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JULY 1972

Will Capital Reflows Induce Domestic
Interest Rate C han g es?................................


Income and Expenses of Eighth District
Member Banks— 1971 ..............................
A Review of Empirical Studies of the
Money Supply Mechanism ......................... 11

Vol. 5 4 , No. 7

W ill Capital Reflows
Induce Domestic Interest Rate Changes?

E lV A L U A T IO N of the performance of the U.S.
economy in 1971 frequently has placed considerable
emphasis on the impact of international capital flows
on U.S. interest rates, especially Treasury bill rates.
Similarly, prognostications about economic activity in
1972 have involved predictions of interest rate behavior
which are heavily influenced by anticipated interna­
tional capital movements. A typical description of
events goes something like this:
(1) A large deficit in the U.S. balance of payments
in 1971, particularly due to speculative conver­
sion of dollar assets into assets denominated in
foreign currencies, forced huge quantities of
dollars on foreign central banks who in turn
used them to purchase U.S. Government debt.
These purchases bid up the prices of Treasury
liabilities and thus depressed their yields. The
arbitrage between the Treasury debt market and
other credit and equity markets resulted in de­
pressed yields on all U.S. interest-bearing
(2) The devaluation of the dollar eliminated the
anticipation of further capital gains accruing to
holders of assets denominated in foreign cur­
rency and, when combined with the narrowing
spread between U.S. and foreign interest rates,
should cause the “repatriation” of speculative
funds that moved abroad in 1971. This will then
force foreign central banks to supply dollars
which they will acquire by selling U.S. Treas­
ury securities purchased earlier. Such a massive
sale will depress security prices and raise yields,
and again, through arbitrage, cause an increase
in the yields of all debt and equity instruments
in the United States. Therefore, interest rates
are projected to rise in 1972 over and above
what they would have been without large in­
ternational capital movements.

Since monetary and fiscal policymakers consider in­
terest rate levels important elements of their policy
goals, the discussion of interest rate changes induced
by international capital movements is not an idle ex­
ercise. It is a real problem which, through exercise
of policy, may have substantial effects on the econ­
omy’s performance in 1972-73.
This note is intended to explain, in a simplified
manner, under what circumstances short-term inter­
national capital movements do or do not affect short­
term interest rates, and to examine the proposition
that “repatriation” of dollar balances in the remainder
of 1972 will significantly raise the level of short-term
interest rates in the United States.

Mechanics of International Capital Transfers
International transactions take many forms and vari­
ous degrees of complexity. Ultimately, however, if
there is a net purchase of assets by residents of one
country from residents of another, the payment takes
place either as a transfer of a reserve asset, such as
gold, SDRs, or dollars, or as an accumulation of de­
mand deposits of the selling country’s residents in the
purchasing country’s banks. The sellers are willing to
accumulate these deposits only if it is profitable for
them to do so. If not, then under a fixed exchange
rate system these deposits can be sold to the selling
country’s central bank at a fixed price.
Suppose that international traders anticipate a de­
preciation of the dollar vis-a-vis other national cur­
rencies. This means that they could realize capital
gains by converting their dollar assets into assets
denominated in a foreign currency and converting


JULY 1 9 7 2

them back into more dollars after the depreciation
was realized. Thus, these individuals would use their
existing dollar demand deposits, or convert other do­
mestic assets into dollar demand deposits and proceed
to buy foreign assets. These foreign assets may take
the form of stocks, bonds, time or demand deposits, or
even claims on goods. If the anticipation of dollar
depreciation is generally prevalent, foreign recipients
of these dollar balances will not be willing to hold
them and will sell them to their central banks.
Traditionally, and in some cases by statute, central
banks have converted these accumulated dollar de­
posits into short-term Treasury securities. Thus, a net
capital outflow from the United States results in the
decumulation of dollar denominated assets and de­
posits by private individuals and corporations, and the
accumulation of U.S. Treasury securities by foreign
central banks. Conversely, an anticipation of dollar
appreciation would induce a demand for dollar de­
nominated assets. Since dollars can be purchased from
foreign central banks at a fixed price, there will be a
sale of Treasury securities by foreign central banks
and a purchase of securities and deposits by private
individuals and corporations.
It is these purchases and sales of Treasury securities
by foreign central banks that have given rise to allega­
tions that an outflow of dollars will raise security prices
and lower interest rates, and that an inflow of dollars
will lower security prices and raise interest rates in
the United States.

Dollar Outflows and Interest Rates in 1971
The situation in 1971 set into motion events as
described above. In addition to the perennial excess
of U.S. purchases of goods, services, and long-term
capital over sales, yields on foreign short-term securi­
ties rose relative to those in the United States. This
produced a further accumulation of dollar assets by
foreign central banks and anticipations that foreign
official agencies might stop buying dollars at the
prescribed price. The possibility that the dollar might
be devalued induced transactors to start converting
ever-increasing amounts of dollars into currencies
which were expected to appreciate. The rest is his­
tory. The German mark was floated on May 9, 1971,
and similar action was taken soon thereafter by
several strong-currency countries. On August 15, con­
vertibility of the dollar into gold was suspended and,
in effect, the dollar was permitted to depreciate
according to market forces. On December 18, Smith­
sonian agreements were reached and the dollar was
devalued with respect to gold and most foreign

Y ie ld s on Eu ro d o lla r D e p o sits










Sources: Board of Governors of (he Federal Reserve System and Salomon Brothers and Hutzler
D a ta a re lo st Frid a y of the month.
11 Rates on 9 0-d a y deposits.
[2 S eco nd ary m arket rotes for n ego tiable 90-day CD*.
Latest data plotted: M ay

During this period foreign central banks accumu­
lated $29.8 billion and used them to buy $26.3 billion
worth of Treasury securities. There is no doubt that
if these massive purchases had been net purchases of
Treasury securities, that is, private buyers of foreign
assets did not sell domestic securities or equities at
the same time, the impact on the prices of these securi­
ties, and on interest rates in general, would have been
significant. It would be tantamount to a sudden shift
of $26.3 billion from cash balances to interest-bearing
debt. If, on the other hand, the purchasers of foreign
assets sold Treasury securities to acquire funds, and
foreign central banks ended up buying the same
amount of securities, then the impact on interest rates
would have been nil.
The true picture is somewhat closer to the latter
case. Precise data on where and how capital transfers
originate are not available, but it is possible to make
an educated guess.
During 1971 U.S. private and governmental ex­
penditures on purchases of goods and services and on
gifts exceeded receipts from sales and gifts received
by $2.8 billion. Long-term capital investment abroad
exceeded foreign long-term investments in the United
States by $6.4 billion. Thus, the “basic” balance
—the amount of dollar balances accumulated by for­
eigners through these “basic” operations — amounted
to $9.2 billion. The total amount of dollars acquired by
foreigners during 1971 — the liquidity balance —
was $22 billion. Thus, short-term capital flows and
Page 3

JULY 1 9 7 2


N et A cq u isitio n s of U .S. Trea su ry S ecurities
b y Foreign O fficial Institutions
B illio n s o f D o l l a r s

B illio n s o f D o l l a r s



tage of anticipted exchange rate changes, were hold­
ing dollar denominated assets which were yielding
some nominal rate of return. Thus, their purchases of
foreign assets and the resulting foreign central bank
purchases of U.S. Treasury liabilities were largely off­
set by a sale of U.S. debt and equity instruments. Such
a set of transactions could have had only a minimal
influence on short-term interest rates in the United

“Repatriation” of Dollars in 1972














ii n






Note: First differences of end-of-period data.

errors and omissions made up the difference — $12.8
billion. Official foreign agencies accumulated $29.8
billion, indicating that private foreigners not only sold
to their central banks all that they had accumulated
during the year ($22 billion), but transferred an addi­
tional $7.8 billion of liquid U.S. assets to foreign
official reserves.
If we assume that “basic” transactions are a result
of price level differentials, long-term yield considera­
tions, and various long-term private and govern­
ment commitments, then the difference between the
official transactions balance and the “basic” balance,
or $20.6 billion, was a result of short-term interest
differentials and anticipated devaluation of the dollar.
This estimate is obviously a very rough one, but it
gives some insight into the magnitude of the so-called
“speculative” outflows, which might reverse under
changed conditions.
In considering the impact of these outflows on in­
terest rates and the ease of the Treasury’s financing
of its debt, it becomes crucial to know whether these
dollar balances were originally held in the form of
currency and demand deposits, in some form of inter­
est-bearing assets, or in equities such as stocks. Al­
though there is evidence that equity transactions play
a minor role in international capital transfers, let us
assume that investors shift with ease from one capital
market to another and are sensitive to yield differen­
tials between equities and debt. If this is indeed the
case, then it is possible to assert that the individuals
and corporations engaged in international interest
arbitrage, and who are able and willing to take advan­
Page 4

Now we can turn to the oft-made statement that
the expected return flow of dollars will cause U.S.
interest rates to rise even higher in the remainder of
1972 than the levels they would otherwise reach.
In the first place, the reflow will occur only if
interest rate differentials change sufficiently in favor
of the United States to offset anticipations of further
dollar devaluation. These interest rate differentials
have indeed been narrowing in favor of the United
States. However, recent floating of the British pound
and the resulting attempts to convert dollars into
other European and Japanese currencies indicate
rather strikingly that the dollar is still considered a
“weak currency.” At this time it appears that any
monetary disturbance, irrespective of how far it may
be removed from the actual strength of the dollar,
raises the possibility of further dollar depreciation.
Thus, the expected reflow may not take place.
Secondly, if the reflow does materialize, the
crucial question is what will these returning dollar
balances be converted into? If our rough figures are
correct, these flows should amount to at least $20.6
billion, and again, it is reasonable to assume that they
would be converted into assets which bear some nom­
inal return. Thus, the sale of Treasury securities by
foreign central banks would be offset by the purchase
of other debt and equity instruments by private indi­
viduals and corporations, and the impact on interest
rates would be insignificant.

Any impact of international short-term capital move­
ments on U.S. interest rates in 1971 depended on:
(1) whether the buyers of foreign currency de­
nominated assets simultaneously sold dollar de­
nominated debt and equity, and
(2) with particular reference to the yields on Treas­
ury debt, whether various debt and equity
markets were effectively separate in the minds
of transactors.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JULY 1 9 7 2

The anticipated effects of a “repatriation” of short­
term capital in 1972, if it occurs at all, will depend on:
( 1 ) w hat dollar denom inated assets w ill b e bou g h t
b y the sellers o f foreign assets, and
( 2 ) the substitutability b etw een different d eb t and
equity instruments.

It seems reasonable to assume that individuals and
corporations who engage in these “speculative” trans­
actions are knowledgeable investors who do not keep
large idle balances (idle in a sense that they do not
earn any nominal return) and, therefore, their pur­
chases of assets denominated in one currency are ac­
companied by sales of assets denominated in another.
Given that the risk factors associated with equities

have been rather small in the United States for the
past thirty years, it is highly probable that the rates
on Treasury debt are highly interdependent with the
rates on other debt instruments and yields on equities.
Thus, it is unlikely that capital outflows in 1971 were
the major cause of the decline in Treasury debt rates
or interest rates in general.
For these reasons, together with the recent concern
that the dollar may still be overvalued, prognosticators
of economic activity and policymakers who base their
decisions on these predictions should be wary of as­
sumptions that a “repatriation” of dollars will occur
and, if it does, will cause an increase in U.S. interest

o f Issue



Government Debt, Mo ne y and Economic
A Critical Look at Monetarist Economics
Comments on a Monetarist Approach to De­
mand Management
The Economy in 1972
Operations of the Federal Reserve Bank of
St. Louis — 1971
Projecting With the St. Louis Model: A Prog­
ress Report
March The 1972 National Economic Plan: An Experi­
ment in Fiscal Activism
Monetary Expansion and Federal Open Market
Committee Operating Strategy m 1971
Has Monetarism Failed? — The Record Ex­

o f Issue



Recent Monetary Growth
U.S. Balance-of-Payments Problems and Policies
in 1971
Outlook for Farm Income and Food Prices


Curbing Price Expectations: The Key to Infla­
tion Control
Measurement of the Domestic Money Stock
Problems of the International Monetary System
and Proposals for Reform — 1944-70


Recovery Accelerates
Eighth District Population Centers
The Hunt Commission Report — An Economic
A Look at Ten Months of Price-Wage Controls
Page 5

Income and Expenses
Of Eighth District Member Banks —1971

ET INCOME of member banks in the Eighth
Federal Reserve District increased 7 percent in 1971
to $151 million, compared with a 15 percent increase
in 1970. Chief factors accounting for the slower in­
come growth in 1971 were a decline in the average
rate charged on loans and the increased costs of time
and savings deposits. Trends in the sources and dis­
position of income of all member banks in the nation
were generally similar to those in the Eighth Dis­
trict, with net income increasing 8 percent to $4.1
billion in 1971 following an 11 percent rise in 1970.
Operating income of District member banks in­
creased 8 percent to $944 million in 1971, while op­
erating expenses rose 11 percent to $748 million.
Since expenses rose by a larger dollar amount than
earnings, income before taxes and securities gains or
losses declined 4 percent, compared with a 12 per­
cent gain in 1970. Income taxes applicable to operat­
ing income declined $13.5 million, and net gains on
security transactions after taxes rose $5.8 million, re­
sulting in a net income gain of $9.8 million from the
previous year.

Operating Income
Operating income of commercial banks is primarily
determined by the volume and composition of earn­
ing assets held and their respective rates of return.
Revenue from loans and securities is the major source
of income; other sources include trust department in­
come, service charges on deposit accounts, and other
fees. The dollar volume of earning assets increased
more rapidly in 1971 than in 1970, but the rate of re­
turn on loans, which comprised over half of the asset
portfolio, was less. Thus, operating income rose only
8 percent, compared to a 13 percent rise in the pre­
vious year.
More expansive monetary actions during the first
half of 1971 as well as aggressive competition for
Page 6

Operating Income, Operating Expenses
and Net Income
Eighth D istrict M em ber B an k s
Ratio S c a le
Ratio S cale
M illio ns of D o lla rs
M illio n s o f D o lla rs











Note-. Sta rtin g in 1969 O p e ra tin g E xp en ses a n d N et Incom e a re computed
on the new inco m e reporting b a sis. Fo r fu rth er e xp la n a tio n o f this
revisio n, see the Federal R eserve Bulletin (July 1970), pp 571 and 572.
D a ta for 1968 on the new reporting basis a re estimated.

savings throughout the year enabled District banks to
increase their total assets 13 percent to $17.7 billion,
compared to a 10 percent increase in 1970. Time and
savings deposits became a more attractive investment
for the public because rates of return on most com­
peting market instruments generally declined rela­
tive to rates offered by banks.
Loans outstanding increased 12 percent to $9.1 bil­
lion between December 1970 and December 1971.
Loans accounted for 52 percent of total assets at

JULY 1 9 7 2


Thousands of Dollars

Percent Change




Total O perating income ................. .............. ................................................................................. $ 9 4 4 ,1 9 4 .2
6 0 4 ,2 5 2 .7
Income from Loans ........... -...................................................... -.................-..............................

$ 8 7 7 ,3 7 7 .3

$ 7 7 9 ,8 4 4 .1

7 .6 %

1 2 .5 %

5 9 1 ,0 7 2 .1

5 2 6 ,3 5 3 .3



Income from Securities ................. ...................-..........................................-............................

2 2 9 ,9 1 8 .4

1 9 2 ,2 7 0 .6

1 7 4 ,1 3 5 .3



U .S. Treasury Securities ------ ------ ---- ----- ------------------------- ------

1 1 3 ,2 0 0 .0

1 0 3 ,5 6 3 .3

9 3 ,8 8 4 .8

9 .3


O ther ................. —---- ---- ----- ------------------------- ----- ----------- ----- ----

1 1 6 ,7 1 8 .4

8 8 ,7 0 7 .3

8 0 ,2 5 0 .5

3 1 .6


Trust Department Income -- ---- ----- ------ -------------------------------------

2 3 ,7 3 2 .4

2 0 ,7 1 0 .6

1 9,5 0 8 .1



Service Charges on Deposit Accounts ................................................ ..........................

2 7 ,5 4 9 .2

2 6 ,0 1 1 .9

2 4 ,7 5 0 .4

5 .9


O ther O perating Income .............................. ............................... ..........................................

5 8 ,7 4 1 .5

4 7 ,3 1 2 .1

3 5 ,0 9 7 .0

2 4.2

3 4 .8

Total O perating Expenses .................................................................................-........................

7 4 7 ,5 6 1 .3

6 7 1 ,6 8 2 .5

5 9 5 ,7 1 5 .9

1 1.3

1 2 .8

S a la rie s , W a g e s, and Benefits ...........................................~............... -................ ...........

2 0 0 ,9 9 3 .1

1 8 4 ,4 9 2 .6

1 6 7 ,5 8 6 .2

8 .9


Interest on Deposits --------- --------------------------------- ---- ---- ----- -----

3 1 3 ,8 5 4 .2

2 6 1 ,9 9 3 .0

2 2 5 ,7 1 7 .2



O ther Interest Expenses _______________________________________ ______________ _

3 7 ,5 7 7 .2

5 0 ,1 1 5 .8

5 0 ,9 8 0 .1

— 2 5 .0

— 1 .7

O ther O perating Expenses ................. ............................... .............. .......... ..........................

1 9 5 ,1 3 6 .8

1 7 5 ,0 8 1 .1

1 5 1 ,4 3 2 .4

11 .5

1 5.6

Income Before Income Taxes and Securities G ain s or Losses ................. -.....

1 9 6 ,6 3 2 .9

2 0 5 ,6 9 4 .8

1 8 4 ,1 2 8 .2

— 4 .4

1 1 .7

Less A pp licable Income T a x e s -- -----------------------------------------------------

5 2 ,2 3 1 .8

6 5 ,7 6 7 .4

5 8 ,5 3 8 .6

— 2 0 .6


Income Before Securities G a in s or Losses ........................................... .............................

1 4 4 ,4 0 1 .1

1 3 9 ,9 2 7 .4

1 2 5 ,5 8 9 .6

3 .2

1 1.4

Net Securities G ain s or Losses after Taxes ..--------------------------- ----------

6 ,0 2 8 .2

2 6 0 .7

— 2 ,3 7 8 .5

2 ,2 1 2 .3


Extrao rd in ary Charges or Credits after T a x e s __________________________________

5 0 3 .4

1 ,0 2 4 .7


— 5 0 .9


Less M inority Interest in Consolidated S u bsidiaries _____ .._____ ______________

2 5.8

1 4.9

2 6 .6

7 3 .2

— 4 4 .0

Net Income ...............................................................................................................................................

1 5 0 ,9 0 6 .9

1 4 1 ,1 9 7 .9

1 2 3 ,3 0 1 .6

6 .9

1 4.5

Cash Dividends Paid .................................... ...................................................................................

6 2 ,5 7 3 .7

4 8 ,1 8 5 .5

4 3 ,8 1 1 .4

2 9 .9

10 .0


— 1.3

Number of Banks ............. .................—------- -------------------------------------------


4 59

4 65


all Eighth District member banks, the same as a
year earlier. By size of bank, however, the propor­
tion of loans to total assets varied from an average of
53 percent for those banks with $100 million or more
in deposits to 45 percent for those banks with less than
$5 million in deposits. In 1971 banks held propor­
tionately more consumer loans, fewer commercial
loans, and the same proportion of real estate loans as
in 1970. Outstanding consumer loans rose 14 percent,
largely reflecting a 16 percent increase in automobile
loans. Real estate loans increased 9 percent, and com­
mercial loans rose only 5 percent. Included in the
total loan data are Federal funds sold and securities
purchased under agreements to resell, which com­
bined increased 47 percent to $9.6 million. Eighth
District member banks were net lenders in this mar­
ket in 1971.
Investments at District member banks rose 18 per­
cent to $5 billion between December 1970 and De­
cember 1971. Holdings of U.S. Treasury securities,
which accounted for about 40 percent of total invest­
ments, rose 7 percent and other securities, largely
tax-exempt state and municipal obligations, rose 26
percent. This large increase in other securities resulted
in such holdings rising from 15 to 17 percent of total
assets in 1971. U.S. Treasury securities as well as cash

Page 7

JULY 1 9 7 2


and other noneaming assets declined slightly relative
to total assets.
Average rates of return on earning assets remained
relatively stable from the previous year with the ex­
ception of the rate on loans, which fell about 60 basis
points to 7.1 percent.1 The average rates of return on
U.S. Treasury securities and obligations of U.S. Gov­
ernment agencies remained at 5.8 and 6.3 percent,
respectively. The rate on obligations of states and
political subdivisions combined increased about 20
basis points to 4.1 percent.

Trust income was a more important source of in­
come for the larger than the smaller banks. For ex­
ample, 4 percent of total operating income was de­
rived from trust operations by those banks holding
deposits in excess of $100 million. In contrast, only a
fraction of a percent of the income of banks with less
than $5 million in deposits was derived from trust
The growth in income from securities accounted for
over one-half of the $66.8 million gain in operating
income in 1971. Income from tax-exempt state and
municipal bonds rose $16.4 million, representing al­
most a quarter of the increase. Due to a decline in
average lending rates, returns from loans accounted
for only one-fifth of the gain, compared to two-thirds
in 1970. Trust department income and service charges
on deposit accounts, represented 5 and 2 percent, re­
spectively, of the increase. Miscellaneous income
sources, which include safe deposit box rental, prop­
erty leasing, foreign department operations, and data
processing, accounted for 17 percent of the income

Operating Expenses
Operating expenses of District member banks in­
creased 11 percent in 1971 to $748 million. Expenses
rose at a faster rate and by a larger absolute amount
than operating income, and thus income before in­
come taxes and securities gains or losses fell below
the year-earlier level. This growth in expenses can be
attributed primarily to a larger volume of time and
savings deposits with no change in the average rate
paid. Salaries, wages, employee benefits, occupancy
and equipment expenses, and provision for loan losses
were also higher than in 1970, but interest paid for
borrowed money declined.

Interest and fees on loans accounted for about twothirds of total operating income but showed little
growth in 1971, rising only 2 percent to $604 million.
Interest on U.S. Treasury securities increased 9 per­
cent to $113 million. Returns on all other securities,
primarily tax-exempt state and municipal bonds, were
the most rapidly rising source of income, increasing
32 percent to $117 million. Income from all other
sources, including trust department income and serv­
ice charges on deposit accounts, totaled $110 million,
an increase of 17 percent from 1970.
A11 rates of return are unweighted averages computed from
Reports of Condition for December 31, 1970; June 30, 1971;
ana December 31, 1971 and Report of Income for 1971.
Page 8

Liabilities of member banks increased more rapidly
in 1971 than a year earlier. The volume of time and
savings deposits increased 20 percent to $6.9 billion,
a pace even more rapid than in 1970 when regulatory
ceiling rates were suspended on large-denomination
CDs having maturities of thirty to eighty-nine days.
The growth in 1971 resulted from the decline in short­
term market interest rates from 1970 levels relative to
the average rate paid on time and savings deposits.
Demand deposits at District member banks rose 6 per­
cent to $8.1 billion, and other liabilities increased 30
percent to $1.2 billion. Federal funds purchased and
securities sold under agreements to repurchase, which
constituted the major portion of “other liabilities,” in­
creased 42 percent. This sharp increase reflects a
sizable decline in the interest rate on Federal funds

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

relative to the discount rate. In contrast, during most
of 1970 the Federal funds rate greatly exceeded the
discount rate.
The composition of bank liabilities shifted consid­
erably in 1971 as time and savings deposits continued
to grow rapidly. These deposits increased from 37 to
40 percent of total liabilities and capital accounts,
while demand deposits fell from 49 to 46 percent.
Other liabilities, such as Federal funds purchased and
other borrowed funds, increased from 6 to 7 percent,
while capital accounts decreased slightly relative to
the total.

JULY 1 9 7 2

Trends in Operating Expenses
Eighth District M em ber Banks
Ratio S ca le
Ratio Scale
M illions of D o llars
M illions of D ollars

reporting b a sis. For further e xp la n a tio n of this re visio n , see the Fed era l
Reserve Bulletin (July 1970), p p 571 a n d 5 7 2 . D a ta fo r 1968 on the new
reporting b a sis a re e stim a te d .

penses declined 25 percent to $38 million. This drop
resulted from a decline in the average rate paid on
Federal funds purchased and securities sold under
agreements to repurchase. The average rate on such
borrowings declined from 6.6 percent in 1970 to 6.2
percent in 1971. The volume of other borrowed funds,
consisting largely of Federal Reserve credit, declined
60 percent, reflecting the differential between the
discount rate and market interest rates.

The average rate paid on time and savings deposits
remained at 4.9 percent in 1971. Most banks main­
tained their rates on regular savings and small-denomination time deposits at or near the regulatory
ceilings which have been in effect since early 1970.
However, rates on large-denomination CDs fluctuated
with other money market rates.
Interest on time and savings deposits, the most rap­
idly growing expense item and the only one to exceed
the growth rates of 1970, increased 20 percent to $314
million in 1971. This increase reflected both the rapid
growth of time and savings deposits and the rela­
tively stable average rate paid. Other interest ex­

Salaries, wages, and employee benefit expenses rose
9 percent to $201 million, reflecting both a rise in
average wages paid and an increase of 3 percent in
the number of officers and employees. Salaries and
wages are a larger percentage of expenses of the very
small banks as compared to other banks, reflecting the
greater labor intensity of the small banks. Average
compensation per person increased only 5 percent in
1971, reflecting in part the price-wage freeze initiated
on August 15, 1971. Remaining expenses rose 12 per­
cent to $195 million.

Net Income
Income before taxes and securities gains or losses
of Eighth District member banks in 1971 was $197
million, a decrease of 4 percent from 1970. Income
Page 9

JULY 1 9 7 2


taxes applicable to operating income declined 21 per­
cent to $52 million. This reduction in taxes resulted
from increased holdings of tax-exempt securities, re­
moval of the Federal corporate income surtax, a drop
in income before taxes and securities gains or losses,
and a previous shift in tax accounting techniques
from a cash to accrual basis. This considerable de­
crease in taxes boosted after-tax income 3 percent.
Net securities gains after taxes jumped from $0.3 mil­
lion in 1970 to $6 million in 1971, contributing to
further improvement in earnings. After adjusting for
the net effects of taxes, securities gains or losses, and
extraordinary charges, net income increased 7 percent
to $151 million in 1971.

Bank Capital
Capital accounts of District member banks — equity
capital plus capital notes and debentures — totaled
$1.3 billion at the end of 1971, an 8 percent increase
from the previous year. Equity capital increased 8
percent to $1,271 million, and capital notes and de­
bentures rose 18 percent to $62 million. Because of a
30 percent increase in cash dividends to $63 million,
net retained earnings — the major source of equity
capital —declined 5 percent from the previous year
to $88 million. Net income as a percentage of equity
capital declined from 12 percent in 1970 to 11.9 per­
cent in 1971.

Publications of This Bank Include:








Copies of these publications are available to the public without charge, including
bulk mailings to banks, business organizations, educational institutions, and others.
For information write: Research Department, Federal Reserve Rank of St. Louis,
P. O. Rox 442, St. Louis, Missouri 63166.

Page 10

A Review of Empirical Studies of the
Money Supply Mechanism

The use of a reserve aggregate as an operating target raises questions about the interest rate effects
of policy actions on the ability of the Federal Reserve to achieve a desired growth in the money stock.
Open market operations affect both reserve aggregates and interest rates. Changes in interest rates, in
turn, influence the portfolio decisions of banks and the public, and are believed by some to be a com­
plicating factor in the achievement of a desired money growth. This article surveys empirical evidence
on the interest rate sensitivity of the money supply, and concludes that this interest elasticity appears
to be extremely low. Hence, this factor should exert a negligible effect on the ability of the Federal
Reserve to influence money stock growth through control of a reserve aggregate.

I N RECENT YEARS there has been considerable
discussion concerning techniques for conducting mon­
etary policy. The traditional practitioners of the art of
policymaking have argued for the use of operating
procedures which focus on “money market conditions.”
At various times this has been construed to mean free
reserves, the Treasury bill rate, the federal funds rate,
or a combination of these.1 Alternatively, it has been
argued that the target of monetary policy actions
should be a monetary aggregate, and that this target
can be achieved by control of some reserve aggregate
concept such as the monetary base.2
This article surveys the accumulated empirical evi­
dence on the interest sensitivity of some reserve
multipliers. If these multipliers are highly sensitive to
interest rate changes, then it may be difficult to im­
plement monetary control through the control of re­
serve aggregates. The available evidence consistently
indicates, however, that the interest sensitivity of vari­
ous multiplier concepts is extremely low. This suggests
that control of monetary aggregates through reserve
control should not be very difficult to implement.3
Conditions Inhibiting Control of the
Money Stock
The issue examined here is the feasibility of control
of a monetary aggregate such as the narrowly defined
'Stephen H. Axilrod, “ The FOM C Directive
the Late 1960’s: Theory and Appraisal,”
Policies and O perating Procedures — Staff
ington, D .C.: Board of Governors of the
System, 1971), pp. 1-36.

as Structured in
in O pen M arket
Studies (W ash­
Federal Reserve

2For example, see Albert E. Burger, Lionel Kalish III, and
Christopher T. Babb, “ Money Stock Control and Its Implica­
tions for Monetary Policy,” this Review (O ctober 1971),
pp. 6-22.
3If, however, these multipliers are highly sensitive to interest
rate changes, then accurate monetary control through a
reserve control procedure requires a precise estimate of the
impact o f reserve changes on interest rates, in addition to a
precise estimate of the interest elasticity of the reserve

money stock ( M i ) , given control of some reserve ag­
gregate concept. The problem can be illustrated by
the equation
M = mil
where “M” is the money stock, “R” is some reserve
aggregate concept, and “m” is the appropriate reserve
multiplier.4 Two sources of difficulty can arise in such
a control procedure.
First there can be systematic feedbacks on “m”
through market forces which tend to offset the ex­
pected effect of a change in the reserve aggregate on
the money stock. This influence of the behavior of
reserves on the value of the multiplier can be stated as
m = f(R).
The sources of feedback from changes in “R” to
changes in “m” will vary depending on the choice of
a reserve aggregate concept. If the net source base
concept is used for “R”, the associated multiplier
(m ) is
1 + k
m “ (r -b ) (1+t+d) + k
where “r” and “b” are the ratios of bank reserves and
member bank borrowings to commercial bank deposits,
respectively, “t”, “k” and “d”, respectively, are the ratios
of time deposits, currency held by the public, and
U.S. Government deposits at commercial banks to the
demand deposit component of the money supply.
Therefore, the important behavioral relationships in­
fluencing the stability of the multiplier in the presence
4A number o f candidates have been proposed for “ R” in­
cluding the monetary base, unborrowed reserves plus cur­
rency, total reserves, unborrowed reserves, and reserves
available to support private deposits. For a discussion of
the relative virtues o f many o f these, see Richard Davis,
“ Short-Run Targets for Open Market Operations,” in Open

Market Policies and

O perating

Procedures — Staff Studies

(Washington, D .C .: Board of Governors o f the Federal Re­
serve System, 1971), pp. 37-45.
Page 11

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

of reserve changes are the public’s demand for cur­
rency and time deposits, banks’ demand for excess
reserves and borrowings, and the supply of time
An example of a feedback effect on “m” would be
where there exists a sizable short-run interest elasticity
of demand for excess reserves by commercial banks. In
order to force additional reserves into the banking sys­
tem to expand the money stock, the Federal Reserve
would have to buy Government securities, thus push­
ing short-term interest rates down. If the amount of
excess reserves demanded by banks is very sensitive to
changes in short-term interest rates, this interest rate
movement would induce banks to hold larger quan­
tities of excess reserves This portfolio shift then offsets
the policy to increase the money stock.
The existence of strong feedback effects on the
reserve multiplier does not mean that monetary con­
trol through reserve aggregates is impossible. The
stronger the feedback, the larger the necessary magni­
tude of the open market operation required to achieve
a given change in the money stock and the larger the
associated variance in short-term interest rates.
The second source of difficulty in this type of mone­
tary control procedure is that the relationship between
the reserve aggregate and the money stock is subject
to random fluctuation. Specifically, we can write
mt = f( Rt) + £t
where “et” is an unknown random disturbance to
“mt”. If such fluctuations are truly random, then in
the long run policymakers should be able to hit the
desired average stock of money quite closely. If this
random component is large, then in a short time pe­
riod, such as one or two months, the average “m”
could deviate considerably from the forecast “m” and
cause a large average error around the desired path
of the money stock.
It can be shown that for a given variance of “et”,
under a control procedure such as that recently pro­
posed by Burger, Kalish, and Babb, the variance of
the actual path of the money stock around the desired
path will depend on the sensitivity of the reserve
5For a detailed discussion o f the functional relationship of
the multiplier expression to asset holdings o f the nonbank
public, the banking system, and the Treasury, see Albert E.
Burger, The Money Supply Process (Belmont, California:
Wadsworth, 1971), especially chaps. 4-5, and Karl Brunner
and Allan H. Meltzer, “ Liquidity Traps for Money, Bank
Credit, and Interest Rates, Journal of Political Economy
(January/February 1968), pp. 1-37.
Page 12

JULY 1 9 7 2

multiplier (m ) to changes in the reserve aggregate.8
The smaller the sensitivity of the multiplier, the
smaller will be the variance of the actual money stock
around the desired money stock.
The Nature of Available Evidence
on Multiplier Sensitivity
Over the past decade there has been considerable
empirical research directed at measuring the relation­
ship between the money stock and various reserve ag­
gregates. This work has evolved primarily from at­
tempts to construct econometric models of basic finan­
cial relationships in the U.S. economy. As a by-product,
these studies provide information on the interest elas­
ticities of the behavioral parameters of the reserve
multiplier, the existence of which cause feedbacks
against policy actions as discussed above.
Most of the more detailed studies have worked
with quarterly data, which may be too highly ag­
gregated in time to provide information that policy­
makers desire if the reactions of the banking system
and the public are distributed over time. However,
studies using shorter time horizons do exist for some
components of the money supply mechanism, and
these can be used to obtain information on how the
estimated elasticities are likely to change as the horizon
becomes shorter.
There are several potential sources of feedback
which will offset the expected impact of a change in
reserve aggregates on the change in the money stock.
Some of the feedback, such as a change in the demand
for currency and time deposits by the nonbank public
as a result of increased economic .activity, has been
shown to occur only slowly, and does not cause diffi­
culties for short-run control.7
The troublesome source of changes in the multiplier
relationship is the impact of changes in interest rates on
the behavioral parameters in the multiplier. Changes
in market interest rates and changes in reserves avail­
able to the banking system cannot be controlled simul­
taneously by the Federal Reserve System. When the
Federal Reserve follows a reserve aggregate operat­
ing procedure, interest rates are affected by changes
in reserves. Under a money market conditions operat­
ing strategy, changes in reserve aggregates come
about as a result of the attempt to achieve certain
6Burger, Kalish, and Babb, “ Money Stock Control.”
7See David I. Fand, “ Some Implications of Money Supply
Analysis,” American Economic Review (M ay 1967), pp.


levels of interest rates. Hence, if the goal is to control
money through changes in reserve aggregates, the
major issue is the interest elasticity of the relationship
between the money stock and reserve aggregates.
It will be necessary to distinguish between shortrun, or impact, elasticities of the reserve multiplier
and long-run, or equilibrium, elasticities. The former
include only the impact which comes from the adjust­
ment of economic units to a change in interest rates
within one period of time. Many studies, however,
have indicated that economic units respond to such
changes with a distributed lag; that is, part of the
response takes place in the same period, and the re­
mainder of the response takes place over several pe­
riods following a change in interest rates. The impact,
or short-run, interest elasticity is the percentage change
in the reserve multiplier with respect to a percentage
change in interest rates within the time period in
which the interest rate changes. The equilibrium, or
long-run, elasticity is the total response of the reserve
multiplier after economic units have had sufficient time
to adjust to a new portfolio equilibrium.8
In the studies cited below, estimates have been ob­
tained for the interest elasticity of the money stock
for given values of various reserve aggregates. Thus,
the money stock elasticities computed are the interest
elasticities of the reserve multiplier.

Interest Elasticity Estimates From Data
Prior to 1965

Teigen I
An early econometric investigation of the money
supply relationship was that of Ronald Teigen.8 His
study does not develop the detailed specifications
which are characteristic of more recent studies. In
particular, the stocks of currency in the hands of the
public and demand' deposits at nonmember banks are
assumed exogenous.1 In addition, Teigen takes the
quantity of time deposits at member banks and gov­
8For a discussion o f impact versus long-run responses, see
Arthur S. Goldberger, Im pact M ultipliers and Dynamic Prop­
erties of the Klein-Goldberger M odel (Amsterdam: NorthHolland, 1959).
9Ronald L. Teigen, “ Demand and Supply Functions for
Money in the United States: Some Structural Estimates,”
Econometrica (October 1964), pp. 476-509.
10It is necessary to distinguish here between the construction
of the model from historical data, and the use of the model
to determine interest elasticities. In the construction of the
model, the ratio o f currency to demand deposits at member
banks and the ratio of demand deposits at nonmember
banks to those at member banks are in fact exogenous
variables which vary from one observation to the next. In

JULY 1 9 7 2

ernment deposits at member banks as exogenous
Teigen tests the hypothesis that the banking system
takes more than one period to respond to changes in
interest rates, but this hypothesis is rejected for the
post-war data. Thus his impact and equilibrium in­
terest elasticities of the money supply relationship are
equal. His estimated coefficients of elasticity are
0.1950 for the commercial paper rate and —0.1695
for the discount rate.1

DeLeeuw I
Frank DeLeeuw attempted to obtain more detailed
numerical estimates of behavior in important financial
markets than did Teigen.1 In particular, DeLeeuw
separates bank borrowing and excess reserve behavior,
and explicity estimates functions for currency demand
and time deposit demand at commercial banks by
the nonbank public.
The interest elasticity estimates from this study are
summarized in Table I. In all cases the absolute value
of the long-run elasticities are less than one, and the
short-run elasticities never exceed 0.2 in absolute value.
The available data do not permit reconstruction of
the interest elasticities of excess reserves. However,
DeLeeuw did publish the results of a computation of
the implicit interest elasticities of the money-reserve
determining the value o f the elasticity of the relationship,
these exogenous variables are kept fixed at some point,
conventionally their mean value for the sample period.
Hence, the computations implicitly assume positive interest
rate responses for the public’s currency demand and the
supply o f demand deposits by nonmember banks, which
are equal to the interest rate response of demand deposits
supplied by member banks. For nonmember banks, the as­
sumption probably does not seriously affect the analysis. On
the other hand, the public’s currency demand is usually
found to have a zero, or slightly negative, interest elasticity,
at least in the long ran. If the true interest elasticity of
currency demand is zero, then the bias introduced by the
constant ratio of currency to money stock is indeterminate.
On the one hand, the direct effect of increased currency
in the hands of the public as demand deposits supplied by
banks increase biases the interest elasticity o f the money
supply upward. On the other hand, the indirect effect that
the assumed increase in currency withdraws reserves from
the banking system causes the model to understate the de­
sired amount of deposit expansion. Since the magnitudes
involved are small, the net bias should not be substantial.
n These variables do not explicitly appear in his model. How­
ever, the reserve aggregate which he uses is unborrowed
reserves available to support private demand deposits. Later
studies use more broadly defined aggregates such as un­
borrowed reserves, or unborrowed reserves plus currency.
To make the studies comparable, the model must be re­
formulated with time deposits at member banks and gov­
ernment deposits at member banks explicitly appearing as
exogenous variables.
'-’Teigen, “ Demand and Supply Functions,” p. 502.
13Frank DeLeeuw, “A Model o f Financial Behavior,” in The

Brookings Q uarterly Econom etric M odel of the United
States, ed. James S. Duesenberry et al. (Chicago: Rand

McNally, 1965), chap. 13.
Page 13

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JULY 1 9 7 2

Tab le I

Interest Elasticities of V ario u s Functions
in D eLeeuw 's O rig in a l Brookings M odel

Im pact*


Currency Demand
Private Securities Rate
Time Deposit Rate

- .0 3 2
- .0 1 2

— .3 6 4
— .1 3 6

Time Deposit Demand
Treasury B ill Rate
Time Deposit Rate

— .0 3 8
.0 7 0

- .3 7 4
.6 8 3

B ank Borrowings
Treasury B ill Rate
Discount Rate

.1 3 4
— .1 8 6

.5 0
— .7 0

Excess Reserves
Treasury B ill Rate
Discount Rate

n .a .
n .a.

n .a .
n .a .

♦Impact elasticities are calculated by using the respective equilibrium
elasticities and regression coefficients o f the lagged dependent vari­
ables from various tables in the source cited below. The equilibrium
elasticities fo r currency and tim e deposit dem and are from p . 493,
and fo r bank borrow in gs from p. 512. The respective regression
coefficients used in calculating the im pact elasticities can be found
in Tables 13.2, 13.4, and 13.12.
S ou rce: F rank DeLeeuw, “ A Model o f Financial B ehavior,” in
The B rookings Quarterly E con om etric Model o f the U nited States,
ed. Jam es S. D uesenberry et al. (C h ica g o: R and M cNally, 1965),
chap. 13.

relationship derived from the estimated borrowings
and excess reserves functions. In this computation, he
takes the ratios of currency, time deposits, U.S. Gov­
ernment deposits, and nonmember bank demand de­
posits to money stock as constant. Thus the biases
which were introduced into Teigen’s computations are
again present here. DeLeeuw’s reserve aggregate is
nonborrowed reserves plus currency in the hands of
the public. His estimated long-run elasticities, valued
at the sample means, are 0.172 and —
0.214 for the
Treasury bill rate and the discount rate, respectively.
When valued in 1962 (the end of his sample period)
these elasticities are 0.245 and —0.348, respectively.1
These numbers seem quite compatible with those
obtained by Teigen for approximately the same sample
period. However, DeLeeuw finds that the entire ad­
justment of banks to portfolio changes takes place
only gradually over time, and his impact elasticities
for borrowings are only about one-fourth of the equi­
librium values. This suggests that if the data were
available to compute the short-run elasticity for the
money supply relationship, the estimates over a onequarter period would be considerably lower than
those obtained by Teigen.
The currency and time deposit demand equations
which DeLeeuw incorporates into the above computa­
tions are almost completely insensitive to interest rate
changes over a one-quarter horizon. This implies that
over a one-quarter horizon changes in reserves avail­
able to support private demand deposits, which are
caused by interest induced changes in currency and
14Ibid., p. 518.

Page 14

time deposit demand, are negligible. Thus, it is highly
probable that the assumptions of constant currency/
money stock or time deposit/money stock ratios result
in a net upward bias in the computed interest elastic­
ity of the money supply relationship.

DeLeeuw 11
In a subsequent study for the Brookings model
DeLeeuw produced a condensed model of financial
behavior in which the excess reserve and borrowings
equations were aggregated into a single function to
explain free reserves.1 In that study estimates of the
interest elasticity of the money supply relationship
are not provided. However, using the free reserveinterest rate coefficient estimates and information given
in the earlier study it is possible to replicate the
computations of the larger model.1
The estimated impact elasticities at the sample
means are 0.037 for the Treasury bill rate, and —
for the discount rate.1 The corresponding long-run
elasticities are 0.096 and —
0.118 respectively. The ab­
solute values are lower by a factor of almost fifty
percent from the values obtained in the earlier study,
even though the data and the sample period have
remained essentially unchanged.
It is likely that some downward bias has been in­
troduced into these estimates by aggregating excess
reserves and borrowings into free reserves in the esti­
mation of the model. From the information presented
in the first study, it is not possible to aggregate the
interest elasticities of these two components. However,
the early work suggests that the response of banks to
a disequilibrium in borrowings from the Federal Re­
serve is much faster than the response to a similar
situation with respect to excess reserves.

The most detailed study of financial markets is
found in the work of Stephen Goldfeld.1 In this
study, equations are specified for both the demand for
excess reserves and the demand for borrowings from
the Federal Reserve System. Separate equations are
estimated for country banks and city banks.
The Goldfeld results suggest very large ( in absolute
value) interest elasticities for the borrowings equations
15Frank DeLeeuw, “ A Condensed M odel o f Financial Be­
havior,” in The Brookings Model: Some F u rth er Results,
ed. James S. Duesenberry et al. (Chicago: Rand McNally,
1969), pp. 270-315.
16DeLeeuw, “ A Model of Financial Behavior.”
17Unless otherwise stated, data cited have been computed by
this author.
18Stephen M. Goldfeld, Comm ercial Bank Behavior and Eco­
nomic Activity (Amsterdam: North-Holland, 1966).

JULY 1 9 7 2


relative to those found by DeLeeuw. There do not
appear to be large differences in the impact elasticities
of borrowings across the bank classes, but the speed
of adjustment to interest rate changes is much slower
for borrowings by country banks than for city banks.
This is reflected in the lower impact elasticities and
the higher equilibrium elasticities for the country
banks than the corresponding numbers for the city
The excess reserve interest elasticities reported by
Goldfeld are negligible, particularly when compared
with the borrowings elasticities. In addition, he finds
that banks respond quite quickly to disequilibrium in
excess reserve holdings. Thus, the long-run elasticities
for excess reserve demand are not much different from
the impact elasticities, particularly for city banks.
This result is similar to that of the Teigen study where
no evidence of a distributed lag in bank response
was found.
Goldfeld reports interest elasticities of a money sup­
ply relationship comparable to that derived by both
Teigen and DeLeeuw. The impact elasticities, with
respect to the Treasury bill rate and the discount
rate in this function, 0.042 and —
0.029, respectively,
are derived from the elasticities reported in Table II.
The corresponding long-run elasticities are 0.222 and
—0.076.1 These results are quite close to the values
reported by both Teigen and DeLeeuw for the Treas­
ury bill rate, but considerably below the estimates for
the discount rate in the other studies.
The sources of the differences are fairly conspicuous.
In Teigen’s study, where there is no disaggregation
of excess reserves from borrowings, the Treasury bill
rate and the discount rate appear only as the differ­
ential between the two rates. Hence the regression
coefficient of the discount rate is constrained to have
the same absolute value, but with the opposite sign
from that of the bill rate. Since the mean of the dis­
count rate for the sample period is slightly larger than
that of the bill rate, the computed coefficient of elas­
ticity of the discount rate is, in effect, constrained to
be slightly smaller in absolute value than that of the
bill rate. DeLeeuw constrains this excess reserve
specification to include only the differential between
the bill rate and the discount rate. Given the con­
straints that are imposed in the estimation of the
Teigen and DeLeeuw studies, it would seem reason­
able to conclude that the Goldfeld estimate of the
response of the money supply relationship to discount
rate changes is more reliable for this period.
19Ibid., p. 191.

Table II

Interest Elasticities of V ario u s Functions
in the G o ld fe ld M odel


Currency Demand
Treasury B ill Rate
Time Deposit Rate

- .0 0 8
— .0 1 5

— .0 7
- .1 4

Time Deposit Demand
Time Deposit Rate
Long-Term Governm ent Rate

.0 2 8
— .1 2 5

.3 7
— 1 .62

— .9 8
.8 8

— 2 .3 8 2
2 .1 3 4

— .88
.7 9

- 2 .9 2 6
2 .6 2 5

— .3 8

— .3 5

— .15

— .2 5


Bank Borrowings
C ity Banks
Discount Rate
Treasury B ill Rate
Country Banks
Discount Rate
Treasury B ill Rate
Excess Reserves
C ity Banks
Treasury B ill Rate
Country Banks
Treasury Bill Rate

♦The equilibrium elasticities fo r currency and tim e deposit demand
are found on p . 160 o f the source cited below. The corresponding
im pact elasticities are calculated by using the equilibrium elastici­
ties and regression coefficients o f the lagged dependent variables
from Tables 5.7 and 5.9, respectively. B oth equilibrium and im pact
elasticities fo r bank borrow in gs and excess reserves are found on
p p . 150 and 149, respectively.
S o u rce : Stephen M. Goldfeld, Com m ercial B ank B ehavior and
E conom ic A c tiv ity (A m sterd am : N orth-H olland, 1966).

There seem to be no major discrepancies in the
estimated long-run responsiveness of the money sup­
ply to changes in the bill rate, but considerable vari­
ance exists among the short-run elasticity estimates.
The most uncertain issue, on the basis of the evidence
reviewed so far, is the source of the interest elasticity.
Goldfeld suggests that the source is bank borrowing
behavior, DeLeeuw suggests that it is bank behavior
with respect to excess reserves, and Teigen does not
attempt to discriminate between the two.

Goldfeld and Kane
There exists an additional study by Goldfeld and
Kane which provides some independent information
on the question of the interest elasticity of bank bor­
rowings from the Federal Reserve.2 This study is
based on weekly data from the period July 1953 to
December 1963 and disaggregates banks into four
classes — New York City, Chicago, Other Reserve City,
and Country banks. They find that the estimated
short-run (one week) Treasury bill rate elasticities
range from a high of 0.56 for New York City banks
to a low of 0.08 for Chicago banks. When aggregated
over all classes of banks, the short-run interest elas­
20Stephen M. Goldfeld and Edward J. Kane, “ The Determin­
ants o f Member-Bank Borrowing: An Econometric Study,”
Journal of Finance (September 1966), pp. 499-514, and
Stephen M. Goldfeld, “An Extension o f the Monetary
Sector,” in The Brookings Model: Some F u rth er Results, ed.
James S. Duesenberry et al. (Chicago: Rand McNally,
1969), pp. 317-360.
Page 15

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

ticity for the banking system as a whole is found to be
0.21. Their reported long-run interest elasticities of
borrowings range from 2.8 to 3.9.2
These estimates seem consistent with the results of
the quarterly study by Goldfeld and tend to add to
the uncertainty of the high excess reserve and low bor­
rowings elasticities reported by DeLeeuw. The only
difficulty in reconciling the weekly estimates with the
quarterly work of Goldfeld is the implied definition of
long run. In the quarterly study, the long run is
achieved only after serveral quarters have elapsed. In
the weekly study, the implied long run is a period
of several weeks. The possibility remains that long run
in the two studies has two different meanings. How­
ever, it seems safe to conclude that borrowing behavior
of banks is an important source of interest elasticity
of the money supply relationship when the Treasury
bill rate changes and the discount rate remains

A quarterly study which deals with the period of
the 1950s through the early 1960s is that of Teigen.2
The study contains supply elasticities only for the
demand deposit component of the money supply.
The results for the elasticity of the discount rate are
not very different from those reported by Goldfeld,
but the elasticity of the Treasury bill rate is consid­
erably lower than the results obtained by Goldfeld,
DeLeeuw and Teigen’s earlier results.

Brunner and Meltzer
Karl Brunner and Allan Meltzer have estimated the
interest elasticity of the money supply relationship
using annual data over a sample period including the
interwar and post-war periods.2 In the two stage
least-squares estimates of their “nonlinear” money sup­
ply hypothesis, they find that the elasticity of the
money supply function with respect to the adjusted
monetary base is insignificantly different from one.
Therefore, the interest elasticities of this function can
be interpreted as interest elasticities of the reserve
multiplier. Their estimate of the Treasury bill rate
elasticity is 0.66 and the estimate of the discount rate
elasticity is —0.31.2 Since there are no lagged varia­
2’ Goldfeld and Kane, “ The Determinants of Member-Bank
Borrowing: An Econometric Study,” p. 512.
22Ronald L. Teigen, “An Aggregated Quarterly Model of the
U.S. Monetary Sector, 1953-1964,” in Targets an d Indicators
of M onetary Policy, ed. Karl Brunner (San Francisco:
Chandler Publishing Company, 1969), pp. 175-218.
23Karl Brunner and Allan H. Meltzer, “ Some Further In­
vestigations of Demand and Supply Functions for Money,”
Journal of Finance (M ay 1964), pp. 240-283.
24Ibid., p. 277.
Page 16

JULY 1 9 7 2

bles in the equation, these estimates can be compared
with the equilibrium elasticities derived from the
studies which used shorter time intervals. Both elas­
ticities appear to differ from the implied equilibrium
values of the quarterly studies by a factor of over two.
Given the many difficulties in estimating distributed
lag effects from time series data, such inconsistencies
are not surprising.
Estimates from Data Including
Post-1965 Period
The shortcoming of the studies discussed so far is
that they are based on data generated in the 1950s
and early 1960s. During the 1960s there were many
changes in the environment in which the banking
system operated which could have significantly altered
(and presumably increased) the interest elasticity of
the money supply relationship. These changes included
the evolution of an active market for large negotiable
certificates of deposit, the involvement of large banks
in the Eurodollar market through borrowings from ( or
lending to) their foreign subsidiaries, and the en­
trance of banks into the commercial paper market
through parent one-bank holding companies.
Unfortunately it is difficult to obtain empirical evi­
dence on many of these innovations since they were
effectively legislated out of existence before enough
data were generated to assess their effects. The im­
pact of the CD market can be assessed, along with
the responsiveness of the banking system in terms of
free reserves in the 1960s, through the quarterly finan­
cial model in the M.P.S. model.25 In addition, esti­
mates of the interest elasticity of the money supplyreserve relationship on a monthly basis can be obtained
from a financial market model developed by Thomas
Thomson and James Pierce.2

Evaluation of Quarterly
M oney Supply Elasticities
The quarterly M.P.S. model contains a financial
sector which includes detailed specifications of the
commercial loan market and the mortgage market, as
well as specifications dealing with bank and nonbank
behavior with respect to holdings of currency, time
deposits and free reserves. The estimated elasticities
for the latter set of functions are tabulated in Table
25This model is the publicly available version which de­
veloped out o f the Federal Reserve - M .I.T. - Pennsylvania
econometric model project.
26Thomas D. Thomson and James L. Pierce, “ A Monthly
Econometric Model of the Financial Sector” (A paper pre­
sented at the May 1971 meeting of the Federal Reserve
System Committee on Financial Analysis).


JULY 1 9 7 2

Table III

Interest Elasticities of V arious Functions
in the M .P.S. M odel


Currency Demand
Treasury B ill Rale

.0 0 3 7

.0 2 6

Non-CD Time Deposit Demand
Time Deposit Rate
S&L — Mut. S av. Bk. Rate
Treasury B ill Rate

— .2
— .1 5

2 .9
- 2 .0
— 1.4

CD Demand [1 9 6 9 V alu es]
Treasury Bill Rate
Commercial Paper Rate
CD Rate

— 6 .1 4
— 4 .2 8
1 1 .4 6

— 6 .1 4
— 4 .2 8
1 1 .4 6

- 2 .9 9
— 3 .9 5

- 6 .4 2
- 8 .4 7

3 .2 3
3 .4 8

6 .9 3
7 .4 6

Supply of CDs by Banks £ 1969 Values]
CD Rate
- 1 .0 6
Treasury B ill Rate
.9 8

— 1.06
.9 8

Free Reserves
Treasury B ill Rate
1965 Values
1969 Values
Discount Rate
1965 Values
19 69 Values

III. Both the CD demand and supply functions, which
did not exist in the earlier studies, assume that the
full response to an interest rate change takes place
within one quarter. Thus the impact and equilibrium
elasticities are equal.
The CD demand function, in particular, indicates
a highly sensitive response to interest rate changes,
which is consistent with casual impressions of the
nature of the CD market. However, these estimates
are drawn from a considerably smaller sample than
that for the rest of the specifications, and therefore
there is less certainty about the stability of the func­
tions over time.
The estimates for the currency demand equation
and the demand equation for non-CD time deposits
tend to confirm the DeLeeuw and Goldfeld results of
extremely low impact elasticities. The time deposit
function does suggest higher long-run elasticities than
had been previously estimated. This appears attributa­
ble, in part, to the evolution of special forms of time
deposit accounts, such as small consumer-type CDs,
during the late 1960s.2
The M.P.S. model does not distinguish between
excess reserves and borrowings of member banks, but
does estimate a relationship between the Treasury bill
rate, the discount rate, and free reserves. No con­
straints are applied to the coefficients of the two rates.
In Table III, both the impact and the equilibrium
27The estimated function allows for a change in structure
during the early 1960s, which indicates that the interest
elasticities in the latter part of the sample period are about
fifty percent higher than those estimated for the first part
o f the sample period.

elasticities of this function are considerably higher
than those estimated in the earlier studies. This is
partially due to the fact that the estimated function
is linear, and therefore the value of the elasticity co­
efficient is not constant at all points along the func­
tion. Evaluation of the elasticity coefficient at the very
high values of interest rates in 1969 gives estimates of
the impact and equilibrium Treasury bill rate elastici­
ties which are fifty and twenty-five percent higher,
respectively, than the values at 1965 interest rate
levels. Even after accounting for the higher levels of
interest rates in the late 1960s, it appears that differ­
ences in specifications and/or differences in sample
periods have produced higher interest rate elasticity
estimates for the free reserve relationship than had
previously been found.
Simulation experiments were performed with the
M.P.S. model which permitted relaxation of restrictions
under which interest elasticities of the money supply
relationship were computed in the studies discussed
above. First, in addition to the impact elasticities, the
pattern of response of the money stock over time to a
maintained change in the Treasury bill rate was com­
puted. The simulations were continued for eight quar­
ters, after which the computed elasticities settled
down at close to the equilibrium values.
Second, the response of the demand for currency
and the demand for time deposits to the changes in
interest rates can be included or excluded from the
computation of the elasticities. Time deposit demand
is split into large negotiable certificates of deposit
and other time deposits. The inclusion of the currency
and time deposit responses in the simulation is analo­
gous to a controlled experiment in which the nonbank
private sector demand for bank demand deposits is
shifted once and maintained in its new position. This
shift is allowed to occur without any effect on the
demand functions for time deposits or currency. This
shift generates an initial change in interest rates. The
changes in the money stock, which are observed over
time, are the result of the interest rate induced port­
folio shifts by banks and the nonbank public, and
they trace out the interest elasticity of the money sup­
ply relationship over various time intervals. Finally,
elasticities are computed for both demand deposits
and the M, money stock concept.
The estimated elasticities from three sets of simu­
lations are presented in Table IV. These computations
are generated under the assumption that the Federal
Reserve would not impose a Regulation Q constraint
which would prevent banks from offering new CDs
at competitive rates.
Page 17

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

If such constraints were effective, increases in the
Treasury bill rate would cause a shift in the demand
for CDs. At the constrained new issue rate for CDs
the public would not renew outstanding certificates as
they matured. Over time the stock of CDs would
decline, and there could be a sizable reduction in the
ratio of time deposits to demand deposits. The change
in this ratio would, in turn, cause a fluctuation in the
reserve multiplier. The observed result would also be
highly sensitive to the initial conditions of the Treas­
ury bill rate relative to the Regulation Q ceiling, and
the historical pattern of Regulation Q restraint.
In the first section of Table IV, the interest elastici­
ties include the interest rate induced reactions in the
public’s demand for currency, large certificates of de­
posit as well as other time deposits, and the interest
elasticity of the commercial banking sector’s supply
function for large certificates of deposit. The interest
elasticity of Mj is consistently smaller than the inter­
est elasticity of the demand deposit component. This
is because the model indicates a small negative re­
sponse of the demand for currency to changes in inter­
est rates. Hence, as interest rates increase and the
amount of bank deposits available to the economy
expands, there is an offsetting movement in currency
balances outstanding.
The exclusion of the nonbank private sector’s de­
mand for currency and time deposits other than large
certificates of deposit lowers the interest elasticity of
the money supply relationship.2 This is because a
rise (fall) in interest rates decreases (increases) the
quantity demanded of both of these assets. This rela­
tionship is straightforward in the case of currency. For
time deposits the expected equilibrium response would
be for a large quantity of time deposits to be de­
manded with higher levels of all interest rates. The
model postulates, however, that the rate which banks
offer on non-CD time deposits responds quite slug­
gishly to changes in market interest rates. Thus the
short-run effect is for disintermediation away from
commercial bank time deposits. If the elasticity pat­
terns were computed over a longer time horizon, the
elasticities in the first experiment would eventually
become smaller than those for the second experiment.
In all cases the impact elasticities are essentially the
same size.
These results can be compared with those from
earlier empirical studies which do not include the CD
28This exclusion of currency and time deposit demand allows
these demand functions to shift in such a way that the
quantity demanded at the new Treasury bill rate is exactly
equal to the quantity demanded at the original level of the
Treasury bill rate.
Page 18

JULY 1 9 7 2

Tab le IV

M oney Su pply Elasticity C om putations ---M .P.S. M odel

Currency, Time Deposits, & CDs Included

Q u arter

Demand Deposits



.1 0 6
.1 7 5
.2 1 4
.2 4 0

.0 8 3
.1 3 7
.1 6 7
.1 8 8

First Y e ar A verag e

.1 8 4

Second Y e a r Average

.1 4 4

.2 7 9
.3 0 9
.3 1 7


.2 1 8
.2 4 0
.2 4 7
.2 5 0


.2 3 9

Currency, CDs Included; Time Deposits Excluded

Q uarter

Demand Deposits



.0 9 9
.1 5 7
.1 8 5
.2 0 4

.0 7 8
.1 2 3
.1 4 5
.1 5 9

First Y e a r A verage
Second Y e a r Average


.1 2 6

.2 3 3
.2 5 4
.2 5 6
.2 5 9

.1 9 6
.1 9 8
.2 0 0


.1 9 4


CDs Included; Time Deposits, Currency Excluded
Q u arter
Demand Deposits

First Y e a r A verage
Second Y e ar A verag e

.0 9 4
.1 4 9
.1 7 3

.0 7 4
.1 1 8
.1 3 6
.1 4 7


.1 1 9

.2 0 2
.2 2 0

.1 5 9
.1 6 6
.1 7 3

.2 1 5

.1 6 9

market. It appears from section C of Table IV that
when the CD market is operating freely, the estimated
interest elasticity of the money supply relationship
differs little from the results drawn from studies of
earlier periods. If anything, the elasticities reported in
this section of the Table are generally lower than
those discussed above. On the other hand, sections A
and B of Table IV suggest that the net bias involved
in computing the interest elasticities with a constant
currency/deposit ratio and a constant level of time
deposits tends toward zero. That is, the estimates ob­
tained under these assumptions give estimates of
elasticities which are too low.

Evaluation of Monthly
Money Supply Elasticities
The same type of analysis of the money stockreserve relationship as that performed with the M.P.S.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

quarterly econometric model can be carried out on a
monthly basis using the financial market model of
Pierce and Thompson. The results over an eighteen
month period are presented in Table V. In this model,
demand for currency by the public is specified to be
completely interest inelastic, so the assumptions un­
derlying the calculations of sections B and C of Table
IV are identical to the assumptions made for the
right-hand column of Table V. The analogy to section
A of Table IV is presented in the left-hand column of
Table V.
The implication of the monthly model is that the
money stock —reserve relationship is slightly more
elastic in the short run than the various quarterly
estimates imply. The implied impact elasticity (over
a one-month period in this case) is about 0.15. The
average elasticity over this first twelve months is
estimated at about 0.25, or about one-third more than
the estimate over the corresponding four-quarter hori­
zon from the M.P.S. model. After eighteen months
have elapsed the elasticity values reflect the long-run,
or equilibrium, values. This horizon agrees reasonably
well with the horizon of the M.P.S. model.
It is difficult to draw a finely defined set of conclu­
sions from the set of studies which have been ex­
amined. There exists a range of elasticity estimates
among these studies which cannot be reconciled with
the information which is readily available at the
present time.
However, while a single point cannot be estab­
lished as the most probable value for the interest
elasticity of the money supply, it appears that the
studies do provide information which can be of value
in policy discussions concerning the control of the
money stock. A broad, but valuable conclusion is that
the interest elasticity of the money supply during the
sample period of these studies appears to be ex­
tremely low. It seems appropriate to conclude with
almost complete certainty that the long-run elasticity
during this period was less than 0.5 and that the
impact elasticity (one quarter) was probably no
greater than 0.10 to 0.15. All these elasticities are
relevant for policy actions which result in changes in
the Treasury bill rate, while leaving the discount rate
For the class of policy actions which simultaneously
alters the Treasury bill rate and the discount rate by
the same amount from an initial position where the
two are approximately equal, it is the sum of the
interest elasticities of the money supply which is rele

JULY 1 9 7 2

Table V

M oney Supply Elasticity Com putations
(M onthly Fin ancial M arket M odel)
Time Deposits

Time Deposits

.1 3 8
.1 9 5
.2 5 0
.2 5 2
.2 5 0

.1 3 7
.1 9 2
.2 2 6
.2 4 3
.2 4 4
.2 4 3

.2 1 9

.2 1 4

.2 6 6
.2 7 2
.2 7 5
.2 7 9
.2 8 4
.2 9 2

.2 5 6
.2 6 2
.2 6 2
.2 6 9
.2 7 2

Second 6-Month A verag e .2 7 8

.2 6 7


First 6-Month A verag e
Third 6-Month A verag e

.3 0 3
.2 3 6
.2 2 0
.2 3 3
.2 4 6
.2 5 8

.2 9 0
.2 9 6
.2 2 2
.2 0 2
.2 1 6
.2 3 0
.2 4 3

vant. Two of the studies suggest that the elasticity
with respect to the discount rate is slightly smaller
than that with respect to the bill rate. The estimation
of these relationships involves constraints on parame­
ters, and hence, is not a valid test of the hypothesis
that the two elasticities are significantly different. In
the Goldfeld study, where there are no constraints
imposed on the estimated parameters, the estimated
coefficient of elasticity for the discount rate is con­
siderably smaller in absolute value than that of the
bill rate. Therefore, it would appear that while the
interest elasticity of the money supply relationship
is likely to be smaller when both rates are changed
simultaneously, it is almost certain that the coefficient
of elasticity will remain positive. Furthermore, the
elasticity under such a policy probably does not exceed
one-half to two-thirds of the interest elasticity under
a policy of keeping the discount rate fixed.
The available evidence suggests quite conclusively
that the short-run feedbacks through interest rate
changes, which would be generated by policy changes
in reserve aggregates, are very weak and should cause
little, if any, difficulty for the implementation of policy
actions aimed at controlling the money stock through
the control of a reserve aggregate. Of course, the size
of random fluctuations in the reserve multiplier re­
mains a major factor in determining the size of devia­
tions of the money stock from its targeted value.
An issue which remains to be investigated is the size
of the variance of the multipliers associated with
various reserve concepts.
Page 19

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