services; reductions in tax rates are viewed as directly affecting consumer spending, investment, and aggregate demand; and the initial increase in spending is viewed as setting off a cumulative expansion as given by the multiplier process.39 More advanced discussions go beyond the 45° diagram, introduce the Hicksian IS-LM analysis to account for the capital market effects of changes in fiscal policy; but even this more advanced analysis typically abstracts from the money creation aspects that may be associated with a cumulative expansion. A widely quoted statement describing the “Work ings of the Multiplier” in the Economic Report of the President for 1963 illustrates this tendency to omit the capital market and money creation aspects.40 The direct income-generating effects of the deficit are stressed, but no indication is given whether the rise in income requires stable interest rates, an elastic monetary policy, or a deficit financed through the banking system. Thus, the case for a discretionary tax cut and a reduction in the full-employment smv plus, as presented by the Council of Economic Ad visers (CEA) in 1963, does not bring in any explicit discussion of the method in which the deficit is fi nanced. Their position is stated as follows: Tax reduction will directly increase the disposable income and purchasing power of consumers and business, strengthen incentives and expectations, and raise the net returns on new capital investment. This will lead to initial increases in private con sumption and investment expenditures. These in 39The volume of readings, American Fiscal Policy: Experi ment for Prosperity (Prentice-Hall, 1967), edited by L. Thurow, is a good example. With very few exceptions, the individual papers either abstract from, or ignore, monetary factors, and do not cite any empirical evidence to justify the strategic role assigned to discretionary changes in the full-employment surplus. It appears that such justification was not felt necessary, because the very substantial growth in GNP since 1964 was widely interpreted as the result of the 1964 tax cut and reduction in the full-employment surplus. 40See the section, “Workings of the Multiplier” in the Eco nomic Report of the President for 1963. This is reprinted in A. M. Okun (ed), The Battle Against Unemployment (Norton, 1965), pp. 88-97. Page 23 F E D E R A L R E S E R V E BA N K OF ST. LO U IS creases in spending will set off a cumulative expan sion, generating further increases in consumption and investment spending and a general rise in pro duction, income and employment. The analysis of the 1964 tax cut presented by Arthur Okun in 1965 explicitly justifies the omission of any capital market or monetary effects.41 Although Okun accepts the view that significant changes in the cost or availability of credit would have an important influence on business investment, he does not make allowance for these factors in his quantitative estimates of the multiplier. He rationalizes his procedure as follows: . . . in practice, dealing with the period of the last year and a half, I cannot believe that the omission of monetary variables can make a serious differ ence. By any measure of interest rates or credit conditions I know, there have been no significant monetary changes that would have either stimulated or restrained investment to a major degree. He does concede that “the maintenance of stable in terest rates and stable credit conditions requires mone tary action” and that at least to this extent, “monetary policies have made a major contribution to the ad vance.” But in his view, “that contribution is appro priately viewed as permissive rather than causal.” Okun’s analysis, presented in August 1965, attributing the GNP expansion to the tax-cut multiplier, was a strict fiscal policy interpretation, in contrast to other (monetary and eclectic) interpretations that were presented at that time.42 His analysis was not modi fied when it was published in 1968.43 If the fiscal approach, with its multiplier analysis, emphasizes the deficit or surplus and relegates both the interest rate and the money creation aspects to a 41Okun’s analysis of the 1964 tax cut was presented at the 1965 meetings of the American Statistical Association. His paper, “Measuring the Impact of the 1964 Tax Reduction” has been published in W. Heller (ed), Perspectives on Economic Growth, op. cit., pp. 25-51. 42See D. I. Fand, “Three Views on the Current Expansion” in G. Horwich (ed), Monetary Process and Policy: A Sympo sium (Irwin, 1967), analyzing the views of the fiscal pro ponents, the monetary proponents, and those who take an eclectic position. See also A. F. Bums, The Management of Prosperity (Columbia University Press, 1966); M. Friedman, “The Monetary Studies of the National Bureau,” reprinted as Chapter 12 in his The Optimum Quantity of Money, pp. 261-284; B. Sprinkel, “An Evaluation of Recent Federal Reserve Policy” in the Financial Analysts Journal, August 1965; and G. Morrison, “The Influence of Money on Eco nomic Activity,” in the 1965 Proceedings volume of the American Statistical Association. 43Okun, in a note added in June 1967 to his 1965 analysis of the tax cut, does concede that “any analysis of fiscal impact that covered the more recent period could no longer treat monetary policy as a passive supporting force, nor could it continue to ignore the influence of higher levels of aggregate demand on prices.” See W. W. Heller (ed), op. cit., pp. 27-28. Page 24 J A N U A R Y 1970 secondary role, the monetary approach emphasizes the money stock effects. To the monetarist, the im pact of fiscal actions will depend crucially on how the government deficit is financed: expenditures fi nanced either by taxing or borrowing involve a trans fer of resources (from the public to the government), with both interest rates and wealth effects on private portfolios, but the net effect of a temporary change in fiscal policy on spending may be ambiguous. Simi larly, the effect of a reduction in taxes on private demand, financed through borrowing, will depend on (1) the extent to which it is viewed as a permanent, or temporary, tax cut, and (2) its effect on market interest rates. Accordingly, the direct income-generating effects of a deficit —the pure fiscal effect —may be quite small and uncertain. On the other hand, if the deficit is financed through money creation by the banking system —if the deficit is monetized —the ef fect is unambiguously expansionary. Many income theorists recognized that the multi plier analysis based on the 45° diagram was inade quate, and modified their analysis to take account of interest rate effects through the Hicksian IS-LM frame work. But even this modification, while a step in the right direction, does not really make allowance for the money creation aspects of deficits. What is needed is a macroeconomic model, where the monetary ef fects of the deficit are taken up by introducing an explicit government budget restraint. Recent studies along these lines suggest that many of the standard propositions about the multiplier need to be revised.44 Aside from these theoretical reasons, the need to separate out the monetary effects from the fiscal ef fects has been highlighted by the recent AndersenJordan study, testing the relative effectiveness of monetary and fiscal actions in stabilization.45 Their re44See L. S. Ritter, “Some Monetary Aspects of Multiplier Theory and Fiscal Policy,” Review of Economic Studies, February 1956; C. Christ, “A Simple Macroeconomic Model with a Government Budget Restraint,” Journal of Political Economy, January 1968; and J. M. Culbertson, Macroeco nomic Theory and Stabilization Policy (McGraw-Hill, 1968), pp. 462-464. See also K. M. Carlson and D. S. Karnosky, “The In fluence of Fiscal and Monetary Actions on Aggregate De mand: A Quantitative Appraisal,” Working Paper No. 4, March 1969, Federal Reserve Bank of S t Louis; and K. M. Carlson, “Monetary and Fiscal Actions in Macroeconomic Models: A Balance Sheet Analysis,” an unpublished manu script, for an interesting attempt to define and estimate the monetary effects of fiscal policy actions. 45The Andersen-Jordan results are presented in “Monetary and Fiscal Actions: A Test of their Relative Importance in Stabilization,” op. cit. See also the Comments of DeLeeuw and Kalchbrenner, and the Reply by Andersen and Jordan, op. cit., and R. G. Davis, “How Much Does Money Matter: A Look at Some Recent Evidence,” op. cit.; the earlier study by M. Friedman and D. Meiselman on “The Relative F E D E R A L R E S E R V E BA N K OF ST. LOL’IS J A N U A R Y 1970 suits, while preliminary and subject to further testing, do suggest that the theory of fiscal policy (in the income-expenditure framework), with its emphasis on discretionary changes in the full-employment surplus as the key stabilization instrument, may be incorrect or only partially correct. Their findings also suggest that the tax and expenditure multipliers, as estimated in many income models, tend to confound a ceteris paribus fiscal action (excluding money stock effects), with a mutatis mutandis fiscal action ( incorporating both monetary and fiscal effects). action with restrictions on the growth rate for the monetary aggregates that is acceptable to the mone tarists. A revision of multiplier theory along these lines would enable us to distinguish analytically, and estimate, ceteris paribus fiscal and monetary multi pliers, and thus bridge some of the gap between the income-expenditure theory and the quantity theory. But it requires that we find an acceptable method to separate out endogenous and exogenous changes in the money stock, and to estimate empirically the money stock effects of deficits and surpluses. The need to revise the standard multiplier theory and to develop more discriminating empirical tests of the relative effectiveness of monetary and fiscal actions is recognized even among fiscal policy advo cates. There is a significant modification of the multiplier theory in the Economic Report of the President for 1969, stressing two points in particular: (1) “the results of this multiplier process are affected by the amount of unused resources available in the economy”; and (2) monetary policy does affect the magnitude of the multiplier: Fiscal deficits are obviously often associated with, if not directly responsible for, substantial increases in the monetary aggregates. Our recent experience re minds us once again that a fiscal deficit, financed by the banking system, will tend to accelerate the growth in the money stock; while a fiscal surplus, whether impounded or used to retire debt, will tend to deceler ate the money stock growth. And if the fiscal deficit is financed in part through accelerated monetary expansion, as was the case since the Vietnam escala tion in 1965, the growth in GNP reflects the combined effects of fiscal and monetary action. Developments in financial markets may influence the magnitude of the multiplier. Increases in de mands for goods and services will tend to enlarge credit demands. Unless monetary policy permits supplies of funds to expand correspondingly, in terest rates will rise and credit will become less readily available. In that event, some offsetting re duction is likely to take place in residential con struction and other credit-sensitive expenditures. Generally this will be a partial offset, varying ac cording to how much the supply of credit is per mitted to expand.46 There is therefore a growing consensus that multi plier theory needs to separate out the monetary ef fects from the pure fiscal effects, in order to develop meaningful tests of the relative contribution of mone tary and fiscal policy in stabilization. In particular, we need to define and measure monetary variables so as to separate out exogenous changes in the money stock, resulting from actions taken by the monetary authorities —from endogenous money stock changes —resulting from shifts in the demand for money, so as to remove the identification problem in a manner that is acceptable to the income-expenditure theorists. We also need to define a pure ceteris paribus fiscal Stability of Monetary Velocity and the Investment Multi plier in the United States, 1897-1958” in Stabilization Poli cies (Prentice Hall, 1963), and the subsequent discussion of this study by F. Modigliani and A. Ando, and by T. Mayer and M. DePrano in American Economic Review, September 1963. 46See The Economic Report of the President for 1969, p. 72. Monetary policy, measured in terms of the money stock, typically changes in the same direction as fiscal policy. Accordingly, what we observe in most periods (like the 1964 tax cut) is the effect of a combined action incorporating both monetary and fiscal elements. It is therefore fortunate for the development of sta bilization theory that they were working in opposite directions on two occasions in recent years —thus providing an interesting test case. In 1966 a sharp increase in the deficit was matched by a very substan tial tightening in monetary policy; and the crunch in the latter half of 1966 and the mini-recession in early 1967 clearly demonstrate the power of monetary pol icy. Similarly in 1968, the very substantial increase in the full-employment surplus enacted in the June 1968 Revenue and Expenditure Control Act (and giving rise to widespread fear of overkill ) was apparently offset by the preceding and subsequent growth in the monetary aggregates. In these cases, the mone tary forces seem to have been the stronger ones, not relatively minor (or permissive) factors that can only accommodate (or validate) fiscal policy actions. Hence there has been renewed interest in their relative con tribution to stabilization. This, then, brings us to our first question: How do we define the ceteris paribus fiscal action if monetary policy and fiscal policy often move in the same direc tion? The income-expenditure theorists, who define this Page 25 F E D E R A L R E S E R V E BA N K OF ST. L O U IS J A N U A R Y 1970 as a fiscal action with interest rates held Table II constant, are calibrating monetary policy in IN D IC A T O R S O F M O N E T A R Y ( A M ) A N D FISCAL ( A E ) a manner which is consistent with their view IN FLU EN C ES O N E C O N O M IC AC TIVITY ( A Y ) of the transmission mechanism. On this defi nition, a ceteris paribus fiscal deficit may re A Y = a0 + ai am -f- a2 AE quire a very substantial increase in the stock (Q uarterly First Differences — Billions of Dollars) of money, and appears to the monetarist as a Time Periods Lags* R2 ai Am a2 A e ao mutatis mutandis effect. To the monetarist, a (sum ) (sum) D -W ceteris paribus deficit requires a given money 11/1919 — 1/69 t-6 1.92 2.89 -.0 7 .32 stock growth rate, which may lead to a rise (2.3 4 ) (4 .3 1 ) (.2 8) 1.15 in the interest rate; and to fiscal policy advo ** 11/1919 — 11/29 t-3 .36 5.62 .35 cates, this appears as an offsetting action 1.58 (.5 1) (3 .1 6 ) since the rise in interest rates (which they 111/1929 — 11/39 t-5 -.5 1 5 .40 -7 .9 7 .39 use to calibrate the posture of monetary (•54) (3 .4 1 ) (1.9 5 ) 1.86 policy) is restrictive and tends to offset the 111/1939 — IV /46 t-5 6.32 — 1.21 .66 .35 income-generating effects of the deficit. The (1 3 9 ) (.5 9 ) 1.60 (.8 1 ) ceteris paribus effect for deficits or surpluses, 1/1947 — IV /52 13.82 t-10 3.65 .72 — 3.37 (.8 4) 2.74 (3.5 1 ) (4.12) as defined by the m onetarist, will necessarily 1/1953 — 1/69 t-4 -.8 4 1.42 8.85 .47 differ from the definition adopted by the fiscal (.7 4) (4 .7 0 ) 1.71 (1 0 7 ) policy advocates. This point is illustrated in a recent study of monetary and fiscal in N ote: Regression coefficients are the top figures; their “t ” statistics appear below each coefficient, enclosed by parentheses. R 2 is the percent of variations in fluences on economic activity for the period the dependent variable which is explained by variations in the independent variable. D-W is the Durbin-Watson statistic. 1919-69.47 The evidence summarized in Table ♦Lags are selected on the basis of minimum standard error, adjusted fo r degrees I indicates that when we regress economic of freedom. ♦♦Fiscal variable omitted fo r 1919-29 because it increased the standard error of activity on fiscal policy, the relation is fairly the estimate. good. If, however, we include a monetary aggregate variable in the regression, we find, as shown marized in Tables I and II illustrates the problem of in Table II, that the ceteris paribus fiscal effect, as separating out the fiscal effect from the effect due to defined by the monetarist, is either statistically insig the monetary aggregate. nificant or has the wrong sign. The evidence sumThis difference in concepts helps explain the exist ence of a fairly pronounced communications gap. Toble I What a monetarist regards as a ceteris paribus deficit IM PA C T O F FISCAL IN FLU EN C ES ( A E ) may entail a rise in interest rates, and will therefore appear as an offsetting action to the fiscal advocate; O N E C O N O M IC A C T IV ITY ( A Y ) what a fiscal advocate regards as a ceteris paribus fiscal A Y = f0 + f i a e effect may entail accelerated growth in the money (First Differences — Billions of Dollars) stock, and will therefore appear as a mutatis mutandis ______ _________________ Lags*_______ fo_____ f i Ae (sum ) R3/ D -W monetary effect to the monetarist. This applies es 11/1919 — 1/1 969 t-6 3.83 .81 .13 pecially to the analysis of the 1964 tax cut. (5 .1 6 ) (3.0 1 )________,96_ 11/1919-— 11/1929 t-7 1.73 (2 .4 4 ) 3 .27 (2 .7 8 ) .41 1.58 111/1929 — 11/1939 t-10 -3 .4 5 (2 .2 5 ) 18.28 (2 .1 8 ) .14 1.49 111/1939 — IV / 1 9 4 6 t-4 4.2 9 (2 .9 1 ) .53 (2 .1 1 ) .61 1.43 1/1947 —- IV / 1952 t-4 9.38 (3 .9 1 ) -1 .4 9 (1 .7 6 ) .09 .81 1/1953 - - 11/1969 t-3 6.08 (2 .9 5 ) 1.71 (2 .1 5 ) .08 1.13 N ote: Regression coefficients are the top figures; their “t ” values appear below each coefficient, enclosed by parentheses. R2 is the percent of variations in the dependent variable which is explained by variations in the independent variable. D-W is the Durbin-W atson statistic. ♦Selected on the basis of minimum standard error of estimate, adjusted fo r degrees of freedom. Page 26 The money stock effects of deficits and surpluses need to be quantified if we are to obtain a realistic formulation of the government budget restraint. Once this is done we may be able to estimate the differen tial effects of non-monetized and monetized deficits, and obtain acceptable estimates of fiscal multipliers — for the ceteris paribus and for the mutatis mutandis cases. We would also like to derive such estimates for the monetarist who calibrates monetary actions in 47Michael Keran, “Monetary and Fiscal Influences on Eco nomic Activity —The Historical Evidence” in the November 1969 issue of this Review. F E D E R A L R E S E R V E BA N K OF ST. LO U IS terms of the money stock growth, and for the fiscal advocates who calibrate monetary policy in terms of interest rates. Once this is done, we may be able to translate the results obtained in these two frame works. This should help bridge the communication gap, and it may also help reconcile the two opposing points of view.48 Conclusion In this paper we have discussed four issues in monetary theory which seem central to many of the recent discussions and debates concerning monetary policy. The first issue is the extent to which the cen tral bank can control the nominal money stock. This issue has been raised by those who find it more na tural to formulate Federal Reserve policy in terms of money market and instrument variables, by those who follow the interest rate transmission mechanism specified by the income-expenditure theory and prefer an interest rate criterion for policy making, and by those who believe that the money stock is, in part, an endogenous variable and therefore question whether it can serve as an indicator or target variable. We have tried to formulate these different viewpoints in terms of a money supply function, and reported results of empirical tests which compared the short-run money supply functions (excluding feedbacks from the real sector) with a longer-run, reduced form money supply function (allowing for feedbacks). Our preliminary findings seem to suggest that the central bank has sufficient control of the money stock to make it conform to a given set of guidelines, but that its control may be weaker (and less precise), the shorter the time period available to achieve a given objective. This would suggest that the degree of precision expected of the monetary authorities is not independent of the time period that they have to achieve the policy guidelines. 48A technique that enabled us to separate out exogenous changes in the money stock due to monetary policy from endogenous changes induced by the real sector would also enable us to estimate a ceteris paribus fiscal action in terms of exogenous money stock behavior. This approach would, in principle, be acceptable to the fiscal advocates. See K. M. Carlson and D. S. Karnosky, op. cit. The full-employment surplus (or deficit) is generally accepted as the best measure of fiscal policy, in preference to the actual surplus (or deficit), which is affected by the level of activity and behaves therefore more nearly like an endogenous variable. But the full-employment surplus is available only for the income and product budget and is tied to an income-expenditure framework. It may be de sirable to experiment with “similar” concepts (separating out endogenous effects) for the cash budget and the new, and comprehensive, liquidity budget, to determine which of these budgets provides the most useful measure of fiscal policy. J A N U A R Y 1970 The second question that we have explored is the relation between nominal and real quantities in the income-expenditure theory and modern quantity theory. The stabilization difficulties that we have ex perienced in the last several years may be related to two propositions about money which have been widely accepted in many of the income models. These are: (1) that the authorities can influence real balances if they can control nominal balances; and (2) that the authorities can influence real interest rates (and rates of return) by operations which change nominal market rates. Both of these propositions may lead to serious policy errors when applied to a high-pressure economy such as the United States in the post-1965 period. The third topic that we have considered is various theories of the price level and related frameworks for analyzing inflation. We find that there has been a tendency since World War II to divorce money from prices, to stress real factors in explaining the absolute price level, and to neglect even substantial movements in the monetary aggregates. Moreover, when income theorists highlight the short-run effect of money on interest rates —the liquidity effect —and treat it as a permanent effect, they necessarily mini mize the effect on prices. This corresponds to treating real balances as if it were a variable that could be influenced by the monetary authorities. Having ruled out any direct link between money and prices, income theorists necessarily explain the post-1965 rise in the price level by bringing in aggregate supply variables, other real sector developments, Vietnam escalation, and inappropriate fiscal policy, but continue to ab stract from the very substantial growth in the money stock and other monetary aggregates. The fourth problem that we have considered is that of defining ceteris paribus and mutatis mutandis fiscal effects. A ceteris paribus fiscal deficit —holding money stock growth constant —allows interest rates to rise and will therefore appear as an offsetting action to a fiscal advocate; while a ceteris paribus fiscal deficit — holding interest rates constant — allows money stock growth rates to increase, and appears as a mutatis mutandis effect to the monetarist. These concepts need to be defined both for the monetarists and the fiscal advocates, in order to translate the results obtained in the two frameworks. This may help bridge some of the communications gap in stabilization theory, and also help reconcile the two points of view. This article is available as reprint No. 51. Page 27 Reprint Series O V E R THE YEARS certain articles appearing in the R e v i e w have proved to be helpful to banks, educational institutions, business organizations, and others. To satisfy the demand for these articles, our reprint series has been made available on request. The following articles have been added to the series in the past year. Please indicate the title and number of article in your request to: Research Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Mo. 63166 N U M BER TITLE O F ARTICLE ISSUE 35. A Program of Budget Restraint 36. The Relation Betw een Prices and Employment: Two View s March March 37. M onetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization — Comment and Reply April 1969 38. Tow ards A Rational Exchange Policy: Some Reflections on the British Experience April 1969 39. Federal O pen M arket Committee Decisions in 1968 — A Y e a r of W a tc h fu l W a itin g M ay 1969 40. Controlling M oney M ay 1969 41. The Case for Flexible Exchange Rates, 1969 Ju n e 42. An Explanation of Federal Reserve Actions (1933-68) Ju ly 43. International M o n e ta ry Reform and “ the C raw ling Peg ” February 1969 Ju ly Comment and Reply 1969 1969 1969 1969 1969 44. The Influence of Economic Activity on the M oney Stock — Comment; Reply; and A d ditional Empirical Evidence on the Reverse-Causation Argum ent August 1969 45. A Historical A n alysis of the Credit Crunch of 1966 Septem ber 1969 46. Elements of M o n ey Stock Determination O ctober 1969 47. M o n etary and Fiscal Influences on Economic Activity — The Historical Evidence N ovem ber 1969 48. The Effects of Inflation N ovem ber 1969 (1960-68) 49. Interest Rates and Price Level Changes, 1952-69 December 1969 50. The N ew , N e w Economics and M onetary Policy Ja n u a ry 1970 51. Some Issues in M onetary Economics Ja n u a ry 1970
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