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FEDERAL RESERVE BANK OF ST. LOUIS JANUARY 1975 A Primer on Inflation: Its Conception, Its Costs, Its Consequences.......................... 2 Unusual Factors Contributing to Economic Turmoil An Address by Darryl R. F ra n cis ................. 9 The St. Louis Equation and Monthly D a t a .................................................... 14 Monetary Effects of the Treasury Sale of G o ld ............................................... 18 A Primer on Inflation: Its Conception, Its Costs, Its Consequences HANS H. HELBLING and JAMES E. TURLEY GREAT deal of public rhetoric has recently been advanced regarding our present problem of inflation. In fact, as the various price indices moved pro gressively higher, inflation was elevated to the posi tion of “Public Enemy No. 1” . As we crossed the bridge from single- to double-digit inflation, public discussion of inflation intensified. Concern has been expressed that that bridge might very well be burned behind us unless steps are taken immediately to assure a return trip to price stability. Implicit in a decision by society to seek a lower rate of inflation is some knowledge of the costs in volved. In particular, in demonstrating a willingness to endure some temporary hardship, society decides that the cost of allowing inflation to continue un checked exceeds the cost of pursuing a determined anti-inflation policy. For many of us, these costs are not always readily identifiable and certainly not perfectly predictable. The purpose of this article is to discuss in general terms, without attempting to quantify, the costs and consequences of inflation. Prior to that discussion, inflation is defined and an explanation is provided of how inflationary pressures develop. INFLATION: A DEFINITION In this article inflation is defined as a continuing rise in the average level of prices. Although this defi nition may seem fairly straightforward and generally acceptable to all, there are a few distinguishing fea tures which are often overlooked in its application. Specifically, there are three situations which do not necessarily fit this definition: 1) price increases of individual goods; 2) a once - and - for - all increase in the average level of prices; 3) a temporary increase in the average level of prices. It has been particularly popular in recent times to focus on the price increases of individual goods and Page 2 services and conclude, on the basis of that evidence, that inflation is running rampant. Individual prices neither cause nor lead to inflation, as defined above. What is missing is recognition of the fact that there are a myriad of individual prices which constitute a given average price level.1 At any point in time, there are some individual prices being affected by downward pressures, others by upward pressures. A measure of inflation is obtained only when the changes in all prices are considered. In essence, the price of one commodity may increase in a given period, but that reveals little about price changes in the whole uni verse of other commodities available for consumption. A once - and - for - all jump in the average level of prices could occur as a result of some sustained ran dom event, but a one - time rise does not affect the subsequent rate of increase in the average level of prices. Such a situation is depicted in the accompany ing diagram. The trend rate of inflation is indicated in Figure I by the slope of the line between t0 and tj. At point t, this trend is suddenly interrupted by some random event which, for example, causes a cut back in the supply of commodities available for con sumption. The reduced supply is now consistent with a higher price level. If the price adjustment were instantaneous, we would immediately observe a higher price level but no change in the rate of price increase. In the real world, however, the adjustment to the higher price level would not be instantaneous, but would probably be distributed over some time inter val. This is indicated by the dotted line between tj and t^. Over this adjustment interval, the rate of change in the price level is higher than the previous trend rate of inflation. But, it is noted that the trend rate is re-established after the adjustment is com pleted at point ta; that is, the higher rate of change in the price level during the adjustment period is not a “continuing” phenomenon. Therefore, at most this *For a discussion o f one measure o f changes in the price level, see Denis S. Kamosky, “ A Primer on the Consum er Price Index,” this R eview (July 1 9 7 4 ), pp. 2-7. JANUARY 1 9 7 5 F E D E R A L R E S E R V E B A N K O F ST. L O U I S Figure 1 Price Level Adjustment to a Random Shock Price Level (ratio scale) commodity will be employed to produce a new commodity or more of other existing commodities. THE DEVELOPMENT OF INFLATIONARY PRESSURES A Demand-Supply Imbalance Assuming the market is permitted to function, prices always and everywhere respond to the forces of de mand and supply. When the quantity of goods and services demanded at prevailing prices exceeds the available supply of goods and services, prices tend to rise, frequently with a considerable lag; conversely, when the supply of goods and services available for consumption at prevailing prices exceeds the quantity of those goods and services demanded, prices tend to decline, also with a considerable lag. situation can be referred to as a transitory bulge in the rate of change in the price level. The jump in the price level might be attributable to the operation of “special factors”; it would not be appropriate, how ever, to label this jump as an increase in the rate of inflation. Price is determined by the interaction of supply and demand forces. Both of these forces can be affected by temporary events which can alter their previous relationship. In such situations prices might change, but since the event is considered temporary and likely to reverse in some later period, a label of inflation is not consistent with the definition. For example, if the harvest of some particular crop is affected by un favorable weather conditions, the reduced supply will be distributed among buyers by a rise in the price of the crop. This occurs because at previously exist ing prices total quantity supplied falls short of total quantity demanded. Even though this individual price increase may alfect the average price level, such a de velopment need not be regarded as inflationary since by its very nature “it will be self-limiting, and . . . does not in itself represent any serious policy problem.”-’ Either the supply of the same commodity will in crease again in some later period, or the productive factors which are released in the production of one 2Harry G. Johnson, E ssays in M onetary E conom ics, 2d ed. (C a m b rid ge: Harvard University Press, 1 9 6 9 ), p. 104. Growth of aggregate demand for goods and services over time is influenced by economic policy actions, such as the growth of monetary aggregates and the tax and expenditure actions of the Government. For the most part, potential aggregate supply of goods and services tends to grow at a rate independent of stabilization policy actions. This rate of growth is determined by factors such as increases in the labor force, trends in hours worked, and advances in tech nology which affect productivity and efficiency.3 An effective anti-inflation policy, therefore, would be one in which aggregate demand is permitted to expand at a rate consistent with the expansion in aggregate supply. Noninflationary Actions According to the analysis presented in this article, inflation (that is, continuing increases in the average level of prices) is the result of excessive growth in aggregate demand relative to aggregate supply. Since it is generally recognized that the ability to influence aggregate demand exists, why do inflationary condi tions develop? The search for a cause ultimately leads one to look to the management of Government economic policies.4 :iIt should be noted, however, that there are situations in which stabilization policy actions can affect the level of output avail able for consum ption. As will be argued later, inflation (a policy-in d u ced ph en om en on ) affects production efficiency ad versely, w hich obviously affects the available supply o f goods and services. 4 In a recent question and answer session arranged with the Office o f W om en ’s Programs of the W hite House, Treasury Secretary W illiam E. Simon m ade the follow ing observations on G overnm ent’s contribution to the current rate o f price increases: “ Unsound governm ent policies include our threeyear experiment with w age and price controls. . . . Political Page 3 F E D E R A L R E S E R V E BANK O F ST. LO UIS Human nature is such that our demands for goods and services are insatiable; that is, we (individually and collectively) would prefer to consume more rather than less. The supply of resources available for con sumption, however, is always less than what we would like to consume. Given that the quantity demanded must exceed the quantity supplied for inflation to occur, does this imply that inflation is a perpetual develop ment buoyed by human nature? No; one must distinguish between what we would like to consume and what we are able to consume. The latter is determined by our wealth, or budget, constraint. JANUARY 1 9 7 5 F ig u r e II N o n in flatio n a ry Financing Com m and O ver O utput Equals Output Q u a n t it y Q u a n t it y of Y Q u a n t it y of Y Our constrained demand is an important element in discussing the development of inflationary pressures. To be somewhat more specific than earlier, inflation occurs when the amount of goods and services com manded (that is, the power which economic units possess for making purchases at current prices) persist ently exceeds the available supply of goods and services. Thus, the policy makers’ attention should be directed at maintaining balance between com mand over and supply of goods and services, assuming the avoidance of inflation is regarded seriously as an economic goal. The d ia g r a m s in F ig u r e s e x is t s and g o o d s. The e q u a ls t h e The p r ic e o f g o o d X b u d g e t . In p o in t w h e r e e x c lu s iv e ly III m ake t h a t th e in t im e s t h e of a concept re fe rre d p u rc h a se p ro d u c e s tw o m o n e y , w h ic h q u a n t it y a l g e b r a ic f o r m , t h e t h e li n e c r o s s e s t h e fo r th e u se econom y a b u d g e t , d e n o m in a t e d can to g o o d s--X be a s a b u d g e t c o n s t r a in t . F o r il lu s t r a t iv e and o f X , p lu s t h e p r ic e b u d g e t is re p re s e n t e d h o r iz o n t a l a x i s of good X ; t h a t is , Q x re p re s e n ts = p .T h e Y . In e m p lo y e d a d d it io n , it is o n ly f o r th e of good Y b y th e e x p re s s io n a s it u a t io n p o in t w h e r e w h e re th e lin e a ssu m e d th a t p u rc h a se o f th e se t im e s th e B = q u a n tity P j Qx tw o of Y + PyQ y. t h e b u d g e t is used c ro sse s th e v e r t ic a l B a x i s r e p r e s e n t s c o m p le t e e x h a u s t io n o f t h e b u d g e t f o r th e p u r c h a s e o f g o o d Y ; t h a t i s , 0 y = 'p ~ . B B ' H T h e p o s it i o n o f t h e b u d g e t l i n e d e p e n d s o n -p~ a n d ~p~. S h i f t s in t h e b u d g e t l i n e , t h e n , a r e t h e r e s u l t o f rx T c h a n g e s in th e l e v e l o f t h e b u d g e t ( B ) , t h e l e v e l o f p r ic e s ( P x , P y ) , o r b o t h . In t h e a b o v e d i a g r a m s , a l l o f t h e s h i f t s in t h e A visual presentation of the de velopment of inflationary pressures is displayed in Figures II and III. Fig ure II displays the noninflationary actions of indi viduals and Government, respectively. Figure III shows the inflationary actions of the Government and the induced price level change. In the analysis of the Government’s contribution to the economic climate, the following observations are pressures have long put a prem ium on excessive consum p tion. . . . M onetary policies have been overly stimulative. And Federal budget deficits have been spurring inflation since the early 1960s. “ In fact, to m y w ay o f thinking, these unsound m one tary and fiscal policies have been the most fundamental causes o f present-day rampaging inflation.” [U.S., Treasury D epart ment, Office o f Public Affairs, D e p a rtm e n t of the T reasury N ew s, N ovem ber 20, 1974, p. 4.] Page 4 II p u r p o s e s , it is a s s u m e d th e re b u d g e t li n e a r e th e r e s u l t o f c h a n g e s in t h e s iz e o f th e budg et (B ). made. It is recognized that Government exists to serve the people and that the people, in turn, collectively demand services provided by the Government. When efforts to provide more services lead to expenditures that exceed Government’s revenues, Government must extend its command over resources. The means by which this command is extended is a key considera tion in the determination of inflationary pressures. In the upper panel of Figure II, individual A de sires to increase current consumption above that com manded by his current income. Individual A decides that borrowing is the means by which he will increase F E D E R A L R E S E R V E BANK O F ST. L OUI S his share of available output.5 This is indicated by an outward shift in consumer A’s current budget con straint, or resource command, line. In making such a decision, individual A relinquishes claims to future consumption, to repay the loan, for the purpose of increasing current consumption. Individual B agrees to act as a lender and furnish the funds. This is in dicated by a leftward shift in B’s current budget constraint line. In so deciding, individual B foregoes a part of his current consumption for the sake of in creasing future consumption. In the process A has increased his current purchasing power by the same amount as B has decreased his current purchasing power. There is no change in the total command over available output, only a transfer of command from in dividual B to individual A. No inflationary pressures develop from this process. This same noninflationary process is observed in the lower panel of Figure II. Government, for one reason or another, deems it necessary to increase its com mand over goods and services, as shown by an out ward shift in the Government’s budget constraint line.0 So long as this task can be accomplished by siphoning funds from the private sector (a leftward shift in the private sector’s budget line), no upward pressure on prices develops. The transfer of purchasing power from the private sector to the Government takes place via explicit borrowing or tax increases. Inflationary Actions Figure III reveals the source of sustained price level increases. In this example, Government decides that money creation is the means by which it will extend its power to purchase, while the purchasing power of the private sector is initially unaffected. In the United States the process of money creation takes the follow ing form. In order to cover expenditures that exceed current receipts, the Government attempts to sell securities to the public at a fixed price. If the public is not willing to purchase all of these neio securities, the central bank intervenes in the securities market and purchases already outstanding Government se 5Another means b y w hich a consumer can increase his con sumption o f goods and services is to accept additional eniloyment. This alternative is not considered here, however, ecause in the aggregate it involves an increase in output, violating the im plicit assumption of a fixed supply of goods and services in the short run. ''Increasing Government com m and over goods and services does not necessarily mean that Government grows in size, that is, in terms of the amount o f people it em ploys or the amount o f resources it consumes. Rather, it is possible that the re distributive function o f Government increases; that is, pur chasing pow er is increased for those groups of society who are effective in convincing Government of their “ need” . JANUARY 1 9 7 5 curities from the public. In the process, the central bank gains an asset, the Government securities, and creates a liability, the money paid to the private sector which finances the purchase of the newly issued Government securities. In effect this procedure is tantamount to printing money. The Government has more funds available to spend, while the purchasing power of the private sector appears to remain unchanged. Based on nom inal measures, this method is appealing because it appears that no one is forced to relinquish command over output for the sake of Government’s gain — initially we might conclude that all of us are better off. Such, however, is not the case. There has been an increase in the total command over resources by an amount equal to the quantity of money created. Since the quantity demanded now exceeds available supply at current prices, the economy generates reactions which tend to restore economic balance. The most dominant “balance-restoring” reaction is price level change. This process is indicated in Figure III which shows that increased Government spending under written by monetary expansion results in a price level increase. This, in turn, reduces the private sector’s purchasing power and restores balance between out put and output commanded. If, however, the Govern ment maintains the policy of attempting to satisfy unlimited wants by, in effect, “printing money,” a continuous imbalance between supply and demand results and price level increases will persist.7 COSTS AND CONSEQUENCES OF INFLATION In the United States, as well as in many other countries, price stability has long been regarded as a desirable goal. For almost a decade, however, this goal has remained elusive. One reason for its elu sive quality has been the promulgation of the belief that the short-run cost of reducing the rate of inflation was greater than the cost of allowing inflation to con tinue unchecked. Another reason may be a lack of understanding of the causes and cures of inflation. Wage and price controls were a dramatic attempt to lower the rate of price increases while avoiding the "A G overnm ent-induced deficit is not necessarily the only means b y w hich an im balance betw een supply and dem and at prevailing prices occurs. For example, as noted earlier, if part o f the private sector desires m ore current consumption, enlarged loan dem and w ill exert upw ard pressure on interest rates. T he central bank, in an attempt to resist this upw ard pressure, may respond b y expanding the nation’s m oney supply. In this process, there is no corresponding reduction in consum ption in another part o f the private sector. Page 5 JANUARY 1 9 7 5 F E D E R A L R E S E R V E B A N K O F ST . L O U I S F ig u r e III In flatio n ary Fin ancing C om m and O ve r O utput E x ce e d s O utput In fla tio n -In d u ce d A d ju stm en t Q u a n t it y Q u a n t it y Q u a n t it y of Y of Y of Y In th e d ia g r a m d i a g r a m ) . In on th e th e fa r d ia g r a m le f t , th e G o v e r n m e n t ’ s b u d g e t ( B ) is on th e fa r r ig h t , th e p r iv a t e e x te n d e d th ro u g h se c to r’ s com m and over temporary costs of transition. As the “control” effort proceeded, underlying inflationary pressures mounted as a result of the maintenance of stimulative monetary and fiscal policies, and economic dislocations devel oped. With the realization that controls were a failure and the recognition of the costs of unchecked infla tion, a re-evaluation of the inflation-price stability alternatives has been necessary. Inflation, at any rate, generates very definite effects. These effects are related to both the transfer of wealth from one economic group to another and the alloca tion of resources from productive to unproductive activity. In addition, if the rate of price level increases is allowed to reach some critical point, there exists a potential for serious distortions in our system of economic as well as political organization. W ealth Transfer There are a variety of features which distinguish one type of inflation from another. An inflation which proceeds at a relatively steady, and hence predictable, pace has one set of effects; an inflation which pro ceeds by “fits and starts,” and is thus not very pre dictable, has another set of effects.8 Holders of money lose wealth during a period of inflation, regardless of the type of inflation. Since cash balances do not earn interest, they do not rise as prices rise. Therefore, purchasing power, or com 8M ilton Friedman, D ollars a n d Deficits: L iving w ith A m erica’s E conom ic P roblem s (E n g lew ood Cliffs: Prentice-Hall, Inc., 1 9 6 8 ), pp. 46-50. Digitized forPage FRASER 6 th e c re a tio n o u tp u t is of re d u ce d m o n e y , le a v in g over t im e th e th ro u g h p r iv a t e se c to r’ s b u d g e t in c r e a s e s in th e p r ic e un chan ged ( m id d le le v e l ( P ) . mand over resources, declines for those economic units whose assets are held in money form. The generalization that inflation causes a rechan neling of wealth from creditors to debtors is incom plete unless accompanied by statements about the extent to which inflation is correctly anticipated. This effect of inflation is most easily observed in a situation where the price level changes rather sharply over relatively short time spans, catching economic units unprepared. In such a situation, a transfer of wealth occurs when economic units engage in transactions with a less than accurate perception of the future rate of inflation. For instance, sellers may contract to sell their goods and services in the future at prices which in corporate an inadequate adjustment for inflation. It follows that the receipts from the sale of these goods and services, when adjusted for the actual rate of inflation, will not be sufficient to permit the main tenance of the seller’s real standard of living. The buyer, however, has experienced an increase in real wealth as the product purchased has appreciated in price by an amount greater than that anticipated at the time of contract formation. In effect, there has been a transfer of wealth from the seller to the buyer.9 •'A consequence of such an inflation-induced transfer o f wealth may b e a reduction in p eop le’s willingness to lend long term. A reduction o f long-term loans is likely to have allocative effects w hich cou ld reduce econ om ic welfare. For example, the financing o f the U. S. housing industry is predicated on long-term loans. If average m ortgages were reduced to, say, ten years, a great many people w ould find the cost of home ownership prohibitive. F E D E R A L R E S E R V E B A N K O F ST. L O U I S In addition, those receiving pensions fixed in amount or those who maintain their savings in the form of fixed income assets will find that the purchasing power of these assets declines also. In a steady, fully anticipated inflation little wealth redistribution occurs, except for those whose wealth is held in the form of money.10 Economic units ex pect prices to rise at some average rate and thus make a variety of economic arrangements that will adjust for the expected price rise. For example, wage contracts would include escalator clauses or would be drawn up on the basis of the average rate of in flation expected. Interest rates would include a pre mium based on the generally expected increase in the level of prices. As a result of near-perfect antici pation of inflation, no particular group would be forced to transfer wealth to another group because of the change in the price level.11 Resource Utilization and Allocation This is not to say, however, that the steady inflation is without costs. As mentioned earlier, inflation of any magnitude has the effect of making cash balances (money) an expensive item to hold. As inflation pro ceeds, more and more effort is devoted to keeping this expense at a minimum. By constantly scrutinizing one’s cash position, valuable productive time is wasted and, in general, scarce resources are diverted from more productive activity to less productive activity due to the required monitoring of inflation. Otherwise productive members of the labor force become in volved in not only figuring out what the changes in prices and wages are likely to be, but also in hedging against those changes. In the veiy process of predicting inflation, transac tions and information costs are likely to increase. For example, list prices would be difficult to establish for any length of time. Firms issuing catalogs contain ing the prices of their products would find it difficult to continue this practice. Sales representatives would be forced to contact head offices for the most up-todate prices. In general, business planning would be frustrated because it would be necessary to constantly reassess price information. As this sort of activity be comes widespread, society in general experiences a decreased level of output available for consumption. JANUARY 1 9 7 5 Potential Cost: Serious Economic Dislocations As the recently recorded rates of inflation ap proached and exceeded 10 percent, public concern about inflation intensified. In fact, several spokesmen, both within and outside of Government, have painted a very gloomy picture of our future in the event that inflation is not brought under control. According to this view, disruptive forces, inherent in an advanced inflationary process, may surface and cause serious distortions in our economic system. Such distortions could become severe enough to ultimately result in strong desires to change our institutions. In all economies with organized markets, at least one commodity evolves as universally acceptable in exchange for all other commodities. “Money” is the commodity which serves this purpose. Money also provides services as a store of purchasing power and as a unit of account for recording relative values.12 During periods of inflation all of these services from money are diminished. Its function as a store of pur chasing power declines, its credibility as a unit of account suffers, and its reliability as a medium of exchange is subject to greater uncertainty. As these services continue to erode as a result of accelerating inflation, there is a tendency for economic units to restructure their portfolios of real and financial assets. The restructuring takes the form of an attempt to reduce holdings of money and to increase holdings of other assets. At some point in the inflationary process, referred to as the inflation threshhold, it is generally believed that this sort of activity reaches epidemic propor tions and proceeds at a very rapid pace. Such a re action could be triggered by the recognition that the cost of holding money, especially that cost related to declining purchasing power, is so great that wide spread divestment of money by individuals is pur sued. Society as a whole, however, is not able to divest itself of the available stock of money; it can only circulate the existing stock of money at a faster rate. As a consequence, inflation changes from a canter to a gallop, being spurred by changes in the velocity of money circulation, completely independent of cur rent monetary policy actions. If inflation were to proceed to such an extent that money, as customarily defined, no longer serves as a medium of exchange, another commodity or commodi- '"Friedm an, D ollars a n d D eficits , p. 47. 11 It should he noted, however, that even in a noninflationary climate there are always changes in relative prices taking place. Associated w ith such relative price changes are transfers o f w ealth from one group to another. '-F o r a theoretical discussion of the services o f money, see Karl Brunner and Allen H. Meltzer, “ The Uses o f M oney: M oney in the Theory o f an Exchange E con om y,” T he A m erican E conom ic R eview (D ecem b er 1 9 7 1 ), pp. 784-805. Page 7 F E D E R A L R E S E R V E B A N K O F ST. L O U I S ties would emerge as money. Initially, however, it is not likely that any other single commodity would be accepted as a means for conducting transactions. A single commodity may eventually emerge to serve as money or what is more likely, a new form of currency would be introduced. During the transition, however, barter would probably become the common mode of transacting. This, then, is what is meant by serious economic distortion — barter (that is, goods and services being directly exchanged for other goods and services) becomes the dominant method of ex change. It is the consequence of a period of runaway inflation. SUMMARY AND CONCLUSION This article defined inflation as a continuing rise in the average level of prices. The cause of inflation was identified as the accommodation of unlimited wants through excessive monetary expansion. The costs of inflation include: a less than optimal resource use; an arbitrary redistribution of income in the case where inflation is less than perfectly anticipated; and to the extent that inflation is permitted to accelerate, the eventual occurrence of severe disruptions in our eco nomic system. In evaluating the inflation-price stability alterna tives, a great deal of attention has been focused on Page 8 JANUARY 1 9 7 5 the costs of achieving price stability. Often ignored, however, is the recognition that these costs are of a short-term nature; that is, declines in production and increases in unemployment occur during the period of adjustment to a lower rate of inflation. In an apparent willingness to accept these costs, society may demand the initiation of an anti-inflation policy. However, once the short-term costs associated with such a policy manifest themselves and inflation appears to remain unaffected, society may demand a hasty policy reversal. Failure to recognize the long lags associated with the initiation of an anti-inflation policy and the expected results of that policy results in short-run costs being incurred while the long-run benefits are not given sufficient time to materialize. One can only hope that both the short- and longrun aspects of an anti-inflation policy will continue to be discussed. If attention is focused only on the short-term costs of reducing inflation, public senti ment toward the achievement of this goal might weaken. In such a case a high and accelerating rate of inflation is likely to plague the economy for many years to come. If, however, concern about the long term effects of accelerating inflation remains strong, then the adoption and continuation of a determined anti-inflation policy may eventually succeed. Unusual Factors Contributing to Economic Turmoil Remarks by DARRYL R. FRANCIS, President, Federal Reserve Bank of St. Louis, Before The Wesleyan Associates, Illinois Wesleyan University, Bloomington, Illinois, December 6, 1974 _I_ HE YEAR we are about to end has been very unusual in that it was characterized by one of the most rapid increases in the price level, and by one of the sharpest drops in reported real output in the postWorld War II period. In order to understand the view we hold at the Federal Reserve Bank of St. Louis regarding the outlook for 1975, it is necessary to take time to develop, in some detail, the interpretation we apply to the events in 1974. First, let’s review some definitions of economic con cepts. We all talk about inflation; we hear a lot about inflation; but I think that there are some inaccurate ideas prevailing in the press and in the minds of the general public as to what the phenomenon called in flation really is. Inflation is simply a process involving erosion of the purchasing power of a nation’s money supply — that is, simply a deterioration in the ex change rate between money and goods and services. I use the word “process” because inflation is an on going phenomenon; it is continuous, although not nec essarily at a steady rate. This is distinct from a price increase, or an increase in the price level that is not continuous, or ongoing. That distinction becomes very crucial to understanding the forces influencing our economy and general welfare in 1974. The general phenomenon of a continuous inflation is due basically to monetary causes. Normally, we attribute inflation to a growth in the nation’s money supply which produces a growth of total spending at a rate faster than the growth in real output — in other words, too much money chasing too few goods. Since inflation is a decline in the purchasing power of money, I think that there can be little quarrel with the general idea that inflation is a monetary phenomenon. However, while a persistent inflation occurs only as the growth in money supply and resultant total de mand for goods and services exceeds the total supply of goods and services, a temporary or transitory infla tion can result from forces which produce a decline in the supply, or ability to produce goods, while demand continues to grow. In other words, a temporary bulge in the rate of inflation, while the economy is adjusting to a new higher equilibrium price level, is not neces sarily associated with a marked acceleration in the rate of growth of the money supply. On the contrary, it can be associated with a steady, continuing growth of the money supply and aggregate demand for goods and services, while at the same time there is a sudden drop in the economy’s real economic capacity. It is our view that both a persistent monetary infla tion and a temporary bulge in the rate of inflation occurred in 1974 in the United States and in many other countries of the world. Our analysis holds that the trend growth in the nation’s money supply this year and over the past four years is consistent with an ongoing, sustained rate of increase in the general price level of about 5 to 6 percent per year. This year, how ever, we have seen both the GNP implicit price de flator and the consumer price index increase in excess Page 9 F E D E R A L R E S E R V E BANK O F ST. LOUIS of 12 percent. This is an increase that we do not be lieve can be explained by the growth of the money supply, either this year or over the past few years. W e attribute about half of the increase in the gen eral price level this year to the trend growth of the money stock, and about half to forces which con strained the real economic capacity of the U. S. econ omy. W e consider these forces to have only a one-time, transitional effect, although the process is distributed over a period of time that has so-far lasted about four quarters. Given this view, we would argue that the rate of increase of the general price level will decelerate to the range of 5 to 6 percent per year, even if the rate of growth of the nation’s money supply were to con tinue at about the same average pace observed over the past several years. To put it another way, we think about one-half of the inflation observed this year was of the persistent excessive aggregate demand variety, and about one-half was of the temporary, or transitory, variety. The latter occurred as the economy adjusted to a lower real economic capacity, and therefore, a higher equilibrium level of average prices. Allow me to take a few moments to review the de velopments of the past few years. During 1967 and 1968 there is no doubt that stabilization policies in the United States were highly expansionary. This con tributed both to an acceleration in the rate of inflation and to a high rate of real output growth accompanied by a low rate of unemployment. In 1969 monetary actions turned decisively restrictive as monetary pol icymakers sought to curb the building inflationary pressures. The actions taken in 1969, as indicated by a marked reduction in the rate of growth of the na tion’s money stock, produced a slowdown in aggregate demand in 1970 and resulted in conditions that were characteristic of the previous business cycle recessions in the post-World War II period. Quite appropriately (and some time after the fact) the National Bureau of Economic Research declared that a recession had occurred, lasting approximately from November 1969 to November 1970. During 1970 the rate of growth of the nation’s money stock reaccelerated as policymakers sought to cushion the weakening economy. At the same time, the Federal Government’s budget produced a deficit, indicating ( according to the usual analysis) that fiscal policy was also stimulative. In 1971 the growth of the money stock accelerated further and, then again in 1972 another step-up oc 10 Digitized for Page FRASER JANUARY 1 9 7 5 curred. It was not surprising that growth in the de mand for goods and services rose markedly through this period. I would argue that forces were at work contributing to the building of a familiar inflationary process, wherein too much money is chasing too few goods as the economy approaches its real economic capacity. Thus, we saw an erosion of the purchasing power of the nation’s currency. The inflation was not directly observable in the second half of 1971 and throughout 1972 since the Government chose to impose a rather rigid system of wage and price controls. These controls, if nothing else, had the effect of holding down the reported in creases in prices, and therefore, the rise in the price indices. However, the system of controls began to break down, as was inevitable, and early in 1973 the Administration switched to a much less rigid program of controls, thereby allowing a catch-up to begin. Throughout 1973 the rate of price increase, as meas ured both by the consumer price index and the GNP deflator, accelerated sharply as the process of de-con trol allowed the markets to begin to take us back to conditions consistent with underlying economic forces. The growth of the nation’s money stock in 1973 was somewhat slower than the rate experienced in 1972, but was still at a very high rate by historical standards. According to some empirical research at the Federal Reserve Bank of St. Louis, even though the rate of price increase in 1973 was much more rapid than im plied by the growth in the money stock that year and in the years immediately prior, the price level at the end of 1973 was below the one indicated by the growth of the money stock over the prior few years. In other words, this research indicates that in the sec ond half of 1971 and throughout 1972 the price level was being held below what the prevailing monetary growth would have implied. Therefore, in 1973 the high rate of price increase was simply the expected consequence of the removal of controls and return to the rate of exchange between money and goods that would bring us back to equilibrium conditions. In other words, after the re-adjustment or “catch-up” process was completed, we would expect a level of prices, as indicated by monetary growth, to prevail. It is our judgment that the distortions on prices caused by controls and de-controls had pretty well worked themselves out by the end of 1973. Moreover, we would argue that the rate of inflation in 1974 would have been less than in 1973 (and only about half what has actually been observed in 1974) if there had not been a succession of what have become F E D E R A L R E S E R V E BAN K O F ST. L OUI S JANUARY 1 9 7 5 known as “special factors” which were providing fur ther shocks to the economy. towards the production of clean air, clean water, and greater safety. One of the factors affecting relative prices (and therefore production) in the past few years is related to the depreciation of the dollar that occurred since 1971. The fact that the depreciation occurred indicates that the U. S. price level was out of line with its major trading partners. What had happened was that in the late 1960s and early 1970s, as the United States was pursuing inflationary policies associated with large Government deficits and a high rate of military spend ing, the international agreement on exchange rates (known as Bretton W oods) served to hold down prices of foreign goods to American consumers and pro ducers, while raising prices of our goods to foreigners. In the language of economists, these decisions es sentially amounted to a change in our society’s con sumption basket, wherein we decided to forego the production of some goods, both now and in the future, in favor of the rather intangible benefits of less pollu tion and more safety. Given limited resources, such a re-allocation of resource utilization necessitates a re duction in our ability to produce the usual types of goods and services. In other words, we made a social and political decision which resulted in an absolute decrease in our production capacity for goods and services. This means that for a number of years we were experiencing less inflation to the extent that foreign goods, in relative terms, became successively cheaper. Also, our goods were not being demanded in the same quantities that would have otherwise occurred. But once the dollar was permitted to depreciate, there were sharp shifts in underlying conditions. Demand for some goods declined and demand for other goods increased, bringing about marked shifts in relative prices to U. S. consumers. The prices of foreign goods rose sharply, while the prices of our goods to foreign ers decreased sharply in terms of their currencies. Since foreign goods were now more expensive to us, American consumers and producers shifted their de mands away from foreign goods and towards the rela tively cheaper American produced goods. Similarly, the now cheaper American goods caused foreigners to step-up their purchase orders of our products. The adjustment to these sudden changes in relative prices naturally would be distributed over an extended pe riod of time. In addition to the shifts in demand and the asso ciated changes in relative prices caused by the dollar depreciation, the American social and political process resulted in decisions to shift the utilization of some of our nation’s resources away from the production of conventional goods and services and towards a health ier living environment and a safer working environ ment. These laws took many forms, but basically they have been geared towards less pollution of the air by our factories and automobiles; less pollution of our nation’s rivers and a safer working environment, as well as safer automobiles to transport American citi zens. These decisions to re-allocate a share of our resources towards these objectives naturally implied significant shifts in demand, for both labor and other resources, away from the production of “ widgets” and Furthermore, there were other factors at work con straining the domestic supply of goods. Crops around the world were not good in 1972. Foreign exchange rates were changing in the direction that made Ameri can goods look cheaper, and at the same time foreign countries were producing less grain, less anchovies, and so on; so naturally the demand for American agricultural products increased markedly. And we met that demand through very large increases in the vol ume of goods exported. Consequently, it should not be surprising that there were less goods and services available for American consumers. Then late in 1973 the oil producing and exporting countries outside the United States (called OPEC) took collusive action to bring about a sharp in crease in the world price of petroleum products. Let me digress a moment and characterize what had been going on. The OPEC group had been selling their oil output to the Western world countries at prices that now look quite low indeed. With the revenue received from oil, they purchased goods and services from the Western world. In other words, viewed in barter terms, they were exchanging current output of oil for current goods and services produced by others. By agreeing to raise prices, the OPEC group, in effect, decided that they wanted to receive not only claims to current output in the Western world in exchange for oil, but also claims to future output. The way this takes place is that we wind up selling securities to them, either equities or bonds, which represent claims to our future production of goods and services. In a very crude sense, we are now giving up some of our future production in exchange for some of their present oil. Even at the higher prices, ap parently we are willing to do so rather than accept the alternative of reducing our current rate of oil consumption. Nevertheless, the effects are the same: Page 11 F E D E R A L R E S E R V E BANK O F ST. LO UI S U. S. consumers have had a wealth loss. W e have been made poorer by the actions of the OPEC cartel. The standard of living of American consumers has been reduced, and probably will grow at a slower rate, because of the higher price of oil. The effects of the higher price of oil and substitute sources of energy have created massive shifts in demands, and there fore relative prices, which has been a dominant factor in the developments experienced in 1974. The higher cost of energy, together with the envi ronmental and safety laws, acts as a tax imposed upon the economic productive capacity of the United States. This means that the present value of the existing capital stock was reduced in much the same way as the value of the capital stock would decrease if the Government were to increase sharply the corporate tax rate. The decrease in the present value of the capital stock means that equity prices on the stock market decrease, reflecting the fact that the expected real earning power of corporations has been reduced by these varied actions. The decrease in the real economic capacity of the country is, by and large, a one-time occurrence. How ever, the shifts in demand and changes in relative prices to adjust to a new equilibrium take some time to be fully completed. So far, this year has been one of four calendar quarters of shortages, sharp increases in the prices of many commodities, and a marked de crease in the reported volume of real output; but at the same time a continued high level of total employment. This latter development, a rather high level of total civilian employment, is a development that I do not believe has received sufficient attention this year. The unemployment rate has been widely publicized, but the total number of persons employed has not been. The very sharp increase in the price level, even though about half the rate of inflation was transitory, did have the effect of reducing the standard of living of American consumers. That’s part of the adjustment process. But because of the inflation, many persons who were not otherwise counted as part of our labor force — such as women, and young people — were induced to declare their intentions to seek jobs. More women found it desirable to work to supplement family income, and students chose to postpone enter ing or returning to college. This increase in the overall participation rate in the labor force was very large by historical standards. The increase in the participation rate was much faster than the ability of the economy to absorb these new job-seekers. 12 Digitized forPage FRASER JANUARY 1 9 7 5 But why dwell on the fact that about one-half of the number of new persons seeking jobs did not find them, while neglecting the fact that one-half of these new entrants into the labor market did find jobs. Since one of the inputs to production — energy — has increased sharply in cost, our economic analysis tells us that the demand for other inputs to production, such as labor, would increase since the cost of these other inputs have become relatively cheaper. Since the present value of the existing capital stock in the U. S. economy has declined, there is naturally an increase in the de mand for additions to capital stock; and therefore we have had an investment, or capital goods, boom throughout this year. That’s what we would expect under the circumstances; and the fact that it takes quite a bit of time to put new plant and equipment in place indicates to me that, in the short run, firms will seek more labor as a temporary substitute for capital as they try to maintain production while wait ing to restore real economic capacity. The so-called “real output” numbers derived from the national income accounts give us an idea about changes in the volume of goods and services produced over time. But if we are devoting a much larger pro portion of our resources to the production of such things as a cleaner environment and safer working and living conditions, then I believe it is appropriate to be skeptical of interpretations of the falling real output as being solely indicative of a sluggish economy. Look at what goes into producing 1975 automobiles; in addition to the pollution control and safety devices on the automobile itself, there are environmental and safety restrictions imposed on the manufacturing proc ess. And I think that in terms of inputs, the auto industry continued to command a very large share of our resources until very recently, even though the volume of outputs, measured simply as the number of cars, declined. With this analysis as background, let me turn to a few remarks about appropriate stabilization policy actions. On the one hand there is a temptation to want to do something about the 12 percent inflation, and on the other hand there is the desire to do something about the falling real output and rising unemploy ment rate. According to my interpretation of the events of the last few years, I believe that, without further special actions on the part of either monetary or fiscal authorities, and continuation of monetary growth at the 1973-74 rates, the rate of inflation will decelerate markedly next year to the range of 5 or 6 percent. At the same time, the growth in real output F E D E R A L R E S E R V E B A N K O F ST. L O U I S should resume and I doubt that the rate of unemploy ment will rise as high as some analysts have feared. We have had a wealth loss; our standard of living has declined, and our absolute real economic capacity is now lower than it was a year ago. We should not seek policies designed to close the gap between what we are now producing and what could be interpreted as being real potential before the energy crisis, the environmental laws, the safety laws, the agricultural short-falls, and so on. That is simply unobtainable. In stead, we are forced to be satisfied to see a resump tion of the growth rate of real output consistent with long-term growth trends in population, technology, and so forth — in other words, around three to four percent. But let me quickly add that this would also JA N U A R Y 1 9 7 5 occur without any overt actions by government policymakers. As long as we do not suffer any further adverse shocks to the economy, I believe that the inherent stabilizing properties and the resiliency of the market system will return us to our potential growth path. If Congress wishes to take some sort of action to increase the total output of consumers’ goods, then it will have to think in terms of relaxing the environ mental and safety standards imposed on industry gen erally and on specific consumer products, such as automobiles. Short of that, more spending programs to simply augment aggregate demand runs the risk of creating conditions leading to further acceleration in our underlying, permanent rate of inflation. Page 13 The St. Louis Equation and Monthly Data KEITH M. CARLSON I n THE November 1968 issue of this Revieiv, Leonall C. Andersen and Jerry L. Jordan published a study which reported results relating to the response of GNP to monetary and fiscal actions.1 Since then, there have been a number of articles which have analyzed and challenged these findings.2 Even though the final returns are probably not in yet, one has to be impressed with the way their results have withstood the criticism to which they have been subjected.3 The Andersen-Jordan article was concerned with the relative impact of monetary vs. fiscal actions, testing hypotheses relating to the magnitude, speed, and reliability of the response of GNP. Yet one of the more interesting implications of the St. Louis equa tion (the reduced-form equation developed in their article) was that GNP responds quickly to monetary actions and that the adjustment is essentially com pleted in a year’s time. This finding ran contrary to the prevailing view at that time, which was based, in part, on results obtained by large econometric models. For example, the Federal Reserve — MIT econometric model, a model specifically designed to quantify the effect of monetary actions on the economy, concluded ^Leonall C. Andersen and Jerry L. Jordan, “ Monetary and Fiscal A ctions: A Test o f Their Relative Importance in E co nom ic Stabilization,” this R eview (N ovem b er 1 9 6 8), pp. 11-24. -Representative examples are Frank deL eeuw and John Kalchbrenner, “ M onetary and Fiscal A ctions: A Test of Their Relative Importance in E con om ic Stabilization — Com m ent,” this R eview (A p ril 1 9 6 9 ), pp. 6-11; Richard G. Davis, “ H ow M uch D oes M oney Matter? A Look at Some Recent E vidence,” Federal Reserve Bank o f N ew York M onthly R eview (June 1 9 6 9 ), pp. 119-31; Franco M odigliani, “ M onetary Policy and Consum ption: Linkages via Interest Rate and W ealth Effects in the FM P M od el,” C onsum er S pending a n d M onetary Policy: T he L inkages (Proceedings o f a Monetary Conjerence held on Nantucket Island, Sponsored by Federal Reserve Bank of Boston, June 1 9 7 1), pp. 59-74; Law rence R. Klein, “ Em pirical E vidence on Fiscal and Monetary M odels,” in James J. D iam ond ( e d .) , Issues in F iscal a n d M onetary Policy: T he E clectic E conom ist Views th e C ontroversy (D eP a u l University, 1 9 7 1 ), pp. 35-50; and Alan S. Blinder and Robert M. Solow, “ Analytical Foundations o f Fiscal Policy,” T he E conom ics of P u b lic F in a n c e (W ashington, D .C .: The Brookings Institution, 1 9 7 4), pp. 63-71. 3Professor Klein, for example, draws the follow in g conclusion: “ Hard econom etric evidence points to the fact that large structural models stand up at least as w ell as small reduced form m odels.” [Klein, “ Em pirical E vidence on Fiscal and Monetary M odels,” p. 49.] Page 14 “that monetary policy is ultimately quite powerful but that the lags are long.”4 There is an indication that some of the large econometric models have been modified in such a way that the impact of monetary actions now appears to be quicker than in earlier versions.5 For the most part, however, the St. Louis equation continues to stand apart from other models, showing that virtually all of the GNP response to changes in money occurs in about a year, though mention should be made of another model — the Laffer-Ranson model.6 Arthur Laffer and David Ranson not only found a quick response to monetary actions, but they concluded that monetary actions have an immediate and per manent effect on the level of GNP, rejecting the presence of any lags at all. The purpose of this note is to report the results of estimating the St. Louis equation with monthly data and thereby sharpen our understanding of the lag in the effect of monetary and fiscal actions. The question being asked here is whether the St. Louis equation continues to hold when monthly data are used in the estimation. It is well-known among eco nomic analysts that the use of data aggregated over time can introduce a bias in the results.7 Data The data used to estimate the St. Louis equation consisted of changes in nominal GNP as the depend ent variable and alternative measures of monetary and fiscal actions as the independent variable. For purposes of comparison here, only the specification 4Frank deL eeuw and E dw ard M. Gramlich, “ T he Federal Reserve — M IT Econom etric M od el,” Federal Reserve B ul letin (January 19 6 8), pp. 11-40. •"'See Gary From m and L. R. Klein, “ The N B E R /N S F M odel Com parison Seminar: An Analysis of Results,” forthcom ing in A nnals of E conom ic a n d Social M easurem ent. ^Arthur B. Laffer and R. D avid Ranson, “ A F onnal M odel of the E con om y,” T he Jo u rn a l of B usiness (July 1 9 7 1 ), pp. 247-60. 7Yair Mundlak, “ A ggregation O ver Tim e in Distributed Lag M odels,” In tern a tio n a l E conom ic R eview (M a y 1 9 6 1 ), pp. 154-63, and W illiam R. Bryan, “ Bank Adjustments to M on e tary Policy: Alternative Estimates of the L a g,” A m erican E conom ic R eview (Septem ber 1 9 6 7), pp. 855-64.” JANUARY 1 9 7 5 F E D E R A L R E S E R V E BAN K O F ST. L OUI S Summary of Lag Response M o n th ly v s . Q u a r t e r ly S p e c ific a tio n S a m p le P e rio d : 1953-1973 E F F E C T O F F IS C A L A C T IO N S C u mu l a t e d Mul t i pl i er s Cu mu l a t e d Mul ti pl i er s E F F E C T O F M O N E T A R Y A C T IO N S t-l t-1 t+l t+3 t+5 t+l t t+7 t+9 t+2 t+11 t+3 t +13 1+15 t+4 P e r c en t of T o t a l 1 40 t-l t-l t+17 t+5 Pe r c ent of T o t a l 140 130 120 120 120 110 110 110 100 100 100 90 90 90 80 80 70 70 80 ✓ 60 / 50 / ✓ > / 40 30 20 / ✓ ✓ / 0 ✓ f ✓ ✓ / ✓ / / / 60 60 50 50 / t+l 1 ........ t+3 t t+5 t+l t+7 t+9 t+2 t+11 t+3 t + 1 3 t +15 t+4 t+17 t+5 Pe r c ent of T o t a l 140 1 30 Q u a rte rly t i V V 120 \ \ / 110 N \ 100 90 t 80 t 1 1 t+9 t+2 1 1 t+11 t+3 70 M o n th ly 60 i 1 50 1 40 40 30 30 20 20 .1 / 10 i t+7 / / / / / M o n th ly . _ t+5 t+l 1 / ✓ t ■1 t ■1 ✓ Q u a r te r ly , / ✓ 70 10 ✓ t+3 t Percent of Total 140 130 130 t+l 1 1 t+13 t+15 t+4 1 0 t+17 t+5 1 I 40 / 30 / 20 1 / 10 i 1 l/ 0 t ______ t t +l t 10 \ t+3 t i i t+5 t+l i . 1 t+7 t+9 t+2 1 t+11 t+3 i i . t +13 t +1 5 t+4 i 0 t+17 t+5 Note: Dependent v a ria b le for monthly d ata is d ollar change in personal income and for quarterly data is change in current d o llar GNP. The horizontal scale shown as t-1 through t+17 refers to months, and that shown as t-l through t+5 refers to quarters. preferred by Andersen and Jordan is used. That specification used money, narrowly defined as demand deposits and currency held by the public, as the measure of the monetary variable, and high-employment Federal expenditures as the measure of the fiscal variable. Page 15 JANUARY 1 9 7 5 F E D E R A L R E S E R V E BANK O F ST. LOUIS Table I ST. LO UIS EQ U A TIO N M onthly vs. Q u a rte rly D ata 1953 - 1973 (Fourth Degree Polynom ial with t — j— 1 = t - n = 0 ) M onthly Data____________________________ aefficients t 1- 1 t- 2 A m 2Am .45 .11 (1 .9 6 ) t-4 .3 2 (3 .8 7 ) t- 5 .35 (4 .1 9 ) t —6 .38 (3 .8 6 ) t- 7 .3 9 ( 3 .6 2 ) t- 8 .3 9 ( 3 .6 4 ) -.0 1 ( - .2 6 ) t- 9 .38 (3 .9 3 ) -.0 1 ( - .2 5 ) t - 10 .3 6 ( 4 .3 2 ) t - 11 .3 3 (4 .0 6 ) .2 8 (2 .9 4 ) .95 1.16 1.07 - .0 0 ( - .0 4 ) .02 ( -31) .0 4 ( -64) .05 ( -86) .2 3 (1 .9 7 ) t - 14 .1 6 (1 .3 6 ) .0 9 ( .9 9 ) .0 6 ( -99) .0 4 (1 .0 8 ) 4 .4 0 (7 .3 1 ) .68 (1 .8 1 ) Constant R2 .68 .0 7 (1 .4 6 ) .0 4 ( -85) .01 ( -29) - .0 0 ( - .0 8 ) t - 13 Sum Q u arterly Data Am AE .2 9 * 1.16 (2 .4 9 ) .51 (3 .0 1 ) .2 0 t- 1 1.56 (5 .6 9 ) .2 6 (1 .8 5 ) - .0 0 t- 2 1.43 ( 3 .5 7 ) - .0 6 (- .4 2 ) .0 0 t-3 1.00 (3 .7 1 ) - .1 3 ( - .8 6 ) .1 4 t-4 .4 7 (1 0 2 ) .0 3 ( -16) Sum 5 .6 3 (8 .5 8 ) .61 (1 .5 0 ) .0 9 (1 .8 4 ) .2 7 ( 2 .7 9 ) t - 15 Coefficients .11 (1 .9 6 ) t- 3 t - 12 ___________________ SAE .0 7 ( 1 .9 3 ) .08 ( .9 2 ) .1 5 (1 .2 8 ) .2 2 (1 .8 6 ) Ae .3 8 (1 .2 9 ) .3 9 Constant R2 1.0 9 (1 .1 4 ) .71 S . E. 2 .8 0 S. E. 5.31 D. W . 2 .3 2 D. W . 1.86 N o te: Dependent variable fo r m onthly data is dollar change in personal incom e and for quarterly data it is dollar change in G N P. M onetary variable ( A ^ ) is Mi for both regressions. Fiscal variable ( ^ E ) is high-em ploym ent Federal expenditures fo r both regressions; monthly data are linear interpolations o f quarterly data. 2 ’s for m onthly data are m onthly coefficients summed over quarters. Figures in paren theses are “ t ” statistics. R 2 is adjusted fo r degrees o f freedom . S. E. is the standard error o f estimate, and D. W . is the D urbin-W atson statistic. Total spending — The dependent variable used in the St. Louis equation is the dollar change in nominal GNP. No similar comprehensive measure is available on a monthly basis. As a proxy for GNP on a monthly basis personal income is used. The rationale under lying this choice is that personal income is the most comprehensive measure of aggregate economic activ ity available on a monthly basis. Over the last twenty years personal income has averaged 79.8 percent of GNP. It should be noted, however, that personal Page 16 income leaves much to be desired as a monthly proxy for GNP, since it excludes depreciation, indi rect business taxes, undistributed corporate profits, and includes transfer payments. Monetary variable— The choice of a monthly measure of monetary actions is automatic once a par ticular form of the St. Louis equation is chosen. The quarterly observations on the money stock narrowly defined are simply the quarterly averages of the JANUARY 1 9 7 5 F E D E R A L R E S E R V E BANK O F ST. LO UIS monthly estimates of the seasonally adjusted money data. Fiscal variable— With regard to a monthly meas ure of fiscal actions, no such measures are available on a seasonally adjusted basis. Though complex methods of interpolation could probably be developed using the Treasury’s “Monthly Statement of Receipts and Expenditures,” the procedure followed here was to interpolate linearly between quarterly estimates of higli-employment Federal expenditures. The quarterly observations were assumed to be equal to expenditures for the mid-month of the quarter, and expenditures for the intervening months were calculated by linear interpolation. Results The estimation proceeded by specifying the same constraints as used by Andersen-Jordan in their study. The equation was estimated with ordinary least squares and the lag structure was estimated by the Almon lag technique. The polynominal was con strained to fourth degree but several lag lengths were examined. In each case the coefficients on the ( t — (- 1) and (t — n) lags were constrained to zero. The sample period used was 1953 through 1973. The estimated equations are shown in the accom panying table and a visual summary is given in the accompanying chart. The results for the St. Louis equation estimated with monthly data are compared with the quarterly specification. The R- and the stand ard error are lower for the monthly specification, and the Durbin-Watson statistic suggests the presence of negative autocorrelation in the residuals. Examination of these results indicates that the general quarterly pattern of coefficients on the mone tary and fiscal variables is reproduced with the monthly data. The sums of the coefficients for the monetary and fiscal variables are little different from those for the quarterly model, though there is some indication that the monthly data show a smaller total impact for monetary actions. However, since per sonal income is smaller than GNP, the difference in monetary impact can be interpreted as being at tributable to the difference in scale of the dependent variable. The pattern of lagged response to monetary action, is also reproduced with the monthly data. The optimal lag length, which was determined by estimating with successively longer lags until the lagged coefficients trailed off into insignificance, appears to be about 16 months which is consistent with 5 quarters when estimated with quarterly data. That period, when 50 percent of the monetary impact has occurred, is roughly the same for the two data sets. The quarterly model indicates that almost 50 percent of the impact occurs by the second quarter, which conforms with the monthly result indicating one-half of the impact by the eighth month. The pattern of response to fiscal actions requires additional comment. Since the monthly fiscal variable is a linear interpolation of quarterly observations, reproducing the result of the quarterly model might not seem surprising.8 The quarterly version of the St. Louis equation yields a total fiscal multiplier of 0.61 which is not significantly different from zero at the 5 percent level. However, reproduction of these quarterly results for the monthly version comes as a surprise because the dependent variable, personal income, includes transfer payments which are also included in the fiscal variable on the right hand side of the equation. There is some indication of bias though, because scale considerations alone would imply a sum fiscal coefficient for the monthly specification of less than 0.61. Summary The St. Louis equation was estimated using monthly data. Using changes in personal income as the de pendent variable rather than changes in GNP, the results were consistent with those obtained with quarterly data. Results were presented providing evi dence in support of conclusions relating to the magni tude and speed of the impact of monetary and fiscal actions as derived from quarterly data. Use of monthly data thus appear to carry the potential for evaluating the thrust of monetary and fiscal actions before quar terly data on GNP become available. 8It should be noted that for the monthly version the “ t” statistics for the fiscal variable are probably biased upward because the num ber o f independent observations is overstated as a result o f interpolation. Page 17 Monetary Effects of the Treasury Sale of Gold ALBERT E. BURGER T THE beginning of 1975, it became legal for U. S. residents to hold gold for the first time in 41 years. In early December, the U. S. Government an nounced its intention to offer 2 million ounces of gold for sale to the public early in January 1975 from its holdings of 276 million ounces. The Treasury re ceived bids for only about one million ounces of gold and accepted bids for only 753,600 ounces. The gold was sold at an average price of $165.65 per ounce, hence the sale added about $125 million to the revenues of the Treasury. Table I SO U RCES O F THE M O N ETA R Y BASE I. Factors Supplying M onetary Base Federal Reserve holdings of Government securities1 Loans Federal Reserve float Gold stock account2 plus Special Drawing Rights certificate Treasury currency outstanding O ther Federal Reserve assets II. Factors Absorbing M onetary Base Treasury cash holdings This note illustrates the monetary implications of this sale of gold to the public. It is assumed that the Government did not alter its spending plans as a re sult of the sale of gold. It is assumed that the Treasury used the proceeds from the sale of gold to make expenditures rather than using tax revenues or using the receipts from the sale of bonds to the public. The effects of the transactions between the Treasury and the Federal Reserve are illustrated, and their effects on the monetary base are discussed. The sources of the monetary base are shown in Table I. In the following analysis it does not matter whether a U. S. resident or a resident of a foreign country purchased gold sold by the Treasury. In order to purchase gold at the auction, a foreign individual must have dollars. Hence, when he pays for the gold, demand deposits of foreigners at U. S. commercial banks decrease. Since these deposits are part of the U. S. money stock, the analysis would be the same as when demand deposits of U. S. residents decline. Treasury Monetizes Gold In early December the U. S. Treasury held about 276 million ounces of gold. Of this total amount, 274 million ounces were held in the General Account of the Treasury and 2 million ounces were held in the Exchange Stabilization Fund. Only the 274 million ounces held in the General Account were counted in the monetary base. The Treasury had issued gold certificates to the Federal Reserve Banks against about 271.5 million ounces of gold, valued at $11.5 Digitized for Page FRASER 18 Deposits with Federal Reserve Banks Treasury Foreign O ther2 O ther Federal Reserve liab ilitie s and cap ital III. Reserve Adjustments3 IV. M onetary Base (I — 11 III) in clu d e s acceptances held. 2On January 1, 1970, the United States received an initial alloca tion o f $866.9 m illion o f Special D raw in g R ights (S D R s) from the International M onetary Fund. The Treasury, through its E x change Stabilization Fund, m onetized $400 m illion o f this alloca tion within a few m onths. In m onetizing, the Treasury issued $400 m illion o f SDRs to the Federal Reserve Banks and in return received an equal credit to its E xchange Stabilization Fund at the N ew Y ork Federal Reserve Bank which is included in other deposits. 3Computed by this Bank. It includes the effects o f reserve require m ent changes and shifts in deposits where different reserve requirements apply. billion at the official U. S. price of $42.22 per ounce.1 The remaining 4.5 million ounces of gold was held in the Exchange Stabilization Fund2 and in Treasury cash3 (2 and 2.5 million ounces, respectively). U s the Treasury purchased gold in the past, and w hen the official U. S. price o f gold was changed, the Treasury had “ m onetized” the gold b y issuing gold certificates to the Federal Reserve Banks. In return, the Treasury received de mand deposits at the Federal Reserve Banks. See, Albert E. Burger, “ T he Monetary E conom ics o f G old,” this R eview (January 1 9 7 4), pp. 2-7. -T h e Exchange Stabilization Fund, administered b y the Treas ury, held 2,019,751 ounces o f gold, valued at $85.3 million. This gold had been acquired by the Fund prior to August 15, 1971, when the Fund engaged from time to time in gold transactions with foreign monetary authorities and with the market for the purpose o f stabilizing the value o f the dollar relative to gold. :lTreasury cash holdings represent the funds that the Treasury technically has at its disposal without drawing on its deposits F E D E R A L R E S E R V E B A N K O F ST. L O U I S JANUARY 1 9 7 5 Illustration I Treasu ry M onetizes Previously N onm onetized G o ld (M illio n s of D ollars) M onetary Base Treasury $1 0 7 monetized gold $ 1 0 7 gold certificates Federal Reserve $ 1 0 7 gold certificates — 107 Treasury cash (n o n monetized gold) $ 1 0 7 Treasury demand deposits Sources Uses (~ h )— $107 Treasury cash ( — )$ 1 0 7 Treasury demand deposits at F.R. No change 107 demand deposits *Sign in brackets indicates direction of effect on monetary base. For example, a decrease in Treasury cash increases the base (-{-). In December the Treasury monetized the remaining 4.5 million ounces of gold held in its accounts by purchasing 2 million ounces from the Exchange Stabilization Fund and issuing gold certificates against the entire 4.5 million ounces of gold. In return, it received deposits at the Federal Reserve Banks equal to $192 million. Treasury monetized the gold, is a factor increasing the monetary base; the rise in demand deposits of the Treasury at Federal Reserve Banks is a factor decreasing the monetary base. Therefore, the Treasury action of issuing gold certificates against the 2.5 mil lion ounces of nonmonetized gold in December had no effect on the monetary base. The “monetary” or Treasury gold stock of the United States consists of both the amount of gold against which gold certificates have been issued and gold against which no gold certificates have been issued (nonmonetized gold). Nonmonetized gold is included in the account “Treasury cash holdings” which appears as a factor affecting bank reserves and is included on the sources side of the monetary base. An increase (decrease) in Treasury cash ab sorbs ( releases) bank reserves and hence reduces (increases) the monetary base. The 2 million ounces of gold held in the Exchange Stabilization Fund (E S F ), however, was not pre viously included in the gold component of the mone tary base. In the sources of the monetary base, “other deposits” at Federal Reserve Banks included a special gold account of the Secretary of the Treasury which included the gold held by the Federal Reserve Bank of New York for the Exchange Stabilization Fund. Other deposits also included the special checking account of the Exchange Stabilization Fund. There fore, when the Treasury purchased the 2 million ounces of gold from the Exchange Stabilization Fund and issued gold certificates against this amount to the Federal Reserve Banks, the value of the gold stock in the monetary base rose by $85 million. In the week ended December 11 the gold stock of the monetary base rose by $36 million and then rose by an addi tional $49 million in the week ended December 18. Illustration I shows the effects of the Treasury monetizing the 2.5 million ounces of previously un monetized gold in Treasury cash valued at $107 million.4 In the process of monetizing gold, the Treas ury issued gold certificates to the Federal Reserve Banks, in return for which the Federal Reserve Banks credited the demand deposits of the Treasury. The decrease in Treasury cash, which occured as the at the Federal Reserve or Tax and Loan accounts at com mercial banks. This account includes any currency and coin held b y the Treasury in its ow n vaults plus nonm onetized gold and silver bullion, silver dollars, and nonsilver coinage metal. See Federal Reserve Bank o f N ew York, Glossary: W eekly F e d e ra l R eserve S tatem ents, “ Factors Affecting Bank Reserves” (Septem ber 1 9 7 2 ), p. 20. 4T he Treasury held 2,518,006 ounces o f nonm onetized gold w hich, valued at the official price o f $42.22 an ounce, was w orth $106.3 million. For exposition purposes this amount has been rounded up to $107 milhon. When the Treasury purchased gold from the ESF, deposits of the ESF at the Federal Reserve rose and Treasury deposits fell. The gold from the ESF account was initially transferred into the Treasury’s General Account holdings of nonmonetized gold, hence the item Treasury cash rose. When the Treasury issued gold certificates against the gold it had acquired from the ESF, the gold became classified as monetized gold, Treasury cash decreased, and Treasury demand deposits increased. These transactions are shown in Illustration II. Page 19 JANUARY 1 9 7 5 F E D E R A L R E S E R V E BAN K O F ST. LO UI S Illustration II Treasu ry Purchases G o ld From Exchange S ta b iliza tio n Fund and M onetizes the G o ld (M illio n s of D ollars) Treasury Treasury Purchases Gold From Exchange Stab ilization Fund $8 5 Treasury cash (n o n monetized gold) Federal Reserve No change — 85 demand deposits — 85 gold due ESF Treasury Monetizes Gold — $85 Treasury demand deposits ( - } - ) — $85 Treasury demand deposits at F.R. 85 ESF deposits ( — ) 85 ESF deposits - 8 5 ESF gold ( — ) $85 Treasury cash — 85 Treasury cash 85 monetized gold M onetary Base Sources Uses No change ( + ) 85 Gold ( + ) — 85 Treasury cash 85 gold certificates 85 gold certificates 85 Treasury demand deposits ( — ) 85 Treasury demand deposits at F.R. No change 85 demand deposits Net Effect $85 monetized gold Net Effect $85 gold certificates $ 8 5 gold certificates 85 ESF deposits Net Effect ( + ) 85 gold No change ( — ) 85 ESF deposits *Sign in brackets indicates direction o f effect on monetary base. For example, a rise in Treasury cash decreases the base (—). These transactions between the Treasury and the Federal Reserve had no effect on the monetary base or the money stock. The increase in the gold stock ($85 million) in the monetary base was completely offset by a corresponding rise in deposits of the Ex change Stabilization Fund ($85 million) at the Federal Reserve. However, since the Treasury issued gold certificates against the gold it purchased from the Exchange Stabilization Fund, the amount of gold certificates held by the Federal Reserve Banks rose by $85 million. The combined results of the two steps whereby the Treasury monetized $192 million of gold are shown in Illustration III. All the Treasury’s gold holdings have been monetized, gold certificates held by the Federal Reserve have risen and Treasury deposits at the Federal Reserve Banks have increased. Treasury Sells Gold to Public As the Treasury received payment from the public for the gold it sold and deposited these funds in its accounts at Federal Reserve Banks, the money stock temporarily decreased. Demand deposits of the public at commercial banks, which are part of the money stock, declined; Treasury deposits at Federal Reserve Banks rose, and bank reserves fell. These effects are shown in Stage I of Illustration IV. Since it was assumed that the expenditures of the Treasury are unaffected by the sale of gold, these Illustration III Com bined Results o f Actions Shown in Illustrations I and II (M illio n s of Dollars) Treasury $19 2 monetized gold $ 1 9 2 gold certificates Federal Reserve $1 9 2 gold certificates — 107 Treasury cash 107 demand deposits 1Sign in brackets indicates direction o f effect on monetary base. Page 20 $ 10 7 Treasury demand deposits 85 ESF deposits Sources M onetary Base1 Uses ( + ) $ 85 gold ( H“ ) — 107 Treasury cash ( — ) 85 ESF deposits ( — ) 1 0 7 Treasury demand deposits at F.R. No change JANUARY 1 9 7 5 F E D E R A L R E S E R V E BANK O F ST. L O U IS These effects are shown in Stage II of Illustration IV. The money stock returns to its level prior to the sale of gold. Illustration IV Effect on M oney Stock o f Treasury S a le o f G o ld The effects of the Treasury sale of gold on the monetary base are shown in Illustration V. At the end of December the Treasury held gold in only one account, 276 million ounces against all of which gold certificates had been issued. As the Treasury sold gold to the public in early January, it had to redeem gold certificates from the Federal Reserve representing claims of an equal amount. These gold certificates were redeemed at the official U. S. price of gold ($42.22 an ounce). Hence, the Treasury paid the Federal Reserve about $32 million to redeem gold certificates representing claims on 753,600 ounces of gold. This transaction had no effect on the money stock or the monetary base. Treasury deposits at Federal Reserve Banks decreased by $32 million and the amount of gold in the monetary base (which is valued at the official U. S. price of gold) declined by $32 million. These effects are shown in the upper third of Illustration V. (M illio n s of Dollars) Stage 1 Stage II Treasury Sells Gold Treasury M akes Payments to the Public Federa Federal Reserve -$125 Treasury deposits at Federal Reserve Banks — $12 5 member bank deposits at Federal Reserve Banks $1 25 member bank deposits at Federal Reserve Banks Banks Banks — $125 member bank deposits at the Federal Reserve Banks Reserve $1 25 Treasury deposits at Federal Reserve Banks — $125 demand deposits of the public $125 member bank deposits at the Federal Reserve Banks $1 25 demand deposits of the public transactions will be reversed shortly. The Treasury makes payments for goods and services and makes transfer payments by writing checks drawn on its deposits at the Federal Reserve Banks. Therefore, as the Treasury makes expenditures, Treasury deposits at the Federal Reserve Banks decrease, demand de posits of the public rise, and bank reserves increase. As the Treasury received payment from the public for the gold, Treasury deposits at Federal Reserve Banks rose by $125 million. These effects are shown in the middle of Illustration V. When the Treas ury spent the proceeds from the sale of gold, these transactions were reversed; demand deposits of the Treasury at Federal Reserve Banks fell by $125 Illustration V Treasu ry Sells G o ld to the Public and Redeems G o ld C ertificates a t Federal Reserve Banks (M illio n s Treasury Treasury Redeems Gold Certificates — $32 mone tized gold — $32 gold certificates — 32 demand deposits — 32 net worth 125 demand deposits 1 25 net worth Treasury Receives Payment for Gold of D o llars) Federal Reserve — $ 32 gold certificates No change — $32 Treasury demand deposits 125 Treasury demand deposits M onetary B ase1 Sources Uses — $ 32 gold ( + ) — 32 Treasury demand deposits at F.R. No change ( — ) 1 25 Treasury demand deposits at F.R. — 1 25 member bank deposits at F.R. ( " h ) — 125 Treasury demand deposits at F.R. 1 25 member bank deposits at F.R. — 125 member bank deposits Treasury Purchases Goods and Services with Proceeds of Gold Sale — 125 demand deposits No change No change 125 goods and services — 125 Treasury demand deposits . 0c , . 125 demand deposits of member banks 1Sign in brackets indicates direction o f effect on monetary base. Page 21 F E D E R A L R E S E R V E BAN K O F ST. LO UI S JANUARY 1 9 7 5 Illustration VI Summary o f Effects o f G o ld Transaction s on the M onetary Base (M illio n s of D ollars) M onetary Base Treasury $ 1 6 0 monetized gold $1 60 gold certificates Federal Reserve $1 60 gold certificates 75 demand deposits 85 ESF deposits — 107 Treasury cash 125 goods and services $75 Treasury demand deposits 93 net worth Sources Uses ( + ) $ 5 3 gold ( — ) 75 Treasury demand deposits at F.R. (-}■ )— 107 Treasury cash No change { — )8 5 ESF deposits ■Sign in brackets indicates direction o f effect on m onetary base. million and deposits of member banks at the Federal Reserve Banks rose by $125 million, as shown in the lower third of Illustration V. Illustration VI depicts the final effect on the monetary base, after the Treasury had monetized 4.5 million ounces of gold, sold about 750,000 ounces of gold to the public, and spent the proceeds from the sale of gold ($125 million). Gold in the mone tary base rose by $53 million, equal to the transfer of gold from the ESF ($85 million) less the official dollar amount sold to the public ($32 million). Treasury cash decreased by $107 million reflecting the decrease in nonmonetized gold. ESF deposits (included in “other deposits” ) rose by $85 million, reflecting the purchase of gold from the ESF by the Treasury. The Treasury experienced an increase in net worth because it sold gold, valued on its accounts at $42.22 Digitized for Page FRASER 22 an ounce, to the public at an average price of $165.65 an ounce. Gold holdings of the Treasury, as valued in Treasury accounts, decreased by $32 million, but the Treasury received $125 million from the public. Hence, the Treasury had a gain in net worth of $93 million. One important item to note in the final result for the monetary base is that Treasury demand deposits at the Federal Reserve Banks are $75 million higher even after it has spent the proceeds from the sale of gold. The Treasury received $192 million in deposits at Federal Reserve Banks as a result of monetizing 4.5 million ounces of gold. It spent $85 million to pay for the gold it acquired from the Exchange Stabiliza tion Fund and $32 million to retire gold certificates as a result of the sale of gold. When the Treasury spends the balance of the proceeds from monetizing gold ($75 million) the monetary base will increase by this amount. F E D E R A L R E S E R V E BANK O F ST. L OUI S JANUARY 1 9 7 5 Publications of This Bank Include: Weekly U. S. FINANCIAL DATA Monthly REVIEW MONETARY TRENDS NATIONAL ECONOMIC TRENDS Quarterly SELECTED ECONOMIC INDICATORS - CENTRAL MISSISSIPPI VALLEY FEDERAL RUDGET TRENDS U. S. RALANCE OF PAYMENTS TRENDS Annually ANNUAL U. S ECONOMIC DATA RATES OF CHANGE IN ECONOMIC DATA FOR TEN INDUSTRIAL COUNTRIES (QUARTERLY SUPPLEMENT) Single copies of these publications are available to the public without charge. For information write: Research Department, Federal Reserve Rank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166. Page 23