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V ol. 76, No. 1
J a n u a ry / F e b ru a ry 1994
Federal Reserve Lending to Banks That
Failed: Implications for the Bank
Insurance Fund
Measures of Money and the Quantity
Theory
Financial Innovation, Deregulation and
the “Credit V iew ” of Monetary Policy
THE
FEDERAL
J RESERVE
RANK of
ST. Lot IS
1
F e d e ra l R e s e rv e B a n k o f St. L o u is
R e v ie w
January/February 1994
In This Issue . . .
F e d e ra l R e s e rv e L e n d in g to B a n k s T h a t F ailed: Im p lic a tio n s f o r the
B a n k In s u ra n c e F u n d
R. Alton G ilbert
During the 1980s, many banks failed, imposing large losses on the Bank
Insurance Fund (BIF). The Federal Reserve loaned to many o f the banks
that ultimately failed, an association that convinced many that Federal
Reserve lending practices had increased BIF losses. Based on this concern,
Congress imposed limits on Federal Reserve lending to troubled banks in
the Federal Deposit Insurance Corporation Improvement Act of 1991.
R. Alton Gilbert investigates whether evidence supports the conclusion
that Federal Reserve lending practices increased BIF losses. For example,
among banks that failed in 1985-90, BIF losses were larger at banks that
borrowed from the Fed in their last year o f operation. Other evidence,
however, does not support the view that the lending by the Fed caused
the higher loss rate among the borrowers. Although borrowers remained
open slightly longer than nonborrowers with ratings indicating imminent
danger of failure, the behavior of borrowers during their last year is con
sistent with relatively effective actions o f supervisors in limiting the risk
they assumed. In addition, declines in large-denomination deposits, which
increase the cost to the BIF of resolving bank failure cases through liqui
dation, declined at about the same rate for both borrowers and nonbor
rowers in their last year.
19
M e a s u re s o f M o n e y a n d the Q u a n tity T h e o r y
Jam es B. Bullard
Many economists believe that the quantity theory o f money explains the
relationship between money and inflation over long periods o f time. In
particular, they believe that a permanent increase in the quantity of
money will eventually produce an equiproportionate permanent increase
in the general level o f prices. Similarly, a more rapid, sustained rate of
money growth will produce a higher rate of inflation.
James B. Bullard examines, from a nonstructural, low-frequency point of
view, the basic proposition that money growth and inflation are closely
related in the long run. The article extends the analysis of Robert E. Lu
cas, Jr., whose work is often cited as an illustration of the validity of the
quantity theory. Bullard’s results generally support the quantity theoretic
proposition that money is long-run neutral.
JANUARY/FEBRUARY 1994
2
31
F in a n c ia l In n o v a tio n , D e re g u la tio n a n d th e “C re d it V i e w ” o f M o n e ta ry
P o lic y
Daniel L. Thornton
As analysts search for explanations for the protracted recovery from the
last recession, a great deal of attention has been focused on the "credit
view ” of monetary policy, which argues that monetary policy affects the
economy through the direct affect of policy actions on the supply of
depository institutions’ credit. Daniel L. Thornton outlines the credit view
and argues that the conditions for it are stringent. He then argues that
financial innovation, deregulation and changes in the structure of reserve
requirements during the past decade or so should have significantly
weakened, if not eliminated, the bank credit channel of monetary policy.
Thornton investigates the direct link between monetary policy actions
and bank lending. Consistent with his previous analysis, he finds evidence
of a weak and deteriorating relationship between Federal Reserve actions
and the supply o f bank credit. Thornton’s analysis suggests that the
removal of reserve requirements on a very large proportion of banks’
sources of funds since 1980 has eliminated any direct relationship be
tween the Fed’s actions and bank credit. He concludes that there is little
reason to suspect that monetary policy works through the bank credit
channel, if it ever did, and he considers why interest in the bank lending
channel appears to have been rejuvenated at just the time when justifica
tion for it has eroded.
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FEDERAL RESERVE BANK OF ST. LOUIS
3
R. Alton Gilbert
Ft. Alton Gilbert is an assistant vice president at the Federal
Reserve Bank of St. Louis. Christopher A. Williams provided
research assistance.
IFederal Reserve Lending to
Banhs That Failed: Implications
f o r the Bank Insurance Fund1
D
EBATE THAT LED TO PASSAGE of the
Federal Deposit Insurance Corporation Improve
ment Act (FDICIA) in 1991 focused on changes
in public policy to reduce losses of the deposit
insurance funds. One aspect of public policy
subject to such scrutiny was lending by the Fed
eral Reserve to troubled banks. A report pre
pared by congressional staff indicated that over
300 of the banks that failed in 1985-91 were
borrowing from the Fed when they failed, and
that 90 percent of the banks that borrowed for
extended periods of time eventually failed.2
Other evidence caused the authors of that con
gressional staff report to conclude that Fed
credit extended the life o f borrowers that ulti
mately failed. Critics of Fed lending practices
concluded on the basis of this evidence that
lending to troubled banks increased losses to
the Bank Insurance Fund (BIF).3 This concern
led to constraints on Federal Reserve lending to
troubled banks in FDICIA (see the shaded insert
on page 4, "Restrictions on Federal Reserve
Lending Under FDICIA”).
Restrictions on Federal Reserve lending to
troubled banks raise several issues, including
the proper role o f the discount window and the
necessary freedom of action for a central bank
in limiting systemic impacts of problems in the
operation of a banking system. Failures of banks
may have systemic impacts if they cause other
banks to fail or cause disruptions in the pay
ment system or financial markets. This article
focuses on the more narrow issue of whether
Federal Reserve lending to troubled banks in re
cent years raised the losses of BIF. Critics of
1The author thanks Kenneth Spong and Walker Todd for
helpful information and insights. The views of the author
do not necessarily reflect the views of the Federal Reserve
Bank of St. Louis or the Federal Reserve System.
2See U.S. House of Representatives (1991c).
3See Garsson (1991), Rehm (1991), Starobin (1991) and Todd
(1991, 1992). The FDIC insures the deposits of banks and
savings and loan associations but maintains BIF as a
separate fund for commercial banks and mutual savings
banks. Banks pay insurance premiums into BIF, which then
covers any losses when banks fail.
JANUARY/FEBRUARY 1994
4
Restrictions on Federal R eserve Len din g
U n d er FDICIA
FDICIA restricts Federal Reserve lending to
banks that do not meet the minimum capital
requirements. For purposes of the various
provisions restricting lending, a bank that
fails to meet one or more of the minimum
capital requirements is classified as under
capitalized. In addition, a bank is classified as
undercapitalized if it has a composite CAMEL
rating of 5 by its supervisory agency (or an
equivalent rating under a comparable rating
system), even if it meets the minimum capital
requirements. A CAMEL rating of 5 indicates
imminent danger o f failure. A bank is classi
fied as critically undercapitalized if its tangi
ble equity is less than 2 percent of its total
assets.
Under certain circumstances, the Federal
Reserve may be liable to the FDIC for losses
resulting from loans to undercapitalized or
critically undercapitalized banks. If the Feder
al Reserve lends to a bank for more than five
days after it becomes critically undercapital
ized, and an FDIC deposit insurance fund in
curs a loss greater than would have been
incurred in the absence of the loan, the
Hoard o f Governors may be liable to the FDIC
for part of the additional loss.
Fed lending practices have emphasized anecdo
tal evidence from a few bank failure cases,
particularly the failures of the Bank o f New
England and the Madison National Bank.4 This
article, in contrast, examines whether the record
of Fed lending to many failed banks supports
the arguments of the critics.
The evidence in this study indicates that loans
from the Fed to many of the failed banks in
their last year were concentrated near the time
of failure and were allocated to the banks with
the greatest liquidity needs. The evidence does
not support the argument that Federal Reserve
lending to troubled banks increased the losses
o f the FDIC.
4See Schwartz (1992), Todd (1992) and comments by
policymakers in Rehm (1991). For hearings on the failures
of these banks, see U.S. House of Representatives (1991a,
1991b).
FEDERAL RESERVE BANK OF ST. LOUIS
FDICIA restricts Federal Reserve lending to
an undercapitalized bank to no more than 60
days in any 120-day period, unless the head
o f the appropriate federal supervisory agency
or the chairman of the Board o f Governors
certifies the bank’s viability. A certification of
viability is a determination that, in light of
the economic conditions and circumstances in
the local market, the bank is not critically un
dercapitalized, is not expected to become crit
ically undercapitalized and is not expected to
be placed in conservatorship or receivership.
A certification of viability suspends the limit
on lending for more than 60 days in any
120-day period. A Reserve Bank may lend to
a bank certified as viable for 60 days, begin
ning on the day of the certification. This
60-day period may be extended for additional
60-day periods on receipt o f additional w rit
ten certifications of viability. If the Federal
Reserve extends credit to an undercapitalized
bank beyond the limit of 60 days in any
120-day period without a certificate of viabili
ty in effect, the Board of Governors may be
liable to the FDIC for part of the additional
loss incurred by one of its deposit insurance
funds as a result.
FEDERAL RESERVE PO LIC Y ON
LENDING TO T R O U B LE D BANKS
P R IO R T O FDICIA
Prior to passage o f FDICIA in 1991, the Feder
al Reserve had a long-standing policy of not
lending to nonviable institutions, except when
such lending would facilitate an orderly resolu
tion of institutions. Lending to facilitate orderly
resolutions had been undertaken in cooperation
with the institutions’ supervisors and with the
deposit insurance authorities. Under this policy,
the Federal Reserve loaned to some troubled
banks for extended periods of time. Two of the
large banks that received Fed credit for extended
5
periods of time were the Franklin National Bank,
in 1974, and the Continental Illinois National
Bank, in 1984.5
In response to public criticism that the Feder
al Reserve had subsidized the Franklin National
Bank, the Fed amended its lending regulations
to establish a new, higher special discount rate
for protracted emergency assistance to particu
lar banks. Figure 1 indicates that such emergen
cy assistance—which has been called extended
credit since 1980—at times has been the
predominant form of discount window lending.
Prior to passage of FDICIA late in 1991, there
were no legal constraints on the size or dura
tion of Federal Reserve lending to troubled
banks.
THE DEBATE OVER LENDING TO
TR O U B LE D BANKS
The Issues
Public discussion that led to passage of limits
in FDICIA on the authority of the Federal Reserve
to lend to troubled banks involved two issues.
The first issue, philosophical in nature, involved
the proper purpose for lending. Walker Todd
(1988, 1991, 1992), a major contributor to this
debate, has asserted that the proper role for the
discount window is to lend for short periods of
time to solvent banks that are temporarily illi
quid. Todd has described Federal Reserve lend
ing to troubled banks for extended periods of
time as the substitution of credit from the Fed
eral Reserve for capital of the banks, which he
considered inappropriate use of the discount
window.
The second issue involved the implications of
Federal Reserve lending practices for BIF losses.
This second issue appears to have been more
important to Congress than the philosophical is
sues raised by Todd, because BIF losses may af
fect the budget o f the federal government. For
that reason, this article focuses on the second
issue in the debate, the implications of Fed lend
ing practices for BIF.
Critics o f Fed lending practices cited two rea
sons why lending to troubled banks may have
5For a view on the history of Federal Reserve discount win
dow lending, see Schwartz (1992). Thrift institutions have
had access to credit from the discount window since 1980,
under provisions of the Monetary Control Act. This paper
focuses on lending to commercial banks. For convenience,
all depository institutions are called banks.
increased BIF losses. First, credit from the Fed
eral Reserve may have given the borrowers ex
tra time to assume additional risk. Banks may
have increased risk through rapid growth of
their assets, in desperate gambles to regain
financial strength, or through actions to benefit
shareholders, such as paying dividends.
The second argument involved reductions in
borrowers' uninsured deposits. Deposits often
decline when the public becomes aware of a
bank’s troubles, but deposits in denominations
above the insurance limit of $100,000 per ac
count tend to fall more rapidly than fully in
sured deposits. Credit from the Fed may have
allowed the borrowers to remain in operation
while funding relatively rapid declines in their
uninsured deposits. Without credit from the
Fed, these banks may have been unable to fund
deposit withdrawals some time prior to their
failure dates. Chartering agencies might have
closed these banks earlier, when their unin
sured deposit liabilities were larger, if the Fed
had not made its credit available.
Implications of declines in uninsured deposits
for the losses to BIF in bank failure cases de
pend on the methods used by the FDIC to
resolve these failures.6 The simplest method is
liquidation, in which the failed bank is closed
and the FDIC pays insured depositors in full.
The FDIC over time pays the uninsured deposi
tors a fraction of their deposits, which depends
on the value of the failed bank’s assets. If the
value of the assets is less than the value of the
liabilities, the FDIC and the uninsured deposi
tors share as losses the gap between the value
of assets and liabilities. A decline in uninsured
deposits raises the cost to BIF if a case is resolved
through liquidation, since a decline in uninsured
deposits forces the FDIC to absorb more of the
shortfall o f the value of assets below liabilities.
In cases resolved through transfer o f insured
deposits, banks bid for the deposit accounts of a
failed bank in denominations below the insur
ance limit. The winning bidder assumes the in
sured deposit accounts o f the failed bank, and
the FDIC makes a cash payment to the winning
bidder equal to the deposits, minus the premi6See the appendix to Gilbert (1992) for an analysis of the
distribution of losses between the FDIC and uninsured
depositors under alternative methods of resolving bank
failure cases.
JANUARY/FEBRUARY 1994
6
um paid by the winning bidder.7 The cost o f a
resolution arranged as a transfer of insured
deposits tends to be lower than what the cost
would have been under liquidation by the
amount of the premium, net of administrative
costs of arranging the resolution. The FDIC
shares with the uninsured depositors any losses
from resolving the failed bank. Declines in unin
sured deposits have the same implications for
BIF losses under liquidation and transfer of in
sured deposits.
During the years covered by this study,
1985-90, the FDIC resolved most bank failure
cases through a third method called purchase
and assumption (P&A). In a case resolved through
P&A, the bank with the winning bid assumes all
of the deposit liabilities of the failed bank and
purchases some of its assets. The cash payment
from the FDIC to the winning bidder equals all
deposit liabilities (insured and uninsured), minus
the value o f assets purchased by the winning
bidder, minus the premium. The FDIC does not
share any o f the losses with uninsured deposi
tors in cases resolved through P&A, since the
winning bidder assumes all o f the deposit liabili
ties. Even in cases resolved through P&A,
however, declines in uninsured deposits may
increase BIF losses. In some cases, resolution
costs might have been lower if the failed banks
had been closed prior to the declines in unin
sured deposits and resolved through liquidation
or transfer of insured deposits.
their supervisory agencies (the rating that
indicates imminent danger of failure).8
3. Borrowers that failed remained open for
10-12 months on average after being rated
CAMEL 5 by their supervisory agencies. The
report implies that the banks would not have
stayed open that long after being rated CAMEL
5 without Federal Reserve credit.
4. Borrowings increased dramatically as the con
dition of institutions deteriorated.
5. The Federal Reserve took the highest quality
assets as collateral when banks borrowed, in
amounts substantially in excess o f the loan
amounts.
6. Of the 530 failed institutions that borrowed
from the Federal Reserve in the three-year
period prior to their failure, 320 were bor
rowing at the time o f their failure, with $8.3
billion in discount window credit outstanding.
This paper investigates the implications o f these
conclusions for BIF losses.
B O R R O W IN G S BY A SAM PLE OF
FAILED BANKS
1. Ninety percent of all institutions that received
extended credit during this period subse
quently failed.
This section presents information on Federal
Reserve lending to a sample o f banks that failed
from 1985-90. The number of bank failures per
year was relatively large during that period.
Including these years yields a large sample of
failed banks. The sample ends in 1990 to avoid
failures in periods in which Federal Reserve
lending to troubled banks was influenced by the
provisions in FDICIA. Since the content of
FDICIA was discussed and debated throughout
most of 1991, the sample ends with the failures
in 1990. Note in Figure 1 that extended credit
borrowings were relatively low throughout 1991
and have been zero or relatively small since late
1991, when FDICIA was enacted.
2. The Federal Reserve routinely extended credit
to institutions with CAMEL ratings of 5 by
The sample is restricted to failed banks that
reported their deposits to the Federal Reserve
The Evidence
The staff of the House Banking Committee is
sued a report in 1991 that summarized patterns
in Federal Reserve lending to insured depository
institutions from January 1, 1985, through May
10, 1991. The report concluded:
W in n in g bidders in cases resolved through transfer of in
sured deposits often purchase some of the assets of the
failed banks.
aWhen government supervisors examine a bank, they give it
ratings from 1 (the best) to 5 (the worst) on five aspects of
its operations: Capital adequacy, Asset quality, Manage
ment, Earnings and Liquidity (CAMEL, for short). In addi
tion, supervisors assign a composite CAMEL rating from 1
to 5, based on the ratings for these five components.
Banks with composite ratings of 4 or 5 are classified as
FEDERAL RESERVE BANK OF ST. LOUIS
problem banks and subjected to relatively close supervi
sion. Banks rated composite CAMEL 5 are in such poor
condition that their supervisors consider them to be in
imminent danger of failing.
7
Figure 1
Total and Extended Credit Borrowings
Billions of dollars
9
8
7
6
5
4
3
2
1
each week in their last year, because the analy
sis involves deposit data in their last year. This
restriction affects the size distribution o f the
banks in the sample. Relatively small banks
report their deposit liabilities and vault cash
for one week in a quarter, and their required
reserves are set at the same level for a quarter
based on their reports. The maximum asset size
of the quarterly reporters was changed over the
years 1985-90.
Restricting the sample to those that reported
deposit data to the Fed in each of their last 52
weeks reduces a potential sample o f 870 failed
banks to 318. Figure 2 presents the size distri
bution of the banks in the sample, based on
their total assets as o f failure date. Restricting
the sample to banks that reported their deposits
weekly for their last 52 weeks eliminates the
very small banks. None o f the banks in the sam
ple had total assets below $10 million, and only
19 of the 318 banks had total assets below $20
million as of their failure date.
Results derived from this sample o f 318 banks
may not apply for smaller banks. In several
ways, however, the observations on borrowings
in the report of the House Banking Committee
are similar to the patterns of borrowings by
banks in this study. Also, among the 870 banks
in the broader sample, ratios o f BIF loss to total
assets are not related systematically to asset
size, and the distributions o f banks by resolu
tion methods are similar for the larger and
smaller samples o f banks.
Table 1 presents the distribution of the 318
banks in the sample by year of failure and bor
rowings in their last 52 weeks. Failures o f the
banks occurred fairly uniformly over the 198590 period. About 58 percent of these banks bor
rowed in at least one o f their last 52 weeks.
Borrowings tended to be concentrated in the
weeks just prior to failure. Of the 185 banks
that borrowed in their last 52 weeks, 154 (83.2
percent) borrowed in at least one of their last
13 weeks. For the 318 banks as a group, about
54 percent of the total dollar amount o f bor
rowings in their last 52 weeks occurred in their
last 13 weeks. This observation confirms the
conclusion in the report by the staff of the
House Banking Committee that borrowings in
creased as the condition o f the banks deteri
orated.
JANUARY/FEBRUARY 1994
8
Figure 2
Distribution of Banks in the Sample by Total Assets as of Failure Date
Total Assets as of Failure Date
(in Millions of Dollars)
0-9.99
10-19.99
20-29.99
30-39.99
40-49.99
50-59.99
60-69.99
70-79.99
80-89.99
90-99.99
100-149.99
150-199.99
200-299.99
300-399.99
400-499.99
500-599.99
600-699.99
700-799.99
800-899.99
0
20
Conclusions of the staff report of the House
Banking Committee leave the impression that
many failed banks borrowed for long periods
prior to their failure. For instance, the observa
tion that borrowers remained in operation 10 to
12 months on average as CAMEL-5 rated banks
leaves the impression that credit from the dis
count window was essential for keeping the
borrowers in operation during their last 10 to
12 months. This study indicates, in contrast,
that only a small minority of the banks bor
rowed for at least half of their last year. Only
28 of the 318 banks (8.8 percent) borrowed in
at least 26 of their last 52 weeks.9 The discount
window may have become less accommodating
to troubled banks in 1989-90; only four of the
94 banks that failed in those years borrowed in
half or more of their last 52 weeks.
The sample o f failed banks is distributed very
unevenly across Federal Reserve Districts, with
9The extreme cases in this sample involved two banks in
the Kansas City District that borrowed almost continuously
for about two years and then failed.
FEDERAL RESERVE BANK OF ST. LOUIS
40
Total Number of Banks
60
80
88 percent o f the banks located in Districts 6,
10, 11 and 12 (Table 2). These Districts also ac
count for most o f the banks that borrowed in
their last 52 weeks. The banks that borrowed in
half or more o f their last 52 weeks were con
centrated in Districts 10 (Kansas City) and 11
(Dallas), which may reflect differences in Reserve
Bank lending practices. While the 12 districts
follow the same general policies on lending, the
staff of the district Reserve Banks have some
freedom to follow different lending practices.
Banks in the sample also differ substantially
by the amount of their borrowings relative to
the size o f their total deposits. For most of the
banks that borrowed from the Fed in their last
year, average borrowings w ere small relative to
their average total deposits. Over their last 52
weeks, for instance, 85 percent of the failed
banks either didn’t borrow from the Fed or
their borrowings were less than 1 percent of
9
Table 1
Distribution of Sample Banks by Borrowings from the Federal Reserve in Their
Last Year
Year of failure
Number
of
banks
1985
1986
1987
1988
1989
1990
50
60
60
54
44
50
TOTAL
Borrowed in
their last
52 weeks
(percent)
Borrowed in at
least 26 of
their last
52 weeks
(52.0)
(60.0)
(71.7)
(55.6)
(59.1)
(48.0)
24
28
39
26
18
19
4
8
6
6
2
2
185 (58.2)
154
28
26
36
43
30
26
24
318
Borrowed in
their last
13 weeks
Table 2
Distribution of Sample Banks by Federal Reserve District
Federal Reserve District
Number of
banks
Borrowed in
their last
52 weeks
1
2
3
4
5
6
7
8
9
10
11
12
4
7
0
3
0
36
14
2
7
66
148
31
2
3
0
2
0
22
6
1
2
46
85
16
1
1
0
1
0
19
4
1
2
37
75
13
0
0
0
0
0
2
2
0
0
10
12
2
TOTAL
318
185
154
28
their average total deposits (Table 3). In con
trast, borrowings w ere large relative to total
deposits at a few of the banks. Borrowings of
three banks exceeded 10 percent of their total
deposits over their last 52 weeks. Ratios of bor
rowings to total deposits tended to be higher
over the last 13 weeks than over longer periods
prior to failure dates, since borrowings tended
to rise and deposits decline as banks approached
their failure dates. For instance, borrowings of
15 banks exceeded 10 percent of their total
deposits over their last 13 weeks.
Borrowed in
their last
13 weeks
Borrowed in at
least 26 of
their last 52 weeks
IM PLIC ATIO N S OF B O R R O W IN G S
FOR THE B A N K INSURANCE
FUND
Direct Comparisons o f BIF Loss
Ratios
Analysis o f the effects o f Federal Reserve
lending to troubled banks on the losses of BIF
begins with comparisons in Table 4 of BIF losses
associated with the failed banks that borrowed
from the Federal Reserve and those that did not
JANUARY/FEBRUARY 1994
10
Table 3
Distribution of Sample Banks by the Size of Their Borrowings Relative to Their
Average Total Deposits____________________________________________________
Sum of borrowings divided by the sum of total deposits
_____________ over the following periods ending on failure dates:
Last 13 weeks
Range of ratios of
borrowing to total deposits
Zero
0.000
0.001
0.005
0.010
0.020
0.050
0.100
0.200
No. of
banks
< X < 0.001
< X < 0.005
< X < 0.010
< X < 0.020
< X < 0.050
< X < 0.100
< X < 0.200
< X
164
28
29
23
20
25
14
11
4
Cumulative
percent
51.57%
60.38
69.50
76.73
83.02
90.88
95.28
98.74
100.00
borrow in their last year. The mean BIF loss ra
tios in Table 4 for banks that did and did not
borrow from the Fed in their last year are not
adjusted for differences among the banks, other
than borrowings, that might explain differences
in BIF loss ratios, such as the condition of banks
prior to borrowing or regional effects.
Mean BIF loss ratios are about 5 percentage
points higher among the failed banks that bor
rowed from the Federal Reserve in their last
year, and differences in the mean loss ratios are
highly significant. The high /-statistics for differ
ences in mean BIF loss ratios indicate that there
is only a very small chance that the BIF loss ra
tios of the borrowers and nonborrowers were
drawn from the same distribution.
The association between borrowings and BIF
loss ratios in Table 4 does not necessarily indi
cate that Fed lending practices caused higher
BIF losses. Perhaps the banks that borrowed
from the Fed in their last year would have had
higher BIF loss ratios than the other banks if
the Fed had not loaned to them. Two observa
tions raise doubts about the argument that
loans by the Fed caused the higher BIF loss ra
tios among the borrowers. First, borrowings of
most banks w ere concentrated near the time of
their failure dates, long after they had assumed
the risk that led to their failure. Second, if Fed
eral Reserve lending caused the higher BIF loss
FEDERAL RESERVE BANK OF ST. LOUIS
Last 26 weeks
No. of
banks
149
54
29
23
22
24
10
5
2
Cumulative
percent
46.86%
63.84
72.96
80.19
87.11
94.65
97.80
99.37
100.00
Last 52 weeks
No. of
banks
133
65
52
21
23
15
6
2
1
Cumulative
percent
41.82%
62.26
78.62
85.22
92.45
97.17
99.06
99.69
100.00
ratios among the borrowers, w e would expect
the banks that borrowed the most relative to
their deposit size to have the highest BIF loss
ratios. This is not the case. Figures 3 and 4
present information on the association between
BIF loss ratios and ratios of borrowings to
deposits among the banks that borrowed in
their last year. Measuring borrowings over the
last 13 weeks (Figure 3) and the last 52 weeks
(Figure 4), there does not appear to be a posi
tive association between BIF loss ratios and bor
rowings ratios.
The remainder o f this section attempts to de
termine whether Fed lending practices caused
the higher BIF loss ratios among the borrowers
by investigating whether evidence supports the
assumptions that underlie such a direction of
causality.
Did Federal R eserve Credit Help
K eep P ro b lem Banhs Open?
Credit from the Fed may have allowed the
borrowers to remain open longer as troubled
banks than the nonborrowers. Supported by
Fed credit, the borrowers may have assumed
additional risk just prior to their failure, result
ing in larger losses to BIF when they failed. The
report by the staff o f the House Banking Com
11
Table 4
Association Between BIF Loss Ratio and Borrowings by Failed Banks in Their
Last Year
Group of banks based on borrow
ings from the Federal Reserve
Borrowings in last 13 weeks:
Yes
No
Borrowings in last 26 weeks:
Yes
No
Borrowings in last 52 weeks:
Yes
No
Number of banks
Mean BIF loss ratio*
(standard deviation in
parentheses under mean)
154
0.3067
(0.1181)
164
0.2514
(0.1253)
169
0.3079
(0.1228)
149
0.2445
(0.1186)
185
0.3007
(0.1253)
133
0.2468
(0.1175)
t-statistic for
difference in means
4.01
4.73
4.02
*The BIF loss ratio is the ratio of the loss to BIF from a bank failure divided by total assets of the failed bank as of its
failure date.
mittee emphasized such a link between borrow
ings and BIF losses. One of the key conclusions
was that the failed banks which borrowed from
the Federal Reserve in their last three years re
mained open on average about 10 to 12 months
after supervisors rated them as CAMEL 5. The
report implies that these banks would have
been closed earlier if the Federal Reserve had
not provided credit.
There are two problems with such an infer
ence. First, the report does not indicate when
in their last three years these banks borrowed
from the Federal Reserve. Suppose a bank bor
rowed for one day three years prior to its failure
and was rated CAMEL 5 one year prior to
failure. This case would be included among the
observations supporting the inference that Fed
eral Reserve credit helped some CAMEL 5 banks
stay open for relatively long periods.
A second problem is a lack o f comparison to
the length of time that nonborrowers were rated
CAMEL 5 prior to their failure dates. Table 5
provides such a comparison. The sample o f 318
failed banks is divided into two groups: those
that borrowed from the Federal Reserve in
their last 13 weeks and those that did not. Bor
rowings are observed over the last 13 weeks be
cause any banks kept open only through access
to Federal Reserve credit would be borrowing
from the Fed near the time of their failure. Ta
ble 5 presents the distributions of these banks
by the length o f time they were rated CAMEL 4
or 5, and rated CAMEL 5, prior to their failure.
Banks rated CAMEL 4 or 5 are classified as
problem banks. It is relevant to know whether
Federal Reserve credit helped banks rated
CAMEL 4 or 5 remain in operation for relatively
long periods prior to their failure, in addition to
analysis that focuses exclusively on CAMEL
5-rated banks.
The distributions of banks by the number of
months they w ere rated CAMEL 4 or 5 prior to
their failure are almost identical for the borrow
ers and nonborrowers. The median number of
months between the time the banks were rated
problem banks and their failure was 20.5 months
JANUARY/FEBRUARY 1994
12
Figure 3
Relationship Between Borrowings Ratios and BIF Loss
Ratios Among Banks that Borrowed: Last 13 Weeks
Average Total Borrowings Divided by Average Total Deposits
Loss to BIF Divided by Total Assets as of Failure Date
Figure 4
Relationship Between Borrowings Ratios and BIF Loss
Ratios Among Banks that Borrowed: Last 52 Weeks
Average Total Borrowings Divided by Average Total Deposits
0 .6 -|---------------------------------------------------------------------------------
0 .5 0 .40 .3-
01 0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Loss to BIF Divided by Total Assets as of Failure Date
FEDERAL RESERVE BANK OF ST. LOUIS
0.8
13
Table 5
Cumulative Distributions of Banks by the Length of Time They Were Problem
Banks Prior to Failure
Borrowed.from the Federal Reserve
in their last 13 weeks:
No. of months rated CAMEL 4
or 5: less than
Yes
No. of banks
1
2
5
10
15
20
25
30
36
36 or more
5
11
15
27
47
72
96
111
130
154
No
Percent
3.2%
7.1
9.7
17.5
30.5
46.8
62.3
72.1
84.4
100.0
6
10
13
27
52
77
105
120
135
164
Percent
3.7%
6.1
7.9
16.5
31.7
47.0
64.0
73.2
82.3
100.0
20
20. 5
Median no. of months rated CAMEL 4 or 5
No. of banks
No. of months rated CAMEL 5: less than
1
2
5
10
15
20
25
30
36
36 or more
Median no. of months rated CAMEL 5
15
30
46
77
111
135
148
152
153
154
9.5
for the borrowers and 20 months for the nonborrowers.10
The banks that borrowed in their last 13
weeks tended to be rated CAMEL 5 somewhat
longer than the nonborrowers. The median
period the banks w ere rated CAMEL 5 prior to
failure was 9.5 months for borrowers, com
pared to seven months for the nonborrowers.
Access to credit from the discount window,
however, does not appear to have been the only
9.7%
19.5
29.9
50.0
72.1
87.7
96.1
98.7
99.4
100.0
22
40
63
102
130
146
153
158
162
164
13.4%
24.4
38.4
62.2
79.3
89.0
93.3
96.3
98.8
100.0
7
factor determining how long the borrowers and
nonborrowers rated CAMEL 5 remained in
operation. If access to Fed credit had been the
only factor, all of the borrowers would have
been rated CAMEL 5 for relatively long periods
prior to their failure, and all of the nonborrow
ers rated CAMEL 5 for relatively short periods.
This was not the case. Periods that both bor
rowers and nonborrowers were rated CAMEL 5
ranged from less than one month to three years
or more. About 20 percent of the borrowers
were closed within two months o f the time
,0The median is used, instead of the mean, because the few
failed banks that remained open for long periods as
problem banks could distort comparisons of means. For
instance, among the 154 borrowers, three banks were rated
CAMEL 4 or 5 for over 60 months prior to failure; among
the 164 nonborrowers, four banks were rated CAMEL 4 or
5 for over 60 months.
JANUARY/FEBRUARY 1994
14
when their supervisors rated them CAMEL 5,
whereas many of the nonborrowers remained
in operation rated CAMEL 5 for much longer
periods.
Suppose Table 5 is interpreted as indicating
that access to credit from the Federal Reserve
allowed borrowers to remain in operation slight
ly longer as CAMEL 5-rated banks. What would
this imply for losses to BIF? The idea that trou
bled banks should be closed promptly to keep
them from taking actions that expose BIF to
larger losses is based on the assumption that
supervisors have been ineffective in preventing
troubled banks from taking such actions. This
author, however, has found evidence that super
visors have been effective in constraining the
behavior o f most of the troubled banks under
their jurisdiction.
Some of the evidence reveals the behavior of
banks while their capital ratios were below re
quired levels or while supervisors rated them as
problem banks. Supervisors attempt to limit as
set growth, dividends and loans to officers and
directors o f the banks (the insiders) of under
capitalized and problem banks. Gilbert (1991)
reported that large majorities of the banks that
operated in 1985-89 for four or more consecu
tive quarters with capital ratios below the mini
mum capital requirement in effect at the time
reduced their assets, refrained from paying divi
dends and had lower insider loans while under
capitalized. Gilbert (1992) found that the banks
undercapitalized the longest prior to failure had
the fastest declines in their total assets in their
last year, and the group o f banks undercapital
ized the longest prior to their failure had the
smallest percentage paying dividends in their
last year. Gilbert (1993) found that banks reduced
the growth rates of their assets and reduced
their dividends when supervisors downgraded
them to problem status.
Another study tests directly the association
between the length o f time prior to their failure
that banks operated with capital ratios below
the minimum required level and the losses to
the deposit insurance fund resulting from their
failures. Gilbert (1992) found no association be
tween losses to the deposit insurance fund and
the length of time banks were undercapitalized
prior to their failure. Thus, if Federal Reserve
lending practices allowed some CAMEL 5-rated
banks to remain in operation slightly longer
than others, it is not clear that those lending
practices had any effect on BIF losses.
FEDERAL RESERVE BANK OF ST. LOUIS
Behavior o f the Banks That
B orrow ed
Conclusions about the behavior of most trou
bled banks may not apply to those that bor
rowed from the Fed near the time of their
failure. Since these banks w ere privileged to
have access to credit from the discount window
near the time of their failure, they may have
had other privileges not available to all troubled
banks.
The articles cited above indicate that troubled
banks subject to relatively close supervision
tended to reduce their assets and refrain from
paying dividends. Table 6 examines the deposit
growth and dividends of borrowers and nonbor
rowers that were rated CAMEL 4 or 5 one year
prior to their failure. Of these 238 banks, 96
did not borrow from the Fed in their last year,
and the remaining 142 banks borrowed at least
once in their last year. The 142 borrowers are
divided into several groups, based on their aver
age borrowings over their last year as a percen
tage of average total deposits over their last
year. For each of the groups in Table 6, based
on their borrowings ratios, the mean of the per
centage change in total deposits in their last
year was negative. The borrowers tended to
have more rapid declines in total deposits in
their last year than the nonborrowers, and
those that borrowed more relative to the size of
their total deposits tended to have faster rates
of decline in total deposits than the banks with
lower borrowings ratios. These observations are
consistent with the view that the banks that
borrowed most relative to their deposits had
the greatest liquidity needs.
About 15.5 percent of the banks rated CAMEL
4 or 5 in their last year paid dividends in their
last year, and this percentage was about the
same for the borrowers and nonborrowers.
Dividends as a percentage of total assets, how
ever, were smaller among the borrowers that
paid dividends in their last year (mean of 0.29
percent) than among the nonborrowers that
paid dividends in their last year (mean of 0.45
percent). Based on deposit growth and divi
dends, supervision of the problem banks that
borrowed in their last year appears to have
been at least as strict as the supervision of
problem banks that did not borrow from the
Fed.
15
Table 6
Deposit Growth and Dividends of Banks Rated CAMEL 4 or 5 Over Their
Last Year
Range of ratios of borrowings
to total deposits over the last
52 weeks
Zero
0 < x ^ 0.001
0.001 < x < 0.005
0.005 < x £ 0.010
0.010 < x < 0.020
0.020 < x £ 0.050
0.050 < x < 0.100
0.100 < x < 0.200
0.200 < x
TOTAL
No. of
banks
Mean of percentage
change in total
deposits over last
52 weeks
96
53
35
16
17
13
5
2
1
238
Did B orrow ers Have Larger
Declines in Uninsured Deposits?
One of the arguments that Fed lending prac
tices raised BIF losses rests on the assumption
that uninsured deposits declined more rapidly
at borrowing banks than at nonborrowing
banks. Table 7 indicates that for the banks that
borrowed in their last year, the mean of the
percentage change in large denomination time
deposits over their last 52 weeks (negative 34.3
percent) was significantly different from the
mean percentage change in other deposits
(negative 9.6 percent). Large denomination time
deposits of the banks that borrowed from the
Fed in their last 26 weeks also declined more
rapidly on average than their other deposits
over their last 26 weeks (negative 26.2 percent
compared to negative 8.6 percent).
This pattern of more rapid declines in large
denomination time deposits than in other
deposits at borrowing banks, however, is almost
"Instructions for reporting deposits call for classifying
brokered deposits in denominations of $100,000 or less as
small denomination time deposits.
-1 2 .1 %
-1 3 .1
-1 7 .2
-2 0 .2
-1 9 .5
-2 7 .3
-2 9 .9
-1 9 .2
-5 8 .3
No. of banks that
paid dividends in
their last year
15
5
8
3
3
0
3
0
0
Of banks that paid
dividends, mean of
dividends as percent
age of average total
assets over the
last year
0.45%
0.12
0.41
0.22
0.27
N/A
0.35
N/A
N/A
37
identical to the record for the banks that did
not borrow from the Federal Reserve in their
last year.12 Credit from the Federal Reserve
does not appear to have facilitated more rapid
declines in large denomination time deposits at
the banks that borrowed from the Fed. These
observations fail to support one of the argu
ments linking access to credit from the discount
window and BIF losses: that declines in unin
sured deposits near the time of failure were
more rapid for borrowers than nonborrowers.
Federal R eserve Lending to
Troubled Banks M ay H ave Limited
B IF Losses b y Prom oting Orderly
Resolutions
Resolution of a failed bank through methods
other than liquidation takes some time for the
FDIC to arrange. The FDIC has to prepare a
package of assets and liabilities for bidders to
nonborrowers, measured over their last 26 weeks and over
their last 52 weeks, are less than 0.2.
12The f-statistics for differences between the mean growth
rates of large denomination deposits at the borrowers and
JANUARY/FEBRUARY 1994
16
Table 7
Deposit Growth of Failed Banks in the Last Year: Borrowers and Non
borrowers
Banks that borrowed from the
Fed in their last 52 weeks
Banks that d id n o t borrow from
the Fed in their last 52 weeks
Mean percentage change in total deposits in
their last:
26 weeks
(f-statistic for difference in growth rates for
borrowers and nonborrowers)
-1 3 .0 %
(-2 .3 8 )
-1 0 .3 %
52 weeks
((-statistic for difference in growth rates for
borrowers and nonborrowers)
-1 7 .3
(-2 .7 9 )
-1 1 .7
Mean percentage change in large time deposits
in the last 26 weeks
-2 6 .2
-2 5 .6
Mean percentage change in deposits other than
large time deposits in the last 26 weeks
-
8.6
-
7.0
f-statistics for difference in means of growth
rates of large time deposits and other deposits
-
9.01
-
5.63
Mean percentage change in large time deposits
in the last 52 weeks
-3 4 .3
-3 3 .5
Mean percentage change in deposits
other than large time deposits in the last
52 weeks
-
9.6
-
6.0
f-statistics for difference in means of growth
rates of large time deposits and other deposits
-
6.83
-
5.51
examine, allow them time to assess its value,
and arrange for transfer of the assets and liabil
ities to the winning bidder. Resolutions arranged
as P&A tend to be less expensive to the FDIC
than other types of resolutions.13 Lending by
the Federal Reserve may have allowed some
banks to remain open while the FDIC worked to
minimize resolution costs.
near the time of their failure. Table 8 indicates
that the percentages of banks resolved by each
of the three methods were about the same for
the banks that borrowed in their last 13 weeks
and those that did not.14 These observations do
not support the argument that Federal Reserve
lending near the time of failure facilitated reso
lutions through methods other than liquidation.
One form o f evidence that Federal Reserve
lending facilitated orderly resolutions would be
a lower percentage of liquidations among the
banks that borrowed from the Federal Reserve
Liquidations of failed banks might have been
more common without Federal Reserve credit to
troubled banks, since borrowers had more
rapid declines in their total deposits in their last
13See Gilbert (1992).
14Results are similar to those in Table 8 if the division be
tween the two groups of banks is based on borrowings in
the 26 weeks ending in failure.
FEDERAL RESERVE BANK OF ST. LOUIS
17
Table 8
Distribution of Banks by Borrowings Near the Time of Their Failure and by
Resolution Method
Borrowed from the Federal Reserve
in their last 13 weeks:
Yes
No
Resolution method
Number
Purchase and assumption
Transfer of insured deposits
Liquidation
122
23
9
TOTAL
154
year than nonborrowers (Table 7). Without
credit from the Federal Reserve, rapid deposit
declines might have forced the FDIC to liquidate
more banks. This argument, however, does not
provide a strong defense for Federal Reserve
lending to troubled banks, since the FDIC has
authority to use its resources to keep troubled
banks open until it can determine the least cost
ly method of resolution. Options available to the
FDIC include lending to troubled banks, inject
ing capital through open bank assistance, and
operating failed banks as bridge banks while
they search for buyers, as in the case of the
Bank of New England.
CONCLUSIONS
About 60 percent of the sample of banks that
failed in 1985-90 borrowed from the Federal
Reserve in their last 52 weeks. In addition, loss
es of the Bank Insurance Fund were larger
among the banks that borrowed from the Fed
eral Reserve in their last year. The combination
of these observations could be interpreted as
evidence that the Federal Reserve engaged in a
major operation of sustaining the life of trou
bled banks that eventually failed, and that the
Federal Reserve increased BIF losses substantial
ly by lending to many banks near the time of
their failure.
This evidence, however, does not necessarily
prove .that Fed lending practices caused the
higher BIF loss ratios of the borrowers. Perhaps
the Fed made loans to banks which would have
had relatively high BIF loss ratios with or without
Percent
79.2%
14.9
5.8
100.0
Number
129
24
11
164
Percent
78.7%
14.6
6.7
100.0
Fed loans. This article investigates whether evi
dence supports the arguments that Fed lending
caused larger BIF losses.
One argument is that Fed credit extended the
life of the borrowers, giving troubled banks
with little to lose additional time to assume risk.
Borrowers were rated CAMEL 5 by government
supervisors (in imminent danger of failing)
slightly longer prior to their failure than the
nonborrowers. Additional evidence, however,
indicates that the borrowers tended to have
faster declines in total deposits and tended to
pay smaller dividends than the nonborrowers in
their last year. These observations on deposit
growth and dividends are consistent with the
view that the banks which borrowed from the
Fed in their last year were under strict supervi
sion appropriate for troubled banks.
The evidence does not support the argument
that borrowers had relatively rapid declines in
their uninsured deposits near the time of their
failure, which would have raised the cost of
resolution through methods other than pur
chase and assumption. Large denomination time
deposits declined at about the same rates on
average for borrowers and nonborrowers over
their last 26-to-52 weeks.
It is possible to make an argument that, in
many cases, Federal Reserve lending to failed
banks helped limit BIF losses. In most cases,
borrowings were concentrated in a few weeks
just prior to failure. These loans may have al
lowed the banks to remain in operation, fund
ing deposit withdrawals, while the FDIC worked
to arrange resolutions less costly to BIF than
JANUARY/FEBRUARY 1994
18
liquidations. Evidence on resolution methods in
the bank failure cases, however, does not sup
port this interpretation. Percentages of failed
bank cases resolved through purchase and as
sumption, transfer of insured deposits to other
banks and liquidation were about the same for
borrowers and other failed banks.
Overall, the evidence does not support the ar
gument that Federal Reserve lending to failed
banks affected the costs of bank failures to BIF.
REFERENCES
Garsson, Robert M. “ Gonzalez Says Fed Actions Fueled the
Bank Fund’s Losses,” American Banker (June 12, 1991).
Gilbert, R. Alton. “ Implications of Annual Examinations for
the Bank Insurance Fund,” this Review (January/February
1993), pp. 35-52.
_______ . “ The Effects of Legislating Prompt Corrective
Action on the Bank Insurance Fund,” this Review
(July/August 1992), pp. 3-22.
________“ Supervision of Undercapitalized Banks: Is There
a Case for Change?” this Review (May/June 1991),
pp. 16-30.
FEDERAL RESERVE BANK OF ST. LOUIS
Rehm, Barbara A. “ Lawmakers Attack Fed Lending: Discount
Window Called Costly Prop for Shaky Banks,” American
Banker (May 13, 1991).
Schwartz, Anna J. "The Misuse of the Fed’s Discount Win
dow,” this Review (September/October 1992), pp. 58-69.
Starobin, Paul. “ Out the Window,” National Journal (June 22,
1991), pp. 1557-62.
Todd, Walker F. “ FDICIA’s Discount Window Provisions,” Fed
eral Reserve Bank of Cleveland Economic Commentary
(December 15, 1992).
________“ Banks are Not Special: the Federal Safety Net
and Banking Powers,” in Catherine England, ed., Govern
ing Banking’s Future: Markets vs. Regulation. Kluwer Aca
demic Publishers, 1991, pp. 79-105.
________“ Lessons of the Past and Prospects for the Future
in Lender of Last Resort Theory,” Proceedings of a Confer
ence on Bank Structure and Competition (Federal Reserve
Bank of Chicago, May 11-13, 1988), pp. 533-77.
U.S. House of Representatives, Committee on Banking,
Finance and Urban Affairs. The Failure of the Bank of New
England Corporation and Its Affiliate Banks. Hearing, 102
Cong. 1 Sess. (Government Printing Office, 1991a).
________Failure of Madison National Bank. Hearing, 102
Cong. 1 Sess. (Government Printing Office, 1991b).
________“An Analysis of Federal Reserve Discount Window
Loans to Failed Institutions” (June 11, 1991c).
19
James B. Bullard
James B. Bullard is a senior economist at the Federal Reserve
Bank of St. Louis. Kelly M. Morris provided research
assistance.
Measures o f M oney and the
Quantity Theory
M
LANY ECONOMISTS BELIEVE THAT, over
long periods o f time, the quantity theory of
money explains the relationship between money
and inflation. In particular, many believe (gener
ally speaking) that a permanent increase in the
quantity of money will eventually produce an
equiproportionate permanent increase in the
general level of prices. Similarly, a constant rate
of money growth will produce a constant rate
of inflation. This belief is often summed up in
the phrase "money is long-run neutral.”
Unfortunately, it has been difficult for econo
mists to investigate such claims satisfactorily.
Part of the difficulty lies in defining what is
meant by measurement at low frequencies,
horizons long enough so that other economic
adjustments have taken place. An additional
problem has been one o f designing investiga
tions that do not rely critically on other details
(sometimes called “structure”) about how the
economy works, details on which there is
notoriously little consensus among economists.
In this paper, the basic proposition that money
growth and inflation are closely related in the
long run is examined from a nonstructural, low-
1Lucas (1980) used quarterly data on M1, the consumer
price index and real GNP from 1953 to 1975.
2Lucas (1980, p. 1006) notes, “ this question of which mone
tary aggregate one would theoretically expect to move in
proportion to prices is much more open than has tradi
frequency point o f view. The nonstructural
aspect of the analysis is attained by using a
technique that does not require a host of en
cumbering theoretical or econometric assump
tions. The low-frequency aspect is achieved by
using a certain filter that extracts a long-run
signal from time series data. The filter was in
troduced to this literature by Lucas (1980). The
purpose of the paper is to extend the analysis
of Lucas, whose work is often cited as an illus
tration of the validity o f the quantity theory,
along two dimensions. The first is simply an ex
tension of the quarterly data set up to the
present.1 The second is to check the robustness
of the results across different measures of
money, an issue not addressed in the original
paper nor in subsequent comments on the
paper by other authors.2
Authors commenting on Lucas (1980) tended
to raise questions concerning the relationship of
the graphically based, nonstochastic methodolo
gy to statistical techniques. Whiteman (1984)
and McCallum (1984) in particular both sug
gested there were limits to the inferences that
could be drawn using Lucas’ empirical analysis.
Recent developments in econometric theory due
tionally been recognized. In [this paper],..money means
M1, but the arbitrariness of this measurement choice
should be emphasized at the outset... .” (italics in original).
JANUARY/FEBRUARY 1994
20
to Fisher and Seater (1993) have suggested a
framework that can be used to answer the
questions raised by these authors, and also to
put Lucas’ original work into statistical perspec
tive. This paper provides a summary of the
Fisher and Seater framework as it pertains to
the neutrality issues investigated here.
The data for the study consists of quarterly
observations from the United States from 1960
through 1992. This data set includes, broadly
speaking, a period of increasing inflation up to
about 1980 and a period o f disinflation there
after. Thus, the data provide a useful natural
experiment in that policymakers have evidently
followed both relatively high and relatively low
inflation policies during this era. This is useful
because the methods used here would be unin
formative if there were insufficient variation in
policy. Tw o measures of inflation and 19 meas
ures of money are used, the latter to check
robustness of the results across different defini
tions o f money. The measures of money used
range from the very narrow to the very broad
and include Divisia versions of some aggregates.
The results indicate, very broadly speaking,
that quantity theory illustrations pan out in the
sense that, by any combination of measures,
higher money growth rates are associated with
higher inflation rates at something like a onefor-one rate. When the measure of money is
broad, such as M2, M3 or L, the illustrations
can be striking, although when other measures
o f money are used, the results are weaker. In
particular, the results of Lucas (1980), which
w ere obtained using M l as the measure of
money, are less satisfactory when data from the
1980s are included.
A VERSION OF THE Q U A N T IT Y
TH EO RY
The equation of exchange is defined as
M V = PT, where M is the quantity of money, P
is the price level, T is a measure of the volume
3More complicated velocity assumptions are possible. One
might suppose, for instance, that the trend in velocity
sometimes changes or that it follows a quadratic. General
ly, more creative velocity assumptions bring one closer to
the tautological equation of exchange, and therefore may
be of limited use. Still, it should be stressed that for any
measure of P, M and Y there is a velocity assumption,
sufficiently complicated, that will lead to a perfect illustra
tion of the quantity theory by the methods used in this
paper. The velocity assumption used here maintains com
parability to Lucas (1980).
FEDERAL RESERVE BANK OF ST. LOUIS
of transactions and V is the transaction velocity
of money, which is simply defined in terms of
the other three variables. The transaction meas
ure typically used is real output Y, so that M V =
PY. An assumption on the behavior of velocity is
required in order to convert this tautology into
a theory. The version of the quantity theory
employed in this paper postulates that the
growth rate of V is constant in the equation of
exchange, and that output movements are un
correlated with changes in the quantity of
money. The constant velocity growth rate will
be denoted by a > -1 ; if a = 0, the level of
velocity is constant. Since the analysis is from a
long-run perspective, these assumptions can be
viewed as applying only over long horizons.
Therefore, while it is true that velocity fluctu
ates over short time horizons, the nature of the
analysis undertaken here makes a constant
growth velocity assumption more attractive.3
The theory’s key proposition for the purposes
of this paper can be found by now taking
logarithms of both sides of the equation and
differentiating with respect to time. This manipu
lation, combined with the velocity assumption,
implies that
(1) 1 dP _ a
P dt
1 dM
1 dY
M dt
Y dt
that is, the inflation rate is equal to the constant
velocity growth rate plus the money growth
rate less the growth rate of output. For con
venience, denote (1/*) id^/dt) by A,*( so that
(2) APt = a + AiW( - AK( .
In the long run, then, according to this theory,
a plot of inflation against money growth less
output growth should produce data points that
lie along a 45-degree line with intercept a. It
is well known that such a proposition does
not hold when the data are measured over
short frequencies such as a quarter, but many
economists believe that it does hold when the
21
variables are viewed from a long-run perspec
tive. To get at this notion, a filter is introduced
in the next section which extracts a long-run
signal from time series data.
LOW -FREQUENCY D A T A
ANALYSIS
A Two-Sided Filter
Lucas (1980) suggested the following filter for
this problem:
(3)*,(/?) = (1 ~
V
P ' \ +k,
(1 + /?)
where
is the variable of interest, and fi is a
parameter restricted to be between 0 and 1. As
P approaches zero, no filtering occurs, while as
P approaches unity, the filtered ,x( (/?) approach
the sample mean of the original series. Higher
values of p, but short of unity, imply greater
smoothing o f the time series. Lucas’ original
idea was to choose a value of P short of unity
which would allow the filter to extract a longrun signal from the time series data, and then
to compare filtered data on money and inflation
to see if the long-run movements are along a
45-degree line, as suggested by the quantity
theory. Lucas found that the value p = .95
worked well, and this value is employed through
out most of this paper.4 Of course, a value of
p = .95 is close to 1, and, hence, the filtered
data will be quite smooth relative to the un
filtered time series.5
The filter is two-sided and extends beyond the
sample in both directions. A technique due to
Cooley, Rosenberg and Wall (1977) can be used
to assign beliefs via a diffuse prior on points
outside the sample; the moving average can
then be calculated as if the entire doubly in
finite record existed. Lucas (1980) reports that
filtered series using this technique are virtually
identical to the filtered series calculated using
zero values for points outside the sample, with
the exception of the data points quite near the
beginning and quite near the end of the sample
data. Lucas discarded the first two years and
last two years of the filtered data so as not to
allow the zero values to have undue influence
on the results. In this paper the same proce
dure is followed.6
The two-sided nature of the filter can be in
terpreted as incorporating within the data anal
ysis the behavior o f agents whose actions today
depend on their expectations o f the future. This
point can be illustrated by envisioning a model
economy with many individual agents. Suppose
that such an economy is characterized by a
growth rate of the money stock and an associat
ed inflation rate which is equal to the money
growth rate. The growth rate o f the money
stock generally has an invariant distribution
with a fixed mean and constant variance; on oc
casion, however, the mean of the distribution
changes according to decisions made by the
policy authorities. Since agents need to know
the inflation rate in order to make decisions,
"structural” policy changes of this type play a
role in influencing their behavior. Suppose final
ly that the agents have to learn the new infla
tion rate following a policy change. The learning
implies a well-defined transitory dynamics fol
lowing a policy change, and these transitory
dynamics would tend to blur the period-byperiod relationship between money growth and
inflation in the model. The essential problem for
the econometrician observing such an economy
is to disentangle the actual long-run relationship
from the surrounding noise introduced by the
transitory learning dynamics. The filter used to
analyze the data from this economy, then,
4To see the effects of other values of ft, see the general
equilibrium example in the next subsection.
5For a detailed discussion of the filter, see Lucas (1980).
6The filter in the text employs the factor (1 - /?)/(1 + p ).
This factor is the inverse of the sum of the doubly infinite
set of weights
where T is the sample size and t is the point in the sample
for which computation is being done. The results in this
paper are qualitatively unchanged if an alternative filter of
this type is employed. This confirms Lucas’ (1980) claim
that the results are not very sensitive to the way in which
the points outside the sample are treated.
and it serves to preserve the mean of the doubly infinite
data set. Since we have assumed zeros for the points out
side the actual sample, one might be tempted to preserve
the mean of the actual finite sample with the factor
JANUARY/FEBRUARY 1994
22
should be one that reliably distinguishes be
tween "signal” induced by the structural policy
changes that occur and the transitory noise.
The filter employed here does extract signal
from noise based on the variance of the noise
term, and indeed this is the principle reason
Lucas (1980, 1987) chose to use the filter. This
motivation for the filter is illustrated in more
detail in a general equilibrium example in the
next section.
Before turning to the example, it is perhaps
worth emphasizing that in an economy with a
constant mean money growth rate and a cons
tant mean inflation rate over the whole sample,
an examination of the data such as the one car
ried out in this paper will yield no information.
One cannot discern the effects o f changes in
money growth rates on inflation if there have
been neither changes in money growth rates
nor changes in inflation rates, by which I mean
shifts in the entire distribution of these rates. In
this sense, the structural policy changes are
crucial to the successful verification of the
quantity theoretic relationship; if no structural
changes occur, the filtered data will simply be
tightly clustered about the mean. Fortunately,
the United States since 1960 has been character
ized both by a period of accelerating inflation
and a period of disinflation. It would appear,
then, that the historical record contains enough
variation in policy to be informative according
to the methods employed here.
An Example in General
Equilibrium
Some of these ideas can be made more con
crete by illustrating the principles in a simple
dynamic general equilibrium model with struc
tural policy shifts. The model economy endures
forever and consists o f overlapping generations
of identical two-period lived agents. The agents
maximize utility U = In ct (t) + In ct (t + 1), where
ct (t) is consumption, subscripts denoting birthdates and parentheses denoting real time. Each
agent receives an endowment of the consump
tion good in each period of life, which we
denote by {w: (/), w( (f + 1 )}. The endowments are
the same for all agents regardless of birthdate.
Agents can hold unbacked paper currency
provided by the government; the government
endures forever and provides currency at gross
7See Bullard (1994).
FEDERAL RESERVE BANK OF ST. LOUIS
rate 6. Currency holdings have a gross rate of
return P(t)/P(t+1), where Pit) is the price of
the consumption good at time t. The nominal
amount of currency in circulation at time f is
denoted by H(t). The population size is constant,
and the identical agents of each generation will
be represented by a single agent.
If we solve the problem of the individual
agent, we can write the equations describing
equilibrium in this economy as
(4) H(t) /P(t) = [w,(f) - w,(f+l)y(r)] / 2
(5) Hit) = e m t - i )
(6) F[P(t + 1)] = yU)P(f),
where y(t) is the expected gross inflation rate at
time t and F[P{t + 1)] is the time t forecast o f the
price at time f + 1. The model can be closed
with an assumption about how agents form ex
pectations of the future price level. The learn
ing assumption employed here is that agents use
a first-order autoregression on prices using in
formation available through time M :
(7) y(f)
P i s - 1)2
2
p(s" 1) ^ s)
These assumptions determine a dynamic system
in yU). For cases where w,(t) > w( (f + l ) and the
pace of currency creation is relatively slow, this
model has a locally stable steady state in which
the gross rate of inflation is equal to the gross
rate of currency creation.7 Local stability means
that if the model is initialized at the steady state
and then subjected to a small, one-time unantici
pated change in the policy parameter 6, the dy
namic path will eventually converge back to the
steady state at y = 6. Thus, in the long run, the
quantity theory holds in this model in the sense
that the rate of inflation is equal to the rate of
currency creation in the steady state.
If the policy parameter changed often enough,
the transitory learning dynamics might cause
money growth and inflation to appear to be un
related period-to-period even though the quanti
ty theory holds in the long run in this model.
To consider a situation like this, view the agents
as sophisticated enough to look forward via the
first-order autoregression to make their savings
decision, but not so sophisticated that they at
tempt to anticipate the next move of the policy
23
authorities. In particular, ascribe to agents the
belief that today’s value of the policy parameter
will persist into the next period (which is the
only period that matters from the perspective of
the young agents). Given this assumption, sup
pose that the actual law o f motion for the
money growth rate is given by
(8) 0(f) = 0 (t - l) + £(f) if 0 ( t - l ) e [0„0J,
0(f) ~ [/[0,,0u] otherwise,
where e(t) is a mean zero noise term with vari
ance (?, 0, and du represent lower and upper
bounds, respectively, on the money growth rate,
and U [•] represents a uniform distribution. If
the variance o f e(f) is chosen to be small relative
to 0u - 0,, the policy parameter changes slowly
within the bounds but can move sharply on oc
casions when the bounds are violated.
Because the system is locally stable near the
monetary steady state, if policy was constant in
the sense that d\ = 0 and 0(0) e [0,,0J, the sys
tem would converge to the steady state from an
initial condition y(0) in the neighborhood o f 0(0)
and remain there for all time. Data plotted from
such an experiment, with money growth on the
horizontal axis and inflation on the vertical axis,
would have virtually all of the observations on a
45-degree line at a single point. To obtain an il
lustration o f the quantity theory—a movement
along the 45-degree line—a policy change is re
quired. If there were a single, unanticipated
policy change at time r such that 0(0) i 2
0(t) e [0,,0U], the system would first converge to
the steady state at 0(0) and then, after some
transitory dynamics following the policy change,
converge to the steady state at 0(t).
The law o f motion for the gross rate of
money growth used here represents a more
complicated situation, where policy changes
occur every period, with most changes being
small and some changes being large. By con
struction, the model obeys the quantity theoret
ic proposition that the rate o f money creation is
reflected in the rate of inflation in the long run.
But because the policy parameter is constantly
changing, the short-run (period-by-period) data
might not provide evidence o f such a relation
8The triangular distribution can be found by setting
x 1 - x2, where x v x2~l/[0,.1].
ship. By simulating the model and using Lucas’
filter, evidence of the long-run relationship can
be recovered.
This principle can be shown through a simula
tion of the model with endowments for all
agents set as {w ( (f), w t ( f + l ) } = {2,1}. The dis
tribution o f £( was set as triangular with mean
zero and bounds -.1 and .1; this implies a vari
ance of .00167.* The system was initialized at
the monetary steady state with y(0) = 0(0) = 1.2,
and the upper and lower bounds on the money
growth rate w ere set as 0, = 1.1 and 0u = 1.3,
that is, between 10 percent and 30 percent per
period. The simulation was run for 500 periods.
The results are reported in Figures 1 through 4.
Consistent with the earlier discussion of the dis
tortion in the points near the beginning and
end of the sample, the first and last 20 observa
tions were omitted, leaving 460 in the charts.
Figure 1 reports the raw, unfiltered data. There
appears to be little or no evidence of a relation
ship between money growth and inflation, even
though such a relationship exists by construc
tion in this model. Figures 2, 3 and 4 show the
same plot based on the filtered data, with the
filtering parameter /} set to .5, .8 and .95,
respectively. In Figure 4, the filtered data lie
virtually exactly on the 45-degree line and, thus,
the long-run relationship between money growth
and inflation that exists in the model is recovvered using Lucas’ (1980) procedure.
SOME ECONOM ETRIC ISSUES
Empirical testing of the money growth-inflation
relationship has been successfully undertaken
by Vogel (1974), Dwyer and Hafer (1988), Duck
(1993) and others using cross-country data. The
general conclusion o f these studies is that coun
tries which experience high rates of inflation
also have high rates of money growth, where
inflation rates and money growth rates are typi
cally averaged over many years. Unfortunately,
as mentioned in the introduction, similar tests
on time series data for a single country have
been difficult to carry out.9 One element of the
problem has been obtaining a suitable approach
to defining the "long run” and detecting longrun relationships; an approach to this problem
is the one used in this paper.
=
9This fact motivated Lucas (1980).
JANUARY/FEBRUARY 1994
24
Figure 1
Figure 2
A Theoretical Example
A Theoretical Example
Inflation
Inflation
1.4
1.3
Filtered, B = .5
Unfiltered data
+
/T
++x+y^+U+
+ ^
H>+ £ «+
+
+ ++*J++V
1. 2
+.
+++ +
jii
■ J ^ ++ +
df ^
+
-
1.2
+ -W f+Tj
+
1.25 -
1.3
i
-
i
+ , + X+Hj. "ttt +
4± A .
"H-
qh
+
++
r . • ++++++
&
1.1
+
1.15 -
-
-4 5 degree line
+
1.1
I ------------ 1------------ r
1.1
1.2
1.3
1.4
-4 5 degree line
+
-----------------------1------------------------------ 1
1.1
Money growth
1.15
1.2
Money growth
Figure 3
Figure 4
A Theoretical Example
A Theoretical Example
Inflation
Inflation
1.3
1.25 -
1.2
Filtered, 13= .8
-
1.15 -4 5 degree line
--------- 1
------------ 1 .......... i............
1.1
1.1
1.15
1.2
Money growth
FEDERAL RESERVE BANK OF ST. LOUIS
1.25
1.3
Money growth
i
1.25
1.3
25
One time series technique for testing neutrali
ty has been developed recently by Fisher and
Seater (1993).10 These authors show how nonstructural tests of neutrality propositions depend
importantly on the order integration of the vari
ables being tested. The Fisher and Seater (1993)
methodology can be used to provide a statisti
cally based rationalization for the technique
used by Lucas (1980, 1987) and in this paper,
and also to clarify some questions raised by
authors commenting on Lucas (1980).
Fisher and Seater examine tests of neutrality
and superneutrality in a nonstructural two vari
able system. The first variable can be thought
of as m, the natural logarithm of the nominal
money stock, and the second variable can be
thought of as p, the natural logarithm of the ag
gregate price level. Let ( x ) denote the order of
integration of }c, so that if jc is integrated of ord
er one, then ( } c ) = 1. Let the lag operator be
denoted by L, and let A = (1 -L ). It follows that
the growth rate of a variable can be denoted by
Ajc, and that ( A* ) = { pc ) - 1. Fisher and Seater
study a two-equation system given by
(9) a(L)A m>mt = />I/JA ;i p. + a,
then
(12) LRDp ,m = lim
dP , J du,
dm ,+k/du,
In the case where
3 m, .
(13) l i m ---- — = 0,
3 u.
Fisher and Seater simply leave the long-run
derivative undefined. In this case, there is no
permanent movement in m and a neutrality
proposition cannot be tested. Otherwise, Fisher
and Seater interpret the long-run derivative as
representing the ultimate long-run effect of a
disturbance u on p relative to the effect of the
disturbance on m itself. Fisher and Seater (1993,
p. 404) show that
(14) lim dm . Idu
k~*oo
0 ( 1 ),
where 8(L) = (1 - L ) 1“(m a(L)
and that
(15) lim dpl+k / d u = r ( l ) ,
where T(L) = (1 - L )1 (p)y(L).
They thus conclude that the value o f the longrun derivative, when it is defined, depends on
( m ) - ( p ) through the formula
where a0 = d0
1,
and the vector [ut, wt Y is
(1 - L) mi~l py(L)
independently and identically distributed with
(16) LRD
mean zero and covariance E. Constants and
a ( 1)
trends are suppressed, and variables stationary
Fisher and Seater then define long-run mone
about a deterministic trend are treated as in
tary
neutrality as LRDpm = 1. They categorize
tegrated of order zero. Fisher and Seater work
the
possibilities
into several cases. In the first
with this model in some generality, considering
case,
(
m
)
<
1
and
the long-run derivative is
cases of superneutrality as well as neutrality,
not
defined.
Long-run
neutrality cannot be ad
and also considering cases where the variable
dressed
because
there
are no permanent
opposite m could be either of real or nominal
changes
in
the
money
stock.
In the second case,
magnitude. To focus the discussion here, we
{
m
)
>
{
P
)
+1
>
1
and
long-run
neutrality
will concentrate on the case in which the two
fails
immediately
because
(in
the
simplest
case)
variables are m and p and the only question is
there
are
permanent
shocks
to
the
money
sup
one of neutrality.11
ply but no permanent shocks to the price level.
Fisher and Seater define neutrality in terms of
A third case has ( m ) = ( p ) > 1, and here
a long-run derivative of p with respect to a per
LRDpm = 1 if neutrality holds. Therefore, tests
manent change in m. Their definition is that if
of long-run neutrality can be devised since both
m and p possess permanent changes. Fisher and
dm , ,
(1 1 ) l i m ---- —
Seater also argue that tests can be devised in a
k~°° o u
fourth case where (m) = ( p ) - 1 > 1.
(10) </(/,)A " p, = d/JA " in, + wt,
10For applications of the techniques Fisher and Seater (1993)
describe, see King and Watson (1992) and Bullard and
Keating (1993). Most of the material in the remainder of
this section can be found in greater detail and generality in
Fisher and Seater (1993).
1ln Lucas (1980), the relationship between money growth
and interest rates is also examined. The question of super
neutrality would be important in this context, but this issue
is not dealt with in this paper.
JANUARY/FEBRUARY 1994
26
Lucas’ (1980) graphical technique can be
viewed as equivalent to estimating a regression
coefficient, and if money is assumed to be longrun exogenous, this coefficient can be identified
with the long-run derivative. In particular, Fish
er and Seater argue that if ( m ) = { p } = 1,
one can interpret the slope coefficient in a
regression of filtered Ap on filtered Am as an
estimate of LRDpm.12 In this paper, tests o f in
tegration are not pursued, but there is ample
evidence that { m ) > 1, and that ( p ) > l . 13
Since such tests have low power, economists
cannot say with precision what the order
of integration of these variables is, but it seems
reasonable to proceed for the purposes of the
present paper on the assertion that one of the
above conditions holds. Later in the paper, values
o f the regression coefficients of filtered Ap on
filtered Am are reported as estimates of L/?Dpm.
As mentioned in the introduction, two papers
offering critiques of Lucas (1980) can be under
stood relatively easily in terms of the Fisher and
Seater (1993) paradigm. McCallum’s (1984) “se
cond example” suggested that LRDpm was not
necessarily equal to unity even when long-run
neutrality held. But in the example, (m) = 0 so
that the long-run derivative is not defined. Both
Lucas (1980) and Fisher and Seater (1993) em
phasized that permanent shocks to money were
necessary to test neutrality propositions.
neutrality, however, and Whiteman confirmed
this by showing that when { m ) = { p ) > 1,
the long-run derivative would equal unity in his
model regardless of the Mundell-Tobin effect.
Whiteman’s critique of Lucas (1980), although
valid, does not impinge on the first part of Lu
cas’ analysis or on the analysis here, both of
which focus on long-run neutrality.
RESULTS
In this section, the filter is applied to all three
series as described above, giving the maintained
relationship as APt (ft) = a + AM t (/?) - AYt (ft). If
the filtered inflation data is plotted against the
difference between filtered money growth and
filtered output growth, the form of the quantity
theory used here predicts that the data will lie
on a 45-degree line with intercept a.14 The out
put measure employed is real gross domestic
product.15 Tw o inflation measures are used: the
consumer price index and the gross domestic
product deflator. Along with 19 measures of
money, this yields 38 illustrations of the quanti
ty theory. The measures o f money range from
the very narrow to the very broad. These
series are all available over the entire sample
period of 1960-92. These years keep all meas
ures on equal footing; although some measures
could be taken further into the past, any com
parisons among monetary aggregates would
then be blurred.16
Whiteman (1984) critiqued Lucas (1980) from
the point o f view of a structural model that
could display a Mundell-Tobin effect. In such a
model, a permanent increase in the rate of
money growth would permanently lower the
real interest rate. Because of this, nominal in
terest rates would not rise one-for-one with in
creases in money growth, and superneutrality
would be violated. This is an important con
sideration for Lucas' second set of scatterplots
which are not replicated in this paper. The
Mundell-Tobin effect does not bear on long-run
The results can be summarized in a number
of ways. Lucas' (1980) method simply involves a
graphical interpretation in which the data is
plotted and examined to see if it appears to lie
plausibly on a 45-degree line. A few selected
plots of this type are shown in Figures 5
through 8. One of the main results of this paper
is that, broadly speaking, these plots provide il
lustrations of the quantity theory in that higher
inflation is associated with higher money
growth regardless of the particular measure of
money used.17 In this sense, the results are
12Fisher and Seater (1993) also argue that the LRD interpre
tation holds if ( m ) = { p ) = 2 and Am and Ap are co
integrated.
16The measures of money used are adjusted reserves, total
reserves, nonborrowed reserves, currency, adjusted mone
tary base (St. Louis), adjusted monetary base (Board of
Governors), Divisia M1A, M1A, Divisia M1, M1, Divisia M2,
M2, non-M1 components of M2, Divisia M3, M3, the nonM2 components of M3, Divisia L, L, and the non-M3 com
ponents of L. Barnett, Fisher and Serletis (1992) provide a
survey of the construction and use of Divisia aggregates, a
topic beyond the scope of this paper.
13See, for instance, King and Watson (1992).
14Plots of this type differ somewhat from those found in Lu
cas (1980, 1987) in that the real output growth rate is also
filtered; in the previous work, the output growth rate was
set equal to the average output growth rate over the sam
ple period.
15Replacing actual output with potential output produces
qualitatively unchanged results. Here, actual output is used
to maintain comparability with Lucas (1980, 1987).
FEDERAL RESERVE BANK OF ST. LOUIS
17Plots using the CPI as the measure of inflation are qualita
tively similar.
27
Figure 5
Figure 6
Monetary Base (Board Series)
with GDP Deflator
M1 with GDP Deflator
Filtered inflation
Filtered inflation
Filtered money growth less
filtered output growth
Filtered money growth less
filtered output growth
Figure 7
Figure 8
M2 with GDP Deflator
L with GDP Deflator
Filtered inflation
Filtered inflation
Filtered money growth less
filtered output growth
Filtered money growth less
filtered output growth
JANUARY/FEBRUARY 1994
28
consistent with those provided by Lucas even
when the data from the last 17 years are in
cluded, years that are known for being rocky
from the point of view of reliable empirical
relationships involving monetary aggregates.
The results are particularly striking if the meas
ure of money is broad, such as M2 (Figure 7),
M3 or L (Figure 8). Narrower measures, such as
the monetary base (Figure 5) or M l (Figure 6),
tend not to provide as convincing an illustra
tion.18
The results can be summarized more quantita
tively by computing the mean-square error (MSE)
from the 45-degree line that passes through the
grand mean of the filtered data. This amounts
to measuring the distance of the filtered data
from a fitted regression line where the slope is
forced to unity. Table 1 summarizes the results
using all measures of money and inflation based
on an MSE criterion. In the table, the results
are presented in order from the lowest MSE to
the highest when the measure of inflation is the
deflator, but the results are also presented for
the case where the CPI is the inflation measure.
The MSE is the lowest when the measure of
money is broad, with aggregates like M2, M3
and L and their Divisia counterparts provide the
best performance.
The data in Figures 5 through 8 can be viewed
as representing the coherence between long-run
movements in inflation and long-run movements
in money growth. That is, when the pace of
monetary expansion is increasing, the quantity
theory suggests that the rate o f inflation should
be increasing as well, again, in the special longrun sense used in this paper. Thus, regardless
of the relationship to a 45-degree line that pass
es through the mean of the data, one would
like to know if the data is moving in the “right
direction”—along a line with slope one—most of
the time. It may be, for instance, that the rela
tionship between some measure of money and
inflation is subjected to an occasional shift dur
ing the sample period. The filtered data in such
a case might normally plot along a 45-degree line
except for brief interludes corresponding to the
occasional shifts. Thus, it may be useful to con
sider a coherence measure that does not require
the data to stay on the same 45-degree line at
all times in order to do well.
18ln the charts, the grand mean is the mean of all the plot
ted pairs of filtered money and filtered inflation.
FEDERAL RESERVE BANK OF ST. LOUIS
Table 1
Mean-Square Error Criterion
MSE
Measure
M2
Divisia L
L
Divisia M3
Divisia M2
M3
Currency
Adjusted monetary base STL
Non-M1 components of M2
M1A
Divisia M1A
Adjusted monetary base BOG
Adjusted reserves
Divisia M1
M1
Non-M3 components of L
Total reserves
Nonborrowed reserves
Non-M2 components of M3
Deflator
10.1
19.8
19.8
27.3
27.6
36.1
90.2
96.0
97.2
105.5
112.3
119.2
126.9
135.8
162.9
255.9
383.3
462.7
4233.3
CPI
24.9
37.5
22.8
53.9
50.0
52.7
68.8
81.4
136.4
130.7
130.8
98.6
131.9
117.5
141.7
194.4
362.0
437.8
4475.9
One way to measure coherence of this type is
to proceed as follows. First, construct a line be
tween each pair o f adjacent filtered data points.
Second, measure the angles in radians between
the constructed lines and a 45-degree line. Final
ly, square each radian measure and sum across
all data points to obtain a measure of coherence.
This coherence measure has a maximum value
which occurs when each constructed line is ex
actly perpendicular to the 45-degree line. The
results according to a coherence criterion are
presented in Table 2, and rankings are again
computed using the deflator as the measure of
inflation. The broad simple-sum measures M2,
M3 and L again do well, but currency, base
measures and the non-Ml components of M2
also fare well. The results concerning the mone
tary base (and to some extent currency, which
is a large portion of the base) can be inferred
from Figure 5. The base certainly moves in the
right direction much of the time, as the coher
ence criterion requires, even though the plotted
29
data is rarely on the 45-degree line that passes
through the grand mean.
Table 2
Coherence Criterion
Squared radians
Measure
L
Currency
M3
Non-M1 components of M2
Adjusted monetary base BOG
M2
Adjusted monetary base STL
Divisia M3
Non-M3 components of L
Divisia M2
Divisia L
Divisia M1
M1
Adjusted reserves
M1A
Divisia M1A
Total reserves
Nonborrowed reserves
Non-M2 components of M3
Deflator
CPI
12.3
20.5
23.2
24.7
26.0
26.6
27.5
30.1
30.4
31.5
32.5
35.1
37.4
63.2
75.5
76.8
80.6
88.6
90.9
8.1
15.5
17.5
36.9
20.5
23.7
22.2
44.6
25.5
44.1
46.0
29.4
31.6
57.7
82.3
82.4
75.5
87.6
92.8
Table 3
Long-Run Derivative
LRD
Measure
M2
Divisia M1A
Adjusted reserves
L
M3
Divisia M3
Divisia L
Adjusted monetary base STL
Divisia M2
Currency
Non-M1 components of M2
Adjusted monetary base BOG
Divisia M1
M1A
M1
Non-M3 components of L
Total reserves
Nonborrowed reserves
Non-M2 components of M3
Deflator
0.99
1.08
0.83
0.80
0.78
1.24
1.25
0.75
1.28
0.71
0.68
0.66
0.64
1.38
0.57
0.45
0.22
0.16
0.01
CPI
1.08
1.27
1.02
0.88
0.84
1.32
1.37
0.90
1.39
0.85
0.70
0.80
0.78
1.58
0.71
0.54
0.32
0.25
-0 .0 1
Finally, the results can be summarized accord
ing to the estimate o f the long-run derivative as
defined by Fisher and Seater (1993), that is, by
the slope of an ordinary least-squares line fitted
to the filtered data. This time, both the slope
and intercept are estimated, instead o f forcing
the slope to unity as in the MSE criterion. The
main concern is whether the estimated slope is
close to 1. As a simple metric, the squared
difference between the estimated slope and
unity is used as the measure of how close the
estimated long-run derivative is to 1. In Table 3,
the results are shown ranked according to this
metric when the measure of inflation is the
deflator. The table shows the estimated slope
coefficient, instead of the squared difference
between this coefficient and 1. Again, the broad
aggregates and their Divisia counterparts tend
to rank in the top half. In this case, Divisia M IA
and adjusted reserves also perform well.
SU M M A R Y
The results presented in this paper are gener
ally supportive of a quantity theoretic proposi
tion that has been difficult for economists to
investigate satisfactorily using time series data
from a single country. The proposition is that
money is long-run neutral. By using a certain
filter suggested by Lucas (1980), a long-run sig
nal can be extracted from time series data, and
filtered data on money growth and inflation can
be examined to see if it conforms to quantity
theoretic predictions. When broad measures of
money are used, such as M2, M3 and L, striking
illustrations of the quantity theory are obtained.
These results can be verified using either Lucas’
original graphical procedure or by using alter
native goodness-of-fit criteria. The results have
some statistical basis in the sense that they can
be described within the framework for testing
neutrality and superneutrality propositions re
cently worked out by Fisher and Seater (1993).
REFERENCES
Barnett, William A., Douglas Fisher, and Apostolos Serletis.
“ Consumer Theory and the Demand for Money,” Journal of
Economic Literature (December 1992), pp. 2086-128.
Bullard, James. “ Learning Equilibria,” Journal of Economic
Theory (forthcoming, 1994).
JANUARY/FEBRUARY 1994
30
_______ , and John Keating. “ Superneutrality in Postwar
Economies,” manuscript (September 1993).
Cooley, Thomas, B. F. Rosenberg, and Kent D. Wall. “A Note
on Optimal Smoothing for Time Varying Coefficient
Problems,” Annals of Economic and Social Measurement
(fall 1977), pp. 453-6.
Lucas, Robert E., Jr. “Adaptive Behavior and Economic
Theory,” in Robin M. Hogarth and Melvin W. Reder, eds.,
Rational Choice: The Contrast Between Economics and Psy
chology. University of Chicago Press, 1987, pp. 217-42.
________“ Two Illustrations of the Quantity Theory of Money,”
The American Economic Review (December 1980), pp.
1005-14.
Duck, Nigel W. “ Some International Evidence on the Quantity
Theory of Money,” Journal of Money, Credit and Banking
(February 1993), pp. 1-12.
McCallum, Bennett T. “ On Low-Frequency Estimates of Long
Run Relationships in Macroeconomics, Journal of Monetary
Economics (July 1984), pp. 3-14.
Dwyer, Gerald P., and R. W. Hafer. “ Is Money Irrelevant?”
this Review (May/June 1988), pp. 3-17.
Mills, Terence C. “ Signal Extraction and Two Illustrations of
the Quantity Theory,” The American Economic Review (De
cember 1982), pp. 1162-8.
Fisher, Mark E., and John J. Seater. “ Long-Run Neutrality
and Superneutrality in an ARIMA Framework,” The Ameri
can Economic Review (June 1993), pp. 402-15.
King, Robert G., and Mark W. Watson. “ Testing Long Run
Neutrality,” working paper no. 9218, Federal Reserve Bank
of Chicago (October 1992).
http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis
Vogel, Robert C. “ The Dynamics of Inflation in Latin America,
1950-1969,” The American Economic Review (March 1974),
pp. 102-14.
Whiteman, Charles H. “ Lucas on the Quantity Theory:
Hypothesis Testing Without Theory,” The American Eco
nomic Review (September 1984), pp. 742-9.
31
Daniel L. Thornton
Daniel L. Thornton is an assistant vice president at the Federal
Reserve Bank of St. Louis. Kevin White provided research
assistance.
Financial Innovation, Deregula
tion and the “Credit View” o f
Monetary Policy
I t is GENERALLY ACENOWLEDGED that
monetary policy affects real economic activity in
the short run and inflation or the price level in
the long run, but much less of a consensus ex
ists on exactly how monetary policy affects out
put and prices. The possibility that monetary
policy affects the economy through credit chan
nels has received considerable attention lately.
Tw o distinct credit channels for monetary
policy have been described.1 Both of these chan
nels are based on lending problems associated
with asymmetric information and control.2 The
cost of acquiring information and controlling
borrower’s behavior drives a wedge between
the cost of internal and external finance. For
1These channels have been discussed by a number of
writers. Bernanke (1993) and Gertler and Gilchrist (1993b)
are two of the more accessible.
inform ation asymmetry gives rise to two important
principal-agent problems, adverse selection and moral
hazard.
3For evidence that banks and other financial intermediaries
mitigate the problems associated with asymmetric informa
tion, see James (1987); Gilson, Stuart and Lang (1990);
Hoshi, Kashyap and Scharfstein (1990, 1991); and Slovin,
Sushka and Polonchek (1993). For evidence that shocks to
bank capital are due to changes in regulations or adverse
changes in the economy, see Baer and McElravey (1993)
and Calomiris (1993).
some borrowers the premium for external
finance is so large that it is impractical for them
to obtain funds in impersonal financial markets.
Depository financial intermediaries (hereafter,
banks), reduce the wedge by specializing in ac
quiring information about and assessing the risk
characteristics of such borrowers.3
One broad credit channel has been called the
“excess sensitivity hypothesis” by Gertler and
Gilchrist (1993b). According to this hypothesis,
monetary policy actions induce changes in inter
est rates and prices that are propagated through
their effect on borrowers' balance sheets.4 For
example, restrictive monetary policy may reduce
the net worth of borrowers, causing the premi-
Unless it is explicitly stated otherwise, the word bank is
used in this article to denote the four traditional depository
financial intermediaries: commercial banks, savings and
loan associations, mutual savings banks and credit unions.
The last three are jointly referred to as “ thrifts.”
4Monetary policy is propagated through changes in net
worth or cash flow that alter the size of the external
finance premium. For evidence that investment is sensitive
to balance sheet and cash flow consideration, see Fazzari,
Hubbard and Peterson (1988); Oliner and Rudebusch
(1992); and Calomiris and Hubbard (1993).
JANUARY/FEBRUARY 1994
32
urns that small borrowers must pay for external
finance to rise. Gertler and Gilchrist point out
that this credit channel is operative "even if the
central bank has no direct leverage over the
flow of bank credit.”5 An alternative credit
channel, called the “credit view ” of monetary
policy by Bernanke and Blinder (1988), Bernanke (1993) and Gertler and Gilchrist (1993b),
requires monetary policy actions to have a
direct effect on bank lending.
(Bernanke and Blinder, 1988; Bernanke 1993;
Gertler and Gilchrist, 1993b; and Kashyup, Stein
and Wilcox, 1993) have defined the credit view
more precisely within this broader framework.
It is now generally understood that the credit
view is the idea that monetary policy actions
not only affect the economy through their effect
on the liability side of banks’ balance sheets,
that is, by affecting the quantity of money, but
also through their direct effect on bank lending.
This article outlines the credit view of mone
tary policy and points out that the conditions
that are necessary for it are stringent. Conse
quently, there is reason to doubt whether the
bank lending channel of monetary policy has
ever been empirically significant. This article,
however, does not attempt to evaluate whether
the bank credit channel of monetary policy ever
existed. Rather, it points out that financial inno
vation and deregulation have altered the struc
ture o f financial markets in ways that should
have weakened the bank credit channel of
monetary policy over time. In addition, it points
out that the bank credit channel of monetary
policy should have been further diminished by
the Monetary Control Act of 1980 and subse
quent changes in the structure o f Federal
Reserve reserve requirements that have signifi
cantly weakened the link between monetary
policy actions and bank lending. Finally, the ar
ticle presents evidence which suggests a weak
and deteriorating relationship between Federal
Reserve actions and the supply of bank credit.
In this literature, the "monetary view ” of
monetary policy tends to be rather narrowly
focused on interest rates.6 Proponents of the
credit view argue that even under extreme
conditions where either interest rates do not
respond to monetary policy actions or where
spending is unresponsive to changes in interest
rates, monetary policy actions affect the econo
my because of their direct effect on bank
loans.7
W H A T IS “THE CREDIT VIEW ?”
The credit view of monetary policy is part of
a much broader literature on the role of credit
in the macroeconomy. Several recent papers
5Gertler and Gilchrist (1993b, p. 7), emphasis added.
6More generally, the monetary view of monetary policy is as
sociated with the effects of policy actions on the supply of
money and the subsequent effect of the change in the
supply of money on the economy through a number of
channels. Two important papers on the monetary transmis
sion mechanism are Brunner and Meltzer (1976) and Stein
(1976).
H'he clearest statement of this is Bernanke (1993, pp.
55-57). Bernanke summarizes the distinction between the
credit and monetary views by stating, “ In a nutshell, the
credit view asserts that in addition to affecting short-term
interest rates, monetary policy affects aggregate demand
by affecting the availability or terms of new bank loans” (p.
56).
8For example, see Bernanke (1993), Gertler and Gilchrist
(1993b), and Kashyap and Stein (1993).
FEDERAL RESERVE BANK OF ST. LOUIS
Consequently, proponents of the credit view
believe that the effects of monetary policy ac
tions on the economy are larger than those that
can be attributed to the effect of monetary poli
cy actions on interest rates alone. For a
separate bank credit channel for monetary poli
cy to exist, it is generally acknowledged that
two necessary conditions must be satisfied: Bank
lending must be special and monetary policy
actions must affect bank lending.8
Bank Lending Must B e “Special”
For bank lending to be special, banks must
play a special role in the credit market, in that
they make loans to a particular class of borrow
ers who find it difficult (very costly) or impossi
ble (prohibitively costly) to obtain credit from
other sources.9 This has been characterized
9The credit view should not be confused with “ credit ration
ing,” the idea that banks limit the availability of credit
regardless of price. Several authors (for example, Ber
nanke, 1993; Bernanke and Blinder, 1988; Gertler and Gil
christ, 1993b; Kashyap and Stein, 1993; and Friedman and
Kuttner, 1993) have pointed out that credit rationing is not
essential for the credit view. In credit rationing models, in
dividuals who are willing and able to pay the market in
terest rate are constrained from obtaining credit. In credit
view models, this is not necessarily the case. All markets
may clear. Friedman and Kuttner (1993, p. 14) note, “ The
fact that credit view models can encompass market non
clearing does mean that they necessarily do so, however,
and on this point, too, substantial confusion exists.”
33
(Bernanke and Blinder, 1988; and Bernanke,
1993) as the condition that bank loans and
other credit are not perfect substitutes to either
borrowers or lenders. That lenders are unwill
ing to make the same loans to all borrowers is
plausible.10 Discontinuities associated with the
size of transactions, costs associated with
monitoring and controlling the behavior of bor
rowers, information costs and reputation may
make it difficult, if not impossible, for some
borrowers to raise funds in the open markets.11
Indeed, it can be argued that banks and other
nonbank financial intermediaries exist because
o f such credit market "imperfections.” Banks
have traditionally filled this void by specializing
in gathering information and assessing the risk
characteristics of such borrowers. They close
the intermediation process by obtaining funds
from individuals (bank depositors), some of
whom have imperfect access to market-based
liquid forms of savings.
P olicy Actions A ffect Bank
Lending
the Federal Reserve must raise bank assets and
liabilities by an equal amount.13 If bank loans
rise proportionately with other bank assets, the
effect of policy actions on the supply of bank
loans is tautological. The issue o f whether bank
credit is a separate channel for monetary policy
deals with the broader question of whether
policy actions induce a larger change in the total
quantity o f credit than that associated with the
open market operation alone. Alternatively, the
credit view deals with the question of whether
Federal Reserve actions can alter the spread be
tween the bank lending rate and open market
interest rates.
An Illustration o f the R o le o f the
Specialness o f Bank Lending to the
Credit View o f M onetary P olicy
The credit view o f monetary policy is made
clear by two cases: one in which there is no
separate credit channel for monetary policy be
cause borrowers are free to obtain credit either
from banks or in the open market, and one in
which the access of bank borrowers to the
open market is limited.
The second necessary condition is that mone
tary policy actions have a direct effect on the
supply of bank loans. The potential for a direct
relationship between bank lending and policy
actions arises from the fact that the Federal
Reserve imposes legal reserve requirements on
bank deposits.12 Consequently, an open market
operation that increases the quantity of reserves
and bank deposits means that, other things
being the same, banks have more funds to
make more loans.
Figure 1 illustrates the effect of Federal
Reserve actions on the supplies of bank and
nonbank credit when lenders are indifferent to
whom they supply credit. The banks’ credit sup
ply curve is vertical under the assumption that
the supply of bank credit is totally determined
by their deposit liabilities which, in turn, are
assumed to be determined by the quantity of
reserves supplied by the Federal Reserve.
Care must be taken, however, to avoid the
credit-view tautology. Other things being the
same, an open market purchase of securities by
Under these assumptions, an open market sale
of government securities by the Federal Reserve
reduces the supply o f bank credit and, thereby,
10There is evidence that many small and medium-size firms
do not have the same access to credit markets as large,
well-known firms. This does not necessarily imply that the
credit view is correct, however. For example, much of the
empirical evidence—Gertler and Gilchrist (1993a, b),
Bernanke and Lown (1992), and Oliner and Rudebusch
(1993)—suggests that the important distinction is between
“ large” and “ small” firms rather than between bankdependent and nonbank-dependent firms. Consequently,
while monetary policy may not operate directly through the
credit channel, for a variety of reasons, small firms may be
affected more by monetary policy actions than large firms.
12The relationship is pointed out in Bernanke and Blinder
(1992), Gertler and Gilchrist (1993b), Kashyap and Stein
(1993), Romer and Romer (1990) and Lebow (1993). In the
absence of deposit insurance, banks would hold
“ reserves” in the form of cash and highly liquid assets
even if there were no statutory reserve requirements. The
extent of the relationship between policy actions and bank
lending under such a voluntary reserve system is an empir
ical issue.
13Assuming, of course, no immediate effect on bank capital.
11For these, and perhaps others, the loan market is not com
pletely impersonal. For example, borrowers may not be in
different from whom they borrow—even under identical
terms—if they believe that establishing a relationship with
a particular lender will reduce their future search costs.
JANUARY/FEBRUARY 1994
34
total credit. This is shown as a leftward shift in
the banks’ credit and total credit supply curves
in Figure 1, panels a and c, respectively. The
reduction in the supply of bank credit initially
raises banks’ lending rate relative to the rate on
alternative sources o f credit, from ib to i'b. As
some borrowers go elsewhere, the demand for
other credit increases and the demand for bank
credit falls. This is illustrated by a rightward
shift in the other credit demand curve in Figure
1, panel b, and a leftward shift in the demand
for bank credit in panel a. Eventually, a new
equilibrium is achieved, where once again bank
rates and other rates are equal.
Federal Reserve actions fell disproportionately
on bank credit, as the rise in interest rates
resulted in an increase in the equilibrium level
o f other credit. Nevertheless, there was no
separate bank credit channel for monetary poli
cy. The decline in the supply of bank credit
merely induced bank borrowers to go else
where.14 The change in the total quantity of
credit is equal to the decrease in bank credit
plus the increase in private credit induced by
the rise in interest rates.
Figure 1
(a)
Bank Credit
(b)
Other Credit
(c)
Total Credit
Im perfect Substitution
Now assume that some bank borrowers do
not have access to alternative forms of credit.
The fact that bank credit and other credit are
not perfect substitutes requires this illustration
to begin from an equilibrium in which the rate
on bank loans is above the rate on other credit.15
In this case, the same policy-induced decline in
14Kashyap, Stein and Wilcox (1993) claim that the identifica
tion problem that arises in this literature can be circum
vented by seeing whether policy actions affect the credit
MIX, the ratio of bank loans to commercial paper. The idea
is that if monetary policy affects the market in general and
does not operate through the credit channel, there should
be no correlation between the policy variables and the MIX
variable. On the other hand, if monetary policy works
through this credit channel, there should be a positive
correlation between these variables. This illustration,
however, shows an example in which there is no unique
role for monetary policy through its effect on bank credit,
yet monetary policy actions and the MIX variable are posi
tively correlated.
15The fact that the rates on bank loans are generally higher
than the rates on government securities and other credit is
not sufficient for the credit view. Loans, securities, bank
debt and other debt are not equally risky, so neither banks
nor the market will be indifferent about their portfolio struc
tures. The rates paid on each form of debt will differ by
a risk premium that reflects both the banks’ and the
market's perception of their respective risk characteristics,
including differences in the liquidity characteristics of the
various assets.
FEDERAL RESERVE BANK OF ST. LOUIS
35
the quantity o f bank credit is associated with a
smaller increase in the demand for other credit,
as illustrated in Figure 2, as not all bank bor
rowers can obtain credit in the market. Conse
quently, when the new equilibrium is established,
the bank loan rate will have risen relative to
the rate on other credit.
Figure 2
(a)
Bank Credit
(b)
Other Credit
The effects of monetary policy in this case
differ from the previous one in two critical
respects. First, the restrictive policy action causes
the equilibrium bank rate to rise relative to
other rates. This means that if there is a separate
credit channel for monetary policy, monetary
policy actions would affect the spread between
bank lending rates and rates on other forms of
credit.16
Second, the change in the total quantity of
credit is larger than in the previous case. This
is most easily seen by noting that in the extreme
case where none of the banks’ customers can
access the other credit market, there would be
no mitigating effect of the open market opera
tion on total credit resulting from a rise in the
interest rate in the other credit market.17 Note
that the effect of monetary policy actions on
total credit will be larger, the smaller the pro
portion o f bank borrowers who have access to
other credit sources.
Arbitrage
In the above analysis, the Fed’s ability to alter
the spread between bank lending rates and
other rates depended critically on the assump
tion that some bank borrowers were unable to
obtain credit in the open market. Less obvious
is the results’ dependence on the implicit re-
16This implication of the credit view is widely recognized in
the literature, for example, Bernanke (1993), Kuttner (1992)
and Romer and Romer (1993). Bernanke (1993) argues that
this approach to testing for the empirical significance of
the credit view has not been pursued widely because of
problems associated with measuring the “ true” price of
bank loans. Nonetheless, Kuttner (1992) and Romer and
Romer (1993) have looked at this issue using the spread
between the prime rate and the commercial paper rate.
Kuttner finds that the evidence does not support the credit
view, while Romer and Romer find evidence supporting the
credit view.
17The outcome is actually more complicated than this simple
illustration suggests because in reality it is the banks’
depositors, not the bank, who are making the loan to the
banks’ loan customers. The bank is simply an intermediary
to the transaction. This means that some of the depositors
of banks are forced to move funds into other assets.
Hence, eventually the effect of an open market operation
on the total supply of credit must be limited to the extent of
the open-market operation.
striction that banks themselves cannot arbitrage
the spread between the bank loan rate and
market interest rates.
It is important to recognize that banks do not
create credit, they merely allocate it. Banks are
financial intermediaries. They acquire funds,
primarily from depositors, and lend these funds
to others in such a way as to maximize profits. ^
Consequently, as the bank loan rate rises rela
tive to other rates banks have an incentive to
arbitrage the larger rate differential by inducing
JANUARY/FEBRUARY 1994
36
more depositors to, in effect, make more bank
loans.
Suppose that the banking industry is competi
tive so that individual banks are powerless to
influence the rates paid on either bank loans or
other earning assets like government securi
ties.18 Further assume that banks can access
other credit markets by issuing debt (that is,
deposits) against themselves that is a substitute
for other market debt. Now assume that restric
tive monetary policy actions reduce the supply
of bank credit, causing the rate on bank loans
to rise relative to other rates as before. In
dividually, banks would have an incentive to
borrow more from the private credit market to
make more bank loans. Banks would raise the
rates that they pay depositors to induce more
private creditors to intermediate credit through
banks.
Generally speaking, if the banking system is
competitive and banks are as creditworthy as
other debtors, the supply of bank credit will
rise and the supply o f other credit will fall until
the rate differentials once again reflect the banks'
and the market’s perception of the differential
risk. Consequently, if banks are free to arbitrage
the interest rate differential, monetary policy
actions will not be able to alter the spread be
tween bank loan rates and open market interest
rates, and there will be no separate bank credit
channel for monetary policy.19
M onetary P olicy Actions and the
Supply o f Bank. Credit
The critical issue is whether the banking sys
tem as a whole will be able to arbitrage the
wider rate differential if the Federal Reserve
controls the total quantity of reserves and,
hence, bank loans, as was assumed in Figures
1 and 2. The credit view of monetary policy
depends critically on the relationship between
monetary policy actions and bank lending, and
is weakened by the extent to which banks have
18That banks have some degree of market power does not
alter this conclusion.
19This does not, however, rule out the possibility that mone
tary policy actions have an indirect effect on the rate
differential. For example, if monetary policy actions affect
economic activity, this could raise the rate on bank loans
relative to open market rates by increasing the likelihood of
default by bank-dependent borrowers relative to other bor
rowers. This effect might be considered as part of a broad
er role for credit in the propagation mechanism of
monetary policy influences to the economy. For example,
see Gertler and Gilchrist (1993b, c) and Bernanke (1993).
FEDERAL RESERVE BANK OF ST. LOUIS
access to funds that are not affected by the
Fed’s actions. This section considers the extent
to which Federal Reserve actions influence bank
lending and how financial innovation, deregula
tion and changes in the structure of reserve
requirements have altered the Fed's ability to
influence bank lending.
The Federal Reserve directly influences the
supply of bank loans through its system of
reserve requirements. The relationship is identi
cal to that which allows the Federal Reserve
to exercise direct control over the supply of
money.20 An open market sale o f government
securities by the Fed reduces the supply of
reserves. Because of reserve requirements,
banks as a whole are forced to reduce their
deposit liabilities. As banks’ liabilities contract,
other things being the same, so too do bank
assets, including loans. The crucial issue, how
ever, is the extent to which reserve require
ments impose limits on the ability of banks to
make loans.
The Federal Reserve can completely control
the supply of bank loans, as assumed in Figures
1 and 2, only if uniform reserve requirements
are imposed on all sources o f bank funds. If
this w ere the case, an open market purchase of
government securities would cause banks to
reduce both their liabilities and assets equally.
If banks reduced their loans, loan rates would
rise relative to open market rates. Individually,
banks would have an incentive to arbitrage this
interest rate differential by creating deposit lia
bilities against themselves. Banks as a whole,
however, would not be able to increase their
deposit liabilities because of the Federal Reserve’s
control over the total quantity of reserves.
In reality, reserve requirements have never
been this stringent. Reserve requirements have
never applied to all bank sources of funds, nor
have they been uniform across all banks or all
deposit liabilities. The fact that reserve require
ments have varied across classes of deposits and
20For recent discussions of this process, see Garfinkel and
Thornton (1991) and Thornton (1992).
37
institutions means that the effect of a given
open market operation on total bank loans can
vary, perhaps widely, with the distribution of
deposits.21
nificantly weakened the Federal Reserve’s ability
to influence bank lending through open market
operations.
In addition, there is the possibility of substitu
tion on the asset side of banks' balance sheets.
Banks may choose to alter loans and securities
proportionately or may simply absorb the entire
effect of policy actions in their holdings o f secu
rities. Indeed, banks would tend to substitute
away from government securities to bank loans
as bank loan rates rise relative to the rates on
securities, dampening the effect o f restrictive
monetary policy actions on bank loans. The
magnitude of this effect, however, is uncertain.
Moreover, if restrictive policy actions affect out
put, they could increase the default risk of bank
borrowers relative to that o f the government,
inducing banks to shift their portfolios in the
direction of government securities.22
FINA N CIA L IN N O V A T IO N
Nevertheless, the ability of banks to alter their
asset portfolios may be particularly relevant for
counter-cyclical monetary policy. For example, if
reserve growth accelerates sharply after the
economy is already in recession and loan de
mand is weak, as in the early 1990s, banks may
be content merely to increase their holdings of
securities; policy actions may have little effect
on the quantity of bank loans.23
Finally, as the differential between bank lend
ing rates and other open market rates widens,
banks would have an incentive to seek funds
that are not subject to reserve requirements. In
addition, nonbank financial intermediaries would
have an incentive to increase their loans to
traditional, bank-dependent borrowers. The
extent to which these possibilities have led to
financial innovation and deregulation is difficult
to say. Nevertheless, financial innovation and
deregulation appear to have lessened the extent
to which bank lending is special and have sig
21Such slippage has been long recognized as a problem for
monetary control. Indeed, one objective of the Monetary
Control Act of 1980 was to reduce the sources of slippage
between Federal Reserve actions and the M1 monetary ag
gregate (see Garfinkel and Thornton, 1989, for a discussion
of these changes). While the Monetary Control Act
strengthened the relationship between policy actions and
M1, it significantly weakened the relationship between poli
cy actions and M2 [see Thornton (1992)] and the supply of
bank loans. The reasons for this will be apparent later.
Increasingly, banks have had to compete with
nonbank financial intermediaries for loan cus
tomers. Moreover, banks’ access to financial
markets has increased significantly, resulting in
an increasing proportion of bank funds coming
from sources that are not affected directly by
Federal Reserve actions. In addition, the phasing
out and eventual elimination of Regulation Q
interest rate ceilings in 1986 enabled banks to
compete with nonbank financial intermediaries
for such funds. An analysis of such changes in
the structure of financial markets, coupled with
changes in the structure of reserve require
ments, suggests that the so-called bank credit
channel of monetary policy may no longer be
relevant empirically, if it ever was.
The Specialness o f Bank Credit
Financial innovation and deregulation have
widened the array o f financing options available
to many small and medium-size firms, reducing
their dependency on banks. Changes in technol
ogy and the structure of financial markets have
reduced the information and monitoring costs
associated with making loans to many business
es, increasing many firms’ direct access to finan
cial markets and nonbank sources of funds.
Access o f a wider array of firms to the com
mercial paper market and the rise in business
lending by domestic finance companies have
significantly reduced the specialness of bank
credit.24 Meanwhile, financial innovation has all
but eliminated the specialness o f bank credit for
a wide array of other types of bank borrowers.
Banks now face stiff competition from nonbank
23Bernanke and Lown (1991) suggest that if banks respond to
an easier monetary policy by simply holding more govern
ment securities, “ the ‘credit channel’ of monetary policy
will be shut down, and the real effects of a given monetary
expansion will be smaller.” This assumes, of course, that
those desiring bank loans will be unable to obtain credit
elsewhere.
24See Wheelock (1993) for a discussion of these and other
developments.
22This could bias empirical tests in favor of finding a sig
nificantly positive relationship between monetary policy
actions and bank loans.
JANUARY/FEBRUARY 1994
38
Figure 3
Credit Issued by Financial Intermediaries as a Percent
of Total Domestic Credit, and Credit of Banks as a
Percent of Credit of Financial Intermediaries
intermediaries in consumer finance and both
residential and commercial real estate finance.25
Moreover, loans are frequently securitized.
That is, they are combined with similar loans
from a wide variety of such borrowers to diver
sify the default risk. Shares in such pools of
loans are sold as securities in financial markets.
In effect, such borrowers have direct access to
the credit market. Banks often facilitate the
process by initiating the loans and servicing the
loan contracts, but they are not the source of
the credit.
That such financial market innovations have
reduced the role of financial intermediaries in
the allocation of credit is illustrated in Figure 3,
which shows that the proportion of total domes
25For evidence on the changing role of finance companies
and banks in the allocation of credit, and for an analysis of
the importance of costly information in lending, see Remolona and Wulfekuhler (1992).
26Financial intermediaries include the four depository institu
tions plus finance companies, pension funds and life insur
ance companies.
FEDERAL RESERVE BANK OF ST. LOUIS
tic non-financial credit on the balance sheets of
financial intermediaries has declined since the
early 1980s.26 This decline roughly coincides
with the sharp rise in the commercial paper
market.27
More important for the credit view, however,
has been the decline in the proportion o f inter
mediated credit accounted for by banks. The
banks’ proportion of intermediated credit gener
ally rose until the mid-1970s, to a peak near 70
percent. Since then, it has declined dramati
cally—nearly 25 percentage points—and now
accounts for only about 45 percent of the total
intermediated credit.
The proportions of intermediated credit sup
plied by commercial banks and thrifts is shown
27ln addition, there has been increased competition from for
eign banks. By 1989, foreign commercial banks accounted
for about 20 percent of total U.S. commercial bank assets.
39
Figure 4
Credit Issued by Commercial Banks and by Thrifts as a Percent
of All Credit Issued by Financial Intermediaries
in Figure 4. Both have declined in the last de
cade or so, with the proportion of intermediat
ed credit supplied by commercial banks reaching
its peak in the mid-1970s and that of the thrifts
peaking in the late 1970s. The latter peak coin
cides with a sharp acceleration in the growth of
money market mutual funds (MMMFs) in the
late 1970s.
The increased prominence o f nonbank finan
cial intermediaries relative to banks in supplying
credit and the increased reliance on obtaining
funds directly in the markets, rather than
through traditional financial intermediaries,
point to a decline in the specialness of bank
lending.28
The Supply o f Bank Credit
If banks merely satisfied their loan demand by
issuing publicly held debt, there would be noth
28The trend toward increased competition with banks for bus
iness loans is likely to continue. See Goodwin (1992) and
American Banker (1993).
29The increasing recognition of this fact is one reason why
some have turned their attention from the credit view per
ing unique about bank credit. Nothing would be
fundamentally different from a bank making a
loan with funds obtained from the sale o f large,
negotiable certificates of deposit, and a finance
company making a loan with funds obtained
from the sale of commercial paper. Monetary
policy actions would have a similar effect on
bank and other credit—there would be no
separate bank lending channel for monetary
policy.
The credit view of monetary policy is weakened
by financial innovation and deregulation that
have significantly increased banks’ access to
financial markets and reduced their dependence
on sources o f funds that are subject to the
reserve requirements of the Federal Reserve.29
Two important innovations were the introduc
tion of large, negotiable certificates o f deposit
and the development of the Eurodollar market.
se to the role of credit market “ frictions” in propagating
monetary policy impulses. For example, this type of analy
sis forms the foundation of what Gertler and Gilchrist
(1993b, c) call the “ excess sensitivity hypothesis.”
JANUARY/FEBRUARY 1994
40
Negotiable Certificates o f Deposit
Citibank introduced the first negotiable cer
tificate o f deposit in 1961, to make CDs more
liquid and, thus, more attractive to investors.
Because of their large denomination—$100,000
or more—they w ere frequently purchased by
money market investors who otherwise would
not have maintained large savings balances with
banks. As the popularity of these instruments
increased, they became a major source of funds
for banks.
These deposits are part of banks' so-called
managed liabilities, which banks can tap during
periods of increasing loan demand or restrictive
monetary policy actions. At such times, banks
raised the rate that they paid on large CDs, cir
cumventing the Regulation Q interest rate ceil
ing on other deposit sources of funds.
Eurodollar B orrow ing
The development o f the Eurodollar market
also provided banks with a new source of nontraditional funds. Eurodollars, dollar-denominated
deposits in foreign branches of U.S. banks, ini
tially w ere not subject to the reserve require
ments of the Federal Reserve. Consequently,
banks discovered they could obtain funds that
w ere free from reserve requirements and simul
taneously circumvent the Fed’s Regulation Q
interest rate ceilings by borrowing Eurodollars
from their foreign branches. Of course, the Fed
realized that banks' Eurodollar borrowing cir
cumvented reserve requirements and extended
reserve requirements to these liabilities.30
Since Eurodollars and large CDs were subject
to reserve requirements, it can be argued that
30Banks that were part of a bank holding company found
that they could avoid the reserve tax on funds by having
the holding company borrow funds directly in the market
by issuing commercial paper and by borrowing the funds
so obtained from the bank holding company. The Fed saw
this loophole and imposed reserve requirements on such
funds at the same time it imposed reserve requirements on
Eurodollar liabilities.
31For a discussion of some of these elements of the pricing
of deposits, see Carraro and Thornton (1986).
32There is evidence that the lack of uniformity of reserve
requirements resulted in some considerable slippage
between Federal Reserve actions and the monetary
aggregates M1 and M2 (for example, see Garfinkel and
Thornton, 1989, and Thornton, 1992). Since the argument
that Federal Reserve actions exert considerable influence
over the supply of bank loans is directly related to the exis
tence of such reserve requirements, the slippage must
FEDERAL RESERVE BANK OF ST. LOUIS
the total amount of these liabilities were con
strained by the Federal Reserve. This conclu
sion, however, need not be valid. It ignores the
possibility that banks change the relative prices
of their deposit liabilities in response to changes
in credit market conditions. The “price” of
deposits includes service fees, minimum and/or
average balance requirements and other incen
tives and inducements, as well as the explicit in
terest paid.31 Because checkable deposits had a
higher percentage reserve requirement than
that of savings-type deposits, including large
CDs and Eurodollar deposits, banks could effec
tively increase the supply of loans for a given
level of reserves by raising the cost of checkable
deposits relative to noncheckable deposits. In
this way, the total supply o f loans could in
crease without an increase in the supply of
reserves.
If the bank loan rate were to rise relative to
other rates, individually banks would attempt to
attract more funds by making their deposits
more attractive. In so doing, they would have
an incentive to make savings deposits somewhat
more attractive than transaction deposits since
they would not only attract new depositors, but
also induce existing depositors to switch from
checking to savings accounts.
Unfortunately, information about banks’ pric
ing of deposits is scarce, so there is no evidence
that banks followed such pricing practices.32 In
any event, the possibility that banks could change
the relative price of high-reserve-requirement
and low-reserve-requirement liabilities could be
part of the explanation for the apparent, histori
cally weak association between bank lending
and policy actions presented later.
be about the same as the slippage between Federal
Reserve actions and M2. The fact that about 10 percent of
M2 is composed of assets that are not the liabilities of
banks makes it difficult to make a stronger statement. If
these deposit liabilities are ignored, the slippage between
Federal Reserve actions and bank loans must be at least
as large as that between Federal Reserve actions and M2.
This is so because the fact that banks can also adjust their
asset portfolios—and would have an incentive to do so in
the way described in the text— means that there is an addi
tional source of slippage in the relationship between Feder
al Reserve actions and bank loans that is not present in
the relationship between Fed actions and M2.
41
The Rise o f M on ey Market
Mutual Funds
A financial innovation that had an even more
profound effect on the empirical relevance of
the credit view was money market mutual
funds (MMMFs).33 Tw o factors gave impetus to
the creation of MMMFs: the high inflation of
the 1970s, which became embedded in market
expectations, and the rise of market interest
rates to levels much higher than those permit
ted by Regulation Q interest rate ceilings. The
resulting outflow of deposits from banks into
MMMFs had two consequences for the credit
view.
The first was the decision to eliminate Regula
tion Q interest rate ceilings on bank deposits.
As the high inflation of the 1970s pushed nomi
nal interest rates significantly above those that
banks could pay to depositors under Regulation
Q interest rate ceilings, banks confronted in
creased competition for funds by nonbank
financial intermediaries, especially MMMFs. As a
result, Regulation Q interest rate ceilings were
phased out and eventually eliminated (for all
but demand deposits) in March 1986. During
the phasing out of Regulation Q, several new
deposits were introduced, such as all-savers cer
tificates and money market deposit accounts, to
permit banks to compete more effectively with
nonbank financial intermediaries for funds.34
This meant that an increasing number of banks
were now able to compete directly in the mar
ket for funds. Previously, only large banks
could compete effectively in the large CD, Eu
rodollar and commercial paper markets.
The increased competition between banks and
nonbanks for “traditional” bank sources of
funds gave rise to a second change that has had
an even more important consequence for the
credit view—the elimination o f required reserves
on sources of funds by which banks were in
direct competition with nonbank intermediaries.
33MMMFs were introduced in 1970. Their growth, however,
was modest until interest rates rose to historically high
levels in the late 1970s.
The fact that banks were required to hold a
percentage of such deposits in non-interest
bearing reserves—either vault cash or deposit
balances with Federal Reserve Banks—placed
them at a competitive disadvantage relative to
other, nonbank intermediaries.35 Pressure to
eliminate the reserve requirements gave rise to
changes in the structure of reserve require
ments that have significantly reduced the ability
of the Federal Reserve to influence bank credit
through open market operations. The discussion
of these changes begins with the Monetary Con
trol Act of 1980 (MCA).
The M C A, Changes in R eserve
Requirem ents and the Supply o f
Bank Credit
The MCA made two changes to the structure
of reserve requirements that had opposite ef
fects on the Fed's ability to influence bank lend
ing. On the one hand, the MCA extended the
System’s reserve requirements to all depository
intermediaries, instead o f just member commer
cial banks. This increased the Fed’s ability to in
fluence the availability of funds to all banks. On
the other hand, the MCA eliminated reserve
requirements (on all but demand deposits) on a
broad category o f time and savings deposits, sig
nificantly increasing the proportion of bank
deposit liabilities that are not influenced directly
by Federal Reserve actions.
Continued pressure to increase the competi
tive position of banks caused the Fed to eliminate
required reserves on the remaining categories
of time and savings deposits in December 1990.
Today, reserve requirements apply to less than
25 percent o f banks’ deposit liabilities and less
than 20 percent o f banks’ total sources of loana
ble funds. Consequently, it should not be too
surprising to find that current bank lending is
relatively unresponsive to changes in the supply
of reserves.
action deposits. It is not clear whether the combination of
these taxes and subsidies result in a net tax or a net sub
sidy to banks relative to their nonbank competitors.
34See Gilbert (1986) for a more detailed discussion of the
effects of Regulation Q interest rate ceilings and for a chro
nology of their eventual elimination.
35lt should be pointed out that banks also get various
government subsidies in the form of deposit insurance,
access to the Fed’s discount window, and government
regulated oligopoly power in their franchise to issue trans
JANUARY/FEBRUARY 1994
42
EVIDENCE OF THE EFFECT OF
FEDERAL RESERVE ACTIO NS ON
THE SU P P LY OF R ANK CREDIT
The credit view of monetary policy is based
on a chain of causation from the supply of
reserves to the supply of bank loans. The litera
ture on the credit view, however, has not exa
mined the link between the supply of reserves
and the supply o f bank loans closely. This
section investigates the association between
bank loans and total reserves adjusted for
reserve requirement changes.
Whatever its immediate or long-run objectives,
the Fed pursues them through open market
operations, changes in reserve requirements
and changes in the discount rate. These actions
are directly reflected in total reserves. Because
of reserve requirements, bank lending and total
reserves should be positively related, regardless
of whether changes in total reserves represent
an exogenous change in monetary policy or
whether the Fed is merely accommodating
shifts in the demand for deposits subject to
reserve requirements.36 Other commonly used
measures o f monetary policy, like the federal
funds rate or policy indicators based upon an
examination of Federal Reserve documents,
are not necessarily closely related to Federal
Reserve actions that affect the availability of
bank loans.37 Consequently, they cannot neces
sarily provide evidence about the relationship
between the supply of reserves and bank lending.
The availability of reserves can be affected by
the actions of the public, however. For example,
if the demand for currency w ere to rise, other
things being the same, the availability of reserves
to the banking system would decline. Conse
quently, an increase in the public’s demand for
currency would have the same effect on bank
36Some analysts would associate the stance of monetary
policy with reserve growth, but this would certainly not be
true of all. For example, some believe that the Fed controls
the federal funds rate and associate changes in monetary
policy with changes in the federal funds rate despite the
fact that the funds rate can fall (monetary policy becomes
easier) when reserves are declining, for example, the peri
od from April through June 1989. Others prefer to gauge
the thrust of monetary policy from the behavior of M2. For
example, Friedman (1992) and Buchanan and Fand (1992)
argued that monetary policy was excessively tight in
1991-92 because M2 growth was slow and decelerating,
despite the fact that reserve growth accelerated sharply
during this period and increased at double-digit rates.
37Garfinkel and Thornton (1994) argue that there is no mone
tary information in the federal funds rate that is not con
tained in other short-term interest rates.
FEDERAL RESERVE BANK OF ST. LOUIS
liabilities and lending as an equivalent sale of
government securities by the Federal Reserve.
The Federal Reserve’s operating procedures,
however, have tended to automatically accom
modate such shifts.38 The Fed supplies addition
al reserves to offset the reserve drain when the
demand for currency increases. The reverse is
true when the demand for currency decreases.
Total reserves change only when the Fed takes
actions other than those required to accommo
date swings in currency demand. Thus, total
reserves adjusted for changes in reserve require
ments is a good indicator of Federal Reserve
actions that affect banks’ balance sheets.
Interpreting the Relationship
Between Total R eserves and Bank
Lending
Finding that reserves and bank lending are
unrelated would suggest that there is no credit
channel for monetary policy. Finding that
reserves and bank lending are highly and posi
tively associated, on the other hand, does not
ipso facto mean the credit view is valid. The
problem is that bank loans and total reserves
may respond endogenously to the same shocks.
For example, suppose there is a decline in eco
nomic activity and with it, a decline in the de
mand for liquid deposits, nominal interest rates
and credit demand. If the Fed accommodates
the decline in the demand for liquid deposits
by reducing the growth of reserves, reserve
growth and loan growth would be positively as
sociated even if there was no direct association
between reserves and loans.39
This problem is particularly accute for total
reserves because total reserves consist of both
borrowed and nonborrowed reserves. Borrowed
reserves have tended to respond endogenously
38This is the case if the Fed is targeting the federal funds
rate, nonborrowed reserves or borrowed reserves.
39The Fed's preoccupation with interest rate targeting [see
Goodfriend (1991)] would tend to exacerbate this tendency,
as the Fed would attempt to put downward pressure on the
federal funds rate by reducing the growth of reserves.
43
to changes in the spread between the federal
funds and discount rates. Consequently, bor
rowed reserves and, hence, total reserves will
tend to rise and fall when market interest rates
are rising and falling, respectively. Because of
this, some have argued that nonborrowed
reserves is a better indicator o f monetary policy
actions than are total reserves.40
If the objective is merely to measure the
degree of association between reserves and
bank loans that results from the existence of
reserve requirements, this distinction is unim
portant.41 However, if the objective is to deter
mine whether monetary policy works through
the bank lending channel, the distinction is criti
cal. A statistically significant, positive association
between total reserves and loans does not
necessarily imply that policy actions affect bank
loans in the manner suggested by the credit
view of monetary policy. A positive association
between reserves and bank loans could result
from the effect of monetary policy on the econ
omy through the standard monetary channel.
For example, an increase in reserve growth
could stimulate economic activity through the
monetary channel, increasing the demand for
credit and, consequently, the quantity of bank
loans.
Kashyap, Stein and Wilcox (1993) try to deal
with this identification problem by using a MIX
variable, the ratio o f bank loans to the sum of
bank loans and commercial paper outstanding.
They argue that if monetary policy works
through the bank credit channel, a restrictive
monetary policy action should be associated
with a decline in bank loans relative to commer
cial paper, that is, the MIX variable should
decline.42 Alternatively, if monetary policy works
through the standard monetary channel, both
40For example, see Christiano and Eichenbaum (1991, 1992).
This proposition that nonborrowed reserves is a better poli
cy indicator has been challenged by Gilles, Coleman and
Labadie (1993).
41For example, borrowed reserves increased dramatically in
May-June of 1984, when Continental Bank made heavy use
of the Federal Reserve’s discount window. As a result,
there was a sharp drop in nonborrowed reserves, with vir
tually no change in total reserves. There was no need for
banks to contract loans despite the drop in nonborrowed
reserves.
42ln footnote 11, I have noted why a positive association be
tween the MIX variable and Federal Reserve actions does
not necessary mean that the credit view is valid because
such a correlation can arise in the situation in which policy
actions limit bank lending, but where the bank lending is
bank loans and commercial paper should be af
fected more or less equally so that the credit
MIX should be unaffected by policy actions.
If Federal Reserve actions affect bank credit
with a lag, however, it will be particularly
difficult to distinguish the monetary channel
from the credit channel. When the Fed in
creases the supply o f reserves, banks have an
incentive to expand their deposit liabilities
quickly because the Federal Reserve does not
pay interest on reserves. Consequently, an in
crease in the supply of reserves will be associat
ed with an immediate increase in the supply of
money. If bank credit responds with a lag,
there will be little or no immediate change in
the supply of bank credit. Thus, it will appear
as though monetary policy works solely through
the monetary channel even though the bank
lending channel may be operative as well.43
The Contractual Nature o f Loans
Made Under Commitment
The fact that loans are contractual obligations
not quickly changed and that many loans are
made under commitment (for example, a line of
credit) suggests that policy actions may affect
bank loans with a lag. For example, if the Fed
reduces the supply o f reserves, banks will have
an incentive to reduce loans and not issue new
ones. Given such rigidities, however, banks may
initially reduce their holdings o f government
securities and later reduce their quantity of
outstanding loans.
Policy actions that result in a decrease in total
reserves are fairly extreme. Reserves tend to
grow over time, with policy actions character
ized by changes in the growth rate of reserves.
Because of the contractual nature of loans and
not special. Nonetheless, essentially finding no relationship
between policy actions and the MIX variable is indicative of
policy actions effecting both the banks and the credit mar
kets equally. Consequently, the lack of association between
these variables is evidence that there is no unique channel
of monetary policy through bank lending.
43This observation has been made by Bernanke and Blinder
(1992) and Bernanke (1993) as an argument why evidence
by Romer and Romer (1989) and Ramey (1993) that mone
tary aggregates are more closely linked to economic activi
ty than credit aggregates is not necessarily evidence
against the credit view.
JANUARY/FEBRUARY 1994
44
the existence of loan commitments, a significant
slowing o f the growth o f reserves may be
reflected initially more in banks’ holdings of
government securities than in loans.44 A signifi
cant acceleration in reserve growth should be
associated with an acceleration in the growth of
both banks’ holdings o f government securities
and loans. Consequently, policy actions should
affect loans more quickly when the Fed in
creases the growth rate of reserves. Other
things being the same, the contractual nature of
loans and the existence of loan commitments
suggest that the timing of the effect of policy
actions on bank loans should be asymmetric:
Open market purchases should be associated
with an immediate response in bank lending,
while open market sales should affect bank
lending with a lag.45
The Relationship Between Total
R eserves and Bank Loans
Because o f reserve requirements, one would
expect to find a fairly close association between
reserves and bank liabilities prior to the 1980s.
There are several caveats, however. First, prior
to the MCA, only member commercial banks
were required to maintain reserves, so the con
nection necessarily exists only between total
reserves and deposits of member commercial
banks. Second, the percentage reserve require
ment varied by the size of the member bank
and deposit classification. Consequently, the
relationship between total deposits and total
reserves, even among member commercial
banks, might have varied significantly with the
distribution of deposit liabilities. Third, financial
innovations that w ere designed to circumvent
reserve requirements and Regulation Q interest
rate ceilings should have weakened even the
longer-run relationship between total reserves
and bank liabilities, especially since the late
1970s. Finally, the passage of the MCA and the
phasing out and eventual elimination of Regula
44lndeed, in the short run, loans may actually increase as
customers exercise their loan options.
45lt is interesting to note that this interpretation is at odds
with the standard view of the asymmetry of monetary policy
and with the empirical evidence (Cover, 1992; DeLong and
Summers, 1988; and Rotemberg, 1993) that suggests res
trictive monetary policy actions are more effective than
expansionary monetary policy actions. The asymmetry of
the effects of policy actions on bank credit, suggested by
Bemanke and Blinder (1992) and others, that expansionary
policy actions should have more immediate—and perhaps
larger—effects on bank credit and, consequently, economic
activity than restrictive policy actions.
FEDERAL RESERVE BANK OF ST. LOUIS
tion Q should have all but eliminated the rela
tionship since the early 1980s.
Reserves, loans and deposits all tend to rise
over time. This should not be mistaken as evi
dence in favor o f the credit view, however,
since they are all merely expanding with an ex
panding economy and inflation. Statistical tests
o f the association between total reserves and
bank loans must account for the dominant
trends in these data. In the regression analysis
that follows, this is done by taking the first
difference of these variables.46
The reported regression results are from
estimates o f equations of the general form
( 1 ) Ay, = pfUATR' + e,,
where A is the difference operator, that is,
A^( =
y is the dependent variable, L is
the lag operator, that is, Lpc, =
P(L) = p0 +
/?,L + P2L z + ...+ pkLk, and TR denotes total
reserves.
The primary interest is in the contemporaneous
and long-run effects, so it is convenient to re
write equation 1 as
(2) Ay, = 0ATRt_k + R(L)L2TRt i + £,,
where 6 = P0 + p1 +...+ Pk and R0 = P0,
R, = P0 + Pt , and so on. The coefficient 6
the long-run response of the dependent variable
to a permanent change in total reserves. The
credit view requires 6 to be positive and statisti
cally significant. The coefficient P0 (= R 0) gives
the initial response and d~P0 gives the sub
sequent response of the dependent variable to
changes in total reserves.
The Results
Equation 2 was estimated separately for loans
and for deposits of commercial banks, thrifts,
and commercial banks and thrifts com46There is always the danger of over-differencing data. To
see if the results are robust for the filter used, the equa
tions were also estimated using data obtained from the
Hodrick-Prescott (1980) filter. There were no qualitative
differences in these results from those reported here.
45
Table 1
The Relationship Between Bank Deposits and Loans: 1959.1-1979.4
Commercial banks
and thrifts
Thrifts
Commercial banks
Loans
Deposits
Loans
Deposits
Loans
Deposits
Constant
13.059*
(4.30)
3.949
(1.49)
-.2 0 9
(0.17)
P
12.317*
(2.60)
7.232*
(2.08)
.024
(0.01)
e
29.311*
(1.76)
23.128*
(1.77)
-2 .7 2 5
(0.48)
0.876
(0.99)
-3 .9 7 8
(0.24)
9.552
(0.61)
e-p
16.995
(1.07)
15.896
(1.25)
-2 .7 4 9
(0.52)
.384
(0.45)
-1 3 .5 2 2
(0.85)
1.953
(0.13)
R2
.742
.786
.792
.720
.772
.821
6.523
4.899
2.712
0.416
7.106
6.178
S.E.
-0 .0 8 2
(0.46)
0.492*
(1.71)
12.802*
(3.82)
6.540*
(1.97)
9.544*
(1.85)
7.599*
(1.70)
‘ Indicates statistically significant at the 5 percent level using a one-tailed test.
bined. These data, taken from the Flow of
Funds Accounts, are for the last day o f the
quarter and are not seasonally adjusted. The
estimated equations include a third-order lag of
the dependent variable, three quarterly seasonal
dummy variables, and contemporaneous and
eight lags of ATR. Only the estimated constant
and estimates of the p0, 6 and 9 - [ ) 0 are reported.
Garfinkel and Thornton (1989) show that the
MCA was essentially phased in by February
1984, when the large member banks were com
pletely phased in. Because o f the limited num
ber of quarterly observations, however, the
results reported here are for two periods broken
at the introduction of the MCA: 1959:4 to 1979:4
and 1980:1 to 1993:2.
As noted previously, unless demand factors
are explicitly controlled, a positive association
between reserves and bank loans does not
necessarily imply that monetary policy works
through the bank lending channel. In an at
tempt to control demand factors, two cyclical
variables, the spread between the federal funds
rate and the 10-year government securities rate
and the growth rate of nominal GDP, were in
cluded in the regressions. These variables were
generally insignificant and the qualitative results
when these variables were included differed lit
tle from the results when they were not exclud
ed. Consequently, only the latter results are
presented here. In addition the empirical work
was also conducted using nonborrowed
reserves. The qualitative conclusions regarding
the credit view were the same as those obtained
using total reserves, so only the latter results
are reported.
Estimates of equation 2 for both periods are
presented in Tables 1 and 2, respectively. The
estimates show that both deposits and loans
were significantly related to total reserves dur
ing the first period. Not surprisingly, the statisti
cally significant relationship for deposits is due
entirely to commercial banks because deposits
at thrifts are essentially unrelated to reserves.
The statistically significant relationship for loans
is primarily due to commercial banks. While
statistically significant, the relationship between
reserves and loans at thrifts is not large.
The results for the pre-1980s point to the
potential validity of the credit view. Loans and
reserves are positively and significantly associat
ed for both banks and thrifts, although the rela
tionship was quite weak for the latter. All of
the effect is contemporaneous, however, as the
subsequent response of deposits or loans to a
changes in total reserves, 0-/?, is never statisti
cally significant at the 5 percent level.
The magnitude of the effect is quite small,
however. A $1 billion increase in total reserves
JANUARY/FEBRUARY 1994
46
Table 2
The Relationship Between Bank Deposits and Loans: 1980.1-1993.1
Deposits
Loans
Commercial banks
and thrifts
Thrifts
Commercial banks
Deposits
Loans
Deposits
Loans
8.043
(0.64)
-3 .8 4 2
(0.51)
-0 .3 4 2
(0.16)
27.252*
(2.37)
-5 .0 4 4
(0.33)
2.350
(0.69)
-0 .9 3 3
(0.22)
2.813
(0.98)
-0 .5 6 3
(0.73)
8.642*
(2.08)
-1 .4 4 3
(0.26)
e
-1 .5 0 9
(0.26)
4.211
(0.67)
-1 .1 4 5
(0.25)
0.865
(0.68)
1.707
(0.26)
9.721
(1.11)
0-/3
- 3.859
(0.68)
5.145
(0.79)
-3 .9 5 8
(0.87)
1.428
(1.10)
-6 .9 3 5
(1.04)
11.164
(1.19)
R2
.765
.416
.766
.470
.820
.668
13.772
16.254
11.263
3.234
16.836
21.814
Constant
46.435*
(3.97)
P
S.E.
'Indicates statistically significant at the 5 percent level using a one-tailed test.
resulted in a estimated $12 billion long-run in
crease in banks loans. Since total reserves in
creased about $8 billion from 1960 to 1979,
policy actions would appear to account for less
than $100 billion of the about $1,178 billion in
crease in bank loans during this period. While
these estimates should be interpreted cautiously,
they suggest that the direct effect of monetary
policy actions on bank lending during the peri
od was modest.
The estimates for the second period in Table
2 show that there is no statistically significant
relationship between total reserves and loans
for commercial banks or thrifts. Consistent with
the discussion of the effects of financial innova
tion and changes to the structure of reserve
requirements, it appears that the modest associ
ation between Federal Reserve actions and bank
loans that was evident prior to 1980 has vanished.
Commercial and Industrial Loans
and R eserves
Because the credit view is most likely to apply
to businesses that have less access to alternative
sources of credit, most of the empirical work to
47ln each case, contemporaneous and 12 lags of ATR were
included along with three lags of the dependent variable.
FEDERAL RESERVE BANK OF ST. LOUIS
date has focused on commercial and industrial
(C&I) loans. Seasonally adjusted data on C&I
loans are available on a monthly basis, but only
for commercial banks and only since November
1972. Equation 2 was also estimated with com
mercial bank holdings of government securities,
SEC, as the dependent variable, to test whether
any potential lag in the effect of reserves on
C&I loans can be attributed to changes in
banks’ holdings o f liquid assets. Finally, the
equation was estimated using a Kashyap-andStein-type MIX variable, the ratio of C&I loans
to commercial paper. Equation 2 was estimated
separately for the periods o f November 1972 to
February 1984, and March 1984 to May 1993, to
test whether changes in reserve requirements
under the MCA significantly reduced the effect
of policy actions on bank loans.47 All the esti
mated equations include three lags o f the de
pendent variable and contemporaneous plus 12
lags of ATR.
Estimates for the two periods are presented in
Tables 3 and 4, respectively. The results for the
first period indicate a statistically significant
relationship between total reserves and C&I
loans, but not between total reserves and SEC.
47
Table 3
The Effect of Federal Reserve
Actions on Selected Commercial
Bank Assets: 1972.11-1984.2
C&l loans
SEC
Mix
Constant
.247
(0.83)
.459*
(2.02)
-.0 0 0
(0.75)
Po
1.081
(1.37)
1.218
(1.63)
.002
(1.45)
e
7.602*
(2.66)
-1 .1 2 4
(0.36)
- .0 0 4
(0.87)
e-po
6.522*
(2.39)
-2.341
(0.81)
-.0 0 6
(1.34)
R2
.423
.405
.052
1.719
1.566
.003
S.E.
‘ Indicates statistically significant at the 5 percent level
using a one-tailed test.
Table 4
The Effect of Federal Reserve
Actions on Selected Commercial
Bank Assets: 1984.3-1993.5______
C&l loans
SEC
Mix
1.179*
(1.84)
-.0 0 2
(2.98)
Constant
0.271
(0.50)
Po
0.903
(1.02)
-0 .5 8 9
(0.60)
-.0 0 0
(0.14)
8
0.087
(0.06)
0.022
(0.01)
.002
(1.41)
-0 .8 1 6
(0.55)
0.610
(0.36)
.002
(1.42)
.225
.335
-.0 3 8
3.040
3.407
.003
e-Po
R2
S.E.
'Indicates statistically significant at the 5 percent level using
a one-tailed test.
Reserves appear to affect C&I loans with a lag.
There is a positive, contemporaneous relation
ship between reserves and SEC and a negative
subsequent relationship; however, neither is
statistically significant. Nevertheless, these esti
mates provide some qualitative support to the
finding of Bernanke and Blinder (1992) and
others that monetary policy is reflected initially
in banks’ holdings of securities and subsequent
ly in bank loans.
The results for the second period provide no
support for the credit view. None of the coeffi
cients is statistically significant at the 5 percent
level, and the qualitative pattern of first expand
ing SEC and, subsequently, C&I loans that is
evident in the first-period results has vanished.
The results for the MIX variable are not sup
portive o f the credit view in either period. The
coefficient on the contemporaneous MIX varia
ble is positive in the first period, as the credit
view predicts, however, the long-run coefficient
is negative and neither coefficient is statistically
significant.
Finally, changes in C&I loans made under
commitment are regressed on changes in total
reserves.48 These results appear in Table 5. Be
cause these data are available only from Janu
ary 1975 to June 1987, the results are reported
for a sample ending in February 1984 and for
the entire sample period. The relationship be
tween loans made under commitment and total
reserves is positive and immediate. Moreover,
there is no statistically significant long-run rela
tionship. The results suggest that loan commit
ments do not account for the failure of the
lending channel.
CONCLUSIONS A N D CO M M ENTARY
The empirical results presented here lend
little support to the credit view of monetary
policy. There was a positive and statistically
significant relationship between Federal Reserve
actions and both bank lending and bank deposits
prior to the early 1980s. The effect, however,
was quite small.
48The data on loans made under commitment come from a
Federal Reserve Survey of about 138 large, weekly report
ing commercial banks that account for about 85 percent of
all commercial and industrial loans of all weekly reporting
banks. The official survey ran from January 1975 to June
1987.
JANUARY/FEBRUARY 1994
48
credit channel of monetary policy has been re
juvenated at a time when justification for it has
eroded.
Table 5
Effects of Monetary Policy Actions
on Loans Made Under Loan
Commitments_____________________
1975.1-1984.2
Constant
.247
(0.93)
.322
(1.45)
Po
1.419*
(1.92)
2.336
(4.16)
e
1.691
(0.62)
1.160
(1.14)
e-Po
.272
(0.11)
-1 .1 7 6
(1.11)
.233
.258
1.488
1.696
R2
S.E.
'Indicates statistically significant at the 5 percent level
using a one-tailed test.
Consistent with financial innovation and
changes in reserve requirements under the
MCA, the relationship between Federal Reserve
actions and bank lending since the early 1980s
is nil. Consequently, whatever the nature o f the
relationship between bank lending and Federal
Reserve actions prior to the 1980s, it appears
that changes in the structure o f reserve require
ments under the MCA of 1980 have essentially
eliminated it. Indeed, given the existing struc
ture o f r e s e r v e re q u ir e m e n ts , it is difficult to
see how monetary policy can work through the
hypothesized bank credit channel, if it ever did.
These results not withstanding, there is a
growing recognition that the relative position of
depository financial intermediaries in allocating
credit has diminished over time. It is now
generally accepted that banks compete directly
with other intermediaries for most of their
funds and that they no longer have a unique
place in supplying consumer and real estate
credit. Moreover, other intermediaries are be
coming increasingly competitive with banks in
the market once thought to be the bastion of
banks—extending credit to small and medium
sized businesses. At the same time, financial in
novations have significantly redefined the mean
ing of small and medium when it comes to the
size o f firms with direct access to credit mar
kets. Indeed, it is ironic interest in the bank
FEDERAL RESERVE BANK OF ST. LOUIS
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1994 WORKING PAPERS
94-001A - Peter S. Yoo, “ The Baby Boom and Economic Growth.”
94-002A - Peter S. Yoo, “ Age Distributions and Returns of Financial Assets.”
94-003A - Peter S. Yoo, “ Age Dependent Portfolio Selection.”
94-004A - Joseph A. Ritter, “ The Transition From Barter to Fiat Money.” FORTHCOMING: The Ameri
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94-005A - Sangkyun Park, “ The Bank Capital Requirement and Information Asymmetry.”
94-006A - Richard G. Anderson and Kenneth A. Kavajecz, “ A Historical Perspective on the Federal
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Coordination? Some Evidence from Austria, Belgium and the Netherlands.”
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1993 WORKING PAPERS
93-001A - Patricia S. Pollard, “ Macroeconomic Policy Effects in a Monetary Union.”
93-002A - David C. Wheelock and Paul W. Wilson, “ Explaining Bank Failures: Deposit Insurance
Regulation, and Efficiency.”
1992 WORKING PAPERS
92-001A - John A. Tatom, “ The P-Star Model and Austrian Prices.” PUBLISHED: Empirica, 1992,
vol. 19, no. 1.
92-002A - David C. Wheelock and Subal C. Kumbhaker, “ The Slack Banker Dances: Insurance and
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92-003A - Daniel L. Thornton, “ The Market’s Reaction to Discount Changes: What’s Behind the An
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92-005A - John A. Tatom, Heinz Gluck, and Dieter Proske, “ Monetary and Exchange Rate Policy in
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92-006A - John A. Tatom, “ Currency Appreciation and ‘Deindustrialization:’ A European Perspective.”
92-007A - David C. Wheelock, “ Government Policy and Banking Instability: ‘Overbanking’ in the
1920s.” PUBLISHED: Journal of Economic History (December 1993), published as “ Govern
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91-003A - James B. Bullard, “ Collapsing Exchange Rate Regimes: A Reinterpretation.”
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91-005B - David C. Wheelock and Subal C. Kumbhaker, “ Which Banks Choose Deposit Insurance?
Evidence of Adverse Selection and Moral Hazard in a Voluntary Insurance System.”
FORTHCOMING: Journal of Money, Credit and Banking.
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