Full text of Review (Federal Reserve Bank of St. Louis) : July/August 1988

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3 M onetarism Is Dead; Long Live the
Quantity T h eory
19 Prospects fo r International Policy
Coordination: Som e Lessons fro m
the EMS
30 International Linkages in the Term
Structure o f Interest Rates
44 H ow Much Low er Can the
U nem ploym ent Rate Go?
58 A Com parison o f Proposals to
Restructure the U.S. Financial
System

TH E
FEDERAL
A RESERVE
X liY N k o l

ST. LOUIS

1

F ederal Reserve Bank of St. Louis
Review
July/August 1988

In This Issue . . .




The first article in this Review is the text o f the 1988 Hom er Jones M em o­
rial lecture presented by W illiam G. Dewald o f the U.S. Department o f
State. In 'Monetarism Is Dead; Long Live the Quantity Th eoiy,” Dewald
distinguishes between simplistic monetarism, which he believes “was
w idely interpreted as providing an alternative to short-run Keynesian
m odel forecasts" and “ the Quantity Theoiy, whose focus is on the long
run.”
After an analysis o f long-run relationships and short-run forecasts, De­
wald concludes that w e simply don ’t know enough about the magnitude
and timing o f m onetary effects to fine-tune the econom y effectively in the
short run with m onetary policy actions; consequently, he believes that
“monetarism as a short-run forecasting method should be buried.” He
recom mends that Federal Reserve policy procedure should focus on the
long-run relationship between m oney growth and nominal GNP growth, as
em phasized by the Quantity T h eo iy o f Money, to constrain future in­
flation. Dewald suggests that having the Federal Reserve “target a noninflationary nominal GNP growth path for the five-year federal budget cy­
cle would be a step in the right direction.”
*

*

*

Although econom ic policymakers from the m ajor industrialized econo­
mies have called increasingly for greater coordination o f policies, little is
known about how such coordination might work in practice. To investi­
gate the effects that econom ic policy coordination might have, Michael T.
Belongia, in the second article in this issue, examines the perform ance o f
the European M onetaiy System. This group o f countries has agreed, since
1979, to peg bilateral exchange rates within specified bounds, presumably
to enhance overall econom ic performance. In “Prospects for International
Policy Coordination: Some Lessons from the EMS,” Belongia compares the
performance o f this group o f countries against a group that did not (ex­
plicitly) peg exchange rates. He finds no systematic difference in perfor­
mance, either between groups o f countries or before and after the EMS
was formed. Thus, policy coordination appears to have had no important
influence on econom ic performance, one way or another.
*

*

*

During the past 10 years, considerable controversy has developed over
how interest rates are related across countries. One approach focuses on
the relationship o f interest rates across the maturity spectrum, or term
structure. In this view, movements in current short-term interest rates
influence h ow interest rates w ill change in the future. In the third article
in this Review, “International Linkages in the Term Structure o f Interest
Rates,” Clemens J. M. Kool and John A. Tatom use this approach to study
the relationship o f short- and long-term interest rates for five countries:
the United States, Canada, the United Kingdom, West Germany and Japan.

JULY/AUGUST 1988

2

Kool and Tatom explain the theoretical basis for expecting interest rates
to be connected across countries. They show that long-term rates have
been closely related among the five countries, w hile short-term rates have
not. This finding raises a serious challenge to the term-structure view.
The authors point out that the influence o f changes in foreign short­
term rates on both domestic short- and long-term rates could show up
initially only in the latter rate. They find some evidence that changes in
U.S. short-term rates have had a statistically significant influence on long­
term rates in Canada, Japan and West Germany, but that changes in onemonth interest rates elsewhere are not significant. The relationship from
the United States to other countries is not robust either. Kool and Tatom
conclude that the term structure is not a reliable mechanism connecting
interest rates across countries. Instead, they suggest that changes in inter­
national long-term rates are related directly and quickly because o f rela­
tively com m on inflation rates and real interest rate developments.
*

*

*

In light o f recent declines in the nation’s unem ploym ent rate to below
5.5 percent, Keith M. Carlson, in the fourth article in this Review, examines
the question, H ow much low er can the em ploym ent rate go without accel­
erating inflation? This critical rate, usually referred to as the “natural rate
o f unem ploym ent,” was the subject o f major research in the late 1970s. At
that time, estimates o f the natural rate ranged between 5 percent and 7
percent, but generally centered on 6 percent. Carlson reviews the develop­
ments that have affected the natural rate since W orld War II, focusing on
the period since 1979.
The author notes that the most obvious structural change in recent
years has been the shifting age com position o f the labor force, which has
reduced the natural rate about one-half percentage point below its 1979
level. The minimum wage, individual and em ployer tax rates and, possibly,
unemployment benefits also have m oved favorably. As a result, the current
natural rate appears to be w ell below the 6 percent m idpoint estimated in
1979.

Restrictions on the activities o f banking organizations are being relaxed
by federal and state authorities, and Congress is debating a more com plete
restructuring o f the U.S. financial system. In the final article in this Review,
"A Comparison o f Proposals to Restructure the U.S. Financial System,”
R. Alton Gilbert describes six o f the m ajor proposals for restructuring the
financial system and examines h ow they might affect the returns to share­
holders o f banking organizations as w ell as the potential losses to federal
deposit insurance funds.
Examining various methods o f combining a hypothetical bank and non­
banking firm in the same corporation leads the author to conclude that,
under certain conditions, the expected loss to the insurance funds is
smaller if banks offer nonbanking services directly, rather than through
separate corporate entities. Gilbert also concludes that loans by bank sub­
sidiaries to their nonbank affilitates generally are not in the interest o f the
bank holding company.


FEDERAL RESERVE BANK OF ST. LOUIS


3

William G. Dewald
William G. Dewald is deputy director, Planning and Economic
Analysis Staff, at the Department of State. This paper, the second
annual Homer Jones Memorial Lecture, was presented at St.
Louis University on May 6, 1988. Views expressed are the
author's own and do not represent the U.S. Department of State
or the federal government.

Monetarism Is Dead; Long Live
the Quantity Theory

J n OCTOBER 1979, when the Federal Open Market comm ittee adopted new operating procedures
purported to be directed at control o f monetary
aggregates, newspapers reported that economists
at the Federal Reserve Bank o f St. Louis celebrated.
Many had been hired and inspired bv Hom er
Jones, its form er research director, to whose m em ­
ory this lecture is dedicated. The celebration was
premature.
Those new procedures w ere a cover for genu­
inely restrictive policy actions that reversed the
upward ratcheting o f inflation begun in the 1960s.
It threatened to get out o f hand in 1979. Such a
policy reversal was altogether appropriate, but, as
in earlier episodes, it represented an abrupt shift
in direction made necessary because earlier policy
had taken the econom y so far off course. Whether
or not the Federal Reserve genuinely attempted to
control growth in the m onetary aggregates begin­
ning in 1979, it no longer does. The reason is not
that it could not, but that the relationship between
growth in the aggregates and GNP, and in turn
inflation, appeared so unpredictable. Conse­
quently, in recent years the Federal Reserve has
reverted to manipulating open market purchases
and sales o f securities to hold federal funds rates
or free reserves within target ranges as was the
practice from the 1920s until 1979.



In 1961, soon after leaving the Federal Reserve
Bank o f Minneapolis, I gave a talk there in which I
criticized Federal Reserve operating procedures
for focusing on free reserves or interest rates
rather than growth in the monetary aggregates.
The Federal Reserve was characterized as a base­
ball player w ho can't hit a curve. He swings at
where the ball was, not where it is. The example I
cited was the experience in 1960 when the Federal
Reserve persisted in targeting low er and low er
interest rates even as monetary growth turned
negative and the econom y slipped into recession.
The Chairman o f the Board o f Governors o f the
Federal Reserve in those days was William McChesnev Martin. He likened the role o f monetary
policy to “leaning against the w ind,” the idea be­
ing that m oney market conditions as measured by
interest rates or free reserves w ould tighten during
business expansions and ease during contrac­
tions. In 1988, the Federal Reserve no longer tight­
ens, it snugs. Whatever the name, there is a prob­
lem with this approach. Even if the Federal
Reserve takes no action, interest rates can change
because o f changes in total spending in the econ­
om y and associated credit demands. The risk is
that the Federal Reserve w ill attribute a decline in
interest rates, as it did in 1960, to its policies when
in fact, by not selecting a low enough interest rate

JULY/AUGUST 1988

Chart 1

GNP
Deflator
Pre-1946
0.12

- 0 .0 8

Q uarterly Log G row th, Seasonally A djusted

1910

Chart 2

RealPre-1946
GNP

Q uarterly Log G row th, Seasonally A djusted

- 0 .0 8
-

0.12

1910

Chart 3

Nominal
GNP
n
Pre-1946
0.16

0.08

- 0 .0 8

- 0 .1 6


FEDERAL RESERVE BANK OF ST. LOUIS


Q uarterly Log G row th, S easonally A djusted

5

Post- 945

Q uarterly Log G row th, Seasonally Adjusted

0.12
0.08
0.04

/V

0

- 0 .0 4
- 0 .0 8
50




60

70

1980

-

0.12

JULY/AUGUST 1988

6

target, it sells open market securities and forces a
contraction in m onetary aggregates. As a result,
interest rates are prevented from falling as much
as if no action w ere taken.
There are problems associated with interest rate
targets, but what about monetary targets? My pre­
sentation today addresses w hether the relation­
ship between m onetary growth and GNP has be­
come so unpredictable as to justify the
abandonment o f monetary targets which seems to
have occurred.

MONETARISM AND THE QUANTITY
THEORY
Monetarism, the apparent heir of the Quantity
Theory o f Money, was born in the 1960s. Not only
was the name changed but also the concept. Un­
like the Quantity Theory, whose focus is on the
long run, monetarism was w idely interpreted as
providing an alternative to short run Keynesian
m odel forecasts, a view not always shared by its
progenitors.
The Federal Reserve Bank o f St. Louis equation,
which explained quarterly GNP growth largely as a
function o f monetary growth, became a major
monetarist forecasting tool.' Its simplicity and
apparent reliability captured the one-dimensional
attention o f Wall Street and Washington. GNP
growth was estimated to reflect growth in nar­
rowly defined money, M l, in the current quarter
and the previous year; and it was found to rise
about 3 percent a year independently o f m onetaiy
growth. With hindsight, w e know that this stable
M l velocity trend was peculiar to the period on
which the estimates w ere based, initially the 1950s
and 1960s but then the unfolding 1970s as well.
The Federal Reserve Bank o f St. Louis m odel
went beyond the estimated GNP or demand
growth equation to incorporate potential supply
growth which together determ ined inflation and
unemployment, and a credit market which deter­
m ined interest rates.2By the end o f the 1970s and
into the 1980s, the weekly publication o f M l
changes became a major news event and market

'Leonall C. Andersen and Jerry L. Jordan, “ Monetary and Fiscal
Actions: A Test of Their Relative Importance in Economic Stabi­
lization,” this Review (November, 1968), pp. 11-24.
2Leonall C. Andersen and Keith M. Carlson, "A Monetarist Model
for Economic Stabilization,” this Review (April, 1970), pp. 7-25.
3Meltzer, Allan H. “ On Monetary Stability and Monetary Reform”
in Y. Suzuki and M. Okabe, eds., Toward a World of Economic
Stability (Tokyo: University of Tokyo Press, 1988), pp. 51-74.


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FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

force because these data provided a basis for fore­
casts o f total dem and growth, inflation and inter­
est rates.
The problem with the simplistic monetarism
that afflicted Wall Street and Washington was that
it accepted Milton Friedman's dictum that in­
flation is always and everywhere a monetary p h e­
nom enon but not his stipulation that lags are long
and variable.
M y point today builds on this theme. Monetary
policy actions are appropriately directed at longrun stability o f the general level o f prices but not
at offsetting undesired short-term movements in
total demand, unemployment, or, for that matter,
prices. I shall argue that w e know enough to keep
inflation trends within bounds but not enough to
fully stabilize the price level let alone the business
cycle. A corollary is that monetarism as a shortrun forecasting m ethod should be buried; but the
Quantity Theory, defined as the predictability of
GNP growth on the basis o f growth in the m one­
tary aggregates, should be recognized as the cor­
rect principle for controlling inflation in the long
run; and Federal Reserve operating procedures
should be made consistent with that principle.

SHORT-TERM FORECASTS
Let me make a few remarks about short-term
forecasts. None are very good for very long. Based
on Federal Reserve “green” books, Allan M eltzer
reports that the Federal Reserve's record o f fore­
casting nominal GNP growth a year ahead over the
period 1967 through 1982 had a root mean square
error equal to about 60 percent o f average nominal
GNP growth.3 Since GNP growth averaged about 10
percent a year, the forecast error is 6 percentage
points, indicating that one-third o f the time fore­
casts w ould miss bv more than 6 percentage
points and half the time by more than 4 percent­
age points. Furthermore, and most important, the
Federal Reserve forecasts w ere way off track, miss­
ing average growth by more than 5 percentage
points, the result o f the Federal Reserve persist­
ently underestimating GNP growth during a pe­

7

Chart 4

Federal Debt and Deficit Ratios to GNP

riod o f a rising inflationary trend. These striking
results are confirm ed in an analysis o f Federal
Reserve forecasting that Karamouzis and Lombra
presented at the Carnegie-Rochester Conference
last month.4They found that the Federal Reserve
forecasts systematically underpredicted GNP
growth during expansions and overpredicted dur­
ing contractions. According to Meltzer, private
forecasters have had a somewhat better record
than the Federal Reserve, but one still is talking
about errors o f 4 percentage points a third o f the
time and nearly 3 percentage points, half the time.
Since inflation is such a lagging factor, changes in
nominal GNP growth are initially translated into
real growth changes. Hence, errors o f 3 percentage
points or more in real GNP growth half the time
translate into being unable to distinguish reliably

between a boom and a recession in either the
current quarter or a year ahead.
M eltzer was mainly summarizing the perfor­
mance o f non-monetarist forecasts, but one can
make at least as critical remarks about monetarist
short-term forecasts in the 1980s. Like many an­
other forecaster, M ilton Friedm an’s record is
blemished. For example, he forecast a recession
that didn’t materialize in 1984 and an equally illu­
sory inflation in 1986. In 1988, not only Friedman
but others o f comparable persuasion are w orried
about the consequences o f the contraction in
monetary growth in 1987.
I too am concerned, though it is worth m ention­
ing, as Jim Meigs, an early colleague o f Hom er
Jones at the Federal Reserve Bank o f St. Louis, has

“Karamouzis, Nicholas and Raymond Lombra “ Federal Reserve
Policy Making: An Overview and Analysis of the Policy Pro­
cess," Carnegie-Rochester Conference Series on Public Policy,
forthcoming.




JULY/AUGUST 1988

8

Chart 5

Money: M1 and M1a
Pre-1946

Quarterly Log Growth, Seasonally Adjusted

Chart 6

GNP/Money: Various Measures
Pre-1946

Quarterly Log Growth, Seasonally Adjusted

rem inded me, that Hom er was suspicious about
all short-term forecasts, including those based on
monetary growth. It was his persistent question­
ing that created the flurry o f econom etric work
about monetary relationships for w hich the Fed­
eral Reserve Bank of St. Louis becam e famous.

HISTORICAL RELATIONSHIPS: THE
BROAD PICTURE
The historical relationship between monetary
growth and spending confirms Jones’ suspicion.
Let me present some charts which put the experi­
ence o f the 1980s in perspective.
Chart 1 records inflation in the United States
since 1907, with 1907-45 and 1946-87 plotted sep­

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arately. The blue-shaded areas identify reces­
sions. Quite clearly inflation was a lot m ore vari­
able in the initial period, though, because o f
deflations during recessions in the earlier period,
there was no sustained inflation trend as there
was in the second period.
Chart 2 plots the real GNP growth rate — a mea­
sure o f growth in the real supply o f goods and
services. Though it averaged about 3 percent a year
both before and after the end o f 1945, the magni­
tude o f the booms and busts was much greater in
the earlier period. Since real growth averaged
about as much in each period, it follows that the
inflation uptrend in the second period was an
aggregate demand not an aggregate supply phe­
nomenon.
Chart 3 presents the nominal GNP growth rate

9

Quarterly Log Growth, Seasonally Adjusted

Post-1945

0.20
0.15
0.10

0.05

vA,^v-v Wj

0

M1a

M1 (Fed. Res.)

- 0 .0 5
-

50

60

— a measure o f growth in nominal dem and for
goods and services. Though most values are posi­
tive, there are some big negatives in recessions
through 1960. Since then there has been slowed,
not negative, GNP growth during recessions be­
cause w e have had considerable inflation even in
recessions. In terms of proximate causes, Chart 3
shows that slowed GNP growth has always been
associated with slowed real growth in recessions,
and accelerated GNP growth w ith accelerated real
growth in expansions. Thus, decreased variability
in real growth in the post-World W ar II period is
linked to less variability in nominal GNP growth.
What about sources o f nominal GNP growth?
Conventional wisdom to the contrary, the timing
o f government spending and tax changes is not



70

1980

0.10

- 0 .1 5

systematically correlated with GNP growth. The
1980s provide a good example. Fiscal policy by
every measure was expansionary, yet nominal
GNP growth contracted.
Chart 4 plots the ratio o f nominal federal debt
held by the public to nominal GNP. There is a
nominal deficit if the debt rises, but a real deficit
only if the debt rises faster than inflation. An in­
crease in the debt to GNP ratio reflects the real
deficit rising faster than real growth. The historical
record shows that real deficits relative to real GNP
did not amount to much before W orld War I. Big
real deficits occurred in both W orld Wars, the
early 1930s, and since 1980. Since nominal GNP
growth accelerated in the wars but decelerated in
the 1930s and 1980s, there is no consistent rela-

JULY/AUGUST 1988

10

Chart 7

M2

Chart 8

GNP/Money: Various Measures
0.20

Pre-1946

Q uarterly Log G rowth, Seasonally Adjusted

tionship. Furthermore, in the 40 years since the
end o f W orld War II, there have been nine busi­
ness cycle expansions and in only one — the cur­
rent one — did real deficits rise significantly rela­
tive to GNP. Perhaps these official debt figures are
the w rong ones to look at because they do not
incorporate discounted values o f future entitle­
ments and tax receipts. Others might find what
they are looking for in these data, but I conclude

5M1 includes currency and demand deposits; M1A omits de­
posits that pay interest; M2 adds small time and savings de­
posits, overnight repurchase agreements and Eurodollar de­
posits, and, since 1959, shares in thrifts and money market
mutual funds.


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that there is no consistent relationship between
fiscal deficits and GNP growth.
Charts 5 and 6 present the growth rates o f the
monetary aggregates: M l, M IA and M2.5The rec­
ord shows that m ajor increases in GNP growth in
W orld Wars I and I I w ere accom panied by both
accelerated monetary growth and rising fiscal
deficits, and postwar contractions in GNP growth
by the reverse movements. Nonetheless, there are

11

many instances w hen fiscal and m onetary actions
pushed in opposite directions. This divergence
permits identification o f which is the dominating
factor affecting GNP growth. In the early 1930s, real
federal deficits ballooned but monetary growth
collapsed. So did GNP growth. In the 1960s and
1970s, real deficits grew less than real GNP if at all.
Monetary growth increased and so did GNP
growth and inflation. In particular episodes, such
as 1966-67 w hen real deficits went one w ay and
total spending growth the other, it was monetary
growth that tipped the balance.
Charts 7 and 8 present the growth rates in M l
and M2 velocities. By definition, velocity growth is
GNP growth in excess o f m onetary growth. The



charts reveal h ow steadily M l velocity increased in
the 1950s through the 1970s, and how ragged its
changes in eveiy other period. The charts also
show h ow M2 velocity remained largely trendless
in comparison with M l velocity which dipped in
the 1930s but then rose persistently after 1945
until the 1980s. Note well that in eveiy recession
both M l and M2 velocities fell so that to cushion
GNP growth w ould require faster monetary
growth. In the worst recessions, including 1981—
82, m onetary growth did not accelerate as velocity
growth slowed; and in the worst inflations, includ­
ing the late 1970s, monetary growth did not decel­
erate as velocity speeded up. Hence, monetary
growth has often been an ineffective counterbal­
ance to moderate excesses in GNP growth.

JULY/AUGUST 1988

12

Table 1
Average Forecast Errors and Changes in Economic Trends
(weighted least squares)
M1 (1924:4-1987:1)
R2
Constant
Inflation
Real Growth
Interest Rate
Degrees of Freedom

0.30
-1 .0
0.4
-0 .1
0.1

( - 0 .5 )
(1.3)
( - 0 .3 )
(0.3)
9

0.29
-1 .0
0.5
-0 .2

( - 0 .5 )
(1.9)
( - 0 .7 )
—
10

0.26
-1 .0
0.5

( - 0 .5 )
(2.0)
—
—
11

M2 (1919:2-1987:1)
R2
Constant
Inflation
Real Growth
Interest Rate
Degrees of Freedom

0.43
-0 .1
0.4
0.1
-0 .1

( - 0 .1 )
(2.5)
(0.7)
(- 0 .4 )
11

0.42
-0 .1
0.4
0.2

( - 0 .1 )
(2.8)
(1.2)
—
12

0.35
-0 .1
0.4

( - 0 .1 )
(2.6)
—
—
13

T-statistics in parentheses. Independent variables are changes from the last business cycle average
in the estimation period to the average for the forecast period.

HISTORICAL RELATIONSHIPS:
SPECIFIC FORECASTS
William Gavin and I have been studying the
quality o f quarterly GNP forecasts based on the
monetary aggregates.6Though there are many
studies that have examined the post-World War I I
period, w e were interested in a broader historical
experience. Our focus was on out-of-sample fore­
casts — the kind needed to direct monetary aggre­
gate changes to achieve a desired GNP growth
path. Quarterly GNP growth forecasts for each
business cycle w ere based on estimates o f the
relationship between GNP growth and four quar­
terly lags o f monetary growth for the three preced­
ing cycles, that is, a m odified St. Louis equation.
On the average, both M l and M2 changes were
estimated to change GNP growth roughly propor­
tionally w hile velocity trends w ere significant in
relating M l but not M2 to GNP. Overall there were
15 forecast intervals for M2 but only 13 for M l
because there was no quarterly information about
the split between demand and time deposits be­
fore 1914. The first forecast for M l was the busi­
ness cycle 1924:4 - 1927:4.
6Gavin, William T., and William G. Dewald, “ Velocity Uncertainty:
An Historical Perspective,” U.S. Department of State, Bureau of
Economic and Business Affairs, Planning and Economic Analy­
sis Staff Working Paper 87/4, November 1987. Gavin was an
economist at the State Department in 1987 on leave from the
Federal Reserve Bank of Cleveland.


FEDERAL RESERVE BANK OF ST. LOUIS


There are many factors that influence GNP
growth. Consequently, in our single equation
models that relate GNP growth solely to m onetary
growth, w e expected that shifts in the econom y
including m onetary policy reactions to econom ic
performance w ould lead to biases in the forecasts.
For example, w e expected that low er interest rates
in a forecast period w ould decrease velocity and
reduce GNP growth relative to monetary growth.
To measure the effect o f such shifts, w e regressed
average forecast errors on changes in inflation,
interest rates and real growth from the last busi­
ness cycle in the estimation interval to the average
observed in the forecast cycle.

As noted, there was a large decrease in the vari­
ance o f forecasts from the pre-1946 to the post1945 period. To account for such heteroscedasticity, w e weighted observations by the expected
standard deviation o f the mean forecast errors and
then used ordinary least squares to estimate ef­
fects o f shifts in inflation, interest rates and real
growth trends on forecast errors. Table 1 presents
the results. The only consistent link to forecast

13

errors was change in the inflation trend, not inter­
est rates, and not real growth.
Gavin and I also examined cross-countiy evi­
dence. The results appear in table 2. W e estimated
the relationship between annual GNP growth and
current and lagged M l growth for 39 countries for
the late 1950s through 1979. GNP growth forecasts
for each countiy were made for 1980-84. As in our
U.S. time series analysis, these cross-country GNP
forecast errors w ere strongly correlated with
changes in inflation trends, even excluding out­
liers such as Bolivia, Brazil, Mexico and Peru that
had huge inflation accelerations in the 1980s.
Why the consistent link to shifts in inflation
trends? Look at chart 9. It is apparent that w ide
swings in interest rates over the business cycle
w ere not closely related to M l velocity movements.
Furthermore, since real growth averaged about the
same before as after the end o f 1945, one cannot
attribute the persistent rise in M l velocity until
1982 to that source. Rather, the rise in M l velocity
after 1945 was associated with a persistent rise in
the inflation trend.

Table 2
Average Forecast Errors and Changes
in Inflation Trends (M1 models only
for 39 countries)
_________
All countries
R2
Constant
Inflation
Degrees of Freedom

0.7
0.8
0.3 (9.0)
37

Excluding outliers
0.2
0.6
0.3 (2.4)
33

Countries: Australia, Austria, Belgium, Bolivia, Brazil,
Canada, Colombia, Denmark, Dominican Republic, Ecuador,
El Salvador, Finland, France, Greece, Guatemala, Honduras,
Iceland, Ireland, Italy, Japan, Mexico, Netherlands, New
Zealand, Norway, Paraguay, Peru, Philippines, Portugal,
South Africa, Spain, Sri Lanka, Sweden, Switzerland,
Thailand, Turkey, United Kingdom, United States,
Venezuela, West Germany.
Sample periods vary because of data availability but are
approximately 1957-84.

Chart 9

Interest Rates and GNP/M1




JULY/AUGUST 1988

14

Chart 10

Interest Rates and GNP/M2
Velocity

4-6 month commercial paper

Chart 10 reveals a much weaker association
between M2 velocity and interest rates and much
less o f a trend. The shift in the series is attribut­
able to a redefinition o f M2 in 1959 to include a
variety o f non-bank liabilities that were not in the
Friedman and Schwartz definition.
Chart 11, w hich plots only recent data, reveals a
close relationship between M2 velocity and the
Treasury bill rate less a calculated w eighted aver­
age own-rate on M2.7Depository institutions re­
spond to persistent changes in market rates by
altering deposit rates, but, even when uncon­
strained by deposit interest ceilings, adjustments
are not that quick or complete. Since the post-war
ratcheting up o f interest rates reflected an uptrend
in inflation, it follows that lags in setting deposit

7Moore, George, Richard Porter, and Dave Small. “ Modeling the
Disaggregated Demands tor M2 and M1 in the 1980s: The U.S.
Experience,” Federal Reserve Board Conference on Monetary
Aggregates and Financial Sector Behavior in Interdependent
Economies (forthcoming).


http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

Interest rates

interest rates led to rising opportunity costs of
holding M2 balances and to increased M2 velocity
when inflation trended up strongly as in 1978—80.
In the opposite circumstances when inflation
trended dow n strongly as in 1982-87, falling op ­
portunity costs o f holding M2 balances decreased
M2 velocity. Something similar was going on in
earlier years too. Thus, Gavin and I found that
shifts in inflation trends, but not interest rates,
w ere consistently tied to errors in GNP growth
forecasts based on not only M l but also M2
growth.
Table 3 presents the average GNP growth fore­
cast errors for full cycles based on M l and M2
growth. Neither totally dominates the other
though M2 m odels were best on average and in

15

Chart 11

M2 Velocity vs M2 Opportunity Costal

11 Standardized Values

the current cycle. Our finding that forecast errors
are smaller for M2 than for M l or M IA but not by a
large margin suggests robustness to the choice of
the monetary aggregate.8W e also looked at the
monetary base and found that M2 models pro­
vided the best forecasts on average for both 1907—
45 and 1946-87.
Turning again to table 3, some forecast errors
are huge. Root mean square errors average 17 to 18
percent in the pre-1946 period, though only about
6 percent in the post-World War I I period. Bv the
standards that M eltzer discussed, such errors are
comparable to Federal Reserve forecast errors in
the “green" book. An inference is that attempts to
fine tune GNP growth by controlling either M l or
M2 growth w ould miss GNP growth targets by
more than 6 percentage points one-third o f the

time and by 4 percentage points half the time.
What was said about not being able to distinguish
boom from recession holds for our forecasts just
as for the Federal Reserve's. However, there is a
difference. The average forecast error associated
with our simple relationship o f monetary growth
to nominal GNP growth appears to be w ell under
the reported average errors in Federal Reserve
“green” books that M eltzer reported.

OPERATIONAL ISSUES
The operational question is what to do in the
short run to achieve a long-term inflation objec­
tive. Suffice it to say that the Federal Reserve need
not iron out every wrinkle in monetary growth to
eliminate inflation trends, but it is necessary to tie

8For a different opinion, see Michael R. Darby, Angelo R. Mas­
cara, and Michael L. Marlow. ‘‘The Empirical Reliability of Mon­
etary Aggregates as Indicators,” Research Paper No. 87 (U.S.
Department of the Treasury, 1987).




JULY/AUGUST 1988

16

Table 3
GNP Growth Forecast Errors Annual Rates of Percent Change
Business
cycles
1924:4-1927:4
1928:1-1933:1
1933:2-1938:2
1938:3-1945:4
Average
Pre-1946

Root mean square errors

Average forecast errors
M1

M1A

1.8
-5 .9
- 1 .8
- 6 .6
-3 .1

M2

BEST

M1

0.1
1.0
5.3
-0 .1

M2
M2
M1
M2

1.5

M1A

M2

BEST

10.3
15.1
28.1
17.5

9.6
13.6
26.3
18.5

M2
M2
M2
M1

M2

17.7

17.0

M2

4.7
- 1 .3
- 2 .9
- 3 .0
0.6
-0 .1
1.6
- 1 .7
- 2 .3

M2
M1
M1
M1
M2
M2
M1
M2
M2

11.1
7.0
4.4
5.4
4.4
3.7
3.7
7.6
8.6

8.8
7.8
6.1
5.9
3.0
4.1
4.5
6.5
4.3

M2
M1
M1
M1
M2
M1
M1
M2
M2

1946:1-1949:4
1950:1-1954:2
1954:3-1958:2
1958:3-1961:1
1961:2-1970:4
1971:1-1975:1
1975:2-1980:3
1980:4-1982:4
1983:1-1987:1

8.8
0.2
- 0 .6
0.3
- 2 .0
0.3
1.2
-2 .6
- 6 .6

Average
Post-1945

-0 .1

- 0 .5

M1

6.2

5.7

M2

Overall
Average

- 1 .0

- 0 .3

M2

9.8

9.1

M2

1.9
4.8
-3 .2

4.0
11.1
4.9

monetary growth to real growth over the medium
term to avoid the kind o f disturbances that shifts
in inflation trends engender. The Federal Reserve
needs to adopt systematic operational procedures
to shift its policy targets on the basis o f observed
deviations o f GNP growth from desired levels.

growth even as it supplied funds to support accel­
erating monetary growth w hich was reflected in
accelerating inflation, higher interest rates, an
increasing velocity trend and unexpectedly large
GNP growth. Could that sad cycle have been
avoided?

One way w ould have the Federal Reserve set a
GNP growth target equal to long-term real growth
plus an inflation target, perhaps zero in the long
run but not unreasonably only a partial step in
that direction in any one period. The point is not
to set m onetary targets on the basis o f short-run
forecasts o f what real and nominal GNP growth is
predicted — I hope I have made clear how errorprone such forecasts are — but rather on the basis
o f long-run real growth projections plus an in­
flation goal, not a current GNP forecast.9

Suppose in 1978, to pick a year, the Federal Re­
serve had aimed at 3 percent real growth — the
long-term average — and an inflation target 2 per­
centage points below the 6.8 percent inflation in
1977. Target GNP growth for 1978 w ould have been
7.8 percent; for 1979, 5.8 percent; 1980, 3.8 percent;
1981 and thereafter, 3 percent — the long-term
average real growth rate.

Such a procedure in the 1970s w ould have led
to very different results from what w e got. The
Federal Reserve persistently underforecast GNP
9A somewhat similar proposal is found in Bennett McCallum.
“ Robustness Properties of a Rule for Monetary Policy,”
Carnegie-Rochester Conference Series on Public Policy, Vol.
29, forthcoming.


FEDERAL RESERVE BANK OF ST. LOUIS


Fourth-quarter-over-fourth-quarter GNP growth
in 1978 was 14.8 percent, not 7.8 percent. GNP
growth stayed high: 9.5 percent in 1979 and again
in 1980. Inflation accelerated: 7.7 percent in 1978,
8.5 percent in 1979 and 9.4 percent in 1980. Part of
the problem was rising velocity, but the problem

17

was com pounded because the Federal Reserve
validated the inflation process by an open market
policy that permitted monetary aggregate growth
o f no less than 7 percent in any o f those years and
by as much as 11 percent. It was not distinguish­
ing between the w ind it was leaning against and
the thrust o f its ow n actions.
One cannot be certain about velocity m ove­
ments in the short run but in the circumstances of
the late 1970s with a rising inflation trend, one
could have anticipated rising velocities. By what­
ever means the Federal Reserve might have chosen
to control its open market operations — targeting
free reserves, federal funds rates, or monetary base
injections — over the course o f those years it
w ould have had to take actions to restrict m one­
tary growth to prevent inflation from accelerating.
What was required in 1978, if not sooner, was a
genuinely restrictive policy such as w e finally got
in 1980-81. That policy arrived too late to avoid
enormous econom ic destruction. Inflationary
expectations had becom e entrenched in market
contracts denom inated in dollars. The costs of
disinflation: the worst recession since the 1930s,
an overhanging burden o f domestic and interna­
tional debt accumulated on the basis o f mistaken
price expectations, and a legacy o f uncertainty
about whether it might not happen again.

WHY NOT TARGET NOMINAL GNP
GROWTH?
It is my contention that putting a GNP target up
front for the Federal Open Market Committee to
aim at w ould allow it to m obilize its staff to design
the best w ay to keep monetary growth and GNP
growth dow n w hen such a course is obviously
right as it was in the late 1970s. There is doubt­
lessly an element o f discretionary fine-tuning in
GNP targeting, but with a twist. Deviations from
the target nominal GNP path should induce Fed­
eral Reserve actions to move monetary growth up
or down in order to bring forecast GNP growth
back to a long-run non-inflationary path. Perhaps,
there should be some limit on how much change
in targeted GNP to be permitted in a particular
period. In any case, to avoid getting off track as in
the 1970s, the Federal Reserve has to direct its
considerable powers toward controlling inflation
trends by actions that push m onetary growth in
the right direction w hen nominal GNP growth is
off target.



CONCLUSION
To eliminate inflation trends, m onetary growth
must be kept lo w on average and close to real
growth trends. Extraordinary increases as in 197779 or 1985-86 ought to be avoided so that offset­
ting decreases are not necessitated; but the past is
history. What about the future? Certainly w e want
to avoid another cycle o f inflation and disinflation.
By luck or design the Federal Reserve in 1987 and
early 1988 has pursued policies that are not so
different from what I have suggested. Monetary
aggregates are grow ing at about 4 percent annual
rates, close to appropriate rates to bring inflation
down gradually toward zero. I w ould hope that
the lessons o f history could be applied to stay on
such a path.
A positive reform to make clear the responsibili­
ties o f the Federal Reserve regarding long-term
inflation w ou ld be to bring it into the federal
budget process. Have it announce nominal GNP
targets each year on w hich to base Administration
budget projections over the ensuing five fiscal
years. Both GNP growth and inflation are critical to
the budget w ith respect to tax receipts and ex­
penditures, particularly interest outlays. W hy have
the Administration make arbitrary assumptions
about GNP growth and inflation as it does now
when the Federal Reserve, whose powers are so
important in determining nominal magnitudes,
could target such values and be held accountable
for attaining them? It should take responsibility
for what it can control in the medium term —
nominal spending growth and inflation — and not
play meteorologist by leaning against the uncer­
tain winds o f the business cycle.
Can w e devise ways to create the right incen­
tives for Federal Reserve officials to pursue poli­
cies to keep inflation low? The Germans and the
Japanese have. In contrast to their success in
keeping inflation low, w e have gone through the
motions o f having the Federal Reserve announce
monetary target ranges to Congressional Oversight
Committees beginning in 1975, and since then the
worst cycle o f inflation and disinflation since
W orld War II. Setting medium-term targets for GNP
growth as I have recom m ended w ou ld establish a
new responsibility. However, unless the monetary
authorities shoulder that responsibility by taking
actions to stabilize nominal GNP growth around a
medium-term non-inflationary path, nothing
w ould be gained. Establishing yet another target
range w ould make sense only if deviations from it
induced stabilizing policy reactions.

JULY/AUGUST 1988

18

Perhaps, the Federal Reserve must be put on a
shorter leash? We could specify a legal limit to the
monetary base that the Federal Reserve was au­
thorized to put into circulation in a fiscal year.
Budget authority is required for the Treasury to
spend, w hy not for the Federal Reserve? Then
again, it might be somewhat unrealistic to count
on Congress to check the inflationary tendencies
o f the Federal Reserve. An even shorter leash has
been suggested bv Milton Friedman (and not in
jest). He w ould disband the Federal Open Market
Committee and hire a federal em ployee to pur­
chase Treasury securities each week as specified
by law to keep some monetary aggregate on a
long-term zero inflation course. Despite the
budget savings in his proposal, w ide variation in
velocities historically suggests that w e might do
better than fixing a monetary growth rate in per­
petuity.
The fact is that broadly stabilizing monetary
policies have been observed on occasion in his­
tory. Even during the past decade, some countries
have managed their affairs to avoid the worst ex­
cesses o f inflation and disinflation that w e and
many others experienced. W e can’t repeat history,
but w e ought to learn from it. In the light o f the
contribution o f Federal Reserve actions to instabil­
ity in m onetary growth, nominal GNP growth and
inflation, having it target a non-inflationary nom i­
nal GNP growth path over a five-year federal
budget cycle would be a step in the right direc­
tion. Responsibility for control o f inflation w ould
be assigned to the institution that has the most
direct pow er to influence nominal GNP growth
and, in turn, inflation. For nominal GNP targeting
to succeed in eliminating inflation trends, how ­
ever, Federal Reserve officials must have the un­
derstanding and courage to support the necessary


FEDERAL RESERVE BANK OF ST. LOUIS


policy actions to get back to a non-inflationary
GNP growth path whenever the target is missed. If
they did im plement such a policy, they w ould not
likely eliminate all the ups and downs in the econ­
omy, but they w ould avoid repeating the most
egregious mistakes o f m onetary history.

DATA SOURCES
Data used in preparing the charts and statistical study sum­
marized in this lecture came from a variety of sources.
M1 and M2 for May 1907 to December 1958 from Milton Fried­
man and Anna Jacobson Schwartz, A Monetary History of the
United States: 1867-1960, (Princeton University Press, 1963);
and January 1959 to March 1987 from the Board of Gover­
nors of the Federal Reserve System. Values of M1 were
semi-annual until June 1914 and were used in constructing
the charts.
Monetary base for May 1907 to December 1918 from Friedman
and Schwartz; and January 1919 to March 1987 from the
Federal Reserve Bank of St. Louis, adjusted for required
resen/e ratio changes but not seasonality. The Census X-11
program in SAS was used to seasonally adjust these monthly
data from which quarterly averages were calculated.
Commercial paper rate for May 1907 to December 1970 from
Board of Governors of the Federal Reserve System, Banking
and Monetary Statistics, 1976; and January 1971 to March
1987 from the Federal Reserve Bulletin. Quarterly averages
were calculated from the monthly series.
GNP and GNP deflator for 1907:Q2 to 1947:Q4 from Robert J.
Gordon, “ Price Inertia and Policy Ineffectiveness in the United
States, 1890-1980,” Journal of Political Economy (December
1982), 1087-1117; and 1948:Q1 to 1987:Q1 from the Depart­
ment of Commerce, Bureau of Economic Analysis.
All computation were performed on an IBM AT using RATS
PC version 2.0 or LOTUS version 2.01.
Data from different sources were spliced by transforming the
early series to growth rates and computing revised level series
based on actual levels of the most recent series.
The original data used in the Gavin and Dewald study are
available from the author on a LOTUS spreadsheet upon re­
quest with an accompanying 51/4 inch diskette and a stamped,
self-addressed disk mailer.

19

Michael T. Belongia
Michael T. Belongia is a research officer at the Federal Reserve
Bank of St. Louis. Anne M. Grubish provided research assistance.

Prospects for International
Policy Coordination:
Some Lessons from the EMS
"Altogether, then, econom ic co-operation is no match for m otherhood.”
Clive Crook, The E conom ist

H E strong rise in the value o f the dollar in the

early 1980s and its sharp decline since February
1985 are alleged to have had wide-ranging effects
on the econom ies o f the United States and its ma­
jor trading partners. In response to concerns
about the costs o f adjusting to large exchange rate
movements specifically and the effects o f diver­
gent econom ic policies generally, policymakers
have called for greater coordination o f econom ic
policies among the w o rld ’s m ajor industrial coun­
tries.1But, despite the stated official desire for
greater policy coordination, little is certain about
how it might work in practice. Some theoretical

'At the September 1985 Plaza Accord, for example, the G-5
countries agreed to coordinated intervention policies that would
reduce the value of the dollar. Since that meeting, there have
been subsequent economic “ summits” to discuss both target
values for exchange rates (the Louvre Accord of February
1987) and indicators by which policies could be monitored (the
June 1987 Venice Summit). Both the Bank for International
Settlements (BIS) and the OECD have called for greater fiscal
policy cooperation, with lower budget deficits in the United
States and expansionary policies in Japan and Germany. See
Bank for International Settlements (1987) and Organization for
Economic Cooperation and Development (1987).
2Models using game theory have tended to conclude that policy
cooperation will produce lower social welfare losses than non­




results suggest that there are potential gains from
coordinated policy actions; these results, however,
are not robust.2
One example o f an explicit agreement for policy
coordination is the European Monetary System
(EMS). Established in 1979, the EMS was form ed to
stabilize bilateral nominal exchange rates among
m em ber countries. Because it is difficult to iden­
tify the direct benefits o f more stable exchange
rates per se, analysts typically have discussed the
potential benefits o f such coordination in terms of
increased trade flows, faster real growth and pol­
icy convergence among m em ber nations.

cooperative policies. Some empirical work has provided evi­
dence that supports the game theory results; see Currie and
Levine, for example. It should be noted, however, that both lines
of work are based on arbitrary social welfare functions and the
existence of a benevolent policymaker. The public choice litera­
ture, in contrast, suggests that the wealth of the policymaker
dominates social objectives as a criterion for choosing particular
policy paths. If true, a quite different loss function would apply to
policy choices. More generally, the game-theoretic results
depend heavily on the loss function specified. Fischer (1987)
and Frankel and Rockett (1987) also have shown that the
results depend importantly upon the economic models used to
evaluate policy effects.

JULY/AUGUST 1988

20

As the one case in which some form o f explicit
cooperation has been adopted, the EMS offers an
opportunity (and data) to examine its effect on a
variety o f econom ic indicators. This article reviews
the econom ic experience o f EMS countries relative
to non-EMS countries during the 1980s to see
whether exchange rate coordination has been
associated with differential gains in other m ea­
sures o f econom ic well-being as well as to draw
inferences about the likely effects o f policy coordi­
nation on a greater scale by the industrial econo­
mies.

THE EMS: AN OVERVIEW
The EMS, w hich was established formally on
March 13,1979, was first com posed o f the nine
European Community (EC) countries: Belgium,
Denmark, France, West Germany, Ireland, Italy,
Luxembourg, The Netherlands and the United
Kingdom. Greece, which subsequently joined the
EC, became an EMS partner in 1985 but Spain and
Portugal, w hich joined the EC in 1984, have not yet
becom e members o f the EMS. Briefly, EMS m em ­
bership requires each nation first to deposit 20
percent o f its gold and gross dollar assets with the
European Monetary Cooperation Fund (EMCF). In
exchange, each nation receives an equivalent
amount o f European Currency Units (ECUs),
which serve primarily as a unit o f account for EMS
functions (see Appendix). This asset exchange,
however, is not so much a separate part o f joining
the EMS as it is a preliminary step to pursuing the
System s objectives.3The second part o f EMS
membership involves the agreement to pursue
stable nominal exchange rates, at agreed levels, for
each bilateral set o f rates. One rationale for this
policy objective is that exchange rate variability is
a source o f uncertainty that reduces trade and the
traded goods sector is a large portion o f each EMS
member econom y.4
Although exchange rate objectives are “set,” the
EMS is not strictly a fixed-rate system; adjust­

3A detailed summary of the ECU, as well as the evolution of the
EMS, is in Lingerer, et al. (1986). Karamouzis (1987) presents a
shorter overview of the system and policy coordination.
“Both the theoretical and empirical evidence on a link between
exchange rate variability and trade are ambiguous. DeGrauwe
(1987,1988), for example, provides evidence suggestive of a
negative effect. Many others, surveyed in Farrell, et al. (1983),
find no significant relationship between measures of exchange
rate variability and trade. And, moving in the opposite direction,
Franke (1987) provides theoretical reasoning for a positive
relationship between exchange rate variability and trade. On
balance, however, the predominant result seems to be that
there is no important relationship between the two variables.


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ments to the exchange rate levels have been made
from time to time.5For example, in a major ex­
change rate realignment in March 1983, the
French franc, Italian lira and Irish pound w ere
devalued between 2.5 percent and 3.5 percent,
while the remaining currencies w ere revalued
between 2.5 percent (Danish krone) and 5.5 per­
cent (German mark). As the IMF explains:
Like previous realignments, this realignm ent had
becom e necessaiy as a result o f continued differ­
ences in the underlying strength o f the participat­
ing countries’ external positions, w hich reflected
in turn divergences in econ om ic policies and costprice perform ance. These differences had gen er­
ated expectations o f exchange rate changes and
led to large speculative capital flows."

Similarly, in 1985, the lira was devalued 6 percent
and other currencies revalued 2 percent when
[t]he worsening o f the current account reflected
prim arily the m aintenance o f a rate o f grow th in
dom estic dem and higher than that o f Italy’s part­
ners as w ell as the lagged effects o f a significant
loss o f com petitiveness vis-a’-vis other EMS coun­
tries over the previous tw o years .7

Thus, when fundamental differences in econom ic
performance require changes in the established
exchange rate targets, the EMS has revalued them.
Table 1 shows the dates o f these revaluations and
their effect on individual currencies.
Between revaluations, bilateral rates are allowed
to vaiy within margins o f 2.25 percent o f the d e­
sired values; because Italy historically has had
higher rates o f inflation than the other EMS coun­
tries, the lira has a band o f 6 percent. Should bilat­
eral rates violate these margins, however, the cen­
tral banks in control o f the two currencies are
expected to intervene in foreign exchange markets
in amounts necessaiy to bring the rates back into
the agreed-upon ranges.8
The foregoing discussion represents a simple
characterization o f EMS policy coordination. The
most important exception to this characterization
for this study is that, although the U.K. exchanged

5Ungerer, et al., table 10.
6lbid, p. 12.
7lbid, p. 13.
8See Ungerer, et al., pp. 4-8, for a discussion of how interven­
tions are conducted by the central banks of nations that partici­
pate in the exchange rate mechanism (ERM).

21

Table 1
EMS Realignments: Percentage Changes in Bilateral Central Rates
German
mark
1979 9/24
11/30
1981 3/23
10/5
1982 2/22
6/14
1983 3/21
1985 7/22
1986 4/7
8/4
1987 1/12

Belgian
franc

Danish
krone

French
franc

Irish
pound

Italian
lira

Dutch
guilder

-6
-3

+ 5.5

-2 .8 6
-4 .7 6

+2

-3

+ 5.5
- 8 .5

-3

+ 4.25
+ 5.5
+2
+3

+ 1.5
+2
+1

+ 2.5
+2
+1

+3

+2

- 5 .7 5
- 2 .5
+2
-3
-8

- 3 .5
+2

-2 .7 5
- 2 .5
-6

+ 4.25
+ 3.5
+2
+3

+2

SOURCE: Deutsche Bundesbank, Intereconomics (September/October 1987).

gold and dollar reserves for ECUs, it did not agree
to participate in the cooperative effort to stabilize
exchange rates.9Thus, while the U.K. is an EMS
member, its exchange rate is not specifically tied
to those o f the other EMS nations. To make this
distinction, the EMS countries that participate in
the exchange rate mechanism (ERM) often are
referred to as the ERM countries.

The ERM Has Reduced Exchange
Rate Variability
Various studies have concluded that the ERM
has significantly reduced the variability o f ex­
change rate movements among the m em ber coun­
tries. Table 2, reproduced from an IMF study by
Ungerer, et al. (1986) provides one indication o f
how much the variability o f m onthly average nom ­
inal exchange rates, as measured by the coefficient
o f variation, declined after the EMS was form ed; a
similar pattern emerges if one examines data for
real exchange rates (nominal exchange rates ad­
justed by CPIs) or other measures o f variability,
such as standard deviations; these reductions in
bilateral exchange rate variability between ERM

9Greece, Portugal and Spain also do not participate in the
exchange rate mechanism.
10lbid, pp. 4 -5 and pp. 18-21. Also see related evidence, pro­
vided by Rogoff (1985a), who found that bilateral exchange
rates between EMS members have become more predictable.
"S ee Ungerer, et al., tables 16-21. The coefficient of variation is
the standard deviation of a series divided by its mean.
12A contrary view is presented by Fels (1987). He argues that,
because only n-1 bilateral rates in an n-exchange rate system
are freely determined, the ERM really is nothing more than a




participants are statistically significant." Finally, as
depicted in the bottom portion o f table 2, the IMF
analysis indicates that exchange rates for nonERM countries, such as the United Kingdom, the
United States and Japan, generally experienced
increased variability in the post-1979 period. Thus,
relative to the exchange rate behavior o f non-ERM
industrial countries, the ERM has significantly
reduced fluctuations in the real and nominal bilat­
eral exchange rates among its members.12

ECONOMIC POLICY
COORDINATION: A MORE GENERAL
ANALYSIS
The ERM has achieved greater exchange rate
stability. The usefulness o f such policy coordina­
tion, however, must be judged ultimately on the
basis o f relative econom ic performance. This more
general criterion for judging the efficacy o f such
coordination is important because econom ic the­
ory does not suggest that stable exchange rates,
per se, guarantee generally desirable econom ic
outcomes.

dollar/Dmark system that pulls other exchange rates with it.
More important, he argues that the ERM appears to have
succeeded in the early 1980s only because the dollar’s real
value had risen sharply and stimulated export sales from ERM
countries to the United States. As a consequence, member
nations did not feel the need to pressure Germany to lead a
currency devaluation through expansionary measures. Fels
also conjectures — and is supported by recent developments
— that realignments or other pressures on the ERM will occur
as the dollar weakens.

JULY/AUGUST 1988

22

Exchange Rate Stability, Economic
Policies and Economic Performance
Are Not Necessarily Related!
The ERM does not specify explicitly that m em ­
ber nations must coordinate policy actions. In
other words, although the ERM members may
agree to specific ranges on bilateral exchange
rates, maintaining those ranges may be achieved,
in principle, by a w ide variety of policy actions.
To illustrate this point, consider a simple m odel
o f the nominal exchange rate:
(1) e = (m* - m)
- h(i*-i)
- k(y*-y)
m onetary financial
real
policy
market
output
measure
conditions conditions
where: e

= the exchange rate

foreign $
domestic $

m = the nominal m oney supply;
i = the nominal interest rate;
y = real GNP;
k = the incom e elasticity o f real m oney
demand;
h = the interest response o f real money
balances; and
indicates values in a foreign country.
All variables in equation 1, except the interest rate,
are expressed as natural logarithms.13The equa­
tion implies that a countiy's currency w ill depreci­
ate (one unit o f domestic currency w ill purchase
few er units o f the foreign currency) if domestic
m oney growth accelerates, domestic nominal in­
terest rates decline or domestic real econom ic
growth slows relative to changes in the equivalent
measures in a foreign economy.
Once one recognizes, as in equation 1, that
differences between domestic and foreign eco­
nomic values determine the level o f exchange
rates, one can see clearly that a stable value for the
nominal exchange rate is consistent with many
different econom ic and policy environments and
outcomes. For example, two countries could ex­
hibit individually real growth o f plus or minus 3
percent; as long as the difference between their
real growth rates remained unchanged, however,
the exchange rate, ceteris paribus, w ould be sta­
ble. Similarly, inflation in each countiy could be 20
percent or zero; other things the same, however,

l3This model, taken from Dornbusch (1980), is based on the
standard monetary approach to the balance of payments.


http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

Table 2
Some Representative Comparisons of
Monthly Average Variability in Nominal
Exchange Rates1
Country

1974-78

1979-85

ERM
Belgium
Denmark
France
Germany
Ireland
Italy
Netherlands

20.3
25.0
31.6
29.2
36.0
36.0
21.1

13.6
14.8
15.9
16.3
12.2
19.3
13.2

Non-ERM
Austria
Canada
Japan
Norway
Sweden
Switzerland
United Kingdom
United States

20.3
44.1
44.5
25.3
30.2
44.0
32.7
34.7

12.3
52.0
48.1
24.2
31.6
25.9
37.8
55.7

'Adapted from table 16, Ungerer, et al. (1986). Figures are
average values for the coefficient of variation, based on
bilateral nominal exchange rates weighted by MERM
weights.

the exchange rate w ould be stable so long as the
inflation differential w ere stable. Thus, stable
exchange rates can be observed under a w ide
range o f econom ic policies and conditions.
Equation 1 also points out that the exchange
rate can be affected by policy actions in either the
domestic or foreign country. If, for example, e
were the French franc/DM exchange rate and the
DM were rising (e, measured as French francs per
DM, w ould be rising), e could be decreased (the
DM made to decline) by increasing the German
m oney stock relative to the French m oney stock.
One w ay in which this might be accomplished
w ould involve the Bundesbank and/or the Bank of
France selling DM-denominated assets and buying
franc-denominated assets, thus increasing the
supply of marks and reducing the supply of
francs. These changes in the markets for the franc
and mark effectively w ould change the relative
franc/DM price, that is, the exchange rate.

23

Notice, however, the effects o f such an action.
The m oney supply w ou ld expand in Germany and
decline in France. First, if the Bundesbank were
pursuing m oney growth w ithin specified target
ranges, the need for intervention o f the sort d e­
scribed could well lead to money growth above
the announced target path. Moreover, depending
upon the magnitude and duration o f intervention,
the pursuit o f a stable exchange rate (and its
effects on the German m oney stock) could cause a
rising price level in Germany; other short-run ef­
fects on output, unem ploym ent and interest rates
could be observed as well. Thus, in this one illus­
tration, the two countries could achieve one objec­
tive at the expense o f failing to attain others 14

ECONOMIC PERFORMANCE
BEFORE AND AFTER THE ERM
W hether exchange rate stability has im proved
econom ic performance or brought about greater
policy convergence among ERM countries is an
empirical issue. In this section, this issue is as­
sessed in two com plem entary ways.

ERM vs. N on-E R M Economic
Performance: Another Look at the
Evidence
To compare econom ic conditions before and
after the ERM agreement, a set o f monthly data for
m ajor indicators o f policy actions and econom ic
performance in the ERM countries and selected
large non-ERM econom ies was assembled. The
test consists o f comparing the average growth
rates and variances o f the narrow (M l) m oney
stock, CPI and index o f industrial production and
the average levels and variances o f short-term
interest rates between two periods: February
1975-Februaiy 1979 (before ERM), and April 1983Decem ber 1987 (the “stable” ERM period). The
interval between March 1979—March 1983, which
IMF analysis has characterized as “frequent peri­
ods o f exchange market strain and numerous con­
sequent realignments o f central rates,” was not
examined.15The transition period was om itted to
focus on the comparison between the presumably
less stable pre-ERM period and the relatively sta­
ble ERM period.

14For more general treatments of how policies and economies
are linked, see Frenkel (1986) or Kahn (1987).
,5Ungerer, etal., p. 11.




Specific hypotheses to be investigated with
these comparisons include the following: If greater
exchange rate stability brought about higher out­
put growth and low er inflation, a comparison of
period 1 versus period 3 should reveal significantly
higher output growth (as measured by industrial
production) and significantly low er inflation rates
(as measured bv CPIs) in the later period than in
the earlier one. If these conditions are produced
by the ERM, the same indicators for the non-ERM
countries should exhibit significantly different,
less beneficial output and price performance.
Equation 1 implies that stability in nominal
exchange rate levels may be associated with
greater volatility in m oney growth, interest rates or
output, the equation’s right-hand-side arguments.1”
If this is the case, measures o f variability for these
variables may have increased significantly in the
ERM countries since 1979. Conversely, equation 1
w ou ld im ply no change in the variability o f these
variables since 1979 in the non-ERM countries that
did not attempt (at least explicitly) to reduce bilat­
eral exchange rate variability.
Some caution in making these comparisons is
necessary because they rest on a ceteris paribus
assumption. The simple tests used here do not
control for the effects o f events that are unique to
some countries (for example, a crop failure in
Europe) or the differential effects across countries
o f a com m on phenom enon (for example, the en­
ergy price decline o f the 1980s). Thus, rather than
attributing a specific result — for example, a
change in average m oney growth rates or the vari­
ance o f interest rates — to the ERM, the com pari­
sons are intended solely to reveal consistent pat­
terns o f change in the ERM and non-ERM
countries. If there are consistent differences in the
econom ic or policy perform ance between the
ERM and non-ERM nations, it may be an initial
indication o f the possible effects o f exchange rate
coordination.

Differences in the Average Values o f
Selected Economic Indicators
The results in table 3 examine the econom ic
measures that the simple theoretical m odel sug­
gested as important in achieving greater exchange
rate stability. The table 3 entries compare the

,6Wood (1983), examining data for all EMS countries, found
greater nominal exhange rate stability to be associated with
greater variation in unanticipated interest rate changes in all
cases except Ireland.

JULY/AUGUST 1988

24

Table 3
Mean Values of Major Economic Indicators
Country
ERM
Belgium
Denmark
France
Germany
Italy
Netherlands
Ireland
Non-ERM
United Kingdom
United States
Canada
Japan
Austria
Nora/ay
Sweden
Switzerland

Period

Money growth
(M l)

Inflation
(CPI)

Short-term
interest rates

2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87

6.72’
5.792
13.70
17.132
10.96
8.652
10.75
6.54
18.00*
11.64*3
10.35
6.00
19.98*
7.50*

6.77*
3.36*
8.72*
4.70*
9.08*
4.75*
3.72*
1.24*
13.95*
7.35*
6.21*
1.43*
N.A.
N.A.

5.93*
7.51*
11.67*
10.11*
8.25’
9.84*
3.85*
4.84*
12.84*
14.95*
5.45
5.72
N.A.
N.A.

2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87

15.71
17.222
6.79
8.85
7.76*
17.35*2
10.01
5.39
7.87
5.81
10.01
14.395
12.24
4.092
10.39*
1.61 *2

13.69*
4.59*
6.96*
3.46*
8.16*
4.11
6.35*
1.27*
5.30*
2.71*
7.92
6.50
9.50*
5.88*
1.84
2.022

9.46
9.98
6.23*
8.15*
8.53“
9.44
6.70*
5.39*
N.A.
3.72
8.40*
12.89*5
8.10*
11.23*
1,62*6
3.00*

Growth of
industrial production

6.18
2.822
4.19
5.192
3.79
1.42
3.11
2.99
14.22
3.132
2.57
2.85
7.18
8.55
2.75
3.20
6.61
5.23
4.09
7.162
6.23
5.88
3.53
3.322
6.20
12.24
-2 .6 9
4.73
N.A.
N.A.

All data are monthly. Asterisks denote that values are statistically different at the 0.05 level.
'Data begin in 1976.02.
2Data end in 1987.09.
3Data end in 1987.06.
■'Data begin in 1978.05.
5Data end in 1986.12.
6Data begin in 1975.09.
SOURCE: International Financial Statistics, International Monetary Fund.

mean values for major econom ic indicators prior
to 1979 and since 1983; entries designated with an
asterisk are values that differ significantly between
the tw o periods shown.
The data show that the inflation rate o f each
ERM country has been reduced significantly since
1983. Some observers expected this result from an

' 7DeGrauwe and Verfaille, pp. 29-30, also show that the uncoordinated policy actions of non-ERM industrialized economies
achieved lower average rates of inflation, and did so more


FEDERAL RESERVE BANK OF ST. LOUIS


exchange rate agreement, arguing that the policies
o f low inflation countries, such as Germany, could
dominate those o f the high inflation countries,
such as Italy. The bottom portion o f table 3, h ow ­
ever, indicates that inflation rates in the United
Kingdom and other non-ERM countries — despite
the absence o f any explicit exchange rate agree­
ment — also were significantly reduced.17This

quickly, than the coordinated ERM actions. This result is consistent with the theoretical reasoning in Rogoff (1985b).

25

Table 4
Variances of Major Economic Indicators
Country
ERM
Belgium
Denmark
France
Germany
Italy
Netherlands
Ireland
Non-ERM
United Kingdom
United States
Canada
Japan
Austria
Norway
Sweden
Switzerland

Period

Money growth
(M1)

Inflation
(CPI)

Short-term
interest rates

2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87

188.80'
181.012
591.03*
2.406.07*2
176.02*
707.15*2
146.27
177.64
172.73*
91.25*3
507.71*
153.99*
358.50
409.71

15.35
15.03
130.37*
37.27*
7.85
10.85
11.50
7.37
54.18*
15.66*
42.69*
19.64*
N.A.
N.A.

5.06*
2.87*
27.22*
2.56*
1.57*
3.83*
0.45
0.53
8.56
7.03
11.65*
0.29*
N.A.
N.A.

2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87
2/75-2/79
4/83-12/87

298.06
417.332
17.89*
48.71*
96.47*
518.58*2
289.58*
712.13*
311.31
205.05
1,334.30*
580.04*5
815.42*
1,489.48*2
618.98*
146.38*2

100.73*
26.00*
9.17
6.86
18.88*
7.99*2
97.78*
42.50*
25.82
29.51
45.21*
25.83*
34.73
31.72
10.36
14.402

5.50*
1.40*
2.36
2.32
2.68<
2.05
6.06*
1.57*
N.A.
0.18
6.50*
1.32*5
2.90
4.27
1.036
1.28

Growth of
industrial production

12,371.77*
2,826.57*2
2,904.63
2,982.492
645.52
439.13
302.35*
1,116.63*
29,548.77*
749.01 *2
508.84*
1,808.63*
2,018.50
2,266.872
715.70*
158.17*
75.98
63.41
214.42*
443.98*2
162.64*
287.42*
529.33*
1,135.33*2
1,610.54*
17,020.64*
408.92*
1,455.67*
N.A.
N.A.

All data are monthly. Asterisks denote that variances are statistically different at the 0.05 level.
'Data begin in 1976.02.
2Data end in 1987.09.
3Data end in 1987.06.
“Data begin in 1978.05.
5Data end in 1986.12.
6Data begin in 1975.09.
SOURCE: International Financial Statistics, International Monetary Fund.

result suggests that some common, worldw ide
phenom enon is a m ore likely source o f low er in­
flation rates observed among the industrialized
countries than the policy coordination associated
with the ERM nations.
The remainder of the data in table 3 fail to iden­
tify any unique econom ic circumstances associ­
ated with the ERM group alone. M oney growth
declined significantly for two ERM countries, in­
terest rates rose in four (and fell in one) and indus­
trial production was statistically unchanged in all



seven. The non-ERM group also displayed gener­
ally higher interest rates and unchanged indus­
trial production growth. Thus, there is no change
in the average value o f a particular econom ic indi­
cator that can be identified uniquely w ith the ERM
countries.

Variation in Economic and Policy
Indicators
The results in table 4 show a mixed pattern of
performance with respect to the variances o f the

JULY/AUGUST 1988

26

Table 5
Growth in Real Trade Flows (Exports plus Imports)
Period
ERM country
Belgium
Denmark
France
Germany
Ireland
Italy
Netherlands
Non-ERM country
Austria
Canada
Japan
Norway
Sweden
Switzerland
United Kingdom
United States

With ERM countries

With non-ERM countries

1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86

7.7%
2.2
12.8
3.8
6.8
2.9
7.0
2.9
20.0
9.4
4.6
8.1
6.2
2.4

12.5%
4.5
5.2
3.2
8.5
5.7
7.6
6.8
8.2
4.8
5.4
10.1
10.5
5.3

1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86
1973-78
1979-86

11.3
4.8
4.4
6.5
11.6
9.5
8.2
9.3
6.0
4.6
8.0
4.5
11.4
5.4
4.4
7.3

4.2
4.0
4.2
7.2
7.2
10.0
9.7
6.6
3.8
4.9
6.8
3.8
5.1
4.2
4.2
8.5

Data are nominal trade values, reported in dollars by the IMF, adjusted by the U.S. GNP deflator and
the Federal Reserve Board's trade-weighted exchange rate index (TWEX).

assorted econom ic and policy indicators. Short­
term interest rates w ere significantly less variable
in the third period for three o f the ERM countries
but significantly more variable in France. Similarly,
industrial production became significantly less
variable in Italy, but more volatile in two other
countries, especially in Germany, where the vari­
ance o f industrial production increased by a factor
of four.
In contrast, for the United Kingdom, which does
not participate in the ERM, the variances o f the
inflation rate, interest rates and industrial produc­
tion all declined significantly. While the variances
o f m oney growth increased significantly in four
non-ERM countries, two o f these countries and
four non-ERM nations overall achieved less vari­

FEDERAL RESERVE BANK OF ST. LOUIS


able inflation rates. Three non-ERM countries
experienced significantly less interest rate volatil­
ity, w hile none experienced greater variability. Five
o f the eight non-ERM countries saw greater output
variability in the more recent period. Overall, as in
table 3, this mixed picture does not yield any
uniquely beneficial results associated with ERM
membership.

Exchange Rate Variability and
Trade Flows
A somewhat different result emerges when data
on trade flows are examined as in table 5. One
possible result o f reducing exchange rate variabil­
ity is that the greater exchange rate certainty
might increase trade flows. Since exchange rate

27

variability did decline among ERM countries but
increased both among the non-ERM nations and
between the ERM and non-ERM countries, it is
interesting to see how trade flows changed after
1979 both within the ERM group and between the
ERM and non-ERM nations.
Table 5 shows that the growth o f intra-ERM
trade declined in ERM econom ies (except Italy)
during the period o f greater exchange rate stabil­
ity. In contrast, trade by non-ERM members both
with each other and the ERM group often rose,
even though these exchange rates became more
variable. Canada, Japan and the United States are
the notable cases o f this result. On the basis of
these results, again holding other things constant,
greater ERM exchange rate stability was not asso­
ciated with relatively larger intra-ERM trade.

SUMMARY
Proposals for policy coordination among the
major industrial econom ies have been discussed
more frequently in recent years. Initially such
proposals were intended to correct what were
perceived as problems created by a “ high” value o f
the U.S. dollar; subsequently, they w ere intended
to mitigate the adverse consequences o f variable
exchange rates and the falling value o f the dollar.
One attempt to coordinate domestic policies in
recent years in pursuit o f stable bilateral nominal
exchange rates is found in the EMS. Evidence
based on data before and after the establishment
o f the EMS suggests that, w hile bilateral exchange
rates have becom e more stable, other measures of
econom ic performance and policy actions fail to
show the effects o f such coordination. Lower in­
flation rates in ERM countries have been matched
by low er inflation rates in major non-ERM econo­
mies. Other variables, such as money growth, inter­
est rates and real output measures also show no
consistent differential response in ERM and nonERM countries in recent years. The data do not
even show that intra-ERM trade has increased any
more than trade with non-ERM countries, despite
the reductions in exchange rate variability among
ERM nations. Overall, the only experience w e have
with conceited policy coordination does not indi­
cate that general econom ic or policy measures have
been much affected — one way or another — by
such coordination.

REFERENCES
Bank for International Settlements.
1987).




Crook, Clive. “ Living With Uncertainty," supplement to The
Economist (September 26, 1987).
Currie, David, and Paul Levine. “ International Cooperation and
Reputation in an Empirical Two-Bloc Model,” paper presented
at the Konstanzer Seminar on Monetary Theory and Mone­
tary Policy, Konstanz, West Germany (June 17, 1987).
DeGrauwe, Paul. “ International Trade and Economic Growth in
the European Monetary System,” European Economic Review
(1987), pp. 389-98.
_________“ Exchange Rate Variability and the Slowdown in
Growth of International Trade," IMF Staff Papers (March
1988), pp. 63-84.
DeGrauwe, Paul, and Guy Verfaille. “The European Monetary
System: An Evaluation,” mimeo (University of Louvain, Janu­
ary 1986).
Dornbusch, Rudiger. “ Exchange Rate Economics: Where Do
We Stand?” Brookings Papers on Economic Activity (1:1980),
pp. 143-85.
Farrell, Victoria, et al. “ Effects of Exchange Rate Variability on
International Trade and Other Economic Variables," Staff
Study No. 130 (Board of Governors of the Federal Reserve
System, December 1983).
Fels, Joachim. "The European Monetary System 1979-87:
Why Has It Worked?" Intereconomics (September/October
1987), pp. 216-22.
Fischer, Stanley. “ International Macroeconomic Policy Coordi­
nation,” Working Paper No. 2244 (National Bureau of Eco­
nomic Research, May 1987).
Franke, Gunter. “ Exchange Rate Volatility and International
Trade: The Option Approach,” Working Paper (revised),
(Universitat Konstanz, August 1987).
Frankel, Jeffrey, and Katherine Rockett. “ International Macroec­
onomic Policy Coordination When Policymakers Do Not
Agree on the True Model," American Economic Review (June
1988), pp. 318-40.
Frenkel, Jacob A. “ International Interdependence and the
Constraints on Macroeconomic Policies,” Weltwirtschaftliches
Archiv (Heft 4, 1986), pp. 615-45.
Kahn, George. “ International Policy Coordination in an Interde­
pendent World,” Federal Reserve Bank of Kansas City Eco­
nomic Review (March 1987), pp. 14-32.
Karamouzis, Nicholas V. “ Lessons from the European Mone­
tary System,” Federal Reserve Bank of Cleveland Economic
Commentary (August 15, 1987).
Organization for Economic Cooperation and Development.
“ Cooperative Policy Action to Restore Satisfactory
Growth,” Economic Outlook No. 41 (OECD, June 1987).
Rogoff, Kenneth. “ Can Exchange Rate Predictability Be
Achieved Without Monetary Convergence? Evidence from the
EMS," European Economic Review (1985a), pp. 93-115.
_________“ Can International Monetary Cooperation Be Coun­
terproductive?” Journal of International Economics (May
1985b), pp. 199-217.
Ungerer, Horst, Owen Evans, Thomas Mayer and Philip
Young. The European Monetary System: Recent Develop­
ments, Occasional Paper No. 48 (Washington, D.C.: Interna­
tional Monetary Fund, December 1986).
Wood, Geoffrey E. “The European Monetary System — Past
Developments, Future Prospects, and Economic Rationale," in
Roy Jenkins, ed., Britain and the EEC (London: Macmillan,
1983).

Annual Report, (Basle,

JULY/AUGUST 1988

28

Appendix
The European Currency Unit
The European Currency Unit (ECUl seives
primarily as a unit o f account for a variety of
functions within the European Community (EC).
For example, the value o f the ECU is a reference
point from which to judge the divergence of
individual currency values from desired values.
More generally, the ECU is a unit o f account for
the EC's budget, its Com m on Agricultural Policy
and its other finance and credit activities.

The ECU originally had been intended to seive
also as a means o f settlement and a reserve asset.
In both cases, however, its use has been small. It is
rarely used as a means o f settlement and, as a
reseive asset, is largely a substitute for the gold
and dollar deposits a m em ber countiy gave up to
join the EMS.

The ECU itself is simply a weighted-basket of
EMS member currencies. As shown in the table, as
o f September 17, 1984, one ECU was equal to the
market value o f 3.71 Belgian francs, 0.219 Danish
krones and so on across the 10 EMS currencies.
Over time, both the weights attached to member
currencies and their market values relative to nonEMS currencies have changed so that the value o f
the ECU has varied (see chart on opposite page).

The private use o f ECUs, however, is a different
matter. Because it represents a basket o f EC cur­
rencies and because a formal agreement exists to
keep constituent currencies within specified
bounds, investors have viewed financial instru­
ments denom inated in ECUs to be less risky than
similar instruments denom inated in a specific
currency. For this reason, sight and time deposits,
loans and bonds all have been offered denom i­
nated in ECUs. Thus, the ECU may be view ed best
as a currency index unit o f account that varies less
than its constituent currencies.

Representative Composition of the ECU
Currency

National currency units
September 17,1984

Percentage weights
September 17,1984

3.71
0.219
1.31
0.719
0.00871
140.00
0.14
0.256
0.0878
1.15

8.2
2.7
19.0
32.0
1.2
10.2
0.3
10.1
15.0
1.3

Belgian franc
Danish krone
French franc
Deutsche mark
Irish pound
Italian lira
Luxembourg franc
Netherlands guilder
Pound sterling
Greek drachma

100.0
SOURCE: Ungerer, et. al. (1986), table 4.


FEDERAL RESERVE BANK OF ST. LOUIS


29

Chart 1

Value of the ECU in U.S. Dollars
Dollars

1979
80
81
NOTE: Data are period averages.




Dollars

82

83

84

85

86

87

1988

JULY/AUGUST 1988

30

Clemens J.M. Kool and John A. Tatom

Clemens J. M. Kool is an assistant professor of monetary eco­
nomics at Erasmus University, Rotterdam, The Netherlands. John
A. Tatom is an assistant vice president at the Federal Reserve
Bank of St. Louis. Anne M. Grubish provided research assistance.

International Linkages in the
Term Structure of Interest Rates
I NTF.RF.ST rales usually differ for assets w illi
different terms to maturity.1The term structure of
interest rates shows the relationship among the
interest rates, or yields to maturity, o f differentlived assets and their terms to maturity.2Analysts
often view the term structure as the link between
current and future short- and long-term interest
rates. This link is important because o f the w idely
held belief that monetary authorities are able to
influence only short-term m oney market rates,
w hile long-term rates are more relevant in making
investment and consumption decisions. An un­
derstanding o f the transmission mechanism from
current short-term rates to future interest rates is
crucial, according to this view, in implementing
and evaluating monetary policy.
This article extends the analysis o f the term
structure by examining whether movements in the
domestic term structure are influenced by foreign
interest rate developments. In the term structure

'A given yield curve implicitly assumes that other characteristics
of the short- and long-term assets are identical. Yields on
financial assets differ for many reasons, including differences
in default risk, marketability and tax treatment. In term structure
research, it is typical to examine short- and long-term govern­
ment securities and to assume that differences in their maturity
are the main determinant of the differences in their yields. See
Wood (1983).
2ln this article, the terms interest rate and yield to maturity are
used interchangeably. Both measures reflect the average
expected rate of return over the remaining life of the underlying
financial asset. These measures usually will differ from the


FEDERAL RESERVE BANK OF ST. LOUIS


view, if interest rates are related across countries,
then foreign short-term interest rate movements
are transmitted both directly to changes in dom es­
tic short-term rates, and indirectly, via the respec­
tive domestic term structures, to changes in long­
term interest rates. Thus, short- and long-term
interest rate changes are closely correlated across
countries and long-term interest rates changes in
one country are related to foreign short-term rates
as well. This hypothesis is com m only thought to
hold for the United States, whose policies are
blamed for adverse interest rate developments
abroad. This article examines the relationships
among the term structures o f interest rates in the
United States, Canada, the United Kingdom, West
Germany and Japan. Our ch ief focus is on the
extent to which movements in short- and long­
term interest rates are related internationally and
w hether changes in foreign interest rates in­
fluence domestic interest rates.

holding-period return, which equals the return on an asset over
a fixed period. For example, the one-year holding-period return
on a 10-year bond is the annual coupon payment plus the
capital gain over the year, while the yield to maturity on the
same bond is the average of all current and expected future
one-year holding-period returns until the end of the bond’s life.
Only when the holding period and the remaining maturity of the
bond are equal will these two measures of return coincide. An
approximately linear negative relation holds between the
change in the long-term interest rate and the holding period
return. For details, see Shillerefa/. (1983).

31

TERM STRUCTURE THEORY
The expectations theory is the principal theoret­
ical approach to the term structure o f interest
rates. This theory assumes that investors view
short- and long-term government bonds as perfect
substitutes, that is, investors are indifferent to the
maturity o f holdings o f government securities.3
This assumption implies that eveiy investment
strategy in government securities has the same
expected return over any given future holding
period. For example, suppose that the current
one-year rate is 6 percent, w hile the interest rate
on a 10-year bond is 8 percent. If investors expect
future one-vear rates to remain constant at 6 per­
cent, it is m ore attractive n ow to buy the 10-year
bond. Over a 10-year holding period, the 10-year
bond vields an 8 percent annual rate o f return;
rolling over a sequence o f one-year assets for the
same 10-year period yields an expected rate o f
only 6 percent. Increased purchases o f 10-vear
bonds bid up their price, thereby depressing their
yield; similarly, sales o f existing one-year securities
(to switch into higher-yielding 10-year bonds)
low er their price and raise their expected yield.
This process continues until the long rate equals
an average o f current and expected future short
rates.

a positive (negative) spread, or difference, between
today’s long- and short-term interest rates will
reflect it.

DOMESTIC TERM STRUCTURE
EQUATIONS
According to theories o f the domestic term
structure o f interest rates, the current spread be­
tween the level o f long- and short-term interest
rates is directly related to the expectation that
future short-term interest rates and, therefore,
long-term rates w ill be higher. Formally, this rela­
tionship for the long-term interest rate, R„ can be
written as:
111 AR, = P0 + P,S, , + e„
where S, , is the lagged spread, (R, , — i, ,), and i, ,
is the lagged short-term interest rate. In theory,
the parameter (30is expected to be negative and (3,
is expected to be positive.4The intercept (3„ is the
negative o f a term or risk premium. Long-term
interest rates, on average, will not change (AR,+i = 0)
when the spread, S„ equals the ratio o f ( _ (3„/f3,|;
this ratio is positive when there is a positive term
premium and zero w hen (30is zero. Long-term
rates are expected to rise (fall) when the current
spread exceeds (is less than) ( —(3„/p,).

Thus, the interest rates on a three-month bill, a
one-year bill and a 30-year bond w ill differ accord­
ing to the market’s assessment of expected inter­
est rates on short-term assets beyond the life of
each instrument. The one-year bill w ill have a
yield that reflects not only the expectation for the
next three months em bodied in the three-month
bill rate, but also the expectations for the subse­
quent nine months. Similarly, a 30-year bond will
have a current vield to maturity that is influenced
by the same expectations as the one-year bill for
the first year, but also by expectations for the re­
maining 29 years o f its life. If future short-term
rates are expected to be higher (lower) than today,

A similar equation can express the same relation
for short-term rates (Ai,). Term structure theory
does not provide a theoretical value for the spread
coefficient in such an equation, since expected
changes in future short rates are not necessarily
distributed uniformly over each future period's
short rate. Thus, a rise in the spread need not
indicate that the short rate w ill be higher next
month, although it does indicate that some
unspecified future short rates (and long rates for
assets that span the period) w ill be higher than
they are now. W hen expected future short-term
interest rate changes are distributed uniformly or
w eighted more heavily to the near future, which

3There are several competing theories of the term structure of
interest rates. For a detailed description of these theories, see
the discussion in a textbook such as Wood and Wood (1985),
chapter 19. They all, however, have a common foundation in
what sometimes is called the traditional expectations theory.
The purpose of this article is not to test competing theories of
the domestic term structure; instead, it uses a general specifi­
cation as a point of departure to study international linkages
among interest rates.

holding-period return on a one-month T-bill is its interest rate, it;
the one-month holding-period return on a 10-year bond is the
interest rate R, plus the annualized expected capital gain; this
capital gain is inversely proportional to the expected one-month
change in the 10-year bond rate, AR,,,. The equality results in
a (3, measure that is positive, but very small in a monthly analy­
sis, and proportional to the average in-sample long rate; the
expression for 0Oequals ( - TP)p, where TP is the average
term premium. See Mankiw (1986) for an example of this
derivation.

4Theoretical expressions for the values of |30 and p, are found
by equating holding-period returns, adjusted for any term
premium. Consider a monthly analysis of one-month Treasury
bills and 10-year bonds, like that below. The one-month




JULY/AUGUST 1988

32

generally is the case in theoretical or empirical
investigations, the spread coefficient in a short­
term rate equation should also be positive.'1
A variant o f the standard term structure equa­
tion used in many macroeconom ic models is:
(2) S, = a„ + a, S,., + a, Ai, + a., Ai, , + e,.
In equation 2, the long-term interest rate is a long
distributed lag o f past short-term rates." Equation
2 can be rewritten as:
(3) AR, = p0 + p,S,_, + (3, Ai, +

Ai, _, + e,

Equation 3 adds information on the current
change in the short rate and a lagged value o f this
change to equation l.7One rationale for adding
“new s” about the short rate is that short-rate
changes reflect new information about expected
future short rates beyond the information con­
tained in the recent spread." If markets are ef­
ficient and adjust within one period, (3a should
equal zero and (3, should be positive. Equations
like this are w idely used to study the term struc­
ture o f interest rates empirically. Accordingly, we
use it as a point o f departure in investigating inter­
national term structure linkages.
5Estimates of long- and short-rate equations like equation 1
often lack predictive content and are systematically at odds
with the theory. See, for example, Shiller (1979), Shiller et al.
(1983), Mankiw and Summers (1984) and Mankiw (1986). Most
studies of the term structure find support for the inclusion of a
term, or risk, premium in a term-structure equation: it is com­
mon to include a constant and nonzero term premium in char­
acterizations of the expectations theory. See Wood and Wood
(1985) or Clarida and Campbell (1987), for examples. More­
over, financial theory indicates that risk premia also are related
to returns in other financial markets, like stocks, and to expec­
tations about general economic conditions. For example, Cox
Ingersoll and Ross (1981) modify the expectations theory to
account for a negative effect on the term premium that is pro­
portionate in magnitude to economic uncertainty. The possibil­
ity of a nonzero average, or constant, term premium is included
in the estimates below. Specifications like equation 1 implicitly
presume that all other influences on interest rates in the next
period, beyond the current spread information and the term
premium, have zero mean and are uncorrelated with the cur­
rent spread. Such restrictions are relaxed in empirical models
like those below.
6See Mankiw (1986). Modigliani and Sutch (1966) used a more
famous variation of such an equation; it had a 16-quarter
distributed lag on past short rates, instead of the lagged spread
term, and so was explicitly backward-looking, rather than
forward-looking as the expectations theory emphasizes.
7This transformation is found by subtracting S, , from both sides
of equation 2 to obtain AS„ then adding Ai, to both sides to
obtain equation 3. Equation 3 also can be derived from equa­
tion 1 and its short-rate variant. This form, however, suggests
that one source of a negative coefficient on the lagged spread
is that short rates are more sensitive to recent spread changes,
which is likely if movements in the current spread are more
informative about near-term prospective short rates than about
all future short rates. Testing this alternative is beyond the
scope or purpose of this paper.


FEDERAL RESERVE BANK OF ST. LOUIS


Domestic Macroeconomic
Determinants o f the Level o f Interest
Rates
Term structure and asset price theoiy explain
differences in yields over time or among assets,
but do not explain the general level o f interest
rates. Closer scrutiny o f the factors influencing
both short and long rates might indicate addi­
tional domestic determinants o f the term struc­
ture that w ould m odify equation 3.
The central factors influencing the general level
o f nominal interest rates, according to Fisher
(1930), are the expected real rate o f return on capi­
tal and the expected inflation rate.11Economic
theory indicates that the expected real rate o f
interest is determined by the marginal productiv­
ity of capital and the marginal utility o f consum p­
tion. Numerous econom ic factors, however, can
impinge, at least temporarily, on these rather ab­
stract determinants and, hence, on the real rate o f
interest.10
One approach to analyzing the term structure of
interest rates m odels the effect o f domestic macro8This view implies that an observationally equivalent view of
equation 2 is that the lagged spread incorporates unbiased
forecasts of future rates as in equation 1, but news reflected in
current short-rate movements is informative about revisions of
expected future rates. The Modigliani and Sutch variant of
equation 2 has been criticized by numerous analysts, including
Phillips and Pippenger (1976). The latter show that a forwardlooking, efficient markets model rejects the Modigliani-Sutch
model without including the lagged spread. The results below
suggest that their specifications can be improved, however.
9These considerations also suggest that the term structure of
nominal interest rates is a combination of a term structure of
expected inflation and a term structure of expected real rates.
When inflation temporarily accelerates (slows) due to a supply
shock, the spread shrinks (widens) because the short-term rate
rises (falls) more than the long-term rate. Garner (1987)
presents evidence for the United States on the close relation­
ship between the term structure of interest rates and the term
structure of inflationary expectations.
10The standard laundry list of other macroeconomic factors
includes the money stock, the price level, tax rates, govern­
ment expenditures and other fiscal variables, and other domes­
tic real variables such as private sector aggregate demand for
goods and services, the business cycle, the mix between
consumption and investment, and risk. Both current values and
expectations of future values of these variables and their
growth rates affect current and expected future real rates.

33

econom ic changes on the two com ponents o f both
long- and short-term interest rates." If financial
markets are efficient, however, investors will have
used the available relevant domestic information
to price assets, including government bonds o f all
maturities. Thus, no additional domestic informa­
tion exists that can improve on the im plicit fore­
cast o f future interest rates reflected in the current
term structure.

International Term Structure
Linkages
W hether additional information on foreign in­
terest rates influences the domestic term structure
depends on the exchange rate regime. Under a
fixed-exchange-rate system, domestic interest
rates and monetary policy are not independent o f
foreign developments. Inflation rates tend to be
equal across the countries that have a fixed-rate
commitment; they equal the rate o f depreciation
o f the purchasing pow er o f the com m odity or the
m oney against which the exchange value o f the
currencies are fixed. In addition, if capital markets
are integrated internationally, a change in the real
rate o f return in anv one country is transmitted to
all nominal rates both domestically and abroad as
investors attempt to maximize real rates o f re­
turn.12Since in this case the expected inflation rate
and real rate are closely linked across countries,
the nominal interest rate, at all maturities, is also
closely linked. Econom ic developments at hom e
or abroad could influence the interest rates com ­
mon to all countries, but foreign factors w ould not
have an independent influence on a domestic
term structure like that shown in equation 3; news
o f such developments w ould be fully captured in
the Ai, term for the domestic economy.
"W ood and Wood (1985) have noted an interpretation problem
with such a procedure; do such variables enter as determi­
nants of a term premium, via a “segmented markets” argu­
ment, for example, or do they provide additional information on
the time path of expected future real interest rates? This prob­
lem mediates against the arbitrary introduction of current
information for such variables. Moreover, the long list of poten­
tially relevant macroeconomic factors and the dynamics of their
effects operating through lags indicate that this approach is
difficult and invariably controversial to implement. Even if
undertaken successfully, however, the effort could be quite
misleading.
,2For a more detailed description of interest rate relations across
countries, see Bisignano (1983) and Kirchgassner and Wolters
(1987). Glick (1987) provides evidence on the real-interest-rate
linkage between the United States and the Pacific Basin coun­
tries.

The relation o f interest rates across countries
for a given maturity, called the covered interest
parity condition, is
(4! i = i* + (f —e ln,
e
where
i and i* = the domestic and foreign interest
rates, respectively, for comparable
assets with respect to maturity and
risk,
e = the current or spot exchange rate
expressed as the number o f domestic
currency units per unit o f foreign
currency,
f = the corresponding forward rate one
period in the future, and
n = the annualizing factor for the term o f
assets being compared, which equals
12 divided by the number o f months
to maturity.
Under a credible fixed rate regime, the expected
forward rate w ould equal the spot rate at all matu­
rities, so that countries w ou ld have the same term
structure o f interest rates. Domestic news in one
country that affects domestic rates and the term
structure w ould be im m ediately transmitted
abroad, so that (i = i*) w ou ld hold for all maturi­
ties.
Even in the absence o f a credible fixed-rate com ­
mitment, m onetary authorities may still have a
long-run exchange-rate objective and may periodi­
cally intervene in the exchange market or conduct
policy to further that goal.'3 If they do, interna­
tional rates could still be related, although the
relationship w ou ld be looser, and changes in short
rates especially w ould not be systematically coin­
cident.
rate of appreciation of the foreign currency. Even if risk premia
exist in foreign exchange markets, the forward rate will be a
close approximation of the future spot rate in most situations,
so the second term will approximate the expected rate of
appreciation of foreign currency. Meese and Rogoff (1983)
argue that this approximation is often unsatisfactory. Covered
interest parity has been tested widely and successfully for
short-term rates; such tests are typically restricted to short-term
assets to ensure that there is an active market in forward
contracts for foreign exchange for a comparable period. See
Frenkel and Levich (1975,1977) or, more recently, papers that
reject the stronger variant called the “ Fisher open" hypothesis
or uncovered interest parity, such as Cumby and Obstfeld
(1984). The strength of international linkages also depends on
the extent to which assets of the same maturity across coun­
tries are substitutes; different tax regimes, transactions costs or
other factors can impair the international interest rate linkage.

13ln the absence of risk premia in foreign exchange markets, the
forward rate would equal the expected future spot rate, so the
second term on the right-hand side would equal the expected




JULY/AUGUST 1988

34

In a “pure float,” or regime with no exchangerate commitments, interest rates across countries
can be independent if countries pursue indepen­
dent inflation rate objectives and if the real inter­
est rate is constant. Movements in foreign interest
rates can be reflected in the prospective change in
the exchange value o f the domestic currency,
rather than in domestic interest rates. Even in this
case, however, the implicit exchange rate change
can have undesirable effects on other policy objec­
tives, such as the price level, so that interest rates
will still not be independent across countries.

changes o f these interest rates and spreads in
each country. The levels o f rates show consider­
able variability, but the mean long rate exceeds the
mean short rate in each country. The mean level
o f short rates in Canada and the United Kingdom
are not significantly different from each other.16
The same is true for West Germany and Japan, but
their mean interest rate levels are low er than those
in the other three countries. The mean U.S. short
rate is significantly higher than in Japan and West
Germany but low er than in Canada and the United
Kingdom.

In particular, a rise (fall) in a foreign interest rate
need not spill over to the domestic rate if the d o­
mestic currency is free to appreciate (depreciate)
relative to the foreign currency. But the apprecia­
tion (depreciation) o f the domestic currency can
depress (raise) the domestic price level as w ell as,
temporarily, the inflation rate. While there may
not be an explicit exchange rate objective, an in­
flation or other objective can be at odds with such
exchange rate effects and, therefore, require policy
actions to raise (lower) interest rates. Hence, for­
eign interest rate changes can result in equal d o­
mestic rate changes despite the absence o f an
exchange-rate comm itm ent.14Finally, w hen do­
mestic short-term interest rate movements are
only temporarily insulated from foreign m ove­
ments by central bank intervention, long rates will
still reflect these foreign changes immediately. In
this case, foreign short-term rates w ould exert an
independent effect on domestic long-term interest
rates, given domestic short-term rates.

The rank ordering o f the mean long rates is the
same as for short rates, but the mean levels o f the
long rate are significantly different for each
pairwise comparison o f countries. The mean
spread is not significantly different for four of the
country pairs: the United Kingdom and Canada,
the United Kingdom and Japan, the United King­
dom and Germany, and Japan and West Germany;
in the other six pairwise comparisons (four o f
which are for the United States), the mean spreads
are significantly different. The mean o f changes in
interest rates is approximately zero for each coun­
try and maturity class. In each country, the stand­
ard deviation o f changes in the short rate far ex­
ceeds the standard deviation o f changes in the
long rate, indicating the greater volatility o f short
rates in all five countries.17

THE EMPIRICAL RELATIONSHIPS
To analyze domestic and international interest
rate relationships, end-of-month observations of
representative short- and long-term interest rates
for the United States, Canada, the United King­
dom, West Germany and Japan w ere selected for
the period from April 1977 to June 1987. This pe­
riod was chosen on the basis o f data availability.”

The Data: Some Simple Statistics
The top panel in table 1 shows the means and
standard deviations o f the levels and monthly

14The theoretical and empirical basis of this absence of indepen­
dence under floating exchange rates has been developed
extensively by Mussa (1979) and Swoboda (1983).
15A description of the data is contained in the appendix to this
article.
l6The tests of differences in the means in table 1 use a “ pooled ttest" with a 5 percent significance level.


FEDERAL RESERVE BANK OF ST. LOUIS


The bottom panel o f table 1 shows correlation
coefficients for both levels and changes o f short
rates, long rates and the spread for each country.
A correlation o f 0.18 or larger in absolute value is
statistically different from zero at the 5 percent
significance level. The evidence suggests that the
short and long rates are highly correlated within
each country. Similarly, monthly changes in short
and long rates are highly correlated in each coun­
try except Japan.
The spread is dom inated by the short rate; this
is indicated by the significant negative correlation
between the spread and the short rate in all five
countries and the absence o f a significant positive
correlation for the spread and the long rate in any
country. The level o f the long rate and the spread
are insignificantly correlated for the United States

17This smaller long-rate variability reflects the notion that, if the
long rate is a weighted average of current and expected future
short rates, some short-rate variability over time is expected to
average out.

35

Table 1
The Term Structure Data For Five Countries (April 1977 to June 1987)
United States
Standard
deviation

Mean
Levels
Short-Rate (i)
Long-Rate (R)
Spread (R - i)
Changes (A)'
Short-Rate (Ai)
Long-Rate (AR)
Spread (AR - Ai)

8.75%
10.51
1.76
0.01
0.01
- 0 .0 0

2.77%
2.32
1.59
1.18
0.54
1.01

Japan

United Kingdom
Standard
deviation

Mean

11.67%
12.39
0.72
0.01
-0 .0 0
-0 .0 1

2.95%
1.88
1.92
0.92
0.59
0.83

Standard
deviation

Mean

6.30%
7.23
0.93
-0 .0 2
-0 .0 3
-0 .0 1

1.66%
1.27
1.16
0.56
0.28
0.59

Germany
Mean

6.44%
7.65
1.21
-0 .0 1
-0 .0 0
0.01

Canada

Standard
deviation

Mean

Standard
deviation

2.71%
1.34
1.62

10.98%
11.49
0.52

3.20%
2.20
1.76

0.63
0.31
0.57

0.01
0.01
0.00

0.84
0.55
0.75

Correlation of Interest Rates Within Each Country2
0.77
0.82
0, R)
-0 .7 8
-0 .5 5
(i, Spread)
-0 .2 1
0.03
(R, Spread)

0.71
- 0.65
0.07

0.90
- 0 .9 3
-0 .6 8

0.85
0.76
0.31

0.47
-0 .7 8
0.19

0.13
0.89
0.35

0.43
- 0 .8 7
0.07

0.49
0.76
0.19

(Ai, AR)
(Ai, A Spread)
(AR, A Spread)

0.52
-0 .8 9
-0 .0 7

Data sources listed in the appendix to this article.
'Data tor changes are from May 1977 to June 1987.
C ritical value for 95 percent confidence level is 0.18; for 99 percent confidence level, it is 0.23.

and Japan. For the other three countries, this cor­
relation is even negative. In first differences, the
correlations between the long rate and the spread
are always positive, though significantly so only in
the United Kingdom, Japan and Canada, w hile the
changes in the short rates remain significantly
negatively correlated with the changes in the
spread.
Table 2 presents correlations o f rates across
countries that allow a preliminary assessment of
w hether and how rates are linked internationally;
the critical level for 5 percent significance is the
same as in table 1, 0.18. All long rates appear to be
highly correlated in levels. This correlation is
strongest among the United States, Canada and
West Germany. The same is true for the level of
short rates. W hile changes in long rates are signi­
ficantly positively correlated across all five coun­
tries, only the United States and Canada exhibit a

'“Monthly rates of increase in consumer prices also support this
suggestion. The smallest pairwise correlation over this period
is 0.17 for Germany and Japan, and for Canada and the United
Kingdom; these are significant at a 6.5 percent significance
level. The other eight pairwise correlations exceed 0.33 and
are significant at a 1 percent level. On the same basis (and like
the long-rate results above), the mean inflation rate is not




strong significant positive correlation between
changes in short-term interest rates. Changes in
short-term rates in West Germany and Canada, as
w ell as in West Germany and Japan, are marginally
significantly related but the other seven country
pair correlations are not.
The strong and significant correlations for both
long-term interest rate levels and changes across
all five countries suggest that these countries ex­
perienced strongly similar inflationary develop­
ments between 1977 and 1987.18The fact that there
is generally an absence o f a significant correlation
between contem poraneous short-rate changes is
important for at least two reasons. First, it suggests
that the period was characterized by a free float.
Second, it suggests that the strong positive corre­
lation of changes in long rates does not arise
through a term structure transmission mechanism
that runs from foreign short rates (and associated

significantly different for Germany and Japan, for the United
States and Canada, or for Canada and the United Kingdom.
The other seven pairwise comparisons are significantly differ­
ent from zero and the rank ordering is the same as for long
rates.

JULY/AUGUST 1988

36

Table 2
Correlations of Levels and Changes of Interest Rates in Five Countries
(April 1977 to June 1987)
United States

United Kingdom

Japan

Germany

Canada

Short-term rate1
United States
United Kingdom
Japan
Germany
Canada

1.00
0.58
0.43
0.80
0.88

1.00
0.57
0.68
0.63

1.00
0.63
0.43

1.00
0.90

1.00

Long-term rate
United States
United Kingdom
Japan
Germany
Canada

1.00
0.71
0.68
0.91
0.97

1.00
0.71
0.80
0.73

1.00
0.80
0.64

1.00
0.91

1.00

1.0
-0 .0 3
0.05
0 .1 7 '

1.0
0.19
0.09

1.0
0.18

1.0

1.0
0.35
0.32
0.32

1.0
0.53
0.30

1.0
0.48

1.0

Changes in the short-term rate2
United States
United Kingdom
Japan
Germany
Canada

1.0
-0 .0 1
0.01
0.13
0.34

Changes in the long-term rate2
United States
United Kingdom
Japan
Germany
Canada

1.0
0.33
0.35
0.52
0.80

'Critical value for 95 percent confidence level is 0.18; for 99 percent confidence level, it is 0.23.
2Data for changes are from May 1977 to June 1987.

foreign long-rate movements) to domestic short
rates and, again via a term structure, to domestic
long rates. These implications can be tested more
directly using domestic term structure equations.

in the equation. The unconstrained version o f
equation 3 used here is:

Domestic Term Structure Estimates

If the constraint in equation 3 holds, (34equals
ip3—(3,). Insignificant terms generally are omitted
in the estimates o f equation 5 that are reported in
table 3. In particular, the i, , term is generally in­
significant and omitted. In this case, (3, w ould
equal —(3, if the spread constraint holds: (34can be
compared directly with the coefficient on R, ,.
Additional lags o f long-term and o f short-term
rates up to four months earlier w ere checked for
significance, but their addition to the table 3 equa­
tions was uniformly rejected.

The domestic term structure equation 3 is used
to examine international linkages.19The coefficient
P, involves the constraint that the effect o f R, is
equal and opposite to that o f i, „ given Ai, and
Ai, Viewed another way, the term i, , enters
equation 3 through three right-hand-side terms
(S, „ Ai„ Ai, ,). Therefore, unconstrained estimates
o f the equation are used to avoid any bias im ­
posed by the constraint and to examine each term

l9Estimates (not reported) of equation 1 for AR, and a short-rate
equation for Ai, have little or no explanatory power; only four of
the 20 intercept and slope terms are significantly different from
zero. These are the positive lagged spread coefficients in the
short-rate equations for the United States, United Kingdom and
Japan, and a significant negative constant in the Japanese


FEDERAL RESERVE BANK OF ST. LOUIS


(5) AR, = (3„ + p, R, , + (3, Ai, + 3, i, , - p3i,
+ £,.

equation. Often (three of five cases), the insignificant laggedspread coefficient flj,) in the long-rate equation is negative,
contrary to the theory.

37

Table 3
Domestic Long Interest Rate Regressions (September 1977 to June 1987)
United States
AR, = 0.30 +
(1.49)
Canada
AR, = 0.50 +
(1.93)
United Kingdom
AR, = -0 .0 1 +
(-0 .1 2 )
West Germany
AR, = 0.91 +
(2.32)
Japan
AR, = -0 .0 2 +
(-0 .9 0 )

r2

DW

h

SE

P

0.26Ai, + 0.09i, ,
(3.42)
(7.28)

-

0.1 OR, ,
(-3 .3 4 )

0.33

2.04

-0 .2 3

0.45

-

0.33Ai, + 0.07i, ,
(6.20)
(2.66)

-

0.11R, ,
(-2 .8 5 )

0.27

2.00

0.00

0.48

-

0.24

1.87

-

0.52

-

0.25

1.86

1.40

0.27

0.28
(2.17)

0.01

1.92

-

0.27

-

0.30 Ai, - 0.12Ai, 1
(5.81) (-2 .3 3 )
0.23Ai, + 0.08i, ,
(6.14)
(2.17)

- 0.18R,_,
(-2 .3 6 )

0.06Ai,
(1.39)

For the United States, Canada and West Ger­
many, the coefficient on the lagged spread, indi­
cated by that on R, , in table 3, is negative.20The
observation o f a negative and significant coef­
ficient for p, is a rejection o f the expectations hy­
pothesis, but, as noted above, there may be sound
reasons for this com m on empirical result. For our
pur poses, all that is important is that R, , has a
statistically significant effect on AR, in three o f the
countries and, therefore, should be controlled for
in testing international linkages.
In Japan, neither the lagged long rate nor short
rate have any significant effect; in fact, the change
in the long rate is essentially uncorrelated with
anv domestic interest rate information. No lagged
short rate changes enter significantly in equation
5, except in the United Kingdom, where (1, and (3,
are equal in magnitude but (3, is zero. The current
change in the short rate is the most powerful ex­
planatory variable for the change in the long rate;
for all countries except Japan, a 1 percent change
in the short-term interest rate raises the long rate
^These three equations in table 3, and in table 6 below, include
lagged dependent variables so the Durbin-Watson d-statistic
(labeled DW in the tables) is not the appropriate test for auto­
correlation. This problem arises in tables 4 and 5 below, as
well. The Durbin h-statistic is computed whenever the number
of observations is not too large to prevent this calculation. In
tables 3 and 6, h-statistics can be computed and they reject the
presence of significant autocorrelation. The critical value is
1.65. For the equations for West Germany, a correction for
first-order serial correlation is necessary and its estimated
coefficient, p, is indicated in the tables. There is no indication of
further significant autocorrelation in the equations, however.




by about a quarter of a percent in the same month.
Table 4 contains similar domestic regression
results for the change in the short rate in each
country. Past values o f both short-term and long­
term interest rates for up to four periods were
examined sequentially, both individually and
jointly, to see if they provided statistically signi­
ficant explanatory pow er for the change in the
short-term interest rates. For all countries, there is
a significant positive relation between the current
change in the short rate and the first or second
month's lagged change in the long rate.2' This is
broadly consistent with the expectations theory
that indicates the change in the current long rate
reflects changes in expected future short rates. If
these expectations are realized, the change in the
long rate presages these future short-rate changes.
In the Canadian case, the short rate is a threemonth rate instead o f the one-month rate that is
available for the other countries; the use o f a
three-month rate imparts a natural second-order
moving average process in the residuals o f this

21The computed h-statistics indicate the absence of significant
autocorrelation. The statistic cannot be computed for the short­
term interest rate equations in table 4 for Canada or the United
Kingdom. In these countries, Durbin's alternative test that
regresses errors on the lagged error and all right-hand-side
variables is used. The coefficient on the lagged error term
provides the test statistic for autocorrelation. This coefficient is
not statistically significant in either country, so no correction for
autocorrelation was computed.

JULY/AUGUST 1988

38

Table 4
Domestic Short-Rate Regressions (September 1977 to June 1987)
United States
Ai, = 1.15 - 0.13i,_,
(3.22) (-3 .3 6 )
Canada
Ai, = 0.61 + 0.24Ai,_,
(2.38)
(2.49)
United Kingdom
Ai, = -0 .3 1 - 0.25Ai,_,
(-0 .5 5 ) ( -2 .3 9 )
+ 0.15R,_2
(2.09)
West Germany
Ai, = - 0 .0 0 - 0.16Ai,„,
(-0 .0 2 ) (-1 .8 2 )
Japan

r2

DW

h

SE

0.14

1.96

0.21

1.11

- 0.05i,^2 + 0.35AR,_,
(-2 .4 5 )
(2.41)

0.20

2.01

N.C.

0.76

- 0.13i, a + 0.57AR,.,
(-2 .8 0 )
(3.69)

0.13

2.11

N.C.

0.87

+ 0.46AR, 2
(2.48)

0.06

2.03

-0 .5 5

0.62

0.35

1.73

1.60

0.46

+

0.73AR, ,
(3.83)

Ai, = - 0 .0 6
0.14i, , + 0.50Ai,_3
(-0 .2 4 )
(-3 .6 5 )
(6.71)
+ 0.45AR,_, + 0.13R, 2
(2.80)
(2.46)
N.C. means the h-statistic cannot be computed.

equation.2- Correction for this simply affects the
standard error o f the reported coefficients; except
for the constant and lagged dependent variables,
no standard error is reduced (or t-statistic raised I
by more than 5 percent, so that the variable selec­
tion process is unaffected.23

Foreign Influences on Domestic
Rates

Although in most countries the dynamics ap­
pear to be m ore com plicated for the short rates
than the long rates, the explanatory pow er o f the
estimated equation is rather low, except in Japan.
In Japan, most o f the explanation comes from the
three-period lagged change in the short rate. Out­
liers are not the source o f this curious dynamic
relation whose explanation is unknown to us. In
general, only a small fraction o f future short-rate
changes is explained with such domestic informa­

The estimates in table 3 generally show that
typical determinants o f the domestic termstructure, like lagged spread information and cur­
rent short-rate changes, provide significant and
similar information across countries. These esti­
mates can be used to examine w hether foreign
short-term interest-rate changes exert an indepen­
dent influence on the domestic term structure.
The correlation evidence above indicates that long
rates are systematically linked across countries.

“ Hansen and Hodrick (1980) point out this problem for equa­
tions such as this. Note that this problem could also arise for
the United States for data after April 1984 because of data
problems described in the appendix, but we could find no
evidence of bias due to this in the U.S. equations in tables 4 or
5.

24Bisignano (1983) specifies a long-rate term structure equation
that includes either the realized change in the short rate or the
news in the short rate; the difference is marginal. He also
concludes that current short-rate changes are unpredictable.
Krol (1986) examines the impact of current and lagged domes­
tic short-term interest rate changes on Eurodollar bond rates
and doesn’t find a significant effect for lagged changes; only
current, U.S. short-term interest rate changes appear to be
relevant in explaining Eurodollar bond rate changes.

23The differences in the information content apparently shows up
in the positive coefficient on Ai,_,, unlike the negative coeffi­
cients for this variable in other countries. For one-month rates
in other countries, a rise in the rate is systematically related to
a subsequent decline; a rise in the three-month rate in Canada
is related systematically to a rise in the next month’s threemonth rate.


http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

tion; current changes in the short rates are largely
unexplained.24

39

Table 5
Short-Rate Regressions with Changes in Foreign Short Rates as
Explanatory Variables (September 1977 to June 1987)
United States
Ai,us = 1.22
0.14i{?,
(3.53)
(-3 .6 9 )
Canada
+
0.27Ai«
AipA = 0.42
(2.97)
(1.70)
+ 0.21A i^
+ 0.15Ai,UK
(3.57)
(2.06)
United Kingdom
0.25AW
Ai,UK = -0 .3 1
(-0 .5 5 )
(-2 .3 9 )
+ 0.1 5R,uk2
(2.09)
West Germany
Ai«G = 0.00
0.43Ai™°,
(-3 .5 2 )
(0.05)
Japan
0.16ijlp1
Aiilp = -0 .0 3
( —0.08)
(-3 .0 9 )
+ 0.15Ri?2 + 0.17Ai"G
(2.16)
(2.75)

+

0.44ARS
(2.16)

+

R2

DW

h

SE

0.41 A ifA
(3.17)

0.21

2.10

-0 .5 0

1.07

-

P

- 0.04ipA2
(-1 .7 7 )

+

0.26ARf_A,
(1.89)

0.29

2.23

- 0 .2 0

0.72

-

- 0.13i,UK2
(-2 .8 0 )

+

0.57AR,UK1
(3.69)

0.13

2.11

N.C.

0.87

-

+

0.32Ai/p
(3.41)

0.11

1.95

N.C.

0.60

0.32
(2.35)

+

0.41 AR;,P1
(2.64)

0.40

1.79

0.44

0.24
(2.09)

+ 0.35ARJ*
(1.82)
+

0.53iAi/p3
(7.39)

1.36

N.C. means the h-statistic cannot be computed.

The absence o f systematic significant positive cor­
relations o f changes in short rates, however, raises
the question o f w hether and how short or long
rates are linked internationally through a term
structure relation. The question examined is
w hether current interest-rate changes abroad
exert an independent influence on domestic inter­
est rates beyond the influence o f domestic infor­
mation.25
Table 5 shows the international linkages b e­
tween short rates. For each country, current
changes in all foreign short rates are added to the
domestic equation from table 4; insignificant addi­
tions (individually or as a group) are omitted.28The
data show a strong two-way relationship between

“ Lagged information from foreign markets should not be impor­
tant for current domestic changes. Even if such lagged vari­
ables were significant, those patterns should be unstable over
time, reflecting specific occurrences without having anything to
do with stable transmission mechanisms. The significance of
lagged information was examined; it is significant in some
cases, but not stably so. Thus, the results are omitted.
26As in table 4, correction for a second-order moving-average
process in the Canadian equation has no effect on the coeffi­
cients, summary statistics or variable selection. The h-statistic
reported for Canada is that found from the moving-averagecorrected standard error of the coefficient for the lagged de­




changes in short rates in the United States and
Canada. A similar relationship exists between Ja­
pan and West Germany. No foreign influence is
significant for the United Kingdom, suggesting
that the British authorities follow ed relatively in­
dependent policies, especially with regard to the
exchange rate.27The interaction between the U.S.
and Canadian financial markets reflects the large
degree o f integration o f these econom ies and their
geographical relation.
The lack o f a relationship between changes in
short rates in the United States and those in West
Germany and Japan could be surprising to many
analysts. Monetary authorities in West Germany
and Japan generally are assumed to have at least

pendent variable. The h-statistic indicates that first-order auto­
correlation is rejected for the United States, Canada and, after
correction, Japan. In the United Kingdom and West Germany,
the alternative test discussed in footnote 21 above rejects
autocorrelation.
270ve r the sample period, the United Kingdom was not part of
any exchange-rate system nor was it the focus of international
cooperation arrangements. Most of the discussion of interna­
tional policy coordination focused on the United States vs.
West Germany and Japan.

JULY/AUGUST 1988

40

Table 6
Long-Rate Regressions with Changes in Foreign Short Rates
As Explanatory Variables (September 1977 to June 1987)_______________
United States
ARtus = 0.28
+
(1.39)
+ 0.11 A ifA
(1.89)
Canada
ARfA = 0.34
+
(1.45)
+ 0.17Ai,us +
(4.72)
United Kingdom
ARuk = -0 .0 1
+
(-0 .1 5 )
West Germany
AR»G = 0.57
+
(2.10)
+
+ 0.07 A i ^
(3.72)
Japan
+
A R f = - 0 .0 2
(-1 -0 2 )

R2

DW

h

SE

0.23Aips
(5.82)

0.07i,us1
(2.39)

-

0.08 R,us,
(-2 .5 5 )

0.34

2.04

-0 .2 0

0.45

0.23AifA
(4.49)
0.10AitUK
(2.30)

0.07i“
(3.06)

-

0.10RtCA,
(-2 .8 4 )

0.40

1.93

0.35

0.44

+

017AipA

0.29
(3.07)

1.96

-

0.50

0.27Ai,UK
(5.43)

0.13Ai,UK,
-2 .5 3 )

0.18Ai,WG
(5.53)
0.13AipA
(4.52)

0.06i,WG,
(2.26)
0.04 AipK
( 1.88 )

-

0.12R"0,

0.48
(-2 .2 8 )

1.88

0.78

0.23

0 .0 5A if
(1.18)

0.05Aips
(2.19)

+

0.08Ai,CA

0.14
(2.82)

1.98

-

0.26

implicit exchange-rate objectives w ith respect to
the U.S. dollar, even if they otherwise try to remain
as independent as possible from the United States.
Nevertheless, no significant linkages between
news in the United States, as reflected in its
change in the short-term interest rate, and shortrate changes in West Germany and Japan were
found.
The significant relationship between changes in
short-term interest rates in West Germany and
Japan may also surprise analysts. Yet this positive
relationship, and the absence o f one for the United
States and either West Germany or Japan, are sta­
ble results; both characteristics are found in esti­
mates for only the first or the last half o f the sam­
ple period.
Central bank exchange-rate policies may not be
so sufficiently rigid and automatic that foreign
developments are incorporated instantaneously in
domestic short rates. If there is a longer-run
28At a point in time, the same information is used to determine
both the one-month and the three-month interest rate. The
latter, however, reflects expectations for the two months be­
yond the current one and is influenced not only by current
information influencing this month’s one-month rate, buf also
by current information that is specific to the subsequent two
months. In the simplest expectations model, the three-month


FEDERAL RESERVE BANK OF ST. LOUIS


0.23
(2.05)

exchange-rate objective, however, foreign changes
in short rates w ill contain information about fu­
ture changes in domestic short rates; therefore,
they should produce immediate revisions o f d o­
mestic long rates. Table 6 displays evidence exam­
ining this hypothesis. All foreign short-rate
changes w ere added to the preferred equations
from table 3; only the significant terms are re­
ported in table 6.
An interesting result is that the Canadian shortrate change affects most countries. This phenom e­
non probably arises because o f the use o f a threemonth rate for Canada. Changes in this yield are
more forward-looking, reflecting the expected
yield for the month and the subsequent two
months.28Thus, the Canadian yield used here
contains more information than the other short­
term rates, so its significance may arise because of
this difference rather than unusual properties o f
the Canadian financial market.
rate is approximately equal to the arithmetic average of the
current and two prospective expected one-month rates, or the
one-month rate plus two-thirds of the expected change in the
one-month rate, one month from now and one-third of the
change in the one-month rate, two months from now.

41

The change in the long rate in the United States,
given the influence o f the current change o f the
U.S. short rate, is independent o f all foreign shortrate movements. The change in the Canadian rate
is included in the U.S. equation, despite the fact
that it is marginally insignificant, because it is
strongly significant in the other three countries.
On the other hand, the change in the U.S. short
rate enters significantly in the long-term rate equa­
tions for Canada, Japan and West Germany, sug­
gesting that these three countries follow implicit
exchange-rate policies that involve infrequent and
variable interventions in m oney and currency
markets, with lags beyond one month. The longrate equations for Canada and West Germany im ­
prove considerably with the inclusion o f foreign
short rates. The U.K. long rate is not significantly
affected by the U.S. short rate. The results, with the
exception o f the U.K. equation, are consistent with
a view of the w orld in which foreign financial mar­
kets react to movements in U.S. short-term interest
rates.
Except for the problematical Canadian in­
fluence, the international linkages shown in table
6 are sensitive to the period chosen. One o f the
simplest ways to test for temporal stability of re­
gression estimates is to break the sample period in
half to investigate w hether the estimates are signi­
ficantly different across the periods. Based on
such a consideration, the equations in table 6
w ere re-estimated for each half o f the sample p e ­
riod. The significance o f foreign influences virtu­
ally vanishes when only the last half o f the sample
period (1982:7-1987:6) is used. Only the Canadian
rate change remains significant in the U.S. and
U.K. equations, and even this variable disappears
in the equations for West Germany and Japan. All
the other significant foreign influences shown in
table 6 drop out; the remaining estimates in the
table are virtually unaffected. Thus, although for­
eign changes in short-term rates sometimes in­
fluence domestic long rates, this influence is not
robust.-”
The results in table 2 show that correlations
between changes in long rates internationally are
pairwise significant in all cases; this result persists

even when the sample is split into approximately
equal subperiods. While long rates are not linked
strongly through currency and m oney markets,
there are significant and stable relationships be­
tween them. Apparently, the integration o f inter­
national capital markets assures that nominal
long-term rates move together, despite the fact
that this integration usually is quite direct and
does not arise from the short-term considerations
in currency and m oney market em phasized by
term structure explanations.

SUMMARY AND CONCLUSION
This article explores international linkages
among interest rates. The framework used for this
purpose is a conventional m odel o f the domestic
term structure. In a term-structure framework, a
change in a foreign short-term rate w ould be ex­
pected to alter the foreign long-term rate and, if
interest rates are linked internationally, to alter
domestic short-term rates as well. The latter
change, again via a domestic term-structure rela­
tion, w ould change domestic long-term rates. This
article tests these relationships. It also tests
w hether foreign short-term rate changes exert an
independent term structure influence, given the
current change in the domestic short-term rate.
When foreign interest rates are added to the
domestic, short-term interest rate equations, there
is some marginal, though segmented, connection
between rates across countries. Changes in short­
term rates in either Canada or the United States
affect short-term rates in the other. In addition,
changes in the U.K. short-term rate directly in­
fluence interest rates in Canada. There is a similar
bidirectional connection between short-term rates
in Japan and West Germany. There is no signi­
ficant linkage, however, between changes in U.S.
short-term interest rates and changes in short­
term rates in the United Kingdom, Japan or West
Germany, over the full period examined here.
The evidence suggests that long-term nominal
interest rates are related closely and directly
across countries. The addition o f changes in for­
eign short-term rates to the domestic long-term

^The foreign influences in table 5 are somewhat more robust in
a similar test. For the latter half of the sample period, the sig­
nificant influences of Canadian short rates on U.S. short rates,
U.K. short rates on Canadian short rates and short rates in
Japan on those in Germany remain significant. The bidirec­
tional elements from the United States to Canada and from
Germany to Japan disappear. Thus, no short-run influence is
left running from U.S. short rates to those in any of the coun­
tries.




JULY/AUGUST 1988

42

rate equations, however, generally provides no
significant information. Also, short-term interest
rate changes are not contem poraneously correl­
ated across countries. Thus, the relationship be­
tween long-term nominal interest rates does not
arise indirectly through an international termstructure transmission or through com m on shortterm-rate movements that are transmitted through
the domestic-term structures. Neither of these
channels is found to be significant.

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Federal Reserve Bank of San Francisco Economic Review
(Summer 1987), pp. 31-42.


FEDERAL RESERVE BANK OF ST. LOUIS


Wood, John H., and Norma L. Wood. Financial Markets (Harcourt Brace Jovanovich, Inc., 1985).

43

Appendix
The Interest Rate Data
All data are end-of-month values.

Canada
S hort rate: interest rate on three-month Treasury
bill rates from the database o f the Federal Reserve
Board.
Long rate: interest rate on government bonds with
a remaining maturity o f 10 years from the database
o f the Federal Reserve Board.

Japan
S hort rate: one-month Gensaki rate provided by
the Bank o f Japan.
Long rate: average yield to maturity on a number
o f government bonds with a constant remaining
maturity o f nine years, provided by the Bank of
Japan.

United States
Short rate: Until April 1984, the yield on onemonth T-bill rates was available. From May 1984 to
June 1987, the series was updated using the inter­
est rate on three-month T-bill rates. A test o f the
adequacy o f this approximation was perform ed by
regressing the one-month T-bill rate on a constant
and the three-month T-bill rate over the period
w hen both w ere available, January 1978 to April
1984. The constant is not significantly different
from zero, w hile the coefficient on the threemonth rate is not significantly different from one.
The other statistics also justified the approxima­
tion. The one-month data w ere provided by Pro­
fessor Alex Kane. The three-month data came from
the database o f the Federal Reserve Board.
Long rate: the series is the yield to maturity of
government securities bonds with remaining
maturity o f 10 years from the database o f the
Federal Reserve Board.

United K ingdom
Short rate: one-month interbank deposit rate
from the Financial Times.
Long rate: average yield to maturity on a number
of government bonds with remaining maturity
between eight and 12 years from the Financial
Times.




West Germ any
Short rate: one-month interbank deposit rate
from the Frankfurter Allgemeine.
Long rate: average yield to maturity on a number
o f government bonds with remaining maturity
over eight years from the Frankfurter Allgemeine.

JULY/AUGUST 1988

44

Keith M. Carlson
Keith M. Carlson is an assistant vice president at the Federal
Reserve Bank of St. Louis. Thomas A. Pollmann provided re­
search assistance.

How Much Low er Can the
Unemployment Rate Go?

I n JUNE 1988, the civilian unemployment rate
dipped to 5.3 percent, its lowest rate since May
1974. The Council o f Econom ic Advisers (CEA), in
its 1988 Annual Report, forecast a continuing drop
in the unem ploym ent rate, accompanied by a
decline in the inflation rate from 4.6 percent in
1987 to 3 percent in 1991.'
These developm ents raise an interesting ques­
tion: how low can the unemployment rate be
driven without accelerating inflation? In the late
1970s, considerable research was devoted to the
discussion o f such a critical rate, usually referred
to as the “natural rate o f unem ploym ent.” This
research produced estimates o f the natural rate in
the late 1970s ranging between 5 percent and 7
percent, but generally w ere centered on 6 per­
cent.2With the unemployment rate well above 6
percent for most o f the 1980-87 period, the debate
about the level o f the natural rate had subsided;
with the unemployment rate moving w ell below 6
percent in early 1988, however, the debate has
now resurfaced.

'The CEA report was prepared in February. See Council of
Economic Advisers (1988), p. 50. For further detail on the
Administration’s forecast, see Office of Management and
Budget (1988), pp. 3 b -7 -8 . The annual inflation rate is that for
consumer prices measured from fourth quarter to fourth quarter.
2A representative estimate is that of Cagan (1979), p. 215. For a
more exhaustive survey of alternative estimates, see Weiner
(1986).




This article reviews the factors that determine
the natural rate o f unemployment, focusing speci­
fically on developm ents since 1979. First, it dis­
cusses the concept o f unem ploym ent and summa­
rizes h ow the government measures unem ploy­
ment. Second, it reviews the choice o f benchmark
years as an aid in the analysis. Finally, it examines
the underlying determinants o f the natural rate of
unemployment in detail. Though no attempt has
been made to derive precise estimates of the natu­
ral rate, the direction o f its movement in recent
years has been detailed.3

BACKGROUND: CONCEPTS AND
MEASUREMENT
To analyze recent unem ploym ent trends, it is
useful to summarize the reasons for unem ploy­
ment. Since the focus is on unemployment as
measured by the U.S. government, some detail
about how unem ploym ent statistics are gathered
is also useful (see opposite page).

3Most of the studies were done in the late 1970s and have not
been updated since then. See Weiner (1986). The major excep­
tions are Rissman (1986) and Gordon (1987), in which he
“ assumes” continuation of the natural rate at 6 percent through
1985. He offers statistical evidence in support of this contention
in Gordon (1988).

JULY/AUGUST 1988

45

A Prim er on U.S. Unemployment Statistics
Each month, during the week containing the
12th day of the month, the U.S. Bureau o f the
Census suiveys 65,000 households for the Bu­
reau o f Labor Statistics.1One-fourth o f the
households is replaced each month so that no
household is interviewed more than four
months in a row. This procedure allows for
continuity of the data and reduces the report­
ing burden on families.
In response to a series o f questions, the inter­
viewer determines w hether each household
member 16 years and older is em ployed, unem ­
ployed or not in the labor force. Unemployed
persons are those w ho had no em ployment
during the survey week but w ere available for
work. The interviewer also establishes whether
each unem ployed person (1) made specific
efforts to find work in the preceding four weeks,
(2) was waiting to be recalled to a job from
which he or she had been laid off or (3) was
waiting to report to a new job within 30 days.
Further information is obtained about the
reason for unemployment. The unem ployed are

'For a useful summary of how the government collects
information for its unemployment report, see Bureau of
Labor Statistics (1987).

Types o f Unemployment
Unemployment can be categorized as frictional,
cyclical and structural. A lth o u g h th e g o v e rn m e n t
does n ot present its statistics in this wav, such a
categorization is still helpful in understanding
w hy unemployment occur s.
Cyclical unemployment can be most readily
understood as representing movements o f the
unemployment rate that result from fluctuations
o f aggregate demand for goods and services. These
fluctuations, in turn, can be traced to monetary
and fiscal policy or anything else that affects ag­
gregate demand.
Frictional unem ploym ent results from relative
shifts in the supply or dem and for goods and ser­
vices between industries or occupations. Because
information about jobs is costly to obtain, people
can be “caught between jobs," resulting in terrrpo


classified as (1) job losers (involuntary quits), (2)
job leaver's (voluntary quits), (31 reentrants
(those w ho previously worked, but w ere out of
the labor force before looking for work), and (4)
new entr ants (those w ho never worked before
but w ere now looking for work).

Employed persons are (1) persons who, dur­
ing the survey week, either worked as paid em ­
ployees in their ow n business or as unpaid
workers in a family-operated enterprise, and (2)
those w ho did not work but had jobs from
which they w ere temporarily absent because o f
illness, weather, vacation, strikes or personal
reasons.2

The labor force is the sum o f persons aged 16
and over w ho are classified as em ployed or
unemployed. The unem ploym ent rate is calcu­
lated as the total number unem ployed as a
percent o f the labor force. Unemployment rates
according to sex, age, race and reason for un­
em ployment are also calculated.

2The government also provides information on the distinction
between part-time and full-time employment.

raiv unem ploym ent w hile information about other
jobs is sought. Sometimes, to emphasize its shortrun transitional nature, this type o f unem ploy­
ment is called turnover unemployment and is
consider ed a vital aspect o f the operation o f a freeenterprise economy.
Structural unem ploym ent occurs when there is
a mismatch o f workers and job vacancies either by
reason o f skill or location. It is only artificially dis­
tinguishable from frictional unemployment in that
it is considered longer in duration and involves, in
addition to the costs o f job-information search,
training or relocation costs.
Categorizing unem ploym ent into three types is
a useful w ay to analyze it. The three types o f un­
em ployment involve costs in obtaining informa­
tion about the availability o f other jobs. Because
labor markets are characterized by heterogeneity
of skills and job requirements, it takes time and

JULY/AUGUST 1988

46

resources to get such information. In general, this
process continues until the expected benefit of
the search (present value o f expected future in­
come) equals the cost o f the continued search
(again, in present value terms).

Defining the Natural Rate o f
Unemployment
To analyze unem ploym ent further, one must
clarify the meaning o f the term "natural rate of
unem ploym ent.” This can be done by explaining
the concept using a Phillips curve diagram.
Phillips-curve analysis was popularized in the
1960s and is still useful today as an expository
device.4In essence, the Phillips curve summarizes
the relationship between inflation and the unem ­
ployment rate. When first introduced, it was
thought to be a relationship that policymakers
could exploit. Over the years, however, this inter­
pretation has changed. Analysts now generally
accept that there is a whole family of short-run
Phillips curves, corresponding to different ex­
pected rates o f inflation (Pl in figure 1).

Figu re 1

Phillips Curve Diagram
Percent

note an increase in sales and w ill interpret the
increase as a shift in dem and for their product
and attempt to expand employment. Attractive
wage offers will induce many workers to cut short
their job search and accept employment. Higher
prices and low er unemployment w ill result, m ov­
ing the econom y to point B.
This movement is temporary, however, as both
employers and workers com e to expect inflation.
When the shift in dem and is perceived as general,
workers w ill return to their normal job search
patterns and employers' dem and for labor w ill be
reduced to previous levels. The econom y w ill
move to point C, where unemployment is equal to
its natural rate, Un, once again, but inflation is
higher than it was at point A. The vertical line is
called a long-run Phillips curve because it reflects
a period long enough for inflationary expectations
to adjust fully.
The revised interpretation o f the Phillips curve
yields a definition o f the natural rate o f unem ploy­
ment: when the actual rate o f inflation equals the
expected rate, the unem ploym ent rate that corres­
ponds is the natural rate (shown as U„ in figure 1).
This does not mean that there is anything “natu­
ral” about such a rate. For example, it is not con­
stant over time, but rather is influenced by dem o­
graphic changes as w ell as government policies.
The Phillips curve diagram also allows a more
precise definition o f cyclical unemployment.
W hen unem ploym ent departs from its natural
rate, w e have cyclical unemployment. Or, in other
words, cyclical unem ploym ent results when ac­
tual inflation and expected inflation are unequal.
The governm ent’s unem ploym ent statistics
provide little help in estimating the natural rate.
Conceptually, however, the sum o f frictional and
structural unem ploym ent is equal to natural un­
employment. Consequently, any factor that in­
fluences either frictional or structural unem ploy­
ment (or both) is relevant to the determination of
the natural rate.

In the short run, before expectations o f inflation
change, there is a trade-off between inflation and
unemployment (shown as SR curves in figure II.
Suppose the econom y initially is at point A, with

Past research suggests that the most important
influences on the natural rate are demographic or
institutional. Demographic factors involve such
characteristics o f the work force as age, sex and
racial distribution. One o f the most prominent
demographic factors in the post-World War II
period occurred when the baby-boom generation

expected inflation equal to zero. If monetary and
fiscal policy becom e expansionary, employers will

came o f age and entered the labor market. In re­
cent years, this generation has swelled the size o f

Percent
Unem ploym ent rate

“For a survey, see Santomero and Seater (1978).


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47

Chart 1
Inflation and Unemployment Rates
P ercent
15.0

10.0

Percent

Annual Data

10

Inflation rate*
ISCALE

5 .0

0.0

U nem ploym ent rate

SCALED
-5.0
1945

2
50

55

60

65

70

75

80

85

1 990

•C o n s u m e r prices_________

the prime-age working group (age 25 to 54). Age
groups like this require time to develop the skills
necessary to match the requirements of job vacan­
cies. Such adjustments eventually take place, but
the process is usually longer than, say, the tem po­
rary nature of turnover or even cyclical unem­
ployment.
Institutional factors can have an effect on the
natural rate, for example, the pattern of shifting
demand across industries, the minimum wage,
and government policies that influence jobinformation search (personal and em ployer taxes,
unemployment benefits).

CHOOSING BENCHMARK YEARS
To analyze unemployment trends, one must
begin with the choice of certain benchmark years
that are representative o f full employment.5The

5“ Full employment” is defined here as the employment counter­
part of the natural rate of unemployment.
6This was probably recognized first by the Council of Economic




benchmark years in this study are ones that occur
late in business expansions and are free o f the
influences of war. It is difficult to identify any
years in the 1948-55 period as benchmark years;
they are obviously influenced by the economic
conditions associated with W orld War II, the Ko­
rean War and their aftermath. For this reason, 1956
is chosen as the first benchmark year. This year is
recognized generally as one of “full em ploym ent”
without serious inflation and the other benchmark
years chosen — 1973 and 1979 — are also ones
that occur late in business expansions and are
generally free o f wartime influence.6
Chart 1 summarizes inflation and unem ploy­
ment, with the benchmark years highlighted. As
one can see, the relationship between the two is
highly variable, reflecting a host of complex
factors. A direct examination of the inflation-

Advisers in the early 1960s. Actually both 1955 and 1956 are
used; de Leeuw and Holloway (1983) use 1955, while Cagan
(1979) uses 1956.

JULY/AUGUST 1988

48

Chart 2
Unemployment Rates
Percent

Percent

A nn u al D ata

■

■

m m b b

i m
suganaii^!

H

A
M
n

ib w

Civilian unemployment rate

'

1^

r

A

ii V
1

1 M
1\
1 M
1 \
1 \ \ ll \ J
/
\ N -J /
>
1
\
1
\
1

r
A

J

\
V.
\

A
\

50

55

60

65

unem ploym ent relationship yields little informa­
tion about h ow low the unemployment rate
can go.
Chart 2 summarizes the civilian unemployment
rate along with that for prime-age males for the
1948-87 period. Civilian unemployment in the
three benchmark years ranges from 4.1 percent of
the labor force in 1956 to 5.8 percent in 1979. Com ­
pared with 1979, it appears that the econom y
reached full em ployment in late 1987 when the
unemployment rate fell below 6 percent; com ­
pared with the earlier benchmarks, however, there
seems to be room for further em ployment
expansion.
The structure o f unemployment, especially as it
reflects a changing composition o f the labor force,
is an additional consideration in assessing the
nearness o f actual em ployment to full em ploy­
ment. Chart 2 also shows unemployment for
prime-age males, the group that has the lowest
turnover rate in the labor force. The unem ploy­

FEDERAL RESERVE BANK OF ST. LOUIS


*

\

/II M

'
! Une mployment rate:

\

"W
1945

i
A

\

*».— '

i
i

/

\

\

h \

/
/

\

\

prime-age males

...L l J .................

70

75

80

85

1990

ment rate for this group was 2.9 percent in 1956,
2.6 percent in 1973, and a somewhat higher 3.4
percent in 1979. The 1987 unem ploym ent rate for
this group averaged 5 percent, again suggesting
there is room for further expansion in
employment.
A direct examination o f those unemployment
measures that are considered most important
does not provide a clear-cut conclusion about
whether the 1987 levels o f unemployment indicate
an econom y approaching full employment. There­
fore, w e examine the com position o f the labor
force in further detail.

CHANGES IN DEMOGRAPHIC
FACTORS
The overall unem ploym ent rate reflects a
w eighted average o f many unem ploym ent rates, as
table 1 indicates. As this table shows clearly, cer­
tain groups typically have higher or low er unem-

49

Table 1

Table 2

Unemployment Rate by Age and Sex
_______
(selected years)

Composition of Labor Force by Age
and Sex (selected years)

1956
Total

4.1%

1973
4.9%

1987

1979
5.9%

6.2%

Total'

1956

1973

1979

1987

100.0%

100.0%

100.0%

100.0%

Male
16-19
20-24
25-54
55-64
65 +

11.0
6.9
2.9
3.5
3.5

13.9
7.3
2.6
2.4
3.0

15.9
8.7
3.4
2.7
3.4

17.8
9.9
5.0
3.7
2.6

Male
16-19
20-24
25-54
55-64
65 +

67.7
3.7
5.2
45.6
9.3
3.9

61.0
5.2
8.0
37.8
7.9
2.1

57.9
4.9
8.1
36.1
6.9
1.9

55.2
3.4
6.5
37.9
5.8
1.6

Female
16-19
20-24
25-54
55-64
65 +

11.0
6.3
4.1
3.7
2.3

15.3
8.4
4.4
2.8
2.9

16.4
9.6
5.2
3.2
3.3

15.9
9.4
5.1
3.1
2.4

Female
16-19
20-24
25-54
55-64
65 +

32.2
2.8
3.7
20.6
3.9
1.2

38.9
4.3
6.3
22.4
4.7
1.2

42.1
4.3
6.9
25.3
4.5
1.1

44.7
3.2
6.0
30.4
4.1
1.0

'May not equal 100 due to rounding.

ployment rates than the overall average. The teen­
age group is always the highest, follow ed hv the
20-24 year-old group. Consequently, to under­
stand more fully the significance o f a given unem ­
ploym ent rate, one must examine both the relative
importance o f each age group in anv given year
and the growth rate o f each age group over time.
Table 2 summarizes the relative importance o f
the different age-sex groups for the benchmark
years. One striking observation is the change in
the ratio o f males to females that has taken place
since 1956. This changing proportion, however,
may not be critical in interpreting what has hap­
pened to the overall unem ploym ent rate: as table 1
shows, female unemployment is not always above
that for males.7
What is important in interpreting movements in
the unemployment rate over time is the shifting
importance o f age groups. Obviously, the rise in
importance o f the 16-19 and 20-24 vear-old
groups from 1956 to 1979 was an important factor
in interpreting unemployment trends for that
period. As table 1 shows, the unemployment rate
was always highest for these groups. Significantly,
however, these youngest age groups have declined
as a proportion o f the labor force from 1979 to
1987.

Table 3
Growth of Labor Force by Age and Sex
(selected years, annual rates)
Total

1956-73

1973-79

1979-87

1.8%

2.7%

1.7%

Male
16-19
20-24
25-54
55-64
65 +

3.9
4.3
0.6
0.7
-1 .8

1.5
2.9
1.9
0.4
0.3

- 2 .7
-1 .1
2.3
-0 .5
- 0 .3

Female
16-19
20-24
25-54
55-64
65 +

4.3
5.0
2.3
2.9
1.5

2.9
4.2
4.8
1.8
1.5

- 1 .9
- 0 .2
4.0
0.6
0.6

For the 1979-87 period, the 25-54 year-old group
grew fastest, reflecting the maturation o f the 16-19
and 20-24 year-old groups o f the 1970s.

Table 3 summarizes the growth o f the labor
force by age group between the benchmark years.

To aid in analyzing the effects o f changes in the
underlying demographics, a w eighted unem ploy­
ment rate, w here the weights are based on the
com position o f the labor force, is com m only used.8

7For an analysis of women in the labor market, see Shank
(1988).

8See Clark (1977), Flaim (1979), Cain (1979), Antos, Mellow and
Triplett (1979) and Cagan (1979).




JULY/AUGUST 1988

50

Table 4
Alternative Unemployment Rates
Overall Rate

Fixed Weight1

Prime-Age
Male

Overall Less
Fixed-Weight

1956

4.1%

4.3%

2.9%

-0 .2 %

1.2

1973

4.9

4.4

2.6

0.5

2.3

1979
1980
1981
1982
1983
1984
1985
1986
1987

5.9
7.2
7.6
9.7
9.6
7.5
7.2
7.0
6.2

5.3
6.6
7.1
9.2
9.2
7.2
7.0
6.8
6.1

3.4
5.2
5.5
8.0
8.2
5.9
5.6
5.6
5.0

0.6
0.6
0.5
0.5
0.4
0.3
0.2
0.2
0.1

2.5
2.0
2.1
1.7
1.4
1.6
1.6
1.4
1.2

Overall Less
Prime-Age Male

’Calculated using average of labor force composition in 1956 and 1987 (see table 2).

Table 4 summarizes various unem ploym ent rates
and provides information about h ow the changing
com position o f the labor force influences the over­
all unemployment rate. A comparison o f the alter­
native rates with the overall rate shows that dem o­
graphic shifts w ere most pronounced in the
1956-79 period.9Changes in the com position of
the labor force shifted the unem ploym ent rate
upward by 0.8 percentage points (overall less
fixed-weight column) compared with an actual
rise o f 1.8 percentage points (5.9 minus 4.1). In
other words, the labor market pressure o f 4.1 per­
cent in 1956 w ould have changed to 4.9 percent in
1979 because o f a shift in the com position o f the
labor force toward the youngest groups.
There was also a w idening o f the difference
between the overall unem ploym ent rate and that
for prime-age males, reaching 2.5 percentage
points in 1979, up from 1.2 percentage points in
1956. This differential yields the same general con­
clusion: considering demographic changes, the
natural rate o f unem ploym ent rose quite sharply
between 1956 and 1979.
Since 1979, the com position o f the labor force
has shifted back toward the older groups, which
suggests that the natural rate o f unemployment
has declined. The difference between the fixedweight measure and the overall rate has narrowed
to almost zero. The smaller differential means that
dem ographic considerations no longer loom as

9For a similar table and analysis, see Council of Economic
Advisers (1978), p. 170.


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large in determining if the econom y is at full em ­
ployment. For dem ographic reasons alone, the
1987 natural rate o f unem ploym ent is only about
0.3 percentage points higher than that o f 1956, and
0.5 percentage points low er than that o f 1979. This
interpretation is supported by the change in the
differential between the overall rate and that for
prime-age males. Thus, although methods vary in
calculating the effects o f changing demographics
on the unemployment rate, there seems to be little
doubt that changes in the com position o f the la­
bor force since 1979 have produced a low er natu­
ral rate o f unem ploym ent.10

CHANGES IN INSTITUTIONAL
FACTORS
As noted earlier, in addition to the age-sex com ­
position o f the labor force, many other factors
influence the unem ploym ent rate. These factors
are discussed in this section along with a sum­
mary of their recent trends.

Minimum Wage
Federal minimum wage legislation was intro­
duced in the United States in 1938; by 1985, 80
percent o f the U.S. labor force was em ployed in
sectors subject to its coverage. By paying the
lowest-incom e workers a higher wage than the
competitive market w ou ld pay in the absence o f a

'“See Cain (1979).

51

Chart 3
Minimum Wage
as a Percent of Average Hourly Earnings
P erce n t
60

30
1945

P ercent
60

A nnual Data

50

55

60

65

70

75

NOTE: Average hourly earnings are for the private nonagricultural sector.

minimum wage, this legislation raised the average
level o f real wages above their competitive level."
In re s p o n s e , th e q u a n tity o f la b o r services s u p ­
p lie d w ill e x c e e d th e q u a n tity d e m a n d e d , w ith th e
d iffe re n c e b e in g c la s s ifie d as u n e m p lo y e d .

When the minimum wage was first legislated in
1938, it was $.25 per hour and covered about 40
percent o f the nation’s nonsupervisorv employees.
Over the 1938-81 period, it was raised 15 times,
reaching $3.35 per hour in 1981 and has not been
changed since. By 1985, 87 percent o f nonsupervisoiy employees were subject to the minimum wage
The minimum wage law has had its greatest
effect on teenage em ployment with little effect on
other age groups. Because they have fewer skills
and less education, teenagers’ marginal products
are typically below those o f older, more experi­

enced workers. Consequently the minimum wage
is much more likely to be above the competitive
w a g e for this g ro u p .
To assess the impact o f minimum wage legisla­
tion, the minimum wage must be viewed relative to
average hourly earnings. The comparison measure
used here is average hourly earnings for workers in
the private nonagricultural sector. The movement
o f the minimum wage relative to this measure from
1947 to 1987 is shown in chart 3.
After a large jump in 1950, the minimum wage
relative to average hourly earnings fluctuated be­
tween 45 percent and 55 percent, before dropping
below 45 percent in 1972. It then rose from about
40 percent in 1973 to 46 percent in 1981. With the
minimum wage constant at $3.35 per hour since
1981, however, a steady decline in the relative

11For a survey, see Brown, Gilroy and Kohen (1982).




JULY/AUGUST 1988

52

Chart 4
Replacement Ratio and Unemployment Rate
Annual Data

P ercent

10

1945

NOTE: Replacement ratio is the average of unemployment benefits paid weekly as a percent of average weekly
earnings in the private nonagricultural sector.

minimum wage has occurred since then, reaching
37 percent in 1987.
Although the relative minimum wage declined
from 1957 to 1973, the coverage increased from 45
percent to 75 percent, primarily because o f the
rapid growth o f teenagers in the labor force. The
minimum wage may have pushed the unem ploy­
ment rate upward from 1973 to 1979, but this
trend was sharply reversed from 1979 to 1987.
Since the last benchmark year o f 1979, the m ini­
mum wage movements have had a positive effect
on the labor market; its decline has reduced the
natural rate o f unemployment.

other things equal, individuals w ill search longer
for a job, lowering the amount o f work that they
are willing to supply at a given real wage. Also,
individuals w ho are not in the labor force w ill be
inclined to enter it to obtain a job and be eligible
for unem ploym ent benefits in the future.

Unemployment Benefits

One important measure in assessing the effect
o f unemployment benefits is the ratio o f average
unemployment benefits paid weekly relative to
average weekly earnings. T his ratio is called the
replacement ratio. Chart 4 shows the ratio from
1947 to 1987 as a solid line. Because this ratio
shows cyclical movem ent throughout the period,
the unem ploym ent rate is also charted (dashed
line i.

An increase in unemployment benefits relative
to wages lowers the cost o f job search.'- As a result,

Generally, the replacement ratio and the unem ­
ployment rate move in tandem. From 1965 to 1973,

l2For discussion and references, see Parkin (1984) and Cagan
(1979).


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Louis BANK OF ST. LOUIS

53

however, the replacement ratio rose quite sharply
relative to unemployment. From 1973 to 1979, it
then declined slightly relative to the unem ploy­
ment rate. But since 1984, the divergence between
these measures has been sharp.

social insurance. Introducing (or raising) this tax
reduces the quantity o f labor dem anded for a
given real wage and, because o f the higher cost o f
labor, may also lengthen the amount o f time em ­
ployers take in searching for workers.

A closer examination reveals that the source of
this recent divergence is chiefly a slowing of aver­
age weekly earnings while unem ploym ent benefits
have continued to rise at relatively rapid rates.
Despite this development, the replacement ratio
seems to have had a recent upward effect on the
natural rate o f unemployment. This effect is
dam pened somewhat by two considerations: (1)
recent changes in tax law whereby unemployment
benefits became partially subject to taxation in
1979, and com pletely so in 1987, and (2) a general
tightening o f eligibility requirements in recent
years.13Thus, the actual value o f the replacement
ratio in 1987 relative to 1979 is less than shown in
the chart. It is impossible, however, to say how
much the change is without further research.

Thus, increased tax rates, whether applicable to
em ployers or employees, reduce em ploym ent and
may increase unemployment. To show what has
happened to the tax wedge, em ployee and em ­
ployer taxes are com bined into a summary mea­
sure and plotted against the unem ploym ent rate
in chart 5. This tax w edge measure incorporates
personal incom e taxes (federal, state and local),
em ployer and em ployee contributions for social
insurance, and sales and excise taxes.15Using 1956
as a reference point, the tax w edge has increased
from about 21 percent to more than 32 percent by
1987. The rise was relatively rapid from 1956 to
1973, slightly slower from 1973 to 1979 and even
slower from 1979 to 1987. These trends suggest
that taxes contributed to an increase in unem ploy­
ment before 1979; since then, the tax w edge has
had little effect, except perhaps to reduce unem ­
ploym ent somewhat since 1981.

Taxes
Another factor o f considerable im portance in
determining unem ploym ent trends is the role o f
taxes in influencing the labor markets.14Again, the
analysis is com plex and the conclusions are not
clear-cut. As an aid in understanding the m acroec­
onom ic effects, it is useful to think in terms o f the
effects on labor supply and dem and separately.
Focusing first on labor supply, the tax w edge is
the difference between the real wage that the em ­
ployer is willing to pay and the after-tax value of
that wage to the workers; the size o f this w edge is
important in the work-vs .-leisure decision that
people make. An increase in the tax w edge will
reduce labor services offered at a given real wage
and may encourage a longer job-search by reduc­
ing the cost o f being unemployed.
On the dem and side o f the labor market, the
relevant tax is the em ployer’s contribution for

13See Abraham (1988) and, for a state-by-state summary of
unemployment legislation in 1987, see Runner (1988).
'“Meyer (1981).
15The tax wedge for households (or suppliers of labor services) is
W _ W

(1 - t „ )

P

(1 + tc) ’

P

where W is the nominal wage, P is the price level, tp is the
personal tax rate and tc is the consumption tax rate. This ex­
pression can be manipulated to give




Demand Shift
Recent research has suggested that shifts in
industry dem and also have an effect on the natu­
ral rate.16This effect is com m only called frictional
unemployment. I f changing tastes, technology or
relative factor prices induce rapid shifts in indus­
try demands for labor, there w ill be greater uncer­
tainty in labor markets and increased search time
for both the em ployee and the employer.
Unemployment that occurs for these reasons is
a healthy reflection o f a dynamic econom y. For
our discussion, however, only the long-run m ove­
ments in the com position o f industrial output are
relevant. Chart 6 is one attempt to capture this
phenom enon; it shows the three-year moving
average o f the sum o f the absolute percentage

w (tc+g
P (1+g
Chart 4 shows the value of the expression following W/P
plus the employer’s contribution rate for social insurance. For
further discussion, see Parkin (1984), pp. 184-85.
16For a discussion and critique of this literature, see Johnson and
Layard (1986). See also Lilien (1982), Lilien and Hall (1986),
and Rissman (1986).

JULY/AUGUST 1988

54

Chart 5
Estimate of Tax Wedge and Unemployment Rate

change in sectoral em ploym ent shares.'7By this
measure, there was a downw ard trend in the d e­
gree o f shifting em ployment until the mid-1960s;
since then the measure o f shifting em ployment
has m oved upward, although it has varied sub­
stantially around the trend.
Focusing on the benchmark years, there is a
slight downward movem ent from 1956 to 1973 to
1979, follow ed by an upward movement from 1979
to 1987. From 1982 to 1987, however, the measure
dropped sharply.18Viewed in this perspective, it is

17The measure of demand shift (in year t) is
10
2
i= 1

E „_
E,

E, ,

where Eit is employment in the ith industry in year t and E, is
total employment in year t. Data used were employees on
nonagricultural payrolls by major industry. See Council of
Economic Advisers (1988), pp. 296-97.
,80ne factor operating during this period was the sharp swing in
the value of the dollar, rising sharply from 1980 to 1985, and
then falling sharply to 1987. If these developments affected


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unlikely that shifts in the structure o f the econom y
have influenced the natural rate o f unem ploym ent
substantially. The relationship between “ dem and”
shifts and the unem ploym ent rate appears, rather,
to be a shorter-run phenom enon.

Other Factors
The above list o f factors, w hile not exhaustive,
summarizes most o f the factors that influence
unem ploym ent trends. Government regulations,
however, also affect labor markets. For example,

mainly manufacturing exports, the effect could have been to
raise frictional unemployment (and the natural rate) when the
dollar was rising, and lower such unemployment when it was
falling. But since the focus here is on 1987 vs. 1979, a period
over which the trade-weighted exchange rate rose only 10
percent, there would seem to be little net effect on the natural
rate. Furthermore, manufacturing employment as a percent of
total non-agricultural employment has shown little sensitivity to
exchange rate movements, even of the magnitude experienced
in the 1980s.

55

Chart 6
Measure of Demand Shift and Unemployment Rate

regulations im posed by the Occupational Safety
and Health Administration (OSHA) in the interest
o f safety and health can divert funds that w ould
normally be used for investment spending.1” These
regulations can act like an em ployer tax, driving a
w edge between the wage the em ployer is willing
to pay and the actual cost.
Another example o f regulations that had an
important effect on unem ploym ent are work regis­
tration requirements for various government p ro­
grams like welfare and food stamps. For example,
in 1972, legislation was passed that required w el­
fare mothers w ho w ere able to work to register for
work.20Although some found jobs, others were
added to the count o f the unemployed.

SUMMARY OF FACTORS AFFECTING
NATURAL RATE

direction in w hich the structural factors have been
operating between the benchmark years since
1956. No attempt is made to estimate precisely the
magnitude o f the effects on the natural rate of
unemployment.
The most obvious change in recent years is the
shifting age distribution o f the labor force, which
has reduced the unem ploym ent rate. In other
words, the babv-boomers, w ho made their pres­
ence felt throughout the 1970s by pushing up the
natural rate o f unemployment, are now in the
prime-age group. Having accumulated skills, edu­
cation and experience, this group is now market­
ing its productive skills, thus reducing the natural
rate o f unem ploym ent by about one-half o f a per­
centage point from 1979.

The role o f these factors is brought together in
table 5. Shown are general conclusions about the

The minimum wage has had a favorable effect in
reducing the trend o f unem ploym ent since 1981,
but no attempt was made here to estimate the
magnitude o f effect. Cagan, however, estimated

19For a broad survey, see Licht (1988).

“ Clarkson and Meiners (1977).




JULY/AUGUST 1988

56

Table 5
Summary of Effects on the Natural
Rate of Unemployment
Factor

1956-73

1973-79

1979-87

World W ar II period. In general, the key factors
that influence the natural rate o f unemployment
have served to reduce it in the 1980s. As a result,
the current natural rate appears below the 6 per­
cent rate estimated in 1979“ Shifts in the age
structure o f the labor force alone have reduced it
about one-half o f a percentage point. Other favor­
able developments, as noted in table 5, may have
reduced it even further.

Demographic change

t

f?

1

Minimum wage

T?

T

1

Unemployment benefits

t

1?

t?

SUMMARY

Tax wedge

t

T

0

Demand shifts

i?

4?

t?

Unemployment rates below 6 percent in late
1987 and early 1988 have raised questions about
how far the rate can fall before inflation again
emerges. The fact that inflation has shown no
clear signs o f acceleration suggests that structural
changes in the U.S. econom y have reduced the
natural rate o f unem ploym ent below what it was
in 1979. This article examined some o f these struc­
tural factors.

NOTE: Arrow indicates direction of effect on the natural rate
of unemployment. Question mark with arrow indi­
cates the effect is probably small. A zero indicates no
effect on the natural rate.

that the minimum wage contributed to an in­
crease in the natural rate o f .45 percentage points
from 1956 to 1977.21The relative minimum wage in
1987 was below that in 1956. With the decline in
the proportion o f teenagers in the labor force,
however, the magnitude o f the effect on the natu­
ral rate o f unem ploym ent is probably less than
Cagan estimated.
Unemployment benefits generally appear to
have affected recent unem ploym ent trends nega­
tively. The replacement ratio has risen quite dra­
matically since 1984. This is misleading, however,
because starting in 1987, unemployment benefits
became fully taxable by the federal government,
w hile eligibility requirements have been tightened
in recent years. These developments have raised
the cost o f being unem ployed and have reduced
the trend o f unemployment.
Taxes w ere a factor in the 1956-73 period (and
to some extent from 1973 to 1979), increasing un­
employment, both by reducing the cost o f the job
search (reducing foregone earnings) and increas­
ing the tax w edge between what employers pay to
labor and workers receive. Since 1979, however,
the upward trend o f taxes has slowed, suggesting
that the tax w edge has not worsened. These devel­
opments are assessed as having no effect on the
natural rate in the 1979-87 period.
Despite considerable fluctuation in the shares o f
sector employment, demand-shift factors do not
appear to have been a factor during the post21Cagan (1979).


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Several o f these factors w ere found to have re­
duced the natural rate o f unem ploym ent in recent
years, when com pared with previous experience
from 1956 to 1979. The age com position o f the
labor force, the minimum wage, individual and
em ployer tax rates are a few o f the factors that
have m oved favorably. Any conclusions about un­
em ployment benefit ratios, however, require fur­
ther study. For the unem ploym ent rate to con­
tinue to decline depends critically on the course
o f future government actions, namely, legislation
relating to the minimum wage, tax rates and un­
em ployment benefits.

REFERENCES
Abraham, Katharine G. “ Has the Natural Rate of Unemploy­
ment Fallen?” mimeo (University of Maryland, June 1988).
Antos, Joseph, Wesley Mellow, and Jack E. Triplett. “ What is a
Current Equivalent to Unemployment Rates of the Past?”
Monthly Labor Review (March 1979), pp. 36-46.
Brown, Charles, Curtis Gilroy and Andrew Kohen. “The Effect
of the Minimum Wage on Employment and Unemployment,”
Journal of Economic Literature (June 1982), pp. 487-528.
Bureau of Labor Statistics. How the Government Measures
Unemployment, Report 742 (U.S. Government Printing Office,
September 1987).
Cagan, Phillip. Persistent Inflation: Historical and Policy Essays
(Columbia University Press, 1979).
Cain, Glen G. "The Unemployment Rate as an Economic
Indicator,” Monthly Labor Review (March 1979), pp. 24-35.

22Weiner (1986) and Cagan (1979).

57

“A New Estimate of Potential GNP,” The 1977
Economic Report of the President, Hearings before the Joint

Clark, Peter K.

Economic Committee, Congress of the United States, Part 1
(GPO, 1977), pp. 39-55.

Inflated Unem­
ployment Statistics: The Effects of Welfare Work Registration
Requirements (University of Miami School of Law, March

Clarkson, Kenneth W., and Roger E. Meiners.

1977).
Council of Economic Advisers.
dent (GPO, 1978).

Economic Report of the Presi­

________ . Economic Report of the President (GPO, 1988).
de Leeuw, Frank, and Thomas M. Holloway. “ Cyclical Adjust­
ment of the Federal Budget and Federal Debt," Survey of
Current Business (December 1983), pp. 25-40.
Flaim, Paul O. “The Effect of Demographic Changes on the
Nation's Unemployment Rate,” Monthly Labor Review (March
1979), pp. 13-23.
Gordon, Robert J.
Co., 1987).
________ .

Macroeconomics, 4th ed. (Little, Brown and

“ The Role of Wages in the Inflation Process,”

American Economic Review, Papers and Proceedings (May
1988), pp. 276-83.
Johnson, G. E., and P. R. G. Layard. “The Natural Rate of
Unemployment: Explanation and Policy," in Orley Ashenfelter
and Richard Layard, eds., Handbook of Labor Economics, vol.
II (North-Holland, 1986), pp. 921-99.
Licht, Walter.

“ How the Workplace has Changed in 75 Years,”
Monthly Labor Review (February 1988), pp. 19-25.




Lilien, David M.

“ Sectoral Shifts and Cyclical Unemployment,”

Journal of Political Economy (August 1982), pp. 777-93.
Lilien, David M., and Robert E. Hall. “ Cyclical Fluctuations in
the Labor Market,” in Orley Ashenfelter and Richard Layard,
eds., Handbook of Labor Economics, vol. II (North-Holland,
1986), pp. 1001-35.
Meyer, Laurence H., ed. The Supply-Side Effects of Economic
Policy, Proceedings of a Conference cosponsored by Wash­
ington University in St. Louis and Federal Reserve Bank of St.
Louis, October 24-25, 1980 (May 1981).
Office of Management and Budget. Budget of the United States
Government: Fiscal Year 1989 (GPO 1988).
Parkin, Michael.

Macroeconomics (Prentice-Hall, 1984).

Rissman, Ellen R. “ What Is the Natural Rate of Unemploy­
ment?” Federal Reserve Bank of Chicago Economic Perspec­
tives (September/October 1986), pp. 3-17.
Runner, Diana. “ Changes in Unemployment Insurance Legis­
lation During 1987,” Monthly Labor Review (March 1988), pp.
9-16.
Santomero, Anthony M., and John J. Seater. “ The InflationUnemployment Trade-Off: A Critique of the Literature," Jour­
nal of Economic Literature (June 1978), pp. 499-544.
Shank, Susan E. “ Women and the Labor Market: The Link
Grows Stronger,” Monthly Labor Review (March 1988),
pp. 3-8.
Weiner, Stuart E. “ The Natural Rate of Unemployment: Con­
cepts and Issues," Federal Reserve Bank of Kansas City
Economic Review (January 1986), pp. 11-24.

JULY/AUGUST 1988

58

H. Alton Gilbert
ft. Alton Gilbert is an assistant vice president at the Federal Re­
serve Bank of St. Louis. Dawn M. Peterson provided research
assistance.

A Comparison of Proposals to
Restructure the U.S. Financial
System
G
L _7lN C E the 1930s, commercial banks have been

for banking organizations to underwrite securities.

permitted to offer only a limited range o f financial
services. At the same time, firms engaged in nonfinancial activities, as well as some in financial
industries, have not been permitted to own banks.
Such restrictions w ere intended to limit the risk of
bank failure, to avoid conflicts o f interest and to
prevent undue concentration o f financial power.1
In recent years, however, the separation between
banking and other activities has been relaxed
somewhat; w hat’s more, Congress is considering
further relaxation, including expanding the powers

'These restrictions have not been applied to the ownership of
banks by individuals. Individuals who own bank stock may own
and operate firms in any other industry. Under the Change in
Bank Control Act of 1978, individuals and groups of individuals
acting in concert must apply to the appropriate federal supervi­
sory agency for permission to acquire the stock of a bank over
certain percentages of ownership. See Spong (1985), pp. 9 4 95. The bank supervisory agencies may deny permission to
purchase bank stock under the following conditions:
(1) The purchase would create a monopoly in any part of the
banking industry,
(2) The financial condition of the acquiring party could ad­
versely affect the bank, or
(3) The competence, experience or integrity of the proposed
ownership would not be in the interest of the bank’s deposi­
tors.


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One major reason for permitting the comm on
ownership o f banks and firms in other industries
is based on concern about the role o f banks in
financial intermediation in the future. Some bank
customers have found cheaper sources o f credit
and other financial services outside the banking
industry. Consequently, some analysts say, restric­
tions must be relaxed if banks are to survive.2The
purpose o f this paper is to describe several major
proposals for changing banking restrictions and to

2Corrigan (1987), Federal Deposit Insurance Corporation (1987)
and Huertas (1986, 1987).

59

examine the concepts that underlie these pro­
posals.

Table 1
CURRENT RESTRICTIONS ON
BANKING ACTIVITY
At present, the activities o f federally insured
commercial banks are lim ited essentially to ac­
cepting deposits, holding relatively low-risk secu­
rities and making loans. Banking organizations
may acquire firms engaged in financial activities
through bank holding companies (BHCs) — corpo­
rations that ow n one or more banks. In the Bank
Holding Company Act (BHCA), Congress autho­
rized the Federal Reserve Board to determine what
activities are permissible for BHCs; these activities,
according to the act, should be “ so closely related
to banking as to be a proper incident thereto.”
Banks generally can engage in most activities that
BHCs are allowed to pursue.3A major distinction
between banks and the nonbank subsidiaries o f
BHCs involves opportunities for geographic expan­
sion. The nonbank subsidiaries o f BHCs may have
offices throughout the nation, whereas nationwide
branch banking is not permitted.
BHCs are subject to the supervision o f the Fed­
eral Reserve, w hich periodically inspects them to
determine whether they are operating in a sound
manner and in compliance with regulations, in­
cluding the capital requirements set by the Fed­
eral Reserve.4 On several occasions, the Federal
Reserve Board has ruled that BHCs could not un­
dertake certain activities because they w ere not
closely related to banking, might result in conflicts
o f interest or might have subjected the BHCs to
greater risk.3

3Spong (1985), pp. 95-98. The major exception to this involves
the nonbank banks. The BHCA, which gave the Federal Re­
serve jurisdiction over the acquisitions of banks by corpora­
tions, defined a bank as one that accepts demand deposits and
makes commercial loans. Acquisitions of institutions that did
not accept demand deposits or make commercial loans were
not subject to the jurisdiction of the Federal Reserve in its
capacity as regulator of BHCs. These limited-service banks are
commonly called nonbank banks. The Competitive Equality
Banking Act of 1987 (CEBA) closes that loophole in the law. It
places restrictions on the growth and activities of nonbank
banks acquired on or before March 5,1987, and requires firms
that acquired nonbank banks after that date to sell them or
restrict their activities to those permissible for BHCs. The
following restrictions apply to nonbank banks acquired on or
before March 5, 1987:

Restrictions on Credit Relationships
Between Commercial Banks and Their
Nonbank Affiliates_________________
Restrictions in section 23A of the Federal Reserve Act:
1.
2.
3.
4.
5.

Loans by banks to nonbank affiliates must be fully and
adequately collateralized.
Total credit to any one nonbank affiliate is limited to 10
percent of the bank's capital.
Combined credit to all nonbank affiliates is limited to 20
percent of the bank’s capital.
Purchases by banks of unsound assets from nonbank
affiliates are forbidden.
Bank transactions with affiliates (including transactions
covered by the statute and transactions specifically
exempt) are to be on terms and conditions that are
consistent with safe and sound banking practices.

Restrictions in section 23B of the Federal Reserve Act:
1.

2.

3.
4.

A bank's transactions with affiliates must be on terms
and under circumstances, including credit standards,
similar to those offered to nonaffiliate companies.
A bank, acting as a fiduciary, shall not purchase
securities issued by an affiliate, unless such purchases
are specified in the fiduciary agreement.
A bank shall not purchase securities being underwritten
by a securities affiliate.
A bank shall not state or suggest that it is responsible for
the obligations of its affiliates.

NOTE: Legislation in 1982 removed most of the restrictions
on transactions between commercial banks that are
subsidiaries of the same corporation. If a corporation
owns 80 percent or more of the shares of its
subsidiary banks, the only restriction on transactions
between the subsidiary banks is that one bank may
not sell low quality assets from another bank in the
same organization. See Rose and Talley (1982).

(3) Beginning in August 1988, their assets may not rise by
more than 7 percent in any 12-month period.
CEBA also imposes restrictions on the daylight overdrafts of
nonbank banks.
4Gilbert, Stone and Trebing (1985).
5Volcker (1986), pp. 436-38. The following are some of the
activities not permissible for BHCs and the dates of denials for
those activities by the Federal Resen/e Board: underwriting
general life insurance (1971), real estate brokerage (1972),
land investment and development (1972), operating a savings
and loan association (1974), operating a travel agency (1976)
and acting as a specialist in foreign exchange options on a
security exchange (1986).

(1) They may not engage in new activities,
(2) They may not market the goods or services of affiliates or
have their banking services marketed through nonbank
affiliates, except through those marketing arrangements in
effect before March 5, 1987, and




JULY/AUGUST 1988

60

Table 2
Proposals to Restructure the Financial System

Features
Corporate structure
required of firms
that own banks

Association of
Bank Holding
Companies
(LaWare (1987))

Association of
Reserve City
Bankers (1987)

Robert
Heller (1987)

Federal Deposit
Insurance
Corporation (1987)

FSHCs would own
BHCs and holding
companies that own
firms engaged in
financial
activities in
addition to banking.

FSHCs would direct­
ly own banks and
firms in other
industries.

BHCs could acquire
banks and firms
engaged in
financial
activities. Non­
financial firms
could acquire BHCs.

Firms in any
industry could buy
banks, and banks
could engage in
nonbanking
activities through
their own subsidiaries.

No

Yes

Yes

Yes

Restrictions on
transactions
between banks and
their affiliates

Keep current
restrictions

Eliminate section
23B of the Federal
Reserve Act (see
table 1).

Keep current
restrictions

Impose uniform
restrictions on
dividends and
lending limits of
banks. Make these
restrictions and
those in sections
23A and 23B of the
Federal Reserve Act
apply to transactions
between banks and
their subsidiaries.

Supervisory
authority
of regulatory
agencies

Supervision of
banks and BHCs
unchanged. No
one agency
supervises FSHCs,
which may own BHCs
and holding companies
that own firms in
financial industries
other than banking.
Subsidiaries of FSHCs
in nonbanking
industries subject
to supervision
by their regulatory
authorities.

Same as for the
Association of
Bank Holding
Companies.

No comment on
the supervisory
powers of the
Federal Reserve
over BHCs. Nonbank
subsidiaries of
BHCs subject to
supervision by
their own
government
authorities.

Firms that buy
banks not subject
to supervision by
bank supervisors.
Banks required to
report all
transactions with
affiliates or
subsidiaries to
bank supervisors,
which could audit
the terms of the
transactions.

Obligation to
support bank
subsidiaries

None

None

BHCs must absorb
losses of bank
subsidiaries.
Nonbanking firms
must absorb losses
of their BHCs.

None

Restrictions on
assets of banks

Current
restrictions

Current
restrictions

Current
restrictions

Current
restrictions

Ownership of banks
by nonfinancial
firms permitted


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61

Gerald
Corrigan (1987)

Robert
Litan (1987)

Firms that engage
in financial
activities
exclusively could
purchase banks.

Firms engaged in any
activities could buy
banks, subject to
restrictions on the
assets held by those
banks.

No

Yes

Keep current
restrictions

Prohibit banks owned
by nonbanking
organizations
from lending to
affiliates.

Firms that own
banks subject to
supervision by the
federal bank
supervisors,
including exercise
of powers to limit
risks (such as
capital require­
ments) and
aggregate concentra­
tion in the financial
system.

Nonbank firms that
own banks not subject
to bank supervisors
except to verify
that those banks
held only the
designated safe
assets.

No formal
obligation, but
general commitment
to be a source of
strength for bank
subsidiaries.

None

Current
restrictions

Bank subsidiaries
of nonbanking firms
may hold only
designated low-risk,
liquid assets.




Some banks offer financial services through
their ow n subsidiaries. The Com ptroller o f the
Currency determines w hich activities are permis­
sible for subsidiaries o f national banks; these are
generally restricted to activities that are permissi­
ble for national banks themselves. In recent years,
state governments have allowed subsidiaries o f
state-chartered banks to engage in a variety o f new
activities; among these are insurance, real estate
investment and securities underwriting.6
All federally insured commercial banks are sub­
ject to restrictions on transactions with their affili­
ates; these restrictions are shown in table 1. Thus,
for example, total loans to affiliates are limited to
20 percent o f the bank's capital. Additional restric­
tions apply to sales o f assets to banks and pur­
chases by banks o f securities issued by nonbank
affiliates or underwritten by securities affiliates, as
w ell as restrictions on loans by banks to their of­
ficers, directors and m ajor stockholders.7

PROPOSALS FOR RESTRUCTURING
THE U.S. BANKING SYSTEM
This section describes six proposals for restruc­
turing the U.S. banking system. Although others
could be included, particularly those dealing with
the entry o f banks into specific industries, the
following proposals encompass the range o f op ­
tions being considered in current policy debates.
The key features o f these six proposals are sum­
m arized in table 2. Each proposal w ould permit
banking organizations to engage in a broader
range o f activities than currently allowed. Essen­
tially, the proposals allow nonbanking services to
be offered through corporate entities (affiliates or
subsidiaries) distinct from the banks themselves.
There are two primary differences among the
proposals. First, they differ on w hether to permit
nonfinancial firms to acquire banks or BHCs.
These differences reflect conflicting views on the

6Federal Deposit Insurance Corporation (1987), p. 106. This
paper focuses on the issues involved in the common owner­
ship of commercial banks and firms in other industries. Non­
banking firms may offer a wide range of banking services by
acquiring savings and loan associations (S&Ls). Corporations
in any industry other than securities underwriting may acquire
one S&L each. Regulations prohibit lending by S&Ls to their
nonfinancial parent organizations and restrict other types of
transactions that could benefit the parent organization at the
expense of the S&L subsidiary. See Federal Home Loan Bank
Board (1986).
7Spong (1985), pp. 55-58.

JULY/AUGUST 1988

62

policies necessaiy to avoid conflicts o f interest,
decreased or unfair com petition among firms of­
fering financial services and undue concentration
o f econom ic resources. These issues have been
discussed extensively elsewhere; they are not ana­
lyzed in this article."
Second, the proposals differ on the policies
necessary to limit the risk assumed by banks. Note
that the proposals have some comm on features
designed to limit banking risk. Each proposal in
table 2 requires banking organizations to offer
nonbanking services through subsidiaries or affili­
ates; moreover, each includes restrictions on
banks lending to their nonbank subsidiaries or
affiliates. These proposals rely in part on the legal
concept o f “corporate separateness,” under which
the creditors o f a corporation have no legal claim
on the assets o f a stockholder, even if that stock­
holder is another corporation. Thus, creditors of
the nonbanking units o f a firm that also owns
banks w ould have no claim on its banks’ assets.3
Several proposals include special features to
limit the risk o f bank failure that might result from
affiliation o f banks and nonbanking firms. The
Heller proposal (Heller (1987)) requires BHCs to
absorb all losses incurred by their bank subsidi­
aries; nonfinancial firms that acquire BHCs w ould
absorb all losses incurred by their BHCs. The FDIC
proposal (Federal Deposit Insurance Corporation
(1987)) requires bank supervisors to audit transac­
tions between banks and their nonbank affiliates
or subsidiaries to determine whether they are

“Rose (1985).
9Black, Miller and Posner (1978).
’“Similar proposals have been made by Kareken (1986), Gilbert
(1987), Tobin (1987) and Forrestal (1987). Tobin proposes
limiting the assets of all banks to short-term, low-risk assets.
"T he factors that determine the expected value and variance of
profits of a firm that buys a bank and a nonbanking firm can be
expressed in the following equations:
E(B + N) = E(B) + E(N),
V(B + N) = V(B) + V(N) + 2C0V(B,N),
where E refers to expected value, V to variance, B to the profits
of the bank, N to the profits of the nonbanking firm and COV to
the covariance of the profits of the bank and the nonbanking
firm. Holding constant the covariance of the two profit streams,
a higher variance in the profits of the nonbanking firm means a
higher variance in the profits of the combined firms. The vari­
ance of the combined profit streams depends on the covari­
ance of the two profit streams. Finally, as the size of the non­
banking firm rises relative to the size of the bank, the variance
of the combined profit streams converges to the variance of the
profits of the nonbanking firm.
An analysis of the proposals to restructure the financial
system involves an analysis of the mean and variance of the


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detrimental to the banks. The Corrigan proposal
(Corrigan (1987)) relies on direct supervision o f the
firms that buy banks to limit the risk they assume.
Finally, the Litan proposal (Litan (1987)) requires
banks purchased by nonbanking firms to hold
only low-risk liquid assets.10

A FRAMEWORK FOR ANALYZING
THE RISK OF BANK FAILURE
The proposals for changing bank regulations are
concerned with their likely effect on bank failures.
This section illustrates h ow the probability o f bank
failure is affected when banks and nonbanking
firms combine.

Key Factors Affecting the Profits and
Risks o f Combining Ranks and
Nonbanking Firms 11
If a bank offers nonbanking services, the effect
on both the expected rate o f return and the varia­
bility o f returns to the bank’s shareholders, as w ell
as the risk o f failure for the bank, depend on five
factors. Suppose a bank merges w ith a nonbanking
firm. One important factor is the average level o f
expected profits or rate o f return for the nonbank­
ing service. A second factor is the “risk” associated
with the prospective nonbanking service; risk is
often measured by the standard deviation o f the
profits or rates o f return. A third factor is the cor­
relation between the profit rates o f the bank and

returns to shareholders of a firm that buys a bank and a non­
banking firm and operates them under the conditions of the
various proposals. One approach to this analysis might involve
expressing the mean and variance of the profits of the firm that
buys the bank and the nonbanking firm in terms of the mean
and variance of the profits of the bank and the nonbanking firm
separately, as indicated in the equations above. The problem
with this approach is that the distribution of returns to share­
holders is not the same as the distribution of profits. In some
outcomes, losses exceed the investment of the shareholders;
losses to shareholders, however, are no larger than their in­
vestment in the firm. The distinction between the distribution of
profits and the distribution of returns to shareholders is espe­
cially important for this study, since the various proposals
involve different rules for truncating the losses to shareholders.
Analysis of the mean and variance of returns to shareholders
must be based on specific distributions of the profits of the
bank and the nonbanking firm, as presented in the text, not on
the expected value and variance of the profits.

63

Table 3
Means and Standard Deviations of Profit Rates for Firms in
Financial Service Industries, 1975-84

Industry

Average
after-tax
return on
equity (ROE)

Standard
deviation
of ROE

Commercial banks
Thrift institutions
Securities brokers
Securities underwriters
Large investment banks only
Life insurance underwriters
Property-casualty insurance underwriters
Insurance brokers and agents
All manufacturing

12.3%
3.4
13.0
16.4
21.5
13.7
11.9
12.2
13.1

1.3%
10.7
4.0
5.7
7.7
2.3
6.4
4.1
2.0

SOURCE: Litan (1987), p. 64.

nonbanking firm. A fourth factor is the size o f the
bank relative to the nonbanking firm. The third
and fourth factors are important because the bank
may actually reduce its risk by acquiring a non­
banking firm that has a higher coefficient o f varia­
tion o f profits than the bank. This possibility w ill
be demonstrated later.
The fifth factor that must be considered is the
“ synergies” (increase in profits) involved in com ­
bining banking and nonbanking services in the
same organization. Offering banking and nonbank­
ing services through the same firm may reduce the
cost of providing the services and may attract cus­
tomers w ho value the w ider array o f services of­
fered by the combined bank-nonbank firm. These
synergies could produce profit rates that exceed
the sum o f the profit rates o f banks and firms in
the nonbanking industry operating as separate
corporations.

12Eisenbeis and Wall (1984) survey the studies. For more recent
studies, see Boyd and Graham (1988) and Macey, Marr and
Young (1987). There is evidence that BHCs reduce their risk by
offering nonbanking services. See Boyd and Graham (1986),
Wall (1987) and Brewer (1988). The results of these studies do
not indicate the effects on risk of banking institutions entering
nonbanking industries as permissible under the proposals in
table 2. The nonbanking activities permissible for BHCs now
are primarily those permissible for banks. The diversification of
risk achieved by offering the nonbanking services currently
permissible for BHCs may reflect merely geographic diversifi­
cation.




Some Empirical Estimates o f Rates o f
Return and Risk
A number o f studies have investigated the profit
rates in banking and selected nonbank activities.12
One finding, demonstrated in table 3, is that both
the average profit rate and its standard deviation
are low er in banking than in several industries
that banks w ould be perm itted to enter under the
recent proposals.13Indeed, the standard deviation
of return on equity, one measure o f risk, is lowest
in table 3 for the banking industry. Another key
finding o f these studies is that the profit rates of
banks are not positively correlated with the profits
of firms in many industries that they w ould be
permitted to enter. Thus, banks could diversify
their risk by entering many nonbanking industries,
even if the profits o f firms in those industries are
more variable than those o f banks.

13Some studies measure returns to shareholders using data on
stock prices and dividends. These studies report similar pat­
terns: mean rates of return and variability of returns to share­
holders are higher in several of the industries that banking
organizations would be permitted to enter than in the commer­
cial banking industry. See Boyd and Graham (1988), Eisemann
(1976) and Macey, Marr and Young (1987).

JULY/AUGUST 1988

64

Table 4
Variability of Profits of Hypothetical Firms formed through the
Merger of Banks and Firms in Various Financial Industries,
1962-82
Coefficient
of
variation

Item
Banks
Banks
Banks
Banks
Banks
Banks
Banks
Banks
Banks
Banks

0.22
0.18
0.24
0.22
0.22
0.15
0.29
0.15
0.20
0.20

alone
plus savings and loan associations
plus personal credit agencies
plus business credit agencies
plus securities and commodities brokers
plus life insurance
plus mutual insurers
plus insurance agents
plus real estate operators and lessors
plus subdividers and developers

NOTE: A time series of the profits of each hypothetical firm is formed by assuming that 75 percent of
the assets of the hypothetical firm are devoted to banking and 25 percent are devoted to the
nonbanking activity. The coefficient of variation is derived for the constructed time series.
SOURCE: Litan (1987), p. 88.

Table 4 illustrates the potential reduction in
variability o f bank profits possible through m er­
gers with firms that offer other financial services.
The table illustrates this with the coefficient of
variation, a measure o f relative risk that is calcu­
lated by dividing the standard deviation o f the
profit rates by the mean. The results demonstrate,
using a hypothetical situation involving the rela­
tive size o f banking and nonbanking components
of the firm, that the combined firm can have the
same or even low er risk than the bank itself, even
though risk is higher in the nonbanking industries.
Because banks have not yet entered the various
nonbanking industries, there is little evidence on
the magnitude o f the synergies involved in com ­
bining banks with other firms.14There is evidence,
however, o f synergies for banks and selected finan­
cial activities. For example, before the separation
o f commercial banking and investment banking in

'“Several studies estimate the effects of the combination of
services offered by banks on their costs. See Gilligan and
Smirlock (1984) and Benston, et. al. (1983). The results of
these studies are not relevant in estimating the effects of non­
banking services on the costs of banks, since the data are for
banks subject to current limitations on the services they may
offer.
15White (1986).
16Daskin and Marquardt (1983).


FEDERAL RESERVE BANK OF ST. LOUIS


the 1930s, securities affiliates o f comm ercial banks
held a large share o f the investment banking busi­
ness.15In nations where comm ercial banking orga­
nizations may offer investment banking services,
commercial banking organizations have large
shares o f the investment banking business.16

An Illustration
The effects o f permitting banking organizations
to offer nonbanking services on the risk and re­
turns in banking are analyzed using two probabil­
ity distributions o f profits, one for a hypothetical
bank and another for a nonbanking firm. These
probability distributions, presented in table 5, are
designed to reflect the results o f studies o f risk
and returns in banking and various nonbanking
industries summarized above. Profit distributions
are combined in table 6 under various assump­
tions that reflect the proposals for restructuring

65

Table 5
Probability Distributions of the Profits
of a Bank and a Nonbanking Firm Prior
to Merger or Affiliation
Bank
Outcome

Probability

Profits

Return to
shareholders

A
B
C

0.01
0.98
0.01

-$ 1 1 0
10
130

-$ 1 0 0
10
130

Nonbanking firm
Outcome

Probability

Profits

Return to
shareholders

A
B
C

0.05
0.90
0.05

-$ 1 1 5
15
145

-$ 1 0 0
15
145

Bank

Nonbanking
firm

Expected return to shareholders
as a percentage of capital
10.1%
Coefficient of variation of returns
to shareholders
1.6117
Expected loss to the FDIC
$0.10

15.75%
2.4637

the financial system described in table 2. Table 7
shows the returns to shareholders and the ex­
pected loss to the FDIC for the four cases analyzed
in table 6.
The illustration is designed to be simple. Differ­
ences among the four cases might change under
assumptions that w ould make the analysis more
complex. For instance, the management o f the
firm that buys the bank and the nonbanking firm
is assumed to make no changes that affect the
capital ratios or the probability distributions o f
profits. Analysis o f the cases under alternative
assumptions is beyond the scope o f this paper.
The bank begins the current year with book
value o f equity equal to $100. The market value o f
the bank is assumed to equal its book value prior
to financial restructuring, which permits the af­
filiation o f the bank with the nonbanking firm. As

presented in table 5, the (discrete) probability dis­
tribution o f the bank's profits in the current year
has three possible outcomes: a 1 percent chance
o f a loss o f $110, which w ould cause the bank to
fail, a 98 percent chance o f a profit o f $10 (a 10
percent return on equity) and a 1 percent chance
o f a profit o f $130.17
Table 5 also presents the probability distribu­
tion o f profits o f a nonbanking firm that, begins the
year with book value capital o f $100. The market
value o f the nonbanking firm is also assumed ini­
tially to equal $100. The nonbanking firm is riskier
than the bank: the coefficient o f variation o f its
profits is higher than that o f the bank. This speci­
fication was chosen to reflect the greater variability
o f profits shown in table 3 in some o f the indus­
tries that banking institutions wish to enter.
The effects o f combining the bank and the non­
banking firm in the same corporation are exam­
ined using three indicators: the expected return to
shareholders as a percent o f capital, the coefficient
o f variation o f returns to shareholders o f the con­
solidated firm, and the expected loss to the FDIC
from the bank’s failure. These measures are calcu­
lated in table 5 for both the bank and the non­
banking firm as separate organizations to provide
benchmarks for comparison. The distribution of
returns to shareholders differs from the distribu­
tion o f profits because losses to shareholders are
lim ited to the amount o f their initial investment in
the firm. Thus, losses to shareholders are limited
to $100 for the bank and $100 for the nonbanking
firm. The expected loss to the FDIC is calculated
as follows. The bank fails in only one o f the three
possible outcomes: a loss o f $110, with a chance o f
1 percent. The loss to the FDIC in that outcome
w ould be $10, since the initial capital o f the bank
is $100. Thus, the expected loss to the FDIC is $10
(loss to FDIC) X 0.01 (probability) = $0.10.
In deriving the distribution o f returns to share­
holders in table 6, one must specify their invest­
ment, which determines their maximum loss and
the denom inator used in calculating their ex­
pected rate o f return. The shareholders' initial
investment is measured as the book value o f the
com bined firms. The use o f book value, net o f any
accounting goodw ill resulting from the acquisition
o f the bank and the nonbanking firm, provides a

17The large profit of the bank associated with the small probabil­
ity might reflect the recovery on loans previously charged off as
losses or a large favorable change in market interest rates on
portfolios of assets and liabilities that do not have matched
duration.




JULY/AUGUST 1988

FEDERAL RESERVE BANK OF ST. LOUIS

Table 6
Distributions of Returns to Shareholders for Various Combinations of a Bank
and a Nonbanking Firm
Outcomes
from
underlying
profit
distributions
(bank,
nonbanking
Outcome
firm)

( )

2

(3)

(4)

Affiliation,
corporate
separateness

Affiliation,
Heller proposal

Affiliation, corporate
separateness; bank lends
$10 at a zero interest rate
to its nonbank affiliate

(1)
Merger

Probability
(bank x non­
banking firm)

Return to
shareholders

Loss to
FDIC

Return to
shareholders

$25

-$100- $100= - $200

Loss to
FDIC

Return to
shareholders

$10

-$100- $100 = - $200

1

A, A

0.01 x0.05 = 0.0005

-$ 1 0 0 -$100 = - $200

2

A, B

0.01 x0.90 = 0.009

- 110 +

3

A, C

0.01 X0.05 = 0.0005

- 110 + 145 =

4

B, A

0.98 x 0.05 = 0.049

10- 115= - 105

5

B,B

0.98 x 0.90 = 0.882

10 +

15 =

25

6

B,C

0.98x0.05 = 0.049

10 + 145 =

155

7

C, A

0.01 X0.05 = 0.0005

130- 115 =

15

130- 100 =

8

C, B

0.01 X0.90 = 0.009

130 +

15 =

145

130 +

15 =

145

130 +

9

C,C

0.01 x0.05 = 0.0005

130 + 145 =

275

130 + 145 =

275




15= -

95

- 100 +

35

- 100 + 145 =

15= -

10- 100= -

85

10

- 110 +

45

10

- 110 + 145 =

15 = -

Loss to
FDIC

95
35

$10

Return to
shareholders

Loss to
FDIC

-$100-$100 = -$200
—100 + (15 +1.053) = -100 + (145 + 1.053) =

10.50

46.053

10.50

90

10- 100 = -

15 =

25

10 +

15 =

25

(10 —0.50) + (15 + 1.053) =

25.553

10 + 145 =

155

10+ 145 =

155

(10 - 0.50) + (145 + 1.053) =

155.553

30

130- 100 =

30

(130 —0.50 —10) —100 =

19.500

15 =

145

(130 - 0.50)+ (15+ 1.053) =

145.553

130 + 145 =

275

(130 - 0.50)+ (145+ 1.053) =

275.553

10 +

90

$20.50

83.947

(10 —0.50) —10) —100 = - 100.500

o>

o>

67

Table 7
Returns to Shareholders and Losses to the FDIC Under Various
Combinations of a Bank and a Nonbanking Firm

Case
number

Means of
combining
the firms

Expected
return to
shareholders
as a
percentage
of capital

Coefficient of
variation of
returns to
shareholders

Expected
loss
to the
FDIC

1

Merger

12.51%

1.7754

$0.0125

2

Affiliation,
corporate
separateness

12.93

1.6278

0.1000

3

Affiliation,
Heller
proposal

12.88

1.6434

0.0050

4

Affiliation,
corporate
separateness;
bank lends $10
at zero interest
rate to nonbank
affiliate

12.93

1.6860

0.1100

basis for specifying bankruptcy. Book value also
provides a com m on denom inator for comparisons
o f expected rates o f return in the various cases.
The market value o f the firm that buys the bank
and the nonbanking firm w ill exceed their com ­
bined book value. If this were not the case, the
combination o f these firms in the same corpora­
tion w ould not benefit the shareholders.
The profits o f the bank and the nonbanking firm
are assumed to be statistically independent and,
thus, uncorrelated. This assumption simplifies the
analysis; it is also consistent with some o f the evi­
dence cited previously for several industries that
banks could enter. For each outcom e for the
profits o f the bank, there are three possible out­
comes for the profits o f the nonbanking firm. If
com bined into one firm, there w ould be nine pos­
sible outcomes for the returns to shareholders of
the consolidated firm, as table 6 illustrates.
Tables 6 and 7 ignore the existence o f synergies
from combining a bank with a nonbanking firm;
they assume that there is no increase in the joint
profits resulting from low er costs or a w id er array
o f services to offer customers. As previously m en­
tioned, it is difficult to determine the magnitude o f
such synergies, given that such combinations have



been unlawful for many years. Such synergies, o f
course, must exist to make such combinations
attractive to shareholders; investors can easily
obtain the benefits o f diversification by owning
shares o f firms with uncorrelated profits. In this
paper, however, assumptions about the size o f the
synergies are unnecessary; the relevant com pari­
sons are made between the various cases. An in­
crease in the levels o f profits for each outcome
w ould not alter the differences among the four
cases examined in tables 6 and 7, unless the syn­
ergies eliminate bankruptcy in all outcomes.

Merger o f the Bank and the
Nonbanking Firm: The Simplest Case
Each proposal described in table 2 calls for the
new activities o f banking organizations to be con­
ducted through corporate entities that are sepa­
rate from banks. This feature o f the proposals
reflects the view that the chances o f bank failure
and the potential loss to the FDIC w ou ld be higher
if the organizations that ow n banks offered non­
banking services through their bank subsidiaries,
rather than through subsidiaries that are separate
from the banks.

JULY/AUGUST 1988

68

This view is not valid under all circumstances,
as case 1 in tables 6 and 7 illustrates. In this case,
the bank begins offering nonbanking services by
merging with the nonbanking firm that has the
profit distribution presented in table 5. The capital
o f the bank after the merger is $200. Given the
underlying profit distributions in table 5, there is
only one outcom e in which the bank fails: in out­
come # 1, the returns from the banking and non­
banking activities yield the largest possible losses.
In that outcome, the shareholders lose their total
investment. The bank remains in operation in all
o f the other outcomes. In outcomes # 2 and # 3,
in which the losses from banking operations are
large enough to make the bank fail if operating as a
separate corporation, the profits from the non­
banking operations and the increased capital of
the bank resulting from the m erger keep the bank
from failing.
The expected loss to the FDIC in case 1 depends
on what happens to the liabilities o f the nonbank­
ing firm after the merger. Suppose the nonbanking
segment o f the m erged firm continues to borrow
from the same sources it used before the merger.
If the claims o f these lenders are subordinated to
the claims o f depositors, the merger might reduce
the expected loss to the FDIC, perhaps to zero.
In this illustration, however, the m erged organi­
zation converts all o f its liabilities to federally in­
sured deposits. If the bank involved in the merger
goes bankrupt, the FDIC absorbs losses above the
capital o f $200. In outcom e # 1, because the
bank's maximum loss after its merger with the
nonbanking firm is $225, the loss to the FDIC is
$25. Although the maximum loss to the FDIC is
larger after the merger, the expected loss ($25 X
0.0005) is actually smaller after the merger (com ­
pare tables 5 and 7).
The effects that a m erger have on the possibility
o f bank failure and the expected loss to the FDIC
depend on the size o f the nonbanking firm relative
to the bank. To illustrate, suppose the bank
merges with a nonbanking firm whose distribution
o f profits is 10 times as large for each outcom e as
that presented in table 5 and whose capital is
$1,000. In this case, w hich is not shown in the
table, the expected loss to the FDIC w ould be
$2.04, much larger than the expected loss shown
in table 7. Thus, in considering a restructuring of
the financial system, the size o f the bank relative
to the nonbanking firm is an important determ i­
nant o f the expected loss to the FDIC.

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Affiliation o f a Bank with a
Nonbanking Firm
If banks combine with nonbanking firms, one
way to limit the FDIC's expected loss is to require
that banks remain separate corporations within
their parent organizations and limit FDIC insur­
ance only to the deposit liabilities o f the banks.
Within such structures, the principle o f corporate
separateness w ould prevent the nonbanking firm ’s
creditors from claiming the assets of the bank.
The risk and return characteristics o f a holding
company that buys the bank and the nonbanking
firm are presented in case 2. Under this case, la­
belled “ affiliation, corporate separateness,” losses
to shareholders o f the holding com pany resulting
from losses by the nonbank subsidiary are lim ited
to the capital o f the nonbank subsidiary. The bank
does not rescue the nonbank subsidiary by ab­
sorbing the additional losses. In turn, if the bank
has losses that exceed its capital, the nonbank
subsidiary does not rescue the bank by absorbing
the additional losses. There is assumed to be no
lending among units o f the holding company. The
holding com pany lends to neither the bank nor
the nonbank subsidiary, and the bank lends noth­
ing to the nonbank affiliate. The nonbank affiliate
borrows, instead, from nonaffiliated lenders; the
liabilities o f the bank are covered by FDIC insur­
ance.
The expected return to the shareholders is
higher and the variability of returns is low er in
case 2 than under a similar combination o f firms
arranged through a merger. Thus, the sharehold­
ers benefit more from a combination o f the bank
and the nonbanking firm as affiliates o f a holding
company than through the m erger of these firms.
The benefit to the shareholders, however, comes
partly at the expense o f the FDIC. The FDIC's ex­
pected loss is the same in case 2 as in the ben­
chmark case in table 5 but higher than under the
merger. Under affiliation and corporate separate­
ness, the outcomes in which the FDIC is exposed
to losses are determined by the probability distri­
bution o f the bank’s profits. Under the merger
illustrated in case 1, in contrast, losses in out­
comes # 2 and # 3 that w ou ld make the bank fail
are absorbed by the profits o f the nonbank seg­
ment o f the m erged firm and the capital contrib­
uted by the nonbanking unit. Under affiliation and
corporate separateness, however, the expected
loss to the FDIC does not depend on the size of
the bank relative to its nonbank affiliate.

69

IMPLICATIONS FOR THE
PROPOSALS
Merger or Affiliation
The cases in tables 6 and 7 indicate that, under
some conditions, the risk o f FDIC loss w ould be
low er if a bank engages in a nonbanking activity
directly, rather than through affiliation with a non­
banking firm. In considering proposals for finan­
cial restructuring, therefore, it is unnecessary to
prohibit the direct offering o f nonbanking services
through banks under all circumstances.

The Financial Services Holding
Company (FSHC) Proposal
The proposals by the Association o f Bank Hold­
ing Companies (LaWare (1987)) and the Associa­
tion o f Reserve City Bankers (1987) w ould permit
FSHCs to acquire banks as subsidiaries under the
condition o f affiliation and corporate separate­
ness. The bank could not use its assets to rescue a
failing nonbank affiliate, and the FSHC w ou ld not
be required to rescue a failing bank.
A comparison o f case 2 in table 7 with table 5
shows how the formation o f FSHCs can affect risk
in banking. Affiliation o f a bank with a nonbanking
firm reduces the probability that the bank w ill fail
only if affiliation yields synergies that raise the
profits o f the bank for each possible outcome.
Thus, affiliations between banks and nonbanking
firms that facilitate diversification o f risk for share­
holders o f banking firms reduce the probability of
bank failure and the expected loss to the FDIC
only if there are synergies from combining banking
and nonbanking firms in the same organization.

The Heller “Double Umbrella”
Proposal
The distribution o f returns to shareholders un­
der the Heller (1987) proposal is presented under
case 3 in table 6. The implications o f this proposal
can be illustrated by comparing the distribution of
returns to shareholders under various outcomes
in cases 2 and 3. Under the Heller proposal, the
losses o f the bank and nonbank subsidiary in out­
com e # 1 absorb all o f the capital o f the holding
company. The FDIC has a loss o f $10 in that out­
come, the amount by which the loss o f the bank
exceeds its capital. In outcome # 2, the bank has a
loss that exceeds its capital, but the holding com ­
pany is required to cover that loss, drawing on its
profit o f $15 from the nonbanking subsidiary and
its capital. The holding com pany also covers the



large loss o f the bank in outcom e # 3. In outcomes
# 4 and # 7, in contrast, the holding company
does not absorb all o f the losses o f the nonbanking
subsidiary. Instead, the nonbanking subsidiary
goes bankrupt. The holding com pany writes off its
investment o f $100, and nonaffiliated lenders ab­
sorb the additional loss o f $15 in each o f these
outcomes.
The minimum level o f synergies necessary to
make combinations o f banks and nonbanking
firms attractive to investors is higher under the
Heller proposal than under the FSHC proposal.
The diversification o f risk illustrated in case 2
could be achieved through a mutual fund that
buys shares in firms in banking and nonbanking
industries. Any synergies w ould make the share­
holders’ expected rate o f return higher with the
bank and nonbanking firm combined in the firm
under affiliation and corporate separateness than
through a mutual fund. To make combinations o f
banks and nonbanking firms under the Heller
proposal attractive to shareholders, synergies
w ould have to exceed a level necessary to com ­
pensate the holding com pany for the expected
cost o f bailing out the failing bank subsidiary.
The synergies necessary to make the affiliation
o f banks with nonbanking firms profitable under
the Heller proposal w ou ld be different for each
potential combination o f firms. For case 3, the
synergies w ould have to raise the returns to share­
holders by $0,095 to make them equal to the ex­
pected returns to shareholders in case 2, and even
more to compensate shareholders for the higher
variability o f returns in case 3.

The Corrigan Proposal
Corrigan (1987) assumes that the methods of
insulating banks built into the proposals for FSHCs
w ill be ineffective. This view is based on evidence
that BHCs are integrated organizations that have
used all o f their resources, including those o f their
bank subsidiaries, to support any nonbank subsid­
iary in danger of failing. Corrigan also expresses
concern that, in approving the acquisition o f
banks by nonbanking firms, the federal supervi­
sory authorities w ill extend the federal safety net
to the parent organizations themselves.
The Effects o f Loa ns to N o n b a n k Affiliates on
S to ck h o ld e r Wealth — The Corrigan proposal
reflects these views on the relationship between
banks and their parent organizations. Case 4 in
tables 6 and 7 examines whether such concerns
reflect rational, profit-m axim izing behavior. The

JULY/AUGUST 1988

70

Corrigan proposal assumes that firms are willing
to risk the assets o f their bank subsidiaries to aid
their nonbank subsidiaries. One w ay for a holding
com pany to do this is to allow the bank to lend
directly to the nonbank subsidiary. To illustrate
this, the bank in case 4 lends $10 to the nonbank
affiliate at a zero interest rate, thus subsidizing the
nonbank subsidiary at the expense o f the bank.
Several assumptions have been made to derive
the probability distribution o f returns for share­
holders o f the holding company. First, the bank
loan is assumed to be subordinated to other debt
o f the nonbank affiliate. If the nonbank affiliate
goes bankrupt, therefore, the bank absorbs the
first $10 o f losses to creditors. Second, the interest
rate on riskless assets is assumed to be 5 percent.
The distribution o f profits for the bank is derived
by subtracting $0.50 from the profits for each pos­
sible outcom e presented in table 5; this reduction
reflects the opportunity cost o f foregoing an alter­
native investment o f $10 at the riskless rate.
The nonbank subsidiary saves $1,053 in interest
expense on the $10 it borrows from the bank; this
is the amount that a risk-neutral lender charges to
compensate for the risk-free rate o f 5 percent and
the 5 percent chance o f losing the $10 principal
and foregoing the interest incom e if the nonbank­
ing firm goes bankrupt.18
The effects o f this loan on the distribution o f
shareholders' returns are illustrated in table 6
under case 4. In outcomes # 1, # 4 and # 7, the
bankruptcy o f the nonbanking firm imposes an
additional loss o f $10 on the bank. In outcom e # 1,
in w hich the bank has its largest losses, the FDIC
absorbs a loss o f $20.50 ($10 loss from the underly­
ing distribution in table 5, $0.50 loss o f interest
incom e on the loan to the nonbank affiliate and
$10 loss on the loan to the nonbank affiliate).
The cost saving by the nonbank affiliate due to
the zero interest loan from the bank raises the
returns to shareholders by $1,053 in all outcomes
except those in which the nonbank affiliate goes
bankrupt. The return to shareholders is $0.01
higher in case 4 than in case 2; this difference is

18The interest rate that the nonbank affiliate would pay to borrow
from a nonaffiliated lender is determined by calculating the rate
that would make the expected return on such a loan equal to
the risk-free interest rate. Let rl be the interest rate on the loan
and rs the risk-free rate. In lending $10 to the nonbank affiliate,
there is a 95 percent chance of collecting the principal plus
interest at the rate rl and a 5 percent chance of losing the
principal and collecting no interest. The expected returns on
the alternative investments are calculated as follows:


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FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

not large enough, however, to raise the expected
rate o f return in table 7 by 1 basis point. The im ­
portant difference between the distributions of
returns in case 4 and case 2 is that the coefficient
of variation o f the returns is higher in case 4. Thus,
it is not in the shareholders’ interest to have their
bank lend to its nonbank subsidiary, even at a
subsidized rate. Such loans make their returns
more variable.
Typically, bank supervisors w ou ld make such a
loan even less attractive to the shareholders. Be­
cause the loan to the nonbank affiliate raises the
expected loss to the FDIC, bank supervisors w ould
require the bank to maintain a higher capital ratio.
Though the bank could raise its capital ratio by
reducing its total assets w hile keeping its capital
unchanged, the asset reduction w ould reduce the
level o f profits for each possible outcom e the bank
faces.
This analysis is consistent with evidence that
few banks make loans to their nonbank affiliates
up to the limits allowed by regulation. Bose and
Talley (1983) examine transactions among affiliates
of 224 o f the 229 BHCs that filed reports with the
Federal Beserve from the fourth quarter o f 1975
through the fourth quarter o f 1980. In 1980, 27
percent o f the BHCs had no transactions among
affiliates. Am ong the 16 BHCs in which the bank
subsidiaries made larger loans to the nonbank
affiliates than the nonbank affiliates made to the
banks, loans to the nonbank affiliates in 1980 were
only 1.3 percent o f the capital o f the bank subsidi­
aries.
B anking R isk un d er A ssum ptions O ther Than
P r o fit M a xim ization — The distribution o f returns
in cases 2 and 4 reflect the assumption that, if the
bank does not lend to the nonbank affiliate, the
affiliate's bankruptcy does not affect the bank’s
profits. In a few cases, however, the bankruptcy of
a nonbank subsidiary of a holding com pany has
induced depositors to withdraw their deposits
from the bank subsidiary.13The management o f a
holding company, therefore, might justify loans
from a bank subsidiary to a nonbank affiliate as a
w ay to prevent the nonbank subsidiary from going

rl x $10 x 0.95 - $10 x 0.05 = rs x $10.
If rs is 5 percent,
rl = [0.05 + 0.05] + 0.95 = 0.1053.
,9Cornyn, et. al. (1986).

71

bankrupt and thus make depositors less con­
cerned about the safety o f their deposits. In this
case, the costs o f bailing out the nonbanking sub­
sidiary might be less than the cost o f adverse reac­
tion by depositors.
There have been several cases in which the
management o f a BHC used the resources o f a
bank subsidiary to aid a nonbank affiliate in dis­
tress. In the mid-1970s, for example, the holding
com pany that ow ned the Hamilton National Bank
o f Chattanooga, Tennessee, arranged for the bank
to buy low-quality mortgages from a mortgage
banking affiliate. The mortgage purchase was an
important factor that led to the failure o f the
bank.20In October 1987, to cite another case, the
Continental Illinois National Bank made a loan
that exceeded its limit for loans to one customer
to a subsidiary that deals in options. The subsidi­
ary suffered a large loss after the sharp fall in stock
prices that month.
The rationalization behind bank loans to bail
out the nonbank affiliate overlooks an alternative
that might be more favorable to the shareholders
o f the holding company: let the nonbank subsidi­
ary go bankrupt and sell the bank to another
party. Losses to the holding com pany w ou ld be
limited to its investment in the nonbank subsidi­
ary, with nonaffiliated lenders forced to absorb
any additional losses. If potential bidders are con­
cerned that the bank made loans to the failing
nonbank affiliate or in some way assumed respon­
sibility for the debts o f that affiliate, the FDIC
could facilitate the sale by offering to reimburse
the winning bidder for any losses resulting from
the failure o f the nonbank affiliate.
Management o f the holding com pany may p re­
fer to have the bank absorb the losses necessary to
bail out the failing nonbank affiliate, rather than
sell the bank, which w ill result in the loss o f their
jobs. It may be in managem ent’s interest to ar­
range for the bank to lend to the nonbank subsidi­
ary and pray that some favorable outcom e helps
the holding com pany remain solvent. The possi­
bility o f such action is w hy government supervi­
sors must remain aware o f any financial problems
in firms that own banks and must subject the bank
subsidiaries o f those firms to particularly close
supervision.

“ Ibid., p. 186.
21Suppose the bank has a capital-to-asset ratio of 10 percent.
For all federally insured commercial banks, the average ratio of
loans to assets is about 60 percent. Thus, $600 is a reasonable




The analysis in tables 6 and 7 o f a bank lending
to its nonbank affiliate is based on the assumption
that the loan is used for legitimate business pur­
poses. Loans from a bank to a nonbank affiliate, of
course, could be made for fraudulent purposes.
Suppose a bank is perm itted to make a loan o f any
amount to an affiliate. One m ethod o f stealing
from a bank w ould be to buy the bank through a
holding company, arrange for a loan that ex­
ceeded the investment o f the holding company in
the bank and disappear with the proceeds o f the
loan.
The potential for fraud indicates that it may be
prudent to prohibit loans to affiliates that exceed
the capital o f a bank. This prohibition w ould not
prevent all forms o f fraud in banking, but its viola­
tion w ou ld indicate to the bank supervisors when
a bank is vulnerable to this type o f fraud. It is also
prudent to screen the background o f those w ho
buy banks through holding companies, as the
federal bank regulatory agencies do w hen individ­
uals buy banks.
The FDIC (1987) proposal calls for greater au­
thority to audit the terms o f any loans banks make
to affiliates or subsidiaries. This proposal does not
indicate what bank examiners w ould look for in
such audits. Audits to detect fraud w ould be ap­
propriate.

The Safe Bank Proposal
The so-called safe bank proposal (Litan (1987)) is
intended to reduce the expected level and stand­
ard deviation o f profit rates o f banks subject to the
“ safe bank” asset restrictions. As the appendix
indicates, for each $100 o f assets shifted from busi­
ness loans to Treasury bills, the revenue o f the safe
bank w ould decline by $1.26. The asset limitations
for safe banks may be so restrictive that they
w ould prevent many affiliations o f banks with
nonbanking firms that w ould prom ote diversifica­
tion or benefit society through synergies.
One way to evaluate the safe banking proposal is
to compare the size o f the synergies necessary to
make bank acquisitions profitable for nonbanking
firms to the synergies necessary under alternative
proposals. Suppose the bank had loans o f $600.21 If
the bank becom es a safe bank by reinvesting the
$600 in Treasury bills, its revenue falls by $7.56. It

level for loans of the hypothetical bank with capital of $100 and
a 10 percent capital ratio.

JULY/AUGUST 1988

72

must, however, continue to pay competitive inter­
est rates on deposits after becom ing a subsidiary
to avoid a decline in its deposits. Thus, synergies
from the operation o f the bank as a subsidiaiy
must be worth at least $7.56 to the holding com ­
pany. This amount can be compared to the syner­
gies necessary to make the acquisition o f a bank
subsidiary profitable under the Heller proposal,
which is $0,095 for the case examined above.
This large difference reflects the fact that the
safe bank proposal imposes a significant opportu­
nity cost on a nonbanking firm that buys a bank
under each possible outcome. The Heller pro­
posal, on the other hand, imposes a loss on the
nonbanking firm under an unlikely outcom e —
the failure o f the bank subsidiary. These com pari­
sons suggest that few er combinations o f banking
and nonbanking firms that w ould prom ote diversi­
fication o f risk and, possibly, more efficient use of
resources w ou ld be viable under the safe bank
proposal than under the Heller proposal.

CONCLUSIONS
Several barriers separating banking from other
industries have been rem oved in recent years,
w hile Congress debates a more com plete restruc­
turing o f the financial system. Much evidence
indicates that banking organizations could diver­
sify risk by affiliating with firms in a w ide variety of
other industries, even those with m ore variable
profits than the banking industry. This paper illus­
trates the potential for risk diversification through
the com m on ownership o f a hypothetical bank
and nonbanking firm.
The illustration has several implications for
current proposals for restructuring the financial
system. Banks are not necessarily made safer by
requiring that all nonbanking activities be con­
ducted through separate subsidiaries. On the con­
trary, banks may be less vulnerable to failure if
some nonbanking activities are offered through
the banks directly. Moreover, the expected loss of
federal deposit insurance funds may be low er
even if the nonbanking activities are financed
through insured deposits.
The major proposals for restructuring the finan­
cial system w ould permit firms in various indus­
tries to buy banks and operate them as separate
subsidiaries. Some o f the proposals build in safe­
guards to prevent nonbanking firms from using
the resources o f their bank subsidiaries in ways
that w ould increase both the chance for bank fail­
ure and the expected loss o f the federal deposit

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FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

insurance funds. These restrictions are based on
the presumption that, without such safeguards,
nonbanking firms w ou ld use the resources o f their
bank subsidiaries to benefit their nonbank subsidi­
aries.
The analysis in this paper indicates that the
shareholders o f a holding com pany generally do
not benefit by having their bank subsidiary lend at
a subsidized interest rate to the nonbank subsidi­
ary. In fact, shareholders are made worse off by
such transactions because the holding com pany
profits becom e more variable. Transactions that
benefit nonbank subsidiaries at the expense o f
bank subsidiaries do not increase the sharehold­
ers' wealth. The greatest danger in banks lending
to affiliates involves management o f holding com ­
panies attempting to save their jobs by bailing out
nonbank subsidiaries and fraudulent schemes to
steal from banks through loans to affiliates.
Tw o o f the proposals place special constraints
on the nonbanking firms that buy banks to limit
the risks o f bank failure. One proposal requires
that the holding companies absorb all losses in­
curred by banks, up to the holding com pany’s
total capital. The other proposal requires the bank
subsidiaries o f nonbanking firms to hold only lowrisk liquid assets. Both proposals raise the level o f
synergies necessary to make the acquisition o f
banks by nonbanking firms profitable. Of these
proposals, the safe banking proposal is the more
restrictive. Some consolidations o f banking and
nonbanking firms that w ou ld yield social benefits
in the form o f higher profits and reduced variation
in stockholder returns w ould not be attractive to
shareholders under the safe banking proposal but
w ould be attractive under other proposals.

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Boyd, John H., and Stanley L. Graham. “ The Profitability and
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With Other Financial Firms: A Simulation Study,” Federal
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pp. 3-20.
________ _ “ Risk, Regulation, and Bank Holding Company
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Brewer, Elijah, III. “A Note on the Relationship Between Bank
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serve Bank of Chicago Staff Memoranda SM88-5 (1988).
Cornyn, Anthony, et. al. “ An Analysis of the Concept of Corpo­
rate Separateness in BHC Regulation from an Economic
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ture and Competition (Federal Reserve Bank of Chicago, May
14-16, 1986), pp. 174-212.
Corrigan, E. Gerald. Financial Market Structure: A Longer View
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Eisenbeis, Robert A., and Larry D. Wall. “ Bank Holding
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(Federal Reserve Bank of Chicago, April 23-25, 1984), pp.
340-57.
Eisemann, Peter C. “ Diversification and the Congeneric Bank
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before a Subcommittee of the Committee on Government
Operations, House of Representatives, 99 Cong., 2 Sess.
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of Connecticut, December 4,1987, reprinted in the American
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Gilbert, R. Alton. “ Banks Owned by Nonbanks: What is the
Problem and What can be Done about It?,” Business and
Society (Roosevelt University, Spring 1987), pp. 9-17.
Gilbert, R. Alton, Courtenay C. Stone, and Michael E. Trebing.
“The New Bank Capital Adequacy Standards,” this Review
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Gilligan, Thomas, Michael Smirlock, and William Marshall.
“ Scale and Scope Economies in the Multi-Product Banking
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393-405.
Heller, H. Robert.

“ The Shape of Banking in the 1990s,”




Address before the Forecasters Club of New York, June 26,
1987.
Huertas, Thomas F. “The Protection of Deposits from Risks
Assumed by Non-bank Affiliates,” in Structure and Regulation
of Financial Firms and Holding Companies (Part 3), Hearings
before a Subcommittee of the Committee on Government
Operations, House of Representatives, 99 Cong., 2 Sess.
(December 17 and 18,1986), pp. 325-60.
________ _ “ Redesigning Regulation: The Future of Finance in
the United States,” Issues in Bank Regulation (Fall 1987), pp.
7-13.
Kareken, John H. “ Federal Bank Regulatory Policy: A
Description and Some Observations,” Journal of Business
(January 1986), pp. 3—48.
LaWare, John P. “ FSHCA — The Flexible Alternative for
Financial Restructuring,” Issues in Bank Regulation (Fall
1987), pp. 25-27.
Litan, Robert E. What Should Banks Do? (The Brookings
Institution, 1987).
Macey, Jonathan R., W. Wayne Marr, and S. David Young.
“ The Glass-Steagall Act and the Riskiness of Financial
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Rose, John T. “ Government Restrictions on Bank Activities:
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Issues in Bank Regulation (Autumn 1985), pp. 25-33.
Rose, John T., and Samuel H. Talley. Financial Transactions
within Bank Holding Companies, Staff Studies 123 (Board of
Governors of the Federal Reserve System, May 1983).
Spong, Kenneth. Banking Regulation: Its Purposes,
Implementation, and Effects (Federal Reserve Bank of Kansas
City, 1985).
Tobin, James. “A Case for Preserving Regulatory
Distinctions,” Challenge (November/December 1987), pp.
10-17.
Volcker, Paul A. “ Appendices to the Statement by Paul A.
Volcker, Chairman, Board of Governors of the Federal
Reserve System,” in Structure and Regulation o f Financial
Firms and Holding Companies (Part I), Hearings before a
Subcommittee of the Committee on Government Operations,
House of Representatives, 99 Cong., 2 Sess. (April 22, June
11, and July 23,1986), pp. 391-510.
Wall, Larry D. “ Has Bank Holding Companies’ Diversification
Affected Their Risk of Failure?” Journal of Economics and
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JULY/AUGUST 1988

74

Appendix
The Opportunity Cost Of Holding Safe Assets
The safe bank proposal (Litan (1987)) w ould put
the bank subsidiaries o f nonbanking firms at a
disadvantage in com peting for deposits by restrict­
ing the return on their investments. This disadvan­
tage could be offset slightly by waiving deposit
insurance premiums for the subsidiaries o f non­
banking firms. Under the requirements for holding
only safe assets, the subsidiaries o f nonbanking
firms w ould not expose the federal deposit insur­
ance funds to potential losses; therefore, an argu­
ment could be m ade for exempting “safe” banks
from deposit insurance premiums.
The opportunity cost o f investing in Treasury

securities instead o f loans is estimated using data
from the functional cost analysis program o f the
Federal Reserve. A change in the com position o f a
bank’s assets affects its interest revenue and ex­
penses. The functional cost data includes informa­
tion on interest incom e and expenses allocated to
various categories o f loans, as w ell as expenses
involved in purchasing and holding securities.
Table A l indicates that the gross yields on loans
almost always exceed those on three-month Trea­
sury bills. Net yields on loans, which reflect ex­
penses and losses, are low er than the net yields
on Treasury bills in some years for mortgage and
installment loans.

Table A1
Gross and Net Yields on Bank Assets
Treasury
bills

Real estate
mortgage

Installment
loans

Commercial and
other loans

Year

Number of
banks

Gross

Net

Gross

Net

Gross

Net

Gross

Net

1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986

86
96
99
98
109
102
85
80
59
63
76
90
82
81
75

4.07%
7.04
7.89
5.84
4.99
5.27
7.22
10.04
11.51
14.03
10.69
8.63
9.58
7.48
5.98

3.92%
6.88
7.72
5.67
4.83
5.11
7.08
9.86
11.28
13.81
10.54
8.47
9.43
7.31
5.75

7.58%
8.11
8.57
8.17
8.39
8.84
8.88
9.32
10.01
10.80
10.84
11.02
11.41
11.60
10.21

6.82%
7.35
7.77
7.36
7.46
7.89
7.93
8.39
9.29
9.88
9.95
9.95
10.31
10.33
8.50

10.19%
10.29
10.77
11.01
11.11
11.05
11.43
12.00
12.90
14.90
15.87
14.98
14.39
13.41
12.50

6.54%
6.65
6.90
6.81
6.91
7.31
8.02
8.57
9.18
10.94
11.96
11.07
11.10
10.16
9.11

6.71%
8.44
10.53
8.88
8.22
8.21
9.67
12.23
14.31
16.85
14.96
11.93
12.82
11.30
10.21

5.35%
7.21
9.09
7.17
6.39
6.46
8.16
10.68
12.62
14.86
12.36
9.26
10.34
8.91
7.73

NOTE: Data on the gross and net yields for the three categories of loans are derived from the
functional cost accounting data. These data are for the banks with total assets greater than
$200 million. The second column indicates the number of banks in that size category that
reported data for the investment function each year. The choice of this largest size category in
the functional cost accounting reports is based on the assumption that the safe banks owned
by relatively large nonbanking firms would tend to have assets above this dollar level. Net
yields on loans reflect adjustments of the gross yields for expenses in making and servicing
loans and loss rates on the various types of loans. The gross yields on Treasury bills are the
annual averages of yields on three-month Treasury bills, new issues. Net yields on Treasury
bills are the gross yields minus the costs of buying and holding investments per dollar of
investments in the functional cost accounting data. Under the safe bank proposal, safe banks
could hold longer-term Treasury securities, but the longer-term securities have greater
potential for capital gains and losses. This exercise uses the yields on short-term Treasury
securities and ignores capital gains and losses.


http://fraser.stlouisfed.org/
FEDERAL RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis

75

Table A2 isolates the comparisons between net
yields on Treasury bills and those on three catego­
ries o f loans. Net yields on mortgages and install­
ment loans tend to fall below the net yields on
Treasury bills in periods o f sharp increases in

interest rates. The most stable spread is that be­
tween the net yield on comm ercial and other
loans and the net yield on Treasury securities. On
average, banks lose $1.26 in net incom e before
incom e taxes per dollar transferred from com m er­
cial loans to Treasury bills.

Table A2
Sacrifice of Income Before Income Taxes per $100 Dollars of
Loans Shifted to Treasury Bills
Loan Categories
Year

Real estate
mortgages

1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986

$2.90
0.47
0.05
1.69
2.63
2.78
0.85
- 1 .4 7
- 1 .9 9
-3 .9 3
-0 .5 9
1.48
0.88
3.02
2.75

Mean




.768

Installment
loans
$2.62
-0 .2 3
-0 .8 2
1.14
2.08
2.20
0.94
-1 .2 9
-2 .1 0
-2 .8 7
1.42
2.60
1.67
2.85
3.36
.905

Commercial and
other loans
$1.43
0.33
1.37
1.50
1.56
1.35
1.08
0.82
1.34
1.05
1.82
0.79
0.91
1.60
1.98
1.262

JULY/AUGUST 1988

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