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J L 17
UY 93

Problems of Interpreting Recent
Monetary Developm ents........................
Formulating a M odel of the Mexican
Eco n o m y...................................... ..... .

Vol. 55, No. 7


Problems of Interpreting Recent
Monetary Developments

I t IS GOOD to be here and to have this opportunity
to discuss a topic of paramount importance to those in
the business of banking as well as to the public at
large.1 Most economic analysts now believe that
monetary developments have a pervasive and sig­
nificant effect on all types of economic activity. For
this reason, I appreciate your invitation to express my
views, which I must hasten to admit are not univer­
sally held, but on which I have developed a strong
feeling over several years of association with what I
believe to be the highest quality of empirical research.
This is an especially interesting time to be discuss­
ing monetary developments in view of the consider­
able differences of opinion on how to measure and
interpret the developments in the first half of 1973.
Some analysts interpret recent monetary actions to
have been quite expansionary, indicating an ebullient
economy with an intensification of inflationary forces.
On the other hand, others have indicated concern
over what they deem undue monetary restraint with
a likelihood of a recession late this year or early in
1974. I hope I will not add to the confusion by out­
lining for you my own interpretation of economic
developments so far this year and what they may
imply for the future. Before doing so, I think it would
be useful to review some of the interpretations of re­
cent monetary actions that have received widespread
attention and the facts upon which these interpreta­
tions have been based.

Bank Credit
One prominent view of recent monetary develop­
ments has centered on the growth of commercial bank
iThis address was delivered at the Seventy-Sixth Annual Con­
vention of the Indiana Bankers Association, French Lick, In­
diana, June 13, 1973. Data that have become available since
the presentation was made have been incorporated into this

B a n k C re d it u-









|1 Averages of seasonally adjusted data ior final W ednesday of two consecutive months.
12. Defined as the sum of total loans and total investments at all commercial banks.
Percentages are annual rates of change for periods indicated.
Latest data plotted: June

credit as the reliable leading indicator. Those analysts
that focus on bank credit have been greatly concerned
about the possibility of excessive expansion and a
marked step-up in inflationary pressures. Since last
July, commercial bank credit outstanding has risen
at a rapid 16 percent annual rate. By comparison, dur­
ing the period from mid-1970 to mid-1972, when
aggressive actions — both fiscal and monetary — were
taken to stimulate the economy which was recovering
from the latest recession, bank credit rose at a 12 per­
cent rate. The average rate of bank credit growth
from 1957 to 1970 was about 7 percent.
Actually, bank loans have risen more rapidly in re­
cent months than total bank credit. Total commercial
bank loans outstanding have risen at almost a 23 per­
cent annual rate since last July. Investment holdings
of banks rose only moderately most of last fall, and


have declined since January as banks have sought
funds to finance the requirements of their business
and consumer customers. It has been reasoned that
the accelerated expansion of total bank credit this
year would supplement the funds available for spend­
ing by the public, and therefore should be interpreted
as a strong inflationary force in the economy.
The head of Chase Econometric Associates, Inc.,
the forecasting, analysis, and consulting subsidiary of
the Chase Manhattan Corporation, indicated in a
newsletter that bank credit developments have been
an important element in “the unprecedented increase”
in spending.2 Increases in bank credit have been
much greater than in prior periods of rapid economic
expansion. Although the money stock, defined to in­
clude currency in the hands of the public and private
demand deposits, did slow during the first quarter of
1973, Chase Econometrics noted that banks were able
to expand their credit because of an unusual buildup
in Treasury deposits in commercial banks (which are
not included in the definition of the money stock).
Also, banks sold an increasingly larger amount of
large negotiable certificates of deposit to raise funds
to expand loans. Hence, the huge credit expansion
was accomplished at a time of relatively slow growth
of the money stock. Chase Econometrics concluded
that concentrating on the narrow definition of money,
while neglecting what occurred in credit markets, is
an acute case of “M j myopia.” I would agree that the
tightness or ease indicated by a given growth of M x
should not be analyzed in a vacuum, but I do not go
all the way with the second part of the conclusion —
namely, that the acceleration of bank credit growth
indicates more stimulative monetary actions this year
than last.

Interest Rates
Another approach to assessing monetary develop­
ments has been to focus on the cost of credit rather
than on volume. Interest rates, particularly short-term
rates, have risen substantially since last fall. The rate
on bank loans to prime business customers has risen
from 5V4 percent last August to 8% percent recently.
Yields on Treasury bills, commercial paper, bankers
acceptances and other money market instruments
have risen even more sharply.

JULY 1973

S e le c t e d in te re st R a t e s

R a ti* Sea l*
•f Yields

Ratio Sea l*
•f Yields


6 - M o n lh
C o m m e r c ia lP a p e r J










Sources: Board ol G ove rn o rs of the Federal Reserve System an d Salom on Brothers and Hutzler
L i Effective April 16, 1973, a two-tier o r "d u a l" prime rate w os adopted. The rate to large business
customers is shown here.
[2 Se c ond ary market rate on six-month negotiable time certificates of deposit in denominations
of $100,000 or more. 1965 d ata ore figures for the first Friday of the month. Data from 1966 to the
present are a ve rage s of Friday figures.
13.M onthly ove roge s of d a ily figures.
Latest d ata plotted: June

consumers are forced to trim their expenditures. Ac­
cording to this view, the exceptional rate of increase
in total spending in the past few quarters would have
been even greater if interest rates had not risen. More
importantly, higher costs of credit affect future spend­
ing plans, and hence, some are becoming concerned
that interest rate behavior, possibly even a credit
crunch, could foster an economic downturn in the
near future. An example of this approach was pre­
sented in a recent issue of a national news magazine,
where in discussing the task of restraining inflation it
was stated, “If this tight money policy is continued for
long, . . . it could well lead to oppressive interest
rates, a drying up of credit and a dangerous slowdown
in the economy comparable to the 1970 recession.”3

Money Stock

When credit costs rise and funds become less
readily available, it is reasoned that businessmen and

A third view frequently cited in the press and ad­
visory services has been put forth by some mone­
tarists who have been concerned that monetary ac­
tions may have become too restrictive. The money
stock of the nation rose at only a 2 percent annual
rate from December to March this year. By compari­
son, money rose at a 7 percent rate on average in the
previous two years. It was argued that this sharp slow­
ing in the growth of the narrowly defined money stock,
if continued, would lead to a substantial economic
slowdown. When people have less money than they

2See “The Macroeconomic Forecasts,” of Chase Econometrics,
Inc., April 25, 1973.

3Reprinted by permission from TIME, The Weekly News­
magazine; Copyright Time, Inc. (May 7, 1973,) pp. 75-76.

Page 3


desire to hold, given current economic conditions,
they tend to reduce their rate of spending.
The April 1973 “Monthly Economic Letter” of the
First National City Bank states, “In an atmosphere
in which more and more people are asking whether
credit conditions in 1973 could approach those during
the ‘crunch’ periods of 1966 and 1969, it is increas­
ingly evident that the commercial banking system is
in the midst of a tight squeeze.”4 Loan demand has
been unusually great. Yet, “since late 1972, the mone­
tary authorities have refused to supply any more re­
serves to the banking system. Through December,
total reserves — and consequently the money supply —
continued to rise rapidly because banks sharply in­
creased the reserves they were willing to borrow from
the Fed. But since early January, banks have been so
heavily in debt to the Fed that they have been un­
willing to increase their borrowings much more, de­
spite the continued climb in credit demands and in
interest rates on bank loans. Consequently, . . . re­
serves available against private nonbank deposits, and
the money supply . . . have zigzagged sideways.”
According to the First National City Bank “Letter”,
commercial banks have increased their credit largely
by aggressive bidding for CD funds, which results in
more total deposits with a given amount of reserves.
However, Citibank argues that “the sharp slowdown
in money stock growth has led to speculation about
the possibility of monetary overkill.”

Our View
Turning to our interpretation at the Federal Re­
serve Bank of St. Louis of the developments in early
1973, I cannot agree with those who hold the view
that the recent rapid growth of bank credit can be
taken as an indication that monetary actions have
been more stimulative this year than last. Nor can I
agree with either the interest rate approach or a strict
narrow money approach which argues that monetary
developments so far this year have been unduly re­
strictive. Now, let me see if I can outline for you the
problems with each of the three foregoing positions.
It is true that bank credit has been rising at a
phenomenal rate in recent months. If this credit were
entirely newly-created credit in the sense of being
an addition to total credit, then I would be in more
agreement with those who are concerned about an
acceleration in the growth of bank credit. However,
the facts are that a major share of this credit merely
reflects a re-routing of the flow of funds from savers
4pp. 3-4.
Page 4

JULY 1973

C ertificates o f D e p o sit a n d C o m m e rc ia l P a p e r

1 973
□.Ave rage s of preceding and current end-of-month seasonally adjusted figures.
12. Negotiable time certificates of deposit issued in denominations of $100,000 or more by large weekly
reporting commercial banks. Monthly averages of W e dn e sd ay figures, seasonally adjusted.
Latest d ata plotted: Commercial Paper-May; CDs-June

to borrowers through the banking system rather than
through other channels.
You may recall that earlier this year the Committee
on Interest and Dividends successfully encouraged
commercial banks to refrain from increasing interest
rates on loans — particularly the prime rate — even
though market conditions indicated that such a move
was appropriate. As a result many borrowers found
that rates offered by commercial banks were more
attractive than rates on funds from other sources —
such as commercial paper. Hence, demand for credit
by businesses tended to shift toward banks. In order
to meet the loan demand, banks obtained funds, that
previously had flowed into commercial paper and
other market instruments, by aggressively pricing
their large certificates of deposit. Thus, the rapid rise
in commercial bank credit was largely offset by a
smaller volume of other credit. At the same time, total
credit in the economy was not very much affected by
the somewhat artificial and temporary upward move­
ment in bank credit.
Fears of an economic downturn based on the re­
cent marked rise in interest rates is similarly only a
partial analysis. If the jump in interest rates were
solely the result of a monetary contraction, then I
would agree that a slowing or a decline in economic
activity would likely result. So, let us review the facts
behind the interest rate rise.
Interest rates are a price for the use of borrowed
funds. Rates are determined by supplies of and de­
mands for funds — just as the prices of housing, food,
or other goods are set by demand and supply. There
is no factual indication that the supplies of loanable


JULY 1973

funds have been contracting this year. Personal and
corporate incomes have risen at rapid rates; the pro­
vision of central bank credit, as indicated by the
rapid growth of Federal Reserve credit and the mone­
tary base, has not been cut-off; and the growth of
commercial bank credit has accelerated from last year.
The strongest upward force on market interest
rates late last year and in early 1973 — probably ac­
counting for the bulk of the rise — came from the
demand side. Economic activity — stimulated by the
rapid monetary expansion of 1971 and 1972 — has
been increasing rapidly. Accompanying the greater
activity has been a strengthening in the demand for
credit by businesses and consumers. Also, inflationary
pressures have intensified as the economy has ap­
proached a high level of capacity utilization. In the
past it has been observed that when expectations of
higher inflation rise, interest rates rise even more.
Lenders seek to protect the purchasing power of their
funds, while borrowers accept the higher rates in an­
ticipation of repaying in cheaper dollars.
Hence, the higher interest rates are primarily a
result of the greater credit demands associated with
the rapid expansion of business activity and the rising
expectations about future inflation. In short, present
interest rate levels are primarily the lagged result of
rapid monetary expansion during 1971 and 1972. Cur­
rent monetary actions have probably played only a
minor role in recent interest rate developments.
Hence, any overall restraining effect on the economy
from the marked rise in market interest rates to date
is likely to be slight. Individual borrowers, it is true,
have been finding funds increasingly more difficult
and more costly to obtain as the demand for credit
has been rising even more rapidly than the increasing
supplies. But this does not imply that aggregate eco­
nomic activity is being stifled by inadequate credit.
Most of the time I find myself among those who
follow closely the trends of money stock growth in
analyzing the impact of monetary actions on the econ­
omy. However, I feel the conclusion that monetary
actions were unduly restrictive in the first few months
of this year because of the slow money growth in that
period is unwarranted. For one thing, the time period
was relatively brief. Our research shows that normally
it takes six to nine months for a significant change in
the growth of money to have a measurable impact on
real economic activity, and even longer before prices
are affected. More importantly, the slow growth of
money in those few months was related to several
unusual market developments, which were thought to
be only temporary since the basic forces underlying

the trend growth of money continued to expand
Let’s look at what has happened to money growth
recently. During October and November last year the
growth rate of money slowed somewhat from the rates
earlier in 1972, but in December money rose sharply.
Then from December to March money rose at an
unusually slow 2 percent pace, but since March the
stock of money has gone up at an 11 percent rate. In
view of the fact that money apparently affects eco­
nomic activity with a distributed lag over a period of
several quarters, it seems more useful to analyze
money on balance over the period since sometime last
year rather than focus on each of the shorter run
fluctuations. As of June the level of money was up an
estimated 7.4 percent from a year ago. This was ap­
proximately the same rate of increase which prevailed
in both the seven-month period from last November®
and in the period from fourth quarter 1970 to fourth
quarter 1972.
Contrary to the view of some analysts that the slow
growth of the narrowly defined money stock in the
first quarter was monetary overkill, I have been con­
cerned throughout much of this period that monetary
expansion could continue to be excessive. I am
strongly persuaded that reduction in monetary stimu­
lus is essential to the elimination of inflationary pres­
sures, and postponement of actions to restrain mone­
tary growth implies that a more costly anti-inflation
battle must eventually be waged.
? ce
November 1972 avoids the distortion intro­
duced into rates-of-change calculations from abnormal base
periods, such as December or January.
Page 5

JULY 1973


Contributing to my concern is the observation that
the basic forces underlying monetary growth have
continued to be expansionary. Since last November,
for example, Federal Reserve credit has risen at a very
rapid 13 percent annual rate, after increasing just over
7 percent in the previous year. The growth of the
monetary base, which underlies the growth of the
money stock over a period of several months, has
risen at an 8 percent annual rate since last November,
the same as in the previous year.
The growth of money slowed in the first few
months of this year despite the marked acceleration
of Federal Reserve credit and the persistent path of
the monetary base. The explanation of this paradox
lies in the bunching of several market developments
which prevented the rapidly rising base from sup­
porting a proportionately larger growth of money.
These market developments appear to have been
temporary aberrations, for in the past two months
the growth of money has accelerated sharply to a 12.5
percent rate.
An important factor absorbing the monetary base
early in the year was an unusual buildup in Treasury
deposits in commercial banks. These funds in Treas­
ury accounts are not included in the money stock, but
banks are required to hold reserves against these
Treasury deposits the same as private deposits. Dur­
ing the international monetary turmoil, the Treasury
received a large inflow of funds from foreign central
bank purchases of Government securities, as these
foreign banks sought to invest the dollars accumu­
lated in maintaining exchange rates between their
currency and the dollar. Also, early in the year Treas­
ury receipts from personal and corporate income taxes
and from agencies such as the Social Security Ad­
ministration were running well ahead of payments.
In late March, Treasury balances at commercial banks
averaged about $11 billion, up from an average of
about $7 billion in December. It is well known that
the Treasury does not usually hold large idle cash
balances, and as these funds are spent, the private
money stock has expanded.
Other factors contributing to the slower growth of
money relative to base early this year include the
rapid growth of CDs and a marked increase in cur­
rency in the hands of the public. The growth of CDs
at banks absorbs reserves leaving less available to
support private demand deposits and other time de­
posits. Both of these factors are also likely to be
temporary, and as they return to more normal pat­
terns, it would be necessary to reduce the rate of

Page 6

M o n e t a r y B a se a n d Fe d eral R e se rve Credit

nonmember banks. Adjustments a e made for reserve requirement changes and shifts in deposits
among classes of banks. Data are computed by this Bank.
(2 Total Federal Reserve credit outstanding includes holdings of securities, loans, float, and "other''
ossets. Adjustments are made for reserve requirement changes and shifts in deposits among classes
of banks. Data are computed by this Bank.
Percentages are annual rates of change for periods indicated,
latest data plotted: June

expansion of the monetary base in order to avoid
further acceleration in the growth rate of money.

Economic Outlook
On balance through the first six months of 1973,
the rate of money growth has been somewhat less
than the exceptionally high rate of 1972, but this has
not been true for Federal Reserve credit and the
monetary base. If one can assume that the growth
rate of money from this point is, on average, no more
than in the past six months, some slowing in the
growth of total spending on goods and services from
the unusually rapid growth of the past two quarters
can be expected. The rate of GNP growth will prob­
ably slow to about 8 percent by year’s end, but on
average for 1973 the increase should be in the range
of 10 to 11 percent. Of that total, it now appears to us
that about 6 percent will be in real GNP and about
5 percent in overall price increases for the year.
Moderation of spending is desirable, of course,
since the economy is operating at or very near capac­
ity and consequently inflationary pressures have been
intensifying. Even so, I would hope that cutbacks in
aggregate demand would be gradual; otherwise, pro­
duction and employment would be seriously affected.
Capacity limitations constrain production growth to
about a 4 percent rate in the long run, and given our
experience with prices so far this year, inflation much
below a 5 percent rate on balance for the year is no


JULY 1973

Looking into next year, a
growth rate of money in the
Factors Influencing the M onetary Base in the Past Seven M onths1
range of 4 to 6 percent would
A verages of Daily Figures
likely be accompanied by a
(Dollar Am ounts in M illio n s)
growth of nominal GNP in the
C hange in
range of 7 to 8 percent, and
Source Base
at this point our best judgment
197 2
197 3
C hange
is that about half, and more
Federal Reserve Credit
likely less, would be in real
U.S. Government Sea
+ 1 3 1 .1 %
$ + 4 ,2 3 0
$ 7 5 ,4 4 7
Loans ..... -....-.... —
+ 1,182
output, and the remainder in
+ 36.6
prices. As you can see, I am
9 42
O ther Federal Reserve
7 5 ,9 5 9
+ 4,603
+ 142.6
not convinced of the necessity
for a recession, nor am I assum­
Other Factors
.. 10,410
G old Stock .................................
ing in this analysis any stronger
Special Drawing Rights Certificate
use of economic controls by the
Treasury Currency O utstanding ...
2 40
Treasury Cash H o ld in gs3 ............
Administration or Congress to
-1 ,0 8 6
deal with inflation.6 I do not
Foreign Deposits with F.R. Banks'* .
Other Deposits with F.R. B anks3 ..
believe that price-wage con­
35 4
— 1 1.0
Other F.R. Liabilities and C apital3
.. 2,378
trols in and of themselves
— 1,376
— 42.6
.. 14,215
should be viewed as a basic
100 %
$ + 3 ,2 2 7
Total Source Base ..................
$ 93,401
cure for inflation. Since I hold
.. 6,221
Reserve Adjustment4*5 ..............—
the view that in the longer run
$ + 4 ,0 7 8
$ 1 0 0 ,4 7 3
M onetary Base5 ......................-......
a high level of employment is
$ + 4 ,4 4 9
$ 1 0 0 ,7 5 4
$ 9 6 ,3 0 5
M onetary Base, Season ally Adjusted4*5 ... $ 9 6 ,3 0 5
consistent with relatively stable
xThe m onetary base is defined as the net m onetary liabilities o f the U .S. Treasury and Federal
prices, I continue to advocate
Reserve System held by com m ercial banks and the nonbank public. F or a b rief description o f
each o f the fa ctors influencing the source base see G lossary: W eekly Federal R eserve Statem ents,
achieving a stable rate of mon­
Federal Reserve Bank o f N ew Y ork,
etary growth consistent with
in clu d e s Federal agency obligations and bankers acceptances.
3These items absorb funds and th erefore a reduction in them releases reserves and increases the
that objective. Therefore, as­
base (sign is reversed on dollar changes and percent d istrib u tion ).
sessment of the economic out­
4A djustm ent fo r reserve requirem ent changes and changes in average requirem ents due to shifts in
deposits where different reserve requirem ents apply.
look does not assume that con­
^Computed by this Bank.
Totals m ay not add due to rounding.
trols are either necessary or
desirable in order to restrain
the rise in prices. A return to more strict controls is
longer attainable without an unusually severe reduc­
again rumored, and they may come. If so, they may
tion in production. Over time, the rate of inflation can
affect expectations and market interest rates for a
be reduced; however, if an economic downturn is to
while, and they will certainly affect statistical indi­
be avoided, the transition to stable prices will be a
cators of economic activity. Under-the-table transac­
time-consuming process. This will require both the
tions, black market activity, and product mix changes
patience and the perseverance that is inherent in the
do not show up in the published price indexes. How­
successful avoidance of the traditional massive and
ever, controls can have the appearance of working
abrupt cutback in monetary stimulus when inflation
only if rational fiscal and monetary actions are taken.
is finally recognized as being out-of-hand. Put an­
other way, achieving stability without suffering a re­
Otherwise the conflict between real economic forces
cession is possible, but it will take time and highly
and the administered economic programs will create
a situation which is acceptable to no one.
disciplined monetary and fiscal actions to get there
from here. I believe it can be accomplished, and hope
those of us involved in the stabilization decision­
making process have the patience, perseverance, and
6This presentation was given prior to the June 13, 1973
the wisdom to achieve this.
announcement of a second price freeze followed by Phase IV.
Table I




Page 7

Formulating a Model of the Mexican Economy

In this article Mr. Escobedo presents two alternative approaches to the development of an
econometric model of the Mexican economy. One model is based on a neo-Keynesian framework
of analysis; the other model incorporates the theoretical positions of monetarists. Before sum­
marizing the structure of the two models, Mr. Escobedo expresses his views of the debate be­
tween monetarists and neo-Keynesians.
For some background information into the complexities of the Mexican economy, the reader
may wish to refer to an article by Mr. Escobedo in the June issue of this R e v ie w .

NE OF THE interesting peculiarities of the
evolution of economic theory is that it closely follows
the economic performance of the leading industrial
countries of the Western World. In the present cen­
tury we can trace this trend very clearly. When the
world fell into the “great economic depression” in 1933,
the prevailing theory assumed the problem away and
therefore could not provide a solution for bringing
the economy out of the difficulty. The Keynesian ap­
proach emerged at that time as the “great savior” of
the economic discipline. Monetary variables were con­
sidered irrelevant and fiscal policy came to be re­
garded as the “solution” in a “new era” of Government
intervention in the economy.
In the post-war period, as economies became more
sophisticated and some neo-Keynesian solutions to
economic policy were not proven to be as efficient
as previously thought, monetary theory regained im­
portance.1 Much discussion has occurred in the last
5 or 6 years regarding the relative importance of fiscal
versus monetary policy. The question has not been
settled definitely, although a consensus of opinion
seems to be emerging.2 The present state of the dis­
cussion seems to lie at least in part in what can be
considered the main exogenous policy variable — Gov­
ernment expenditures for Keynesian theory or money
stock for the monetary theory — since each approach
1Milton Friedman, “The Role of Monetary Policy,” American
Economic Review (March 1968).
2Good examples of these discussions are Frank DeLeeuw and
John Kalchbrenner, “ Monetary and Fiscal Actions: A Test of
Their Relative Importance in Economic Stabilization — Com­
ment,” this Review (April 1969), pp. 6-11, and Leonall C.
Andersen and Jerry L. Jordan, “ Monetary and Fiscal Actions:
A Test of Their Relative Importance in Economic Stabiliza­
tion—Reply,” this Review (April 1969), pp. 12-16.

Page 8

assigns an important role to the effectiveness of those
variables in the system.
Furthermore, the discussion has been extended to
the question of how much benefit or loss is added to
the economic system when the policymakers use the
instruments they have available to obtain a desired
goal. Given that the results of these actions are sub­
ject to a high degree of uncertainty, the question
raised is whether it is better for policymakers to use
the imperfect instruments available or whether policy
interference should be kept at a minimum with the
system left to “self correct” as Milton Friedman
The criticism of the “activist” position rests on the
premise that serious limitations exist in the ability to
predict both the behavior of the system in the absence
of action and the effect of action. There is also a time
consuming process involved in correcting the lags
between the recognition of the problem, the formula­
tion of appropriate action, the implementation of
action, and the results of such action. Actions taken
without knowledge of the adjustment process during
these lags would tend to destabilize an inherently
stable economy.
The main criticism of the “self-correcting” position
is focused on the assumptions that the economy
“tends” toward stability and that the use of an activ­
ist policy is only “disruptive.” This assumption cannot
be proven for no test could completely isolate the
system from Government actions which are not aimed
at stabilization. Neo-Keynesians therefore conclude
that “. . . the evidence of both Keynesian and mone­
tarist models of economic activity suggests that we


live in an economy of persistence rather than self­
correction” because the economy is permanently sub­
ject to multiplier effects and therefore intervention in
the economy is called for as a corrective device.3
Whatever the outcome of this controversy might
be, it is clear that there is a recognized influence on
the economy from changes in both monetary and
fiscal variables. The policymaker thus needs to follow
an analytical framework in predicting the behavior of
the economic system, so that the level of uncertainty
of his actions can be minimized. W e will disregard in
this paper a discussion of self-correcting mechanisms
which, even if relevant in countries like the United
States, would not necessarily be applicable in more
Govemment-oriented economies like Mexico.

The Keynesian Approach
The original version of the Keynesian theory em­
phasized the role of fiscal variables, such as Govern­
ment expenditures and taxes, as the most important
policy instruments for influencing economic activity.
The effect of a fiscal action on spending is viewed as
a multiple of the original magnitude of such fiscal
action. Government spending, for example, is trans­
formed into a direct demand for goods and services,
which generates additional income, which in turn is
spent. This process continues until the leakages (sav­
ings and taxes) bring it to an end — the final result
being a multiple of the original Government expendi­
ture. Taxes affect disposable income (a major deter­
minant of consumer spending) and profits of busi­
nesses ( a major determinant of investment spending).
Therefore, according to Keynesians, budget surpluses
or deficits are good measures of the influence of Gov­
ernment spending or taxing on economic activity.
More advanced neo-Keynesian interpretations rec­
ognize monetary actions as an indirect influence on
economic activity through the effect of changes in
market interest rates. But even in this case the way
in which a budget deficit is to be financed has not
always received adequate consideration.
With the help of the Hicksian IS-LM framework,
the effects on the economy of fiscal actions, such as
an increase in Government spending, can be traced.
This increase induces a change in both consumption
and saving, which in turn increases investment (an
3See Arthur M. Okun, “Fiscal-Monetary Activism: Some Analyt­
ical Issues,” Brookings Papers on Economic Activity (No. 1,
1972), p. 147.

JULY 1973

upward movement along the IS schedule as well as
a shift due to an accelerator type effect) and there­
fore income in the next period. But this shift of the IS
curve will have an effect on the demand for money
and, depending on what happens to its supply, market
interest rates may or may not move up. If there is no
displacement to the right of the LM curve, the final
effect of increased Government expenditures will be
a higher level of income, but also higher interest rates
prevailing in the market.
For Keynesians the money stock in equilibrium is
given exogenously, as is the price level. Adjustments
from a low to a higher equilibrium position through
developments in the monetary sector occur as a result
of an outward shift in the LM curve. This shift, in­
duced by a change in the money stock, reduces the
rate of interest which, in turn, promotes investment
and higher levels of income, consumption, and savings.
The process continues until new equilibrium levels of
income and interest rates are achieved.
This static framework has been developed into a
dynamic system allowing prices and credit rationing
effects to affect the slopes and positions of the pairs
of IS-LM curves determined in each income period.4
Presently the Keynesian framework allows for changes
in monetary and fiscal actions to take place at the
same time, and considerations about the financing of
Government expenditures can be introduced. Financ­
ing with monetary expansion will result in the full
Keynesian multiplier effect while financing by either
taxes or borrowing from the public has a smaller
multiplier effect on spending.5
Neo-Keynesians also recognize that exogenous Gov­
ernment expenditures (whether directed towards the
achievement of allocation, distribution or stabilization
objectives) have to be integrated in such a way that
an expenditure intended to achieve stabilization ob­
jectives does not hamper the desired distribution or
allocation of resources.6 This is a difficult distinction
to document empirically, especially in economies near
full employment in which the trade-off between the
goals of economic policy may be sharper. It is also
difficult to classify the amounts and types of debt the

4J. R. Moroney and J. M. Mason, “The Dynamic Impacts of
Autonomous Expenditures and the Monetary Base on Aggre­
gate Income,” Journal of Money, Credit and Banking (N o­
vember 1971), pp. 793-814.
5James Tobin, “An Essay on the Principles of Debt Manage­
ment” in Essays in Economics (Chicago: Markham Publishing
Company, 1971).
8Richard Musgrave, The Theory of Public Finance (New
York: McGraw-Hill, 1959).
Page 9


Government uses to finance each type of expenditure.
Consequently, the portfolio approach, as developed by
James Tobin, attributes both a direct and an indirect
effect on the economy to fiscal actions, depending on
the relative amounts and terms of the debt. This de­
velopment gives greater detail to the final impact of
Government expenditures and brings the fiscal and
monetary approaches closer together.

The Monetarist Approach
Outside the context of the Keynesian framework of
IS-LM analysis, a group of economists in the United
States have developed a theoretical approach that
stresses the influence of monetary and financial varia­
bles on economic activity. This approach is a reform­
ulation of the quantity theory which emphasizes the
role of money as an asset. In this framework, the
demand for money is treated as a part of capital or
wealth theory, and the concern is with the composi­
tion of asset portfolios which provide utility or satis­
faction to holders.7
Two well-defined markets are set forth. Economic
entities make choices in the market for goods and
services and in the market for financial assets, so a
Walrasian framework of supply and demand is neces­
sary for each financial asset. Market interest rates
(prices of financial assets) and changes in the out­
standing stocks of most financial assets are determined
by the market process, along with prices and quanti­
ties of goods and services.8
The modem quantity theorists assume that the real
money stock and the level of real income are deter­
mined by this supply and demand mechanism, which
eventually will come to a high-employment equilib­
rium, since it is assumed that the economy has an
“inherent force” towards stability. Therefore, changes
in the nominal stock of money will not affect “real”
variables in the long run, but will influence only
nominal interest rates, prices, and spending on goods
and services.9
This theory also incorporates the view that the
influence of fiscal actions depends mainly on the
method of financing Government spending. Financing
7Milton Friedman, “Money: Quantity Theory,” International
Encyclopedia of the Social Sciences (vol. X, 1968), pp. 432-47.
8Leonall C. Andersen and Jerry L. Jordan, “ Monetary and
Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization,” this Review (November 1968), pp.
9Milton Friedman uses this argument in “The Role of Mone­
tary Policy” to show how badly monetary policy has been
conducted in the United States.

Page 10

JULY 1973

by either taxing or borrowing from the public involves
a transfer of command over resources from the pubhc
to the Government, giving way to the “crowding out”
effect on private expenditures. That is, the Govern­
ment will use funds otherwise available to the private
sector, therefore affecting the rate of interest and
eventually total spending on goods and services.
Summing up, we could say that the modem quan­
tity theory stresses the influence of money on the pace
of economic activity. Such a relation has been em­
pirically tested only in an aggregated level where the
results are satisfactory, but the monetarists have made
little effort to test the responses to financial variables
in a disaggregated structural-type model.1

The popular Keynesian theory developed in the in­
dustrialized countries during the 1940s and the 1950s
was not directly applicable to the underdeveloped
economies. Special adjustments had to be made to
consider problems such as industrialization, income
distribution, and growth. There were the so called
“developing theories” advanced by nationals of these
countries like Raul Prebisch of Argentina, Juan Noyola of Mexico, Celso Furtado of Brazil, and Anibal
Pinto of Chile, as well as by foreigners such as Nicho­
las Kaldor, Ragnor Nurske, Harry G. Johnson, and
Walt Rostow. These “developing theories” followed
two main courses.

The Structuralist Position
This approach, which was promoted primarily by
the United Nations, stresses that inflation is not a mon­
etary phenomenon, but the result of disequilibria of
a very real nature that are expressed in the form of
the general level of prices. Inflation can be attributed
to structural factors (population and productivity),
dynamic factors (different rates of sectoral growth),
and institutional factors (behavior of public and pri­
vate sectors).1
10Leonall C. Andersen and Keith M. Carlson, “ A Monetarist
Model for Economic Stabilization,” this Review (April
1970), pp. 7-25. See also Gene Fisher and David Sheppard,
“ Effects of Monetary Policy on the United States Econ­
omy,” Organisation for Economic Cooperation and Devel­
opment, Occasional Studies (December 1972).
''Juan Noyola, “ El Desarrollo Economico y la Inflacion en
Mexico y otros Paises Latinoamericanos,” Investigation Eco­
nomica (1956). Also see United Nations Economic Com­
mission for Latin America, Development Problems in Latin
America (Austin: University of Texas Press, 1971), pp.


Once inflation starts, there is an inherent “propaga­
tion” in the economic system due to the state of
income distribution and to the behavior of the private
and public sectors. The conclusion of this group is
that if a choice had to be made between inflation
and economic stagnation or unemployment, inflation
is preferable.
According to this approach, developing economies
should direct their efforts towards the stimulation of
growth by means of industrialization. This would be
achieved by promoting import substitution so that, at
the same time the terms of trade are improved, an
increased capacity to import would make it possible
to sustain the large capital needs of development.
Therefore, Government expenditures should be heav­
ily directed toward promoting the industrial infra­
structure of the country. This process would allow
productivity to increase and ameliorate the problem
of income distribution.
An additional effort would have to be made by the
Government in order to guarantee the productivity of
private investment which sometimes is “poorly ori­
ented, directed to superfluous goods or to foreign
markets.”1 However, at the beginning of the 1960s,
when some of these countries were finishing their
import substitution process, and the pace of indus­
trialization was slowing, a new ingredient was in­
corporated into the problem of development. The
patterns of commercial policy of the advanced coun­
tries had to be changed, so as to make it possible for
those countries in the process of development to ex­
port non-traditional products which, under prevailing
conditions, could not be placed competitively in the
international markets.

The “Orthodox” Position
This approach was promoted mainly by the Inter­
national Monetary Fund and other international agen­
cies. It also has a heavy Keynesian influence, but
gives more consideration to the financial sector and
especially to the rate of exchange. The increase in
prices is viewed as originating with the expansion of
additional income, from the inherent process of de­
velopment, from the expansion of bank and extra-bank
credit, and from increasing costs due to “commercial
12For a more recent interpretation of the structuralist position,
see David Ibarra, “ Mercado, Desarrollo y Politica Econom­
ica,” El Perfil de Mexico en 1980, ed. Siglo XXI, 1970,
and Luis DiMarco, ed., International Economics and De­
velopment, Essays in Honor of Raul Prebisch (New York:
Academic Press, 1972), p. 11.

JULY 1973

Furthermore, this approach holds that external fac­
tors are basic in explaining monetary disequilibria. The
reasoning is that Government spending, or a surplus
in the current account of the balance of payments,
produces an increase in aggregate demand, which
induces increases in investment. In turn, increased
growth of income is promoted and, consequently, im­
ports grow at a higher rate than income.1 Since the
growth of exports is slower, a deficit in the current
account occurs. A change in relative prices — domestic
and foreign — or a monetary policy oriented toward
sustaining output growth at high rates, accentuates
the balance-of-payments deficit and it becomes neces­
sary to devalue in order to restore external equilib­
rium.1 Later developments of this approach rejected
devaluation as a necessary means for restoring equi­
librium, turning more to domestic and foreign savings
for that purpose and, therefore, making development
with price stability the goal of economic policy.
In general, one can conclude that the “developing
theories” have relied very heavily on Keynesian the­
ory. Even the most recent approaches to economic
policy, with a heavy content of social considerations,
are still based on a Keynesian-type mechanism. This
is only natural if one considers that capital markets
and financial institutions have been almost nonexistent
in developing countries and that Government plays a
central role in the economic mechanism.
To a great degree Mexico has been an exception
to the usual experience of developing economies.
In Mexico a wide and competing banking system has
been developed which has attracted not only domestic
but also considerable amounts of foreign savings. Nev­
ertheless, economic policy is still conducted mainly
in the Keynesian tradition, giving relatively little
attention to the role of financial variables in the
economic system. Therefore, the exploration of new
approaches to economic policy seems appropriate.
Such is the purpose of this study, empirical results
of which are summarized in the remainder of this
paper. The analysis has been directed only to shortterm economic policy, but it seems necessary that
similar considerations be given to long-term policy
consistent with the goals of employment and more
equitable income distribution.
13The income elasticity of imports is normally assumed to be
greater than one.
14For a more detailed view of these approaches, see Leopoldo
Solis, “Mexican Economic Policy in the Post-War Period:
The Views of Mexican Economists,” Supplement to Ameri­
can Economic Review (June 1971).
Page 11


The institutional characteristics and the historical
background of Mexico, which were presented in the
June 1973 issue of this Review, provide a foundation
for the two econometric exercises presented below.
From these two exercises we will try to determine if
the recent theoretical and empirical developments in
industrialized countries can be used in developing
economies which are concerned more with growth and
income distribution than with stabilization and full
employment. In so doing, the traditional, but still pop­
ular, approaches given by the “developing theories”
will be disregarded.
The construction of the models could have been
approached from two extremes. The models could
have incorporated “a prioristic policies” based on the­
ories rather than empirical research, or they could
have been constructed around “empirical policies”
based on experience with little theoretical back­
ground.15 Since neither of these extremes is desir­
able, two models have been developed of an inter­
mediate type based on knowledge of past economic
behavior. These models are appropriate for testing
the relative importance of fiscal and monetary poli­
cies in income-expenditure determination. By statisti­
cal simulation we can determine which of the two
approaches fits best.
The models only consider quantitative policy — that
is, moderate changes in quantitative instruments such
as Government expenditures and money supply. The
short-run structure of the economic environment is
assumed to remain unchanged. No consideration is
given to policies of increasing complexity, such as
changes in the monetary or fiscal structure, the pattern
of income distribution, or the state of property
It is hoped that the results of these efforts will be
helpful for a number of puiposes. First, they should
provide a framework for evaluating the attainability
and desirability of alternative policy objectives, given
the maintenance of present relationships. In addition,
the results should indicate whether a change in these
relationships is necessary, and if so, how the alteration
could be accomplished.
A word of caution should be advanced regarding
availability of data. Mexico, as is the case with most
developing countries, suffers from a considerable lack
of statistical data, and this situation has been de15Jan Tinbergen, On the Theory of Economic Policy (Amster­
dam: North Holland Publishing Company, 1955).

Page 12

JULY 1973

teriorating rather than improving in recent years. The
national accounts are only available from 1950 to 1968,
the last input-output table is for 1960, and no flowof-funds tables have yet been produced. Therefore,
the construction of reliable statistical series for our
purposes was a difficult task which excluded those
variables undocumented. Nevertheless, awareness of
the difficulty in gathering consistent and reliable in­
formation is one of the “side-benefits” of model build­
ing and should serve as a feed-back to those institu­
tions involved in statistical development.

A Summary of the Fiscal Model Structure
Consistent with the Keynesian approach, the main
economic policy variable of this model is Government
expenditures which are considered exogenous to the
system.18 The other instrumental variable is the rate
of interest, which the central bank regards as “con­
trollable.” The rate of interest acts as the credit ration­
ing variable.17
The purpose of the model is to estimate the financ­
ing requirements of a given level of Government ex­
penditures while trying to meet the goals of a high
growth rate of gross domestic product, a stable rate
of exchange, and a “minimum” of inflation.
The restrictions imposed on the model are the
budget and balance-of-payments deficits. That is, if
the growth of GDP is to be promoted with a “mini­
mum” of price and exchange rate instability, Govern­
ment expenditures will have to follow a “moderate”
rate of growth. Failure to do this will necessarily
affect both Government and balance-of-payments defi­
cits, and domestic and foreign stability will not be
possible. Therefore, the relevant endogenous variables
responding to different policy shocks are in the fol­
lowing sequence: GDP, taxes, imports, international
assets, domestic credit, and the money supply (see
Exhibit I).

16In other words, in this first model we will test the hypothesis
that Government expenditures are an independent variable
which will have broad and rapid effects on economic
17This necessarily implies the existence of excess demand for
funds at the “official” rates. The assumption of excess
demand for funds implies that since the interest rate is
fixed at an “ official ceiling” there will be times when there
are actually two interest rates: the official and the market
rate. The latter one cannot be measured systematically and,
therefore, the interest rates are not introduced in the
credit equations. Official interest rates enter only in the
bank’s liabilities equations as a variable helping to explain
the total amount of funds received by the banking system
in a given period.

JULY 1973


E x hibit I

M exican Fiscal Policy M od e l

There is a basic channel which, by way of a multi­
plier, transforms private and public investment into
expenditures on goods and services. Government in­
vestment is determined exogenously and private in­
vestment depends on the remaining funds available in
the banking system after Government expenditures
are financed.18 The total amount of credit available
depends on the level of domestic saving and on the
interest rates prevailing in domestic and foreign
Government expenditures will be financed in the
first instance by revenue coming mainly from income
and indirect taxes, which are endogenous to the system
and a function of income and GDP. Four additional
sources are considered for financing these expendi­
tures: a) credit from the private banking system,
b ) credit from the central bank, which will be re­
flected in an increase of the money supply or in a
reduction in the amount of credit discounted, c ) for­
eign credit, and d ) credit from the non-banking sector.
18See Richard A. Musgrave, Theory of Public Finance, Chap­
ter 25, and Roger W. Spencer and William P. Yohe, “The
‘Crowding Out of Private Expenditures by Fiscal Policy
Actions,” this Review (October 1970), pp. 12-24.

Private bank credit to the Government (including
that of investment banks) depends on the legal re­
serve requirements which by law are kept in some
form of Government debt instrument instead of de­
posits bearing no interest. This way of allocating pub­
lic debt permits the central bank to rely less on an
expansion in the stock of money and, therefore, helps
avoid heavy pressures on inflation. Financing with new
money was typical during the inflationary periods in
Legal reserve requirements are a fixed proportion
of demand deposits, time deposits, “bonos financieros”
(a demand deposit bearing interest) and “hipotecarios,” 1 which in turn depend on GDP and the dif­
ferential between domestic and international inter­
est rates.
The amount of credit that the central bank grants
to the Government (the level of Treasury bills pur­
chased), in addition to that coming from domestic and
19A discussion of these terms is provided in the screened
section of “The Response of the Mexican Economy to Policy
Actions,” this Review (June 1973), p. 21.
Page 13


international sources, is also endogenously determined.
In order to extend this credit, the central bank has to
lower its discount rate to private banks, reduce its
holdings of international assets, or in turn increase the
money supply.
Changes in international reserves depend upon the
results of the balance of payments, which is the dif­
ference between exogenously fixed exports minus
endogenously determined imports of consumer goods,
equipment, raw materials, and services. Imports are
mainly a function of current and lagged real output
and investment. If changes in international reserves
are endogenous, part of the monetary base also be­
comes endogenous, and the central bank will have no
other alternative to finance the Government’s deficits
but to reduce the amount of credit available to private
banks. This action will be taken because of the infla­
tionary risk involved in the creation of “new” money
in excess of trend. Therefore, the whole process of
“crowding out” takes place and private investment is
The only way in which this process will not occur
is if the private sector borrows from international
money markets. This borrowing will take place only
when the interest rate differential becomes significantly
important so that the foreign interest rate plus the
“risk” factors involved in foreign borrowing are lower
than the domestic rate. The effect that such borrowing
has on the change of international reserves depends
on changes in imports, exports, and the amount of debt
the Government decides to float in international
Summing up, the four main endogenous variables
in the system are private investment, imports, taxes,
and credit. All are determined mainly by the be­
havior of GDP which, in turn, is heavily dependent
on Government expenditures. The Keynesian multiplier
will work fully if Government spending is financed
with “new” money, but the ultimate impact will be
decreased if any amount of funds is taken from the
private sector. Also, the multiplier is influenced by the
behavior of imports, since part of the increased de-

-’°See Franco Modigliani, “ Long-Run Implications of Alterna­
tive Fiscal Policies and the Burden of National Debt,"
Economic Journal (December 1961), and Albert Burger,
The Money Supply Process (Belmont, California: Wads­
worth Publishing Company, Inc., 1971). The monetary base
in this case would have an additional term for international
reserves so the definition of the base would be: Base
( Ba ) = total bank reserves ( R ) + international reserves
— private bank borrowing (A ) + currency (CP); Ba =
R — A + CP + international reserves.

Page 14

JULY 1973

Table I



(First differences, billions of pesos)
Demand Deposits
Bonos ( Q u a s i-M o n e y ) 1
Money ( M i)
N on-Liquid Liabilities
Total Liabilities
Bank Credit to Private Sector
Total Revenue
Income Tax
Indirect Tax
Import Tax
International Reserves
Total Foreign Capital
Total Imports
Imports of Raw Material
Imports of Industrial G oods
Imports of Consum ption G o od s
Imports of Services
Private Investment
G ross Domestic Product2



27.5 2 0
20.2 5 9
3 4 .1 8 5
5 0 .4 7 6
9.9 7 4
6 7 .0 0 0
4 8 .2 5 0

3 .2 7 4
2 7 .7 3 6
3 4 .1 8 2
4 .2 0 7
3.7 7 4
1 2.009
5 0 .1 5 0
70.7 3 2


1 .2 %
— 1.3
— 1.9



’ Defined as M 2 — Mi
2The “ actual” GD P data series in this table m ay not necessarily
agree with that reported in Table III. The discrepancy is prim arily
the result o f revisions in the data subsequent to form ulation o f the
fiscal model yet p rio r to the developm ent o f the m onetary model.

mand will be transferred to the external sector with no
further multiplier effect on the domestic economy.2

Empirical Remits of the Fiscal Model
This model offers a far more detailed breakdown
than that mentioned above, but it was not considered
relevant to the argument of this paper. There is a
breakdown by type of imports, by taxes, and by the
main assets and liabilities of the banking system. The
user of the model might find these helpful in under­
standing the behavior of the aggregated variables, and
they will also be useful if the model is used for
policymaking purposes.
The estimation of the model was made with annual
figures. Due to the considerable number of variables
involved (41 endogenous and 63 exogenous), and the
availability of data, it was not possible to estimate it
using quarterly data, as was possible in the monetary
model. Therefore, the simulation was done on an
annual basis as was the 1973 forecast.
In Table I the 1970 simulation is compared with
the observed data. W e can see that most of the varia­
bles show acceptable results, with an average error of
10 percent. To judge these results one should keep in
21The reader will notice that this model does not include an
explicit consumption function. There were two main reasons
for this: a) the bad behavior of such an equation due
mainly to statistical deficiences and b ) such an equation is
estimated implicitly when we estimate domestic savings.


mind that the forecast is done in first differences, so
an error of estimation between actual and simulated
values of 10 percent is equivalent in many variables
to less than 1 percent in terms of their levels.
The model has three primary areas of difficulty.
(1 ) One such problem appears in the GDP equation
where the regression coefficients are not significant
( “t” statistics are very small) for the first differences
of the Government expenditure variable. So the level
of such expenditures was used to obtain a better re­
sult. This shortcoming means that the Keynesian
“multiplier” is not a significant variable for explaining
changes in total nominal expenditures. The signifi­
cance of the dummy variable shows the need to try
other explanatory variables in this equation, incor­
porating monetary actions in a more direct form than
the one presented here in which interest rates enter
only indirectly in the process of determining private
investment. (2 ) The estimated financial equations are
heavily dependent on interest rates, which are as­
sumed exogenous and not significant for the changes
in nominal GDP, contradicting the endogeneity ex­
pected in this model. (3 ) The model does not include
a price equation because no satisfactory results were
obtained, even though different approaches were tried.
All the variables in this model are expressed in nom­
inal terms, assuming that such variables have the
same behavior in real terms, prices being relatively
stable (which has been the experience in the sample
period and was typical of most of the early versions
of Keynesian m odels).22
In spite of these limitations, the model performs
within a reasonable degree of confidence. An applica­
tion of the model to a forecast for 1973 is presented
in Table II.

A Summary of the Monetary Model
The main exogenous variable in this model, in con­
trast to the fiscal model, is the money supply, which
is defined as currency plus demand deposits held by
the nonbank public. It follows the monetarist’s view
that the rate of monetary expansion is the main de­
terminant of total spending, in this case measured
as nominal gross domestic product.
Changes in total spending are reflected as move­
ments in “real” output and prices (see Exhibit II). If
22In the monetary model a price equation was estimated,
and its results are acceptable. This equation was found after
numerous disappointing trials, but by that time the fiscal
model had been completed. A future version of the fiscal
model should include such an equation.

JULY 1973

Table II



(First differences, billions of pesos;
percent increase in parentheses)
Case A

C ase B

Government expenditure increase
of 35 billion pesos ( 2 5 % )

Government expenditure
increase of
1 6 billion pesos ( 1 0 % )

Nom inal G D P
Imports of G oods
& Services
Current Account Deficit*
Tax Revenue
Government Deficit
Financing of Government
Private Domestic
Bank Credit
Foreign Credit
International Reserves
Central Bank Credit


(2 4 % )



(2 4 % )
(1 1 % )
(1 8 % )
(5 8 % )

7 (1 3 % )
2 ( 3%)
10 ( 9 % )
6 (2 6 % )

3 (5 0 % )
2 (2 5 % )

3 (5 0 % )
1 (2 0 % )

(2 5 % )
(5 0 % )

2 (1 0 % )


(1 1 % )

^Exports were determ ined exogenously as an average o f the last 10

the rate of growth of nominal GDP is not accelerated
greatly beyond its trend, prices will not be affected
and increased real GDP growth will be possible as
existing capacity will be used more efficiently.
Special consideration is given to the external sector
due to its impact on the level of spending. An in­
crease in imports over exports means that domestic
demand for goods and services exceeded domestic
supply and, therefore, part of the spending stream
was directed to the “rest of the world.” This would
mean that the balance of payments in an open econ­
omy like Mexico plays an important role in total
spending; but it also affects the changes in the stock
of money. If there is a deficit in the balance of pay­
ments, international reserves will flow out of the coun­
try, producing a contraction in the monetary base and
consequently in the money stock if not offset by other
actions of the central bank or by a corresponding
inflow of foreign debt.
Balance-of-payments deficits will be possible only
if the stock of money exceeds the amount demanded.
This excess supply will ultimately lead to higher prices
of domestic goods and/or to additional purchases of
foreign goods, services, and assets, with the consequent
loss of reserves by the central bank. This loss of re­
serves, if not offset by the central bank in the next
period, would result in a reduction of the money sup­
ply (or an equivalent inflow of foreign capital). Oth­
erwise, the process of increased spending in domestic
and foreign goods and services would go on. Since a
deliberate policy has been followed in Mexico to
acquire the foreign capital necessary for the develop­
Page 15


JULY 1973

E x h i b i t II

M e x ican M on e tary Policy M o d e l

ment process, the deficit is considered endogenous in
the model.
Imports and exports are endogenous variables,
which, when netted, produce a balance-of-trade defi­
cit, and act as an exogenous influence on spending in
the following period. Therefore, only indirectly (by
changes in real GNP) can a deficit in the balance of
payments be affected by policymakers.
Fiscal actions are introduced in the model as Gov­
ernment expenditures.23 However, if such Govern­
ment expenditures are not financed by monetary ex­
pansion, but by taxes or private borrowing from the
public, we would expect a “crowding out” of private
expenditures to take place and this variable to have
little effect on total spending.
This point is really the motivation for the econo­
metric exercise presented here. The Mexican experi­
ence demonstrates that during the inflationary period
when budget deficits were financed with “new” money,
23It was not possible ^to estimate the equivalent to a “high
employment budget” which would have been a preferable
variable in this equation.

Page 16

total expenditures were growing at rates faster than
in the period of stability. But the increased expendi­
tures of the first period were transferred in part to
imports and to prices, because real output could not
keep pace with nominal spending. Therefore, Gov­
ernment expenditures were behind the inflation and
balance-of-payments deficit, even though it acted as
a stimulus to the growth of real GDP.
In the recent period when budget deficits have been
financed through the “crowding out” process, the fis­
cal deficit becomes ineffective on total spending
because it only substitutes private outlays for Govern­
ment outlays, and no considerable inflationary pres­
sure is exerted on the economy. Therefore, the money
supply becomes the key variable in short-term eco­
nomic policy, a fact that probably has not yet been
generally recognized in Mexico. This is probably be­
cause the central bank has followed a policy of sus­
taining a fixed rate of growth in the money stock
while financing increased Government deficits with
funds that would otherwise be directed to the private
sector. The experience of 1971 makes this behavior
clear. When money supply was not reduced as sharply
as Government expenditures, pressure on prices did

JULY 1973


Table III

(Billions of Pesos)




4 6 .1 0 0
5 .3 0 0

4 2 .2 7 7
28.5 2 9

— 8 .3 %
- 1 2.4

0.2 2 0

(2 )
As a consequence of (1 ) the “highemployment budget” concept could not be
used in the total spending equation, which
would have been more adequate than Gov­
ernment expenditures. The use of Govern­
ment expenditures instead introduces differ­
ent elements of variability such as seasonal,
postponement, advances, etc.

The price equation, which was obtained
after many unfruitful trials, shows a wellGDP
3 4 .5 0 0
3 8 .4 7 5
defined pattern with the gap between poten­
0.5 7 8
3.5 0 0
-1 8 .7
- 0.1
tial and actual GDP. When the gap is re­
30.0 8 8
30.3 1 4
0 .2 2 0
duced, prices tend to rise in a Phillips curve
‘ F irst differences from IV /1 96 9 — IV /1 97 0 . The “ actual” GDP data series in this
fashion. Also changes in the rate of growth
table m ay not necessarily agree w ith that reported in Table I. The discrepancy is
prim arily the result o f revisions in the data subsequent to form ulation o f the fiscal
of the money stock will affect prices in a
model yet p rior to the developm ent o f the m onetary model.
meaningful way. Net imports act in a re­
2Level prevailing at year end. E xp ort and im port data, as reported here, only in­
clude goods, whereas the trade data reported in Table I include goods and services.
versed pattern; that is, increases in the
balance-of-payments deficit will remove in­
flationary pressures from the Mexican economy.
not ease as much during 1971. However, the increased
total spending together with increased monetary
growth helped real output recover in 1972 and 1973.
Probably the most encouraging result of the model
is the total spending equation, which is one of the
best of all the equations estimated for the two models.
Empirical Results of the Monetary Model
This equation has the advantage that it is potentially
consistent with both Keynesian and quantity theory
As was mentioned before, the estimation of this
models. The results show that only changes in money
model was made with quarterly figures, which was
significantly affect total spending. Government ex­
possible given the availability of data in a small model
penditures and the balance-of-payments deficit help
(6 endogenous variables and 6 exogenous) like this.
in explaining such spending, but the regression co­
The simulation for 1970 and 1971, presented in Table
efficients are not significant.
III, was on a quarterly basis, but aggregated an­

nually to make it comparable with the results obtained
from the fiscal model. These results are also generally
acceptable with a 10 percent average deviation from
observed figures in first difference. The results for
1971 are not as good as those for 1970, but considering
how atypical that year was in the sample period, the
results are quite encouraging. It should also be noticed
how much the simulation for nominal GDP improves
in this model, with much fewer exogenous variables
than the fiscal.
There are two shortcomings in this model. (1 ) Since
there are no figures on unemployment in Mexico, the
assumption was made that the economy will always
be well below full employment with respect to the
total labor force. But considering only the “skilled”
labor force we could very well conclude that the
Mexican economy often has reached “full employ­
ment.” Therefore, the estimation of the gap between
potential GDP and actual GDP was made on a totally
arbitrary basis. Potential real GDP was measured as
the average standard deviation from the maximum
rate of growth of real GDP in the sample period.

The influence of monetary actions, besides being
large, is also rapid as a three-quarter lag was found
significant. The correlation was reduced when this
lag was increased to 9 quarters.2
It seems that even though the Government is “to­
tally free” to determine its level of expenditures, it
only decides which sector will account for the in­
crease in total spending. If the central bank does not
offset the “normal” rate of growth of the money
supply, given an increased Government deficit, total
spending will continue at its pace — assuming that no
structural changes attributable to the development
process take place.25

24It is surprising how this equation followed the results ob­
tained by Andersen and Jordan for the U.S. economy, but
the nature of the method followed to finance Government
deficits since 1959 in Mexico makes the results more
25Structural changes refer to changes in capital formation,
production, natural resources, population, etc.
Page 17


The models help us conclude that in the develop­
ment process of Mexico the increasing role of the
fiscal sector in economic policy proved healthy in
early stages, making the economy better off than if
the Government had not acted. This was particularly
true in the early stages of Mexican economic de­
velopment when the Keynesian multipliers acted fully.
What remains to be seen is whether the multipliers
will continue to operate in the future as they have in
the past; with this knowledge we will be able to
determine the suitability of existing economic policy
to handle new goals. O f course, this will influence
greatly the conclusions we draw about the effects of
the Government sector’s spending productivity com­
pared to that of the private sector’s, especially at a
time in which more social type spending is necessary
and the stage of heavy infrastructure investment is
almost completed.
The questions that the policymakers will have to
answer can be summarized as follows. Should eco­
nomic policy forget about financing the budget in a
non-inflationary way with the risk of reducing the rate
of spending and eventually that of real economic
growth in the future? Should the Government go
back to financing this deficit with “new” money and
increase spending in an inflationary way? Or should
the Government enter the capital market and com­
pete for funds, thus paying higher rates on its debt
than those now paid to the private banks? The an­
swers to these questions will have to be based on the
long-term goals of economic policy, which in turn will
have to be implemented in the short term. With the
structure developed here the costs of alternative short­
term actions can be approximated.
The 1973 forecast of this model (Table IV ) as well
as that presented for the fiscal model can give an idea
of what large Government deficits financed with new
money could do to the Mexican economy and also
how a very restrictive monetary policy depresses the
economy considerably.

The purpose of this paper has been to develop two
short-term econometric models of the Mexican econ­
omy based on the empirical evidence of the last 15
years. Recent theoretical and statistical developments
in the field of short-term economic policy in industri­
alized countries are applied and evaluated. The mod­
els are framed around the two primary theoretical
approaches to income-expenditure determination —
the fiscal and monetary approaches.

Page 18

JULY 1973

Table IV



(First difference, billions of pesos;
percent increase in parentheses)
Case A
Case B
M o n e y Supply Increase
of 8 billion pesos ( 1 5 % )
Nom inal G D P
Real G D P


M o n e y Su p p ly Increase
of 2 billion pesos ( 4 % )
(1 4 % )
( 4%)

( 10%)
2 ( 10%)

( 3%)

27 ( 5 % )
3 ( 1%)
( 4%)

2 ( 10%)
0.6 ( 2%)

In the fiscal model the hypothesis tested is that
Government expenditures, which are exogenous, have
wide and fast effects on economic activity. In the
monetary model the stock of money is the exogenous
variable assumed to have such effects on economic
The particular way in which the Mexican economy
has evolved in the last 15 years made the experiment
feasible. The conditions of continuous growth in real
GDP with price stability, free convertibility of the
peso, and a rapidly growing financial sector are rare
in developing countries. The absence of such condi­
tions would have introduced severe restrictions in the
Both models utilize data from the 1960-1971 period.
Even though the fiscal model uses annual data and
the monetary model uses quarterly data, the simula­
tion and forecasting results were not substantially dif­
ferent. In spite of great data limitations, both models
perform well in general terms and there seems to be
no considerable contradiction between them. In fact,
both models supplement each other well and facili­
tate the analysis of Mexioan economic policy.
The following conclusions can be drawn from this
(1 ) Government expenditures, although an impor­
tant policy variable, do not affect the level o f total
spending (G D P ); they primarily act as a substitute
for the private expenditure that would have taken
place otherwise, through the “crowding out” process.
(2 ) As mentioned earlier, Government deficits are
financed to a great extent by the private banks,
buying Treasury bills to cover reserve requirements,
and therefore leaving less credit available to the
private sector. Increased taxation has not been used
widely as an offset since it is argued that taxes have
large and potentially perverse allocation effects in the
development process. As a result, the central bank


has seldom expanded the money supply beyond trend
rates to finance Government deficits. Money supply
has been increased at a rate consistent with the
growth of real GDP, thus resulting in a “tolerable”
rate of inflation (3 percent).
(3 ) The money stock, with its large and fast (3
quarters) influence on total spending, is a very im­
portant variable in short-term economic policy.
(4) At high levels of employment (small GDP
gap), increased spending will be reflected rapidly
in higher domestic prices and increased imports.
Therefore, Mexican economic policy faces a trade-off
between growth and price stability. If one of the
two goals is pursued actively, the other will not be
achieved. This trade-off is similar to that implied by
the Phillip’s curve.
(5 ) The balance-of-payments deficit is a built-in
constraint to short-term economic policy because im­
ports respond with an elasticity greater than unity to
changes in the rate of growth of real GDP. The growth
process requires increasing amounts of imports, mainly
of capital goods. Also, imports of consumer goods re­
spond to increased income, while exports depend on
world demand and relative prices for Mexican prod­
ucts vis-a-vis the rest of the world.
(6 ) Large and abrupt changes in policy variables
affect investment, imports, and prices. If real growth
is promoted at very high annual rates (7% or more),
pressures develop on prices and on the balance of pay­
ments. If the inflation and loss of international re­
serves accompanying this procedure are extended for
a long period of time, it will eventually be judged
as an excessive pressure and a contraction in the
policy variables will be recommended. This action will
slow economic activity and, again, if extended for
some period of time, will become “too contractionary”
and another swing in policy will be called for. This
process, when carried out for a period of time, will

JULY 1973

produce uncertainty and imbalance in the forces in­
volved in the economic process.
Based on these conclusions, the following short­
term economic policy guidelines are recommended.
(1 ) Sharp changes in Government expenditures
should be avoided and a stable rate o f growth sus­
tained so that real GDP will increase at about 6 or
6.5 percent — a rate which, historically, is not asso­
ciated with excessive price pressure.
(2 ) Sharp changes in the growth of the money
stock should be avoided. Even if recommendation (1 )
is not met, this would be possible as long as the past
procedure for financing Government expenditures is
continued in the future, or Government expenditure
increases are offset by increases in taxes. If recom­
mendations (1 ) and (2 ) are met, prices will increase
at a moderate rate. Net imports and private invest­
ment will also respond in a desired fashion.
(3 ) Once the economy is put on the “right track,”
the structural problems of employment and income
distribution can be attacked. This will undoubtedly
require additional Government expenditures which, if
financed by the “crowding out” process, will affect pri­
vate investment, and consequently real growth. Even
if the alternative of less real growth would be better
income distribution, the Mexican economy may have
a net gain in the long run and an increase in potential
future growth.
The goal of better income distribution requires ad­
ditional study of the industrialization process, the edu­
cational system, the “dual” agricultural system, and
regional development, to mention just a few of the
areas. It should be clear that any structural changes
can take place only if the short-term goals of the
economy are achieved. In addition, long-term policy
targets must be realized in accordance with the avail­
able policy instruments if the prevailing economic
system is to remain in operation.